11.5 Savings and loan crisis
8 min read•august 21, 2024
The Savings and Loan crisis was a pivotal event in American financial history. It exposed flaws in the S&L industry's business model and regulatory framework, leading to widespread failures and a costly government in the 1980s and early 1990s.
The crisis stemmed from economic challenges, , and risky lending practices. It reshaped the banking landscape, prompting stricter regulations and industry consolidation. The S&L crisis offers valuable lessons on financial oversight and risk management that remain relevant today.
Origins of S&L industry
- Savings and Loan (S&L) institutions emerged in the 19th century as community-based financial organizations focused on promoting homeownership
- S&Ls played a crucial role in shaping the American housing market and contributed to the growth of suburban communities
- The industry's development reflects broader trends in American business history, including the rise of consumer finance and the government's role in economic policy
Great Depression reforms
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- Banking Act of 1933 established the Federal Savings and Loan Insurance Corporation (FSLIC) to insure S&L deposits
- Home Owners' Loan Corporation (HOLC) created to refinance distressed mortgages and prevent foreclosures
- Federal Home Loan Bank System established to provide liquidity to S&Ls
- These reforms aimed to stabilize the housing market and restore public confidence in financial institutions
Post-war housing boom
- G.I. Bill of 1944 provided low-interest mortgages to returning veterans, stimulating housing demand
- S&Ls became primary lenders for suburban home construction and purchases
- Rapid expansion of S&L industry with assets growing from 45.7 billion in 1960
- S&Ls specialized in offering long-term, fixed-rate mortgages, aligning with the American dream of homeownership
Regulatory environment
- S&L industry operated under a unique regulatory framework designed to promote homeownership and community development
- Regulations shaped the business model of S&Ls, influencing their ability to compete with other financial institutions
- The regulatory environment for S&Ls reflects the broader trend of government intervention in the financial sector during the mid-20th century
Interest rate ceilings
- Regulation Q imposed caps on interest rates S&Ls could offer on deposits
- Intended to prevent excessive competition and ensure stability in the banking system
- Created a competitive disadvantage for S&Ls when market interest rates rose above the ceiling
- Led to disintermediation as depositors sought higher returns elsewhere (money market funds)
Restrictions on investments
- S&Ls limited primarily to residential mortgages and government securities
- Prohibited from offering checking accounts until 1980
- Geographic restrictions on lending, typically confined to local communities
- Asset-liability mismatch created by long-term, fixed-rate mortgages funded by short-term deposits
Economic factors
- Macroeconomic conditions in the 1970s and early 1980s significantly impacted the S&L industry
- Economic challenges exposed vulnerabilities in the S&L business model and regulatory framework
- These factors set the stage for the subsequent crisis and reflect broader trends in American economic history
Inflation in 1970s
- Consumer Price Index (CPI) rose from 3.2% in 1972 to 13.5% in 1980
- S&Ls faced increasing costs as interest rates on deposits rose with inflation
- Value of long-term, fixed-rate mortgages eroded in real terms
- Net worth of many S&Ls declined as assets lost value faster than liabilities
Volcker shock
- Federal Reserve Chairman Paul Volcker raised interest rates to combat inflation in 1979
- Federal funds rate peaked at 20% in June 1981
- Created severe financial strain for S&Ls with portfolios of low-yielding mortgages
- Many S&Ls became insolvent on a market-value basis but remained open due to regulatory forbearance
Deregulation and consequences
- Policymakers responded to S&L industry challenges with a series of deregulatory measures
- Deregulation aimed to increase S&L competitiveness and profitability
- These changes fundamentally altered the S&L business model and risk profile
- Reflects broader trends of financial deregulation in the 1980s under the Reagan administration
Garn-St Germain Act
- Passed in 1982 to address S&L industry challenges
- Eliminated deposit interest rate ceilings, allowing S&Ls to compete for funds
- Increased federal deposit insurance limits from 100,000 per account
- Relaxed restrictions on loan-to-value ratios and allowed
Expanded S&L powers
- S&Ls permitted to diversify into commercial real estate lending and consumer loans
- Authorized to invest up to 40% of assets in commercial mortgages
- Allowed to offer demand deposits and engage in credit card operations
- Reduced net worth requirements, enabling S&Ls to operate with lower capital ratios
