The Savings and Loan Disaster

By John Steele Gordon

American banking has always suffered from either too much regulation or not enough, making risk management more difficult than it already is. Most countries have only one banking authority, but the United States has well over 50. Not only does each state have its own bank department, but at the federal level there is the OCC, the Federal Reserve and the FDIC. Until the 1980s there was also the Federal Home Loan Bank Board.

And, of course, there is Congress, which has sometimes shielded bankers from the consequences of bad policies. This has occasionally brought on disaster, such as the collapse of the savings and loan industry in the 1980s.

In the early days of American banking, banks catered to business and the well-to-do. Ordinary people kept their savings under the mattress. But ordinary people needed banking services too, and mutual savings banks—owned by their depositors—and savings and loan institutions came into being to provide savings accounts and mortgage loans to the middle class.

After World War II, federal banking authorities created, in effect, a banking cartel by keeping interest rates remarkably steady. When interest rates began to tick up in the early 1960s, Congress set the rates banks could pay and charge. By this time commercial banks were offering a full range of services, while thrifts were restricted to savings accounts and mortgage loans. To keep them competitive, Congress allowed them to pay a quarter percent higher interest.

But when inflation really took off in the early 1970s, something had to give. Wall Street brokers began establishing money market funds, which, being less regulated, could offer higher interest rates but with no federal guarantee. People started shifting their thrift deposits to these funds.

Commercial banks, whose demand deposits paid no interest and who had mostly short-term loans, could cope with this disintermediation. The thrifts could not. Their deposit base was entirely interest-bearing savings, and their loan portfolios were long-term, fixed-interest mortgages.

Basic economics had made the original business model of savings banks and S&Ls obsolete by the mid-20th century. They should either have evolved into full-service banks themselves or merged with commercial banks. Instead, Congress rushed to help. In 1980, Congress removed the limits on interest and raised the limit on funds guaranteed by the Federal S&L Insurance Corporation—the deposit insurer for thrifts—from $40,000 to $100,000.

Wall Street had been making brokered deposits in thrifts, tailored to be below the amount guaranteed. With the new, higher limit, brokered deposits flowed into the thrifts in massive amounts.

These deposits were “hot money” that would flow to the highest interest rate. So the FHLBB limited S&Ls from holding more than 5 percent of their deposits in them. But in 1980, the FHLBB removed this limit. The thrifts had to offer ever higher interest rates to retain their deposits but were still stuck with their long-term mortgage loan portfolios. Having no way to earn the money to pay the higher interest rates, they went broke. In 1980, thrifts had a net worth of $32.8 billion. Two years later it was $3.2 billion.

Lifting the limits on what they could make loans for—making the thrifts effectively full-service banks but with only a fraction of the capital and reserve requirements—was like giving sea water to the thirsty, only making the problem worse. By 1989, the S&L industry had collapsed and the federal government, having ignored what 300 years of experience had taught about sound banking practices, had to pay out billions to make good on its guarantee of deposits.


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