What caused the S&L crisis in the 1980s and 1990s in the US?

[plaguedbyfoibles]

Disclaimer: Not an American, nor am I too well versed in economics (I would like to think I have a reasonably well developed layperson's understanding, although feel free to correct me on any mistakes I make in this regard nonetheless).

How did the S&L (savings and loan) crisis play out the way it did in the US?

My understanding is that S&Ls lend out money in the form of home loans (which can be used either for purchasing homes, making home improvements or building on land they own), that the interest they pay is accrued by the members and the bank itself, and that one aspect of FDR's banking reforms in the early to mid 1930s was the formation of the Federal Savings and Loan Insurance Corporation (FSLIC), part of whose scope was to guarantee the savings of those holding accounts with an S&L, in the event of a collapse.

Now, the S&Ls offered lower than average mortgage rates due to the low returns they offered on savings, and due to the caps placed on the rates that S&Ls could levy on both deposits and loans as a result of the Federal Home Loan Bank of Act of 1932, this rendered S&Ls unable to compete with traditional lenders.

Following the period of stagflation that had dominated the 1970s, Paul Volcker, who had been named chairman of the Federal Reserve by Carter in 1979 (a year before the election that would see Reagan first take presidential office), raised interest rates to attempt to combat inflation, leading to a double digit recession in the 1980s.

Now I'm not too knowledgeable on the proportional relationship between a rise in interest rates and a rise in the likelihood of a recession, but I am guessing that with higher borrowing costs, this will lead to a reduction in commercial / business investments financed by borrowing or by dipping into savings, and reduced consumer spending due to higher interest payments on credit cards and that it's more advantageous to save rather than to spend, etc.

The S&Ls were therefore losing out to traditional lenders that could offer more flexible rates, given that the S&Ls were required by law to offer the low returns they did.

Was it that S&Ls were already in unsustainable positions from the start due to the rigid regulations governing them, or was there too much deregulation in the Reagan era?

A friend has told me that the core cause was that “the Federal Reserve drastically raised ST rates. The S&Ls already had books of LT loans out at lower fixed rates. A move up in ST sent their net interest margin negative. A move up in ST also sent economy into recession making loan payback a greater credit risk, so it was a double whammy.”

By ST and LT, they mean short- and long-term respectively, although I don't know much else other than that.

I am guessing that the S&Ls had issued a lot of these long term loans at lower fixed rates, and that raises in short term interest rates (given that the S&Ls funded the long term, fixed rate house mortgages using short term deposits) meant that they were paying more to their depositors than they made from the loans they issued.

Any replies are welcome.

[Gilgongo]

Reagan did it.

https://www.nytimes.com/2009/06/01/opin ... ugman.html

[plaguedbyfoibles]

Reagan did it.

https://www.nytimes.com/2009/06/01/opin ... ugman.html

Thanks, that was an amusing read.

[bungeejumper]

Indeed, it was basically the fixed rate loans that sank the S&Ls when base rates went up. But there was also the fact that most of them were really, really tiny - and as I recall it, they were largely restricted to operating in just one federal state. (So were most commercial banks, actually. The ban on interstate banking only ended in 1997!)

At the same time, the S&Ls were not allowed to make the same kinds of loans as commercial banks. Which was what made them doubly hard to rescue, because nobody had ever heard of most of them.

So what did they do? Some of them got into quite naughty risks, confident that the government would bail them out if their investments crashed. Which they duly did. Well, surprise surprise.

There's a reasonable write-up at https://www.investopedia.com/terms/s/sl-crisis.asp . Its conclusions are not quite the same as Krugman's....

BJ

[Gilgongo]

I'd say their conclusions are pretty much identical:

Krugman:

"... deregulation in effect gave the industry —- whose deposits were federally insured —- a license to gamble with taxpayers’ money, at best, or simply to loot it, at worst. "

Investopedia:

"Lessons are still being learned from the S&L Crisis and further regulations in the banking industry are needed."

Krugman's dig at Reagan is simply a device to personify the belief in "free markets" and that in banking (if not the entire economy) the fewer rules there are, the better. Yet history shows the opposite is probably true.

[Gilgongo]

As an aside, the S&L crisis would probably be a good example of the complexities around the issue of keeping markets free from distortions. While it was true that distortions had begun to work against the S&L institutions in the 1980s and so government rightly intervened, the solution was to remove regulations (which, it has to be remembered, were put in place for a reason). This produced even more distortions which led to the crisis. Perhaps, paradoxically, more regulation, and not less, would have prevented it.

And while it's aside season: it could be argued that the term "free markets" has come to mean the opposite of that originally intended by Adam Smith. His position was that in order to be truly free, markets must be regulated.

This is perhaps the opposite political problem to "legislation bloat" - the phenomenon of governments tending to create laws in response to everything apart from the economy where they repeal them.