Crisis unfolds
- The S&L crisis emerged as a result of economic factors, regulatory changes, and industry practices
- Rapid expansion and risk-taking by S&Ls led to widespread insolvencies
- The crisis represents a significant episode in American financial history, highlighting the dangers of and regulatory failure
Risky lending practices
- S&Ls engaged in speculative commercial real estate lending and junk bond investments
- Brokered deposits used to fund rapid growth and high-risk ventures
- Land flips and other fraudulent schemes employed to inflate asset values
- Inadequate underwriting standards and poor risk management led to mounting loan losses
Real estate market collapse
- Oversupply of commercial real estate in many markets (office buildings, shopping centers)
- Tax Reform Act of 1986 eliminated key real estate tax shelters, reducing property values
- Regional economic downturns (oil price collapse in Texas, defense spending cuts in California)
- Widespread defaults on commercial real estate loans held by S&Ls
Government response
- Federal regulators and policymakers implemented various measures to address the S&L crisis
- The government response aimed to stabilize the financial system and protect depositors
- These actions had significant implications for taxpayers and the structure of the financial industry
FIRREA legislation
- (FIRREA) passed in 1989
- Abolished the Federal Home Loan Bank Board and created the
- Established the (RTC) to manage and sell assets of failed S&Ls
- Imposed stricter capital requirements and lending restrictions on surviving S&Ls
Resolution Trust Corporation
- RTC tasked with resolving 747 insolvent S&Ls between 1989 and 1995
- Employed various resolution methods (purchase and assumption, insured deposit transfers)
- Managed the sale of over $400 billion in assets from failed institutions
- Innovative approaches to asset disposition (securitization, bulk sales, equity partnerships)
Bailout and costs
- The S&L crisis required a massive government intervention to protect depositors and stabilize the financial system
- The bailout represents one of the largest financial rescue operations in U.S. history
- The costs and consequences of the crisis had long-lasting effects on the economy and public policy
Taxpayer burden
- Total cost of the S&L bailout estimated at 132 billion
- Approximately $87 billion paid directly by U.S. taxpayers through FSLIC and RTC funding
- Additional costs borne by the thrift industry through higher deposit insurance premiums
- Represented a significant portion of the federal budget deficit in the early 1990s
Long-term economic impact
- Contributed to the 1990-1991 recession by restricting credit availability
- Reduced public confidence in financial institutions and regulators
- Led to consolidation in the banking industry as many S&Ls were acquired by commercial banks
- Influenced subsequent debates on financial regulation and government intervention in markets
Key figures and institutions
- The S&L crisis involved numerous individuals and organizations that played significant roles
- Examining these key players provides insight into the complex dynamics of the crisis
- The actions of these figures and institutions highlight issues of corporate governance, regulatory oversight, and political influence
Charles Keating
- Chairman of Lincoln Savings and Loan Association in Irvine, California
- Engaged in high-risk investments and alleged fraudulent activities
- Involved in the "" scandal, where five U.S. senators were accused of improper intervention
- Lincoln's failure in 1989 cost taxpayers $3.4 billion, one of the largest losses in the S&L crisis
Lincoln Savings and Loan
- Acquired by 's American Continental Corporation in 1984
- Grew rapidly from 5.5 billion in 1988
- Invested heavily in junk bonds and speculative real estate projects
- Sold uninsured subordinated debentures to depositors, leading to significant losses for many investors
Lessons and legacy
- The S&L crisis provided valuable lessons for policymakers, regulators, and financial institutions
- The aftermath of the crisis led to significant changes in the regulatory landscape and industry practices
- These lessons continue to influence debates on financial regulation and risk management
Financial regulation reforms
- Stricter capital requirements implemented for depository institutions
- Enhanced supervisory and enforcement powers granted to regulators
- Improved accounting standards and disclosure requirements for financial institutions
- Creation of the prompt corrective action framework to address troubled banks earlier
Impact on banking industry
- Consolidation of the banking sector as many S&Ls were acquired by commercial banks
- Shift away from the traditional S&L model of portfolio lending towards securitization
- Increased focus on risk management and internal controls within financial institutions
