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Savings and Loans Crisis Essay

INTRODUCTION

In the 1980’s, the savings and loan (S&L) industry was in turmoil with the watershed event of this being the implementation of price fixing legislation in favour of home ownership in the 1930’s. Even though it was the basis of the crisis, the trigger lies in more fundamental concepts, including fiscal policy, mismanagement of assets and liabilities, pure imprudence by S&L institutions, brokered deposits and the cyclicality of the regulation/deregulation process and this was fuelled by economic reactions such as inflation. It would be ‘unfair’ to attribute it to only one factor. Therefore, to properly investigate the crisis and with a view of having all round perspective of the crisis, this report will discuss this financial disaster’s main causes.

The impact of the crisis was borne mostly by the S&L industry, the savings and commercial banks in the US and more generally, the US economy. This report will further cover the corrective measures undertaken by regulators and the government with the aim of saving the S&L sector as the number of institutions with worsening financial conditions steeply increased. The consequences of this crisis persisted until the early 1990’s and this long term effect is understood by analysing the regulations enacted in the aftermath of the crisis. The main turning point has been the enactment of the Financial Institutions Reform, Recovery and Enforcement Act in 1989. Finally, there are essential lessons to be learned from the S&L crisis, not only for the S&L institutions, but also the banking industry, regulators and the government.

CAUSES

In the 1930s the S&L industry was a conservative residential mortgage sector surrounded by legislation put in place during that period to promote home ownership. At the same time it has its own regulator which is the federal savings and home loan banking loan, and its own insurance firm to insure deposits at S&L institutions. However the regulatory and interest rate environment started to change dramatically as from the 1960s when congress applied the Regulation Q to the S&L industry by putting a ceiling on the interest rate that S&Ls can pay to depositors. The purpose was to help thrift institutions to extend interest rate ceiling to them in order to reduce their cost of liabilities and protect them from deposit rate wars since there were inflationary pressures in the middle till late 1960s. Regulation Q was price fixing, and in trying to fix the prices, Regulation Q caused distortion where the costs outweigh any benefits it may have offered.

Regulation Q created a cross subsidy, passed from saver to home buyer, that allowed S&Ls to hold down their interest costs and thereby continue to earn, for a few more years, an apparently adequate interest margin on the fixed-rate mortgages they had at that recent past years. The problem was that the S&L industry was not competing effectively for funds with commercial banks and securities market leading to large things in the amount of money available for mortgage lending. The ceiling on interest rate that S&L could offer to depositors as per the Regulation Q led dampening of competition for depositors funds between bank and S&L. But as new money market funds began to compete fiercely during the 1970s for depositors’ money by offering interest rates set by the market, S&Ls suffered significantly withdrawal of deposits during periods of high interest rates. This caused outflows from financial institution into higher yielding investment such as capital market instrument, government securities and money market funds.

This process is known as disintermediation. Disintermediation has several undesirable consequences. Most important, it both restricted the availability of credit to consumers and increased its cost, particularly for home mortgages, the same consequences affected small and medium sized businesses that did not have access to the commercial paper market. In additional, because normal cash outlays increased to meet deposit withdrawals while cash inflows decreased as new funds were diverted to alternative investments, disintermediation slowed the growth of financial institutions and caused them liquidity problems. To have the cash available to meet withdrawal demands, banks and thrifts were often forced either to borrow money at above-market interest rates or to sell assets, often at a loss from book value. At the same time, rise in oil prices in 1979 pushed inflation and headline interest rates up.

Growing inflation in the 1970s received two huge boosts: the first comprised the late-1973 and 1979 oil shocks from OPEC (the Organization of Petroleum Exporting Countries). Soaring oil prices compelled most American businesses to raise their prices as well, with inflationary results. The second boost to inflation came in the form of food harvest failures around the world, which created soaring prices on the world food market. Again, U.S. companies that imported food responded with an inflationary rise in their prices.

In order to combat the increase in inflation, there was a rise in interest rates to encourage people to save and spend less. The Federal Reserve opted for tightening monetary measures in reaction to inflationary concerns. As a result of the subsequent monetary tightening, interest rates rose abruptly and significantly. Interest rates soared from 9.06% in June 1979 to 15.2% in March 1980. Such drastic change in base rates caused the yield curve to become inverted. The spread between the 10 year Treasury bond and the 3-month T-Bill became negative as seen in the table below reaching 373 basis points in 1980.

