An informal history of the Savings and Loan Crisis

Here is a good video from Bill Black on the origins of the Savings & Loan crisis in the U.S. The roots of the crisis go back to the stagflation of the 1970s when interest rates spiked under Paul Volcker. As S&L’s borrowed short and lent long, it meant a mismatch between their long-lived and low-yielding S&L assets and the shorter high-interest S&L demand deposits and liabilities. Many savings and loans became deeply insolvent.

The right thing to do would have been to address the problem straight away and have the regulator seize insolvent institutions, likely resulting in hundreds of billions of losses for taxpayers. Instead, a legislative ‘fix’ was found which allowed the S&L’s to masquerade as solvent institutions, which incented many S&L executives to load up on risk as a ‘fix’ for their insolvency. A lack of regulatory oversight then created a Gresham’s law of bad behaviour driving out good. In describing this phenomenon in this last financial crisis in the UK, I wrote:

The Bradford and Bingleys of the world used lower interest rates to justify jacking [the maximum mortgage debt to income limit] constraints up to 3.5 times or four times income. Eventually these constraints hit six times in the UK.

How do you compete against that as a bank? All of the business is going to Bradford and Bingley and you are getting stuffed. I guarantee you shareholders won’t like that. As an executive, you better find the holy grail of prudent but profitable lending or follow Bradford and Bingley on the road to easy money. Otherwise, you will be out of a job.

Eventually, even the prudent relax their standards too – that’s how risky behaviour drives out good when risk is rewarded. See my comments in “James Galbraith: How financial stability creates instability.”

On the sovereign debt crisis and the debt servicing cost mentality

Related Posts
1 of 1,819
Subscribe to our newsletter

In the S&L days, the result was a criminogenic environment ripe for fraudsters to enter the marketplace. Rates came down, but the competitive landscape had changed. Therefore, many S&L’s loaded up on high risk assets like junk bonds – and not just the insolvent ones. Looting was also commonplace. When the economy turned down, loans went bad in spades and bond defaults skyrocketed. The result was a wave of insolvencies, bank runs and crisis as well as over 1,000 felony convictions of financial executives.

Black explains this in greater detail below (with a fairly good but not unbiased overview of the politics of the affair).

The FDIC has a good S&L chronology I highly recommend. In reviewing this episode in 2008 after the Lehman affair, I wrote:

The S&L crisis bears keeping in mind as many comparisons to that period regarding deregulation, risk, and bailouts are now being made. One note about the S&L crisis that I should make is that relaxing accounting rules caused the crisis to mushroom in size. And this bears noting as the onerous FAS 157 is creating quite a stir right now. Basically, the accounting rule mandates marking-to-market of various securities.

I am sympathetic to calls to relax the rule as it is pro-cyclical, meaning it naturally swings along with the business cycle. Marking to market causes balance sheets to be inflated during booms like the one we just had and it may cause them to be artificially deflated during busts like the present one.

However, experiences like the Savings and Loan crisis show that relaxing accounting rules in order to bail out financial institutions is probably a bad idea and leads to much greater losses. It is better to take the losses in the first place and move on.

Get real time updates directly on you device, subscribe now.

6 Comments
  1. DavidLazarusUK says

    The deregulation of the mortgage markets has not benefitted anyone. First time buyers are forced to over extend themselves in order to get on the housing ladder in a bubble. When it crashes it wipes them out, excluding them for a number of years, till they rebuild their equity, to enter again. When first time buyers are locked out the market loses its support. Considering that a home is most likely to be the biggest single purchase for most people it should not be completely unregulated. The rules should be no foreign currencies, no interest only, no high loan to values, and low income multiples, no fees or charges and only simple repayment mortgages. These would have stopped the problems in the US, Iceland, Latvia, Ireland and the UK. They would have seriously reduced the problems in Spain apart from the fraud.

    1. Edward Harrison says

      I have been thinking about this in light of my post on corporatism. My preference is for de-regulation without the desupervision or the de facto decriminalization that Bill Black talks about.

      If you look back at financial crises and de-regulation in the U.S. and Europe, there is certainly a connection: Scandinavia in the early 1990s, S&Ls in the 1980s, for example. But de-regulation has been accompanied by great benefits to consumers as prices have come down. The question then is: how do you allow deregulation? Do you allow it in non-financial spheres only? Do you heighten regulatory vigilance post-deregulation at least through the first economic cycle? Do you have strict size limits in financial services for anti-trust reasons?

      The bottom line for me is that there are a lot of different approaches that could work and are consistent with both freer markets and less severe crises. But if you have both a lax regulatory environment and easy credit conditions, deregulation is bound to lead to crisis.