- Greater emphasis on diversification and liquidity management in bank operations
S&L crisis vs 2008 financial crisis
- Comparing the S&L crisis to the 2008 financial crisis reveals important similarities and differences
- Both crises highlight recurring issues in financial regulation and risk management
- Understanding these parallels and distinctions provides valuable context for analyzing financial crises
Similarities in causes
- Both crises rooted in real estate market speculation and lax lending standards
- Regulatory failures and inadequate oversight contributed to both crises
- Financial innovation and deregulation played roles in amplifying risks
- Moral hazard issues arising from government guarantees and implicit bailout expectations
Differences in scale
- 2008 crisis involved a broader range of financial institutions and markets
- Systemic risk more pronounced in 2008 due to interconnectedness of global financial system
- Complexity of financial instruments (CDOs, CDSs) greater in 2008 crisis
- Government response in 2008 more extensive, including unconventional monetary policy measures
Cultural impact
- The S&L crisis left a lasting impression on American culture and society
- Public perceptions of financial institutions and government regulators were significantly affected
- The crisis inspired various cultural representations that reflected and shaped public understanding
Public perception of banks
- Erosion of trust in financial institutions and their leaders
- Increased skepticism towards claims of financial expertise and self-regulation
- Greater public awareness of the potential for fraud and mismanagement in banking
- Calls for stronger consumer protection measures and financial literacy education
Representations in media
- Films like "Wall Street" (1987) reflected the era's financial excesses and moral ambiguity
- Books such as "The Best Way to Rob a Bank Is to Own One" by William K. Black examined the crisis
- Television shows (L.A. Law) incorporated storylines related to S&L failures and financial fraud
- Political cartoons and satirical works critiqued the government's handling of the crisis
Key Terms to Review (18)
Adjustable-rate mortgages: Adjustable-rate mortgages (ARMs) are home loans where the interest rate can change periodically based on changes in a corresponding financial index that is associated with the loan. Typically, ARMs offer lower initial rates than fixed-rate mortgages, but they carry the risk of increasing payments in the future as interest rates rise. This characteristic of fluctuating rates can lead to affordability issues for borrowers, especially during economic downturns.
Alan Greenspan: Alan Greenspan is an American economist who served as the Chair of the Federal Reserve from 1987 to 2006, making him one of the most influential figures in U.S. monetary policy during his tenure. His leadership helped shape the Federal Reserve's role in managing economic growth and inflation, connecting him deeply to monetary policies and the financial landscape of the United States. His decisions and strategies, particularly in response to economic crises, had significant impacts on banking stability and the savings and loan crisis.
Bailout: A bailout is a financial rescue operation, typically involving the government or another authority providing funds to prevent the failure of a business or institution. This practice aims to stabilize the economy by ensuring that essential services and operations continue, often during times of financial crisis or distress. Bailouts are controversial, as they can create moral hazard and raise questions about accountability in the financial system.
Banking reform: Banking reform refers to the series of legislative and regulatory changes aimed at improving the stability, transparency, and efficiency of financial institutions. These reforms often arise in response to financial crises or scandals and are designed to protect consumers, prevent excessive risk-taking, and enhance oversight within the banking sector.
Charles Keating: Charles Keating was an American businessman and banker who played a significant role in the savings and loan crisis of the 1980s and early 1990s. As the head of Lincoln Savings and Loan Association, he became infamous for his aggressive business practices, which ultimately led to the institution's collapse and a massive government bailout. His actions exemplified the reckless behavior that characterized many savings and loan institutions during this turbulent period in American financial history.
Cost to taxpayers: Cost to taxpayers refers to the financial burden placed on citizens through taxation to cover government expenditures. In the context of economic crises, such as the savings and loan crisis, this term highlights how taxpayers ultimately bear the financial responsibility for government bailouts and economic interventions aimed at stabilizing failing institutions.