(http://www.milkeninstitute.org/pdf/InvrtdYieldCurvesRsrchRprt.pdf)

The graph below shows the variation of US Treasury three-month T-Bill. The large rise and the volatility of short term interest rates is evident from the graph.

(http://www.milkeninstitute.org/pdf/InvrtdYieldCurvesRsrchRprt.pdf) The following 10-year Treasury against the effective Federal Funds Rate spread also illustrates how the yield curve inverted during the S&L crisis.

(http://www.milkeninstitute.org/pdf/InvrtdYieldCurvesRsrchRprt.pdf) With high volatility of interest rates during these periods, the S&L industry failed to tackle the risk inherent in the funding of long term, fixed mortgages by means of short term deposits. In other words, there was a mismatch of asset/liability with a negative gap and rising short term interest rates.

Aftermath

In the1982’s, to attempt at resuscitating the S&L industry, Congress tried to deal with the crisis by enacting the Depository Institutions Deregulation and Monetary Control Act in 1980 and the Garn-St Germain Depository Institutions Act in 1982, allowed lower capital requirements, which were based largely on book values rather than more market-value oriented techniques, grossly overstate the health of financial institutions. Regulators relaxed regulatory restrictions by decreasing the net worth requirement from 4% to 3% of total deposits, with additional flexibility of not complying with the generally accepted accounting principles (GAAP).

The process of deregulation further included the extension for the period of amortisation of supervisory goodwill and the Bank Board removes the specific limitations for the S&L shareholders, changing the minimum 400 shareholders restriction to only one, with no one shareholder or group holding more than 10% and 25% respectively and the acceptance of means of payment other than cash. In particular, rules on net worth changed so that thrifts could continue to operate even at historically low levels. Also, “supervisory goodwill” was used to balance out the books in terms of capital requirements and accounting numbers.

This goodwill had no economic sense and simply helped to compensate any institutions, in a merger, when taking over economically impaired assets of insolvent institutions. All in all, the changes in accounting and capital treatment of supervisory goodwill enabled S&L’s to post stronger accounting and capital numbers even though the underlying economic situation had deteriorated. There was a cancellation of the ceiling of the loan to value ratio as well. Forbearance or the decline in regulatory oversight was also a major factor of the debacle.

Most importantly, savings and loan interest rate ceilings were removed. S&L’s had a large proportion of variable rate liabilities (deposits) funding fixed-rate assets – they held 84.5% of their assets as home mortgages. These institutions had a negative GAP as the amount of RSL was larger than that of RSA. GAP = RSA – RSL

Therefore, they were exposed to any rise in interest rates as the yield on the assets were fixed while the cost of liabilities increased. With the rapid increase in base rate in the 1980’s, FI’s cost of RSL rose faster than they could adjust their return on their assets. They had to maintain a high level of interest paid on deposit to avoid deposit withdrawal. The Net Interest Income – the difference between interest on assets and cost of liabilities – decreased significantly. NII = Asset Return – Cost of Liabilities

On average, the returns on home loans were 9% with an average deposit rate of 7% – which implied a 2% net interest income. Given the tight regulations surrounding the S&L’s, these institutions relied in the 2% net interest income as their main source of income. However, as the base rate rose dramatically, the NII dropped to negative figures, reaching -1.0% in 1981. Many institutions lost huge amounts of money. Savings and Loans specialised in originating and holding home mortgage loans that were relatively long term assets with fixed interest rates. However, these were funded by relatively short term deposits whose interest rates were variable.

There was a maturity mismatch that was exposed to risk of interest rate rise. With the market value of the assets being more volatile because of its longer maturity, and as a consequence a longer duration, the rise in interest rate decreased the value of the mortgages to very low levels. The value of the liabilities decreased as well but to a smaller extent. Since net worth is the difference between market value of assets and market value of liabilities, this led to negative equity of financial institutions. Δ E = – (DA – DLg) x A x Δr/(1+r)

Since DA > DLg, with Δr > 0, change in net worth value ΔE is negative. The leverage adjusted duration gap between the assets and liabilities was so large and with a large rise in interest rate, the equity value decreased to being negative. By the early 1980s, savings and loans throughout the country were insolvent by about $110 billion and the fund was reporting only $6 billion in reserves (Barth, 1991; Brumbaugh, 1988; Kane, 1989)

The legislation also allowed savings and loans to begin to diversify into commercial real estate loans and other loans commercial banks could already make. Congress hoped that if S&L’s invested in riskier, and thus, higher yielding assets, they would be able to offset the loss they previously made. The savings and loans were also allowed to originate adjustable-rate home loans. By 1983, most S&Ls were deemed economically profitable but 9% of the S&L industry was insolvent.