      1. DavidLazarusUK says

        De regulation has been a disaster in the financial services sector, we have the global financial crisis as a clear demonstration of that. I am in favour of markets. If you deregulate the banks will still create a myriad of products to hide the charges and rip the customer off. So even if the headline rate is low the charges will more than make up for those “low” interest rates.

        I have no problems about silly regulations but comparing them to rules on lending limits and risk are ridiculous. Also we had a perfect example period of total financial deregulation during the recent Bush presidency when regulations were never even enforced. So how much more deregulatory than that do you want?

        In the UK banks were not allowed to offer mortgages until the 80’s and the big bang. Up till then you had to get a mortgage from a mutual building society. That meant saving to get a deposit and tough rules on lending multiples and loans to value meant that we had minimal economic damage as a result of property bubbles. The market was only inflated by excessive savings. Once the banks were allowed to enter the market with their cheap wholesale market. Yes the interest rates fell but then the property bubble increased so you were not saving money but having to borrow even more! The share of income spent on mortgages stayed the same. All the savings went to the financial institutions. The borrower never benefited. The real estate agents trumpeted affordability yet these were only maintained through ever lower interest rates fuelling another speculative property bubble. When that bubble imploded and rates fell to zero how can you revive that?

        If you truly believe in markets then you need regulations to keep competition alive. Businesses will do everything possible to reduce that competition such as take over competitors. Now we have a banking system that is even more concentrated than ever and are now impossible to save again because of the recent crisis draining resources from government. Who are we really protecting banks or their customers? Definitely not the customers.

        I do support size limits maybe through a unitary tax on world wide earnings for any bank with an asset base of say $100 billion or more. Maybe an end to banks operating across state lines or having each state bank restricted to only lending within the state. That makes state regulation more necessary and means that local politicians will actually ensure the regulator does their job. Any banks that has an investment banking arm even if it employs just one person has to have much higher capital requirements. An end to risk based capital and a return to simple leverage ratios will end much of the increased risk. Basel II was a disaster.

        If you had the banks products regulated as well then it would mean that the banks would not be able to raise fees to compensate for the reduction in business. That will eliminate the bonus problem that is troubling the UK.

        In the end you need lots more smaller banks. Much more regulation or face the consequences that it will be regulation through litigation. Which benefits only the lawyers.

        1. Edward Harrison says

          Well said. It is clear that bank deregulation and crises go hand in hand. Banking deregulation has the potential of creating catastrophic losses for society in a way you see in no other industry. If you are going to deregulate, you need to increase oversight at least through the first downturn. But deregulation mixed with desupervision and abnormally low rates creates a criminogenic environment that ends in fraudulent and crisis. We saw that in the 1920s, in the S&L crisis, in Iceland, Ireland, in Sweden in the 1990s, etc, etc. Yet here we are back to square one. We should expect another crisis as a result.

          1. DavidLazarusUK says

            My one huge concern is that business and banks complain about their hands being tied because of over regulation. They have clearly forgotten why they were created in the first place. Maybe they should be looked at on the basis that circumstances have changed. Though I prefer the idea of rationalising them and making them much simpler and eliminating the loopholes that allowed bankers to eliminate transparency of their business, and created a shadow banking system.

          2. Edward Harrison says

            The easiest arbitrage to narrow banking is in moving those activities offshore. I don’t know how you get married banking except by legally ring fencing it and providing no backdrop except for those activities. But then how do you prevent liquidity for the narrow bank from being siphoned off to support other activities.

            There will always be an arbitrage so we need a way to allow the narrow bank to be separated out.

          3. Edward Harrison says

            The easiest arbitrage to narrow banking is in moving those activities offshore. I don’t know how you get married banking except by legally ring fencing it and providing no backdrop except for those activities. But then how do you prevent liquidity for the narrow bank from being siphoned off to support other activities.

            There will always be an arbitrage so we need a way to allow the narrow bank to be separated out.

  2. Anonymous says

    The deregulation of the mortgage markets has not benefitted anyone. First time buyers are forced to over extend themselves in order to get on the housing ladder in a bubble. When it crashes it wipes them out, excluding them for a number of years, till they rebuild their equity, to enter again. When first time buyers are locked out the market loses its support. Considering that a home is most likely to be the biggest single purchase for most people it should not be completely unregulated. The rules should be no foreign currencies, no interest only, no high loan to values, and low income multiples, no fees or charges and only simple repayment mortgages. These would have stopped the problems in the US, Iceland, Latvia, Ireland and the UK. They would have seriously reduced the problems in Spain apart from the fraud.