Depository Institutions Deregulation and Monetary Control Act: The Depository Institutions Deregulation and Monetary Control Act (DIDMCA) was a significant piece of legislation passed in 1980 aimed at deregulating the banking industry and giving the Federal Reserve greater control over monetary policy. This act was intended to enhance competition among depository institutions, reduce interest rate ceilings on deposit accounts, and extend the Fed's authority to a broader range of financial institutions, which had implications for the savings and loan crisis of the 1980s.
Deregulation: Deregulation refers to the process of removing government regulations and restrictions on industries, allowing for greater competition and market freedom. This shift can lead to increased efficiency and innovation, but it also carries risks of reduced oversight and potential negative consequences for consumers and the economy. The impact of deregulation can be seen across various sectors, influencing everything from antitrust laws to financial institutions and consumer protection agencies.
Financial Institutions Reform, Recovery, and Enforcement Act: The Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) of 1989 was a U.S. federal law aimed at addressing the savings and loan crisis by reforming the regulation of financial institutions. It was designed to restore public confidence in the banking system by implementing stricter regulatory standards, providing funds for the resolution of failed savings and loan associations, and enhancing the enforcement powers of regulators.
Financial speculation: Financial speculation refers to the practice of buying and selling assets, such as stocks or real estate, with the expectation of making a profit based on future price movements rather than the intrinsic value of the asset. This practice often involves taking on significant risk, as speculators aim to capitalize on short-term market fluctuations rather than long-term investment strategies.
Garn-St. Germain Act: The Garn-St. Germain Act, enacted in 1982, was a significant piece of legislation that aimed to address issues within the savings and loan industry, particularly by deregulating certain aspects of the operations of savings and loan associations. It allowed these institutions to engage in more diverse investment activities and raised the limits on deposit insurance, which ultimately led to an increase in risk-taking behavior among these organizations.
Increased regulation: Increased regulation refers to the process of implementing more stringent rules and oversight aimed at controlling and managing specific industries or economic activities. This often occurs in response to financial crises or failures to protect consumers, maintain stability, and ensure fair practices. As a result, increased regulation seeks to prevent malpractices, enhance transparency, and promote accountability within the affected sectors.
Keating Five: The Keating Five refers to a group of five U.S. senators who were implicated in a scandal involving the regulation of the savings and loan industry during the 1980s. This group included John McCain, and their actions became a significant part of the broader Savings and Loan crisis, highlighting the intertwining of political influence and financial oversight.
Moral Hazard: Moral hazard refers to the situation where one party takes risks because they do not have to bear the full consequences of their actions. This concept often arises in contexts where insurance or guarantees are provided, leading individuals or companies to engage in riskier behavior than they would if they were fully accountable for the outcomes. This phenomenon is particularly relevant in financial markets and can have significant implications for economic stability and regulatory practices.
Office of Thrift Supervision: The Office of Thrift Supervision (OTS) was a U.S. government agency responsible for regulating and supervising federal and state-chartered savings associations, also known as thrifts, from 1989 until it was dissolved in 2011. It played a crucial role in addressing the savings and loan crisis by enforcing regulations and overseeing the financial health of thrifts, which were heavily involved in residential mortgage lending.
Resolution Trust Corporation: The Resolution Trust Corporation (RTC) was a U.S. government-owned corporation created in 1989 to manage and resolve the assets of failed savings and loan associations during the savings and loan crisis. The RTC played a crucial role in stabilizing the financial system by liquidating or selling off the assets of these failing institutions, thereby protecting depositors and taxpayers while restoring confidence in the banking sector.
Subprime lending: Subprime lending refers to the practice of offering loans to borrowers with poor credit histories or limited creditworthiness, typically at higher interest rates than prime loans. This type of lending emerged significantly in the housing market, where lenders took on higher risks by extending mortgages to individuals who may not be able to repay them. The rise of subprime lending contributed to the proliferation of risky financial products and ultimately played a critical role in financial crises, including the savings and loan crisis.
Thrift Institutions: Thrift institutions are financial entities, such as savings and loan associations, savings banks, and credit unions, primarily focused on accepting deposits and providing mortgages and other loans to their members or customers. They were established to promote savings among the public and facilitate home ownership through accessible financing options, playing a significant role in the American housing market.