However, the Federal Home Loan Bank Board (FHLBB) and the Bank Board, went ahead with their plan of regulating the industry by imposing a 7% net worth limit for new entrants in the thrift industry so as to promote safe risk management practices and investments. Although all these developments were intended to help savings and loans, they gave rise to a subsequent twist in the crisis. The new changes did indeed allow savings and loans to reduce their interest rate risks – but the changes exposed savings and loans to new risks mainly credit risks.

While defaults on the home mortgages were low, defaults and associated losses on other types of loans and investments are typically much higher. By combining interest rate risk with credit risk, spread over a wider geographical area, experienced institutions had greater opportunities to choose a prudent overall balance of risk and return. However, many savings and loans began making commercial real estate loans, activities in which they were relatively inexperienced.

Since investing in real estate loans entailed unique risks and required specific skills, S&L’s eventually made losses on the real estate loans. These credit quality problems are reflected in the net income of the industry plunging once again, but even more than in the early 1980s, when the yield curve inverted. The industry lost nearly $21 billion in 1987 and 1988, and almost another $8 billion in 1989.

Many open but insolvent savings and loans had incentives to take excessive risks and “gambled for resurrection” because of the phenomenon of moral hazard. If ever something turned wrong, the federal deposit insurance fund would bear the losses; yet the owners would reap the rewards if everything went well. The legislation, however, did not change how premiums were set for federal deposit insurance, meaning that riskier institutions and prudent ones were charged the same premium. Actually, the level of insured deposits was raised from $40,000 to $100,000.

The new, lower capital requirements and broader opportunities to lend and invest allowed some savings and loan to take larger risks. With federally insured deposits and the ability to attract more deposits by offering higher rates of interest, deeply troubled savings and loans always had ready access to additional funds. Deregulation encouraged increased risk-taking by S&L’s.

However, in the mid- to late 1980s, with considerable real estate loans and investments, regional recessions struck the USA, which reduced commercial real estate values. In particular, an unexpected plunge in the price of oil in 1986 contributed to recession. To make matters worse, the Congress passed the Tax Reform Act of 1986 that more than eliminated the tax benefits to commercial real estate ownership it had conveyed only a few years earlier. Commercial real estate values fell dramatically as a result. This severely affected the asset value of the S&L’s. In 1987, the Bank Board emphasised the importance of capitalisation by imposing a supervisory approval for S&Ls which engage in investments that are above 2.5 the multiplier of their tangible capital base.

The main turning point was the Financial Institutions Reform Recovery and Enforcement Act (FIRREA), restructuring the industry as a whole by setting up the Resolution Trust Corporation which in total resolved or liquidated 747 thrifts, with assets valued at $394 billion, jettisoning both the FHLBB and FSLIC and setting up a new regulatory institution Office of Thrift Supervision. The key to this act was that instead of trying to save the S&Ls which were barely solvent, it dissolved them and focused on the solvent ones to reform the industry. With the assistance of market fundamentals – favourable conditions of interest rates, the reinstatement of GAAP accounting and real estate market, the industry stabilised.

LESSONS LEARNT

The thrift crisis had a bailout plan of $153 billion, of which around 80% was financed by taxpayers. The number of institutions in the S&L industry receded considerably until 1995 and before then, the ability of the regulators and the government to deal with the crisis was questioned many times. What followed was a series of court battles, corruption charges and major restructuring. Therefore, consequences were substantial enough for everyone to extract some observations and lessons. The starting point of it all was overregulation, which outlined the restrictions and conditions under which an S&L would function. That included rigidity of the institutions to be flexible at a time economic conditions were changing and the financial sector was advancing. With fixed interest rates, it proved difficult for the S&L to engage in competition as their means of investing was limited.

One crucial point is that additional regulations do not necessarily mean fewer risks. S&Ls had to assume additional exposure to interest rate risk and alongside with banks, they were prevented from optimising their credit risk exposure. The government sometimes does not modify the regulations as fast as the structure of the industry is changing leading to new risks emerging and the cycle goes on. To keep up with advancement, the government has to put in place tighter risk management policies and controls. However, regulators and government should not direct the investment decisions of institutions. Rather, investments should be in line with market and economic forces. At a later stage, the industry was deregulated in order to remedy the situation. However, this translated into a decrease in market discipline as the S&Ls made high risk investments as they relied on the safety net of federal guarantee to cover any losses.