    1. Edward Harrison says

      I have been thinking about this in light of my post on corporatism. My preference is for de-regulation without the desupervision or the de facto decriminalization that Bill Black talks about.

      If you look back at financial crises and de-regulation in the U.S. and Europe, there is certainly a connection: Scandinavia in the early 1990s, S&Ls in the 1980s, for example. But de-regulation has been accompanied by great benefits to consumers as prices have come down. The question then is: how do you allow deregulation? Do you allow it in non-financial spheres only? Do you heighten regulatory vigilance post-deregulation at least through the first economic cycle? Do you have strict size limits in financial services for anti-trust reasons?

      The bottom line for me is that there are a lot of different approaches that could work and are consistent with both freer markets and less severe crises. But if you have both a lax regulatory environment and easy credit conditions, deregulation is bound to lead to crisis.

      1. Anonymous says

        De regulation has been a disaster in the financial services sector, we have the global financial crisis as a clear demonstration of that. I am in favour of markets. If you deregulate the banks will still create a myriad of products to hide the charges and rip the customer off. So even if the headline rate is low the charges will more than make up for those “low” interest rates.

        I have no problems about silly regulations but comparing them to rules on lending limits and risk are ridiculous. Also we had a perfect example period of total financial deregulation during the recent Bush presidency when regulations were never even enforced. So how much more deregulatory than that do you want?

        In the UK banks were not allowed to offer mortgages until the 80’s and the big bang. Up till then you had to get a mortgage from a mutual building society. That meant saving to get a deposit and tough rules on lending multiples and loans to value meant that we had minimal economic damage as a result of property bubbles. The market was only inflated by excessive savings. Once the banks were allowed to enter the market with their cheap wholesale market. Yes the interest rates fell but then the property bubble increased so you were not saving money but having to borrow even more! The share of income spent on mortgages stayed the same. All the savings went to the financial institutions. The borrower never benefited. The real estate agents trumpeted affordability yet these were only maintained through ever lower interest rates fuelling another speculative property bubble. When that bubble imploded and rates fell to zero how can you revive that?

        If you truly believe in markets then you need regulations to keep competition alive. Businesses will do everything possible to reduce that competition such as take over competitors. Now we have a banking system that is even more concentrated than ever and are now impossible to save again because of the recent crisis draining resources from government. Who are we really protecting banks or their customers? Definitely not the customers.

        I do support size limits maybe through a unitary tax on world wide earnings for any bank with an asset base of say $100 billion or more. Maybe an end to banks operating across state lines or having each state bank restricted to only lending within the state. That makes state regulation more necessary and means that local politicians will actually ensure the regulator does their job. Any banks that has an investment banking arm even if it employs just one person has to have much higher capital requirements. An end to risk based capital and a return to simple leverage ratios will end much of the increased risk. Basel II was a disaster.

        If you had the banks products regulated as well then it would mean that the banks would not be able to raise fees to compensate for the reduction in business. That will eliminate the bonus problem that is troubling the UK.

        In the end you need lots more smaller banks. Much more regulation or face the consequences that it will be regulation through litigation. Which benefits only the lawyers.

        1. Edward Harrison says

          Well said. It is clear that bank deregulation and crises go hand in hand. Banking deregulation has the potential of creating catastrophic losses for society in a way you see in no other industry. If you are going to deregulate, you need to increase oversight at least through the first downturn. But deregulation mixed with desupervision and abnormally low rates creates a criminogenic environment that ends in fraud and crisis. We saw that in the 1920s, in the S&L crisis, in Iceland, Ireland, in Sweden in the 1990s, etc, etc. Yet here we are back to square one. We should expect another crisis as a result.

          1. Anonymous says

            My one huge concern is that business and banks complain about their hands being tied because of over regulation. They have clearly forgotten why they were created in the first place. Maybe they should be looked at on the basis that circumstances have changed. Though I prefer the idea of rationalising them and making them much simpler and eliminating the loopholes that allowed bankers to eliminate transparency of their business, and created a shadow banking system.

          2. Edward Harrison says

            The easiest arbitrage to narrow banking is in moving those activities offshore. I don’t know how you get married banking except by legally ring fencing it and providing no backdrop except for those activities. But then how do you prevent liquidity for the narrow bank from being siphoned off to support other activities.

            There will always be an arbitrage so we need a way to allow the narrow bank to be separated out.

Comments are closed.

This website uses cookies to improve your experience. We'll assume you're ok with this, but you can opt-out if you wish. Accept Read More