Moral hazard, adverse selection and passive management were noted. Therefore, it exposes the disadvantage of FSLIC at that time which encouraged the S&Ls to take long-term and unreported risks. The deregulation, reducing the capital requirements, left the thrift industry more vulnerable to economic changes. From the failure of resuscitating the industry, it was deduced that forbearance treatment towards insolvent institutions might not always be the best option as it can lead to a freeze in lending and stifle the economy. One of the lessons from the thrift crisis which has been consistently taken into account over the years was the reliance on capital ratios. During the deregulation period of the crisis, there was no monitoring of the capital bases of the thrifts which ultimately lead to insolvency.

From then on, institutions had to follow certain standard capital requirements put in place by regulators. However, this focus proved recently in the credit crunch to be detrimental, showing that banks favour trust and confidence. It is important to realise that capital ratios and other accounting ratios might not reveal the real economic strength of the institution. The crisis led to more disclosure and market value accounting. It has been understood that it would have been best to restrict involvement of public funds as a means of saving the industry.

Using state or public funds to buy-out thrifts below value is not in accord with public welfare. A solution would have been to subdivide the thrifts into insured and uninsured ones with varying degrees of supervisory regulations concerning deposits and investments. One lesson learned was the emergence of an adjustable insurance premium rate which became a function of the institution’s regulatory rating, risk and capital levels.

CONCLUSION

For some years the final bill for the S&L crisis remained uncertain. However, it is known now that, the thrift crisis cost an extraordinary$153 billion – one of the most expensive financial sector crises the world has seen. Of this, the US taxpayer paid out $124 billion while the thrift industry itself paid $29 million. The consequences of the S&L crisis for the structure and regulation of the US financial industry were profound. The number of institutions in the S&L industry fell by about half between 1986 and 1995, partly due to the closure of around 1,000 institutions by regulators, the most intense series of institution failures since the 1930s.

The failures prompted an overhaul of the regulatory structure for US banking and thrifts, a shake-up in the system of deposit insurance and implied Government guarantees. Regulators shifted towards a policy of earlier intervention in failing institutions so that the principal costs are more likely to be borne by shareholders than other stakeholders. There was also a shift towards more risk-sensitive regulatory regimes, with respect to both net worth assessments and the payments to deposit insurance funds, while deposit insurance reform made it less likely that taxpayers would shoulder so great a burden in any future crisis.

At a wider level, the S&L crisis taught politicians, regulators and bankers how misleading rules-driven regulatory and accounting numbers can be in relation to risky bank activities. At different stages of the crisis, reporting of the financial condition of S&Ls was deliberately selected by interested parties to cover up the true economic extent of the unfolding disaster. It was a risk reporting failure on grand scale that greatly worsened the long term economic consequences fort the ultimate stakeholder: the US taxpayer.

REFERENCES

1. Myth: Carter ruined the economy; Reagan saved it.
http://www.huppi.com/kangaroo/L-carterreagan.htm
[Accessed 31 October 2010 to 18 November 2010]
2. The U.S. banking debacle of the 1980’s : A lesson in government mismanagement http://www.thefreemanonline.org/featured/the-us-banking-debacle-of-the-1980s-a-lesson-in-government-mismanagement/ [Accessed 31 October 2010 to 18 November 2010]

3. Inverted Yield Curve Research Report, Milken Institute http://www.milkeninstitute.org/pdf/InvrtdYieldCurvesRsrchRprt.pdf [Accessed 31 October 2010 to 18 November 2010
4. The Cost of the Savings and Loans Crisis, FDIC Banking Review http://useconomy.about.com/library/s-and-l-crisis.pdf
[Accessed 31 October 2010 to 18 November 2010]
5. The S&L Crisis: A Chrono-Bibliography, FDIC
http://www.fdic.gov/bank/historical/s%26l/index.html
[Accessed 31 October 2010 to 18 November 2010]
6. The Savings and Loan Crisis
http://wapedia.mobi/en/Savings_and_loan_crisis.html
[Accessed 31 October 2010 to 18 November 2010]
7. US Savings and Loans Crisis, Sungard Bancware Erisk
http://www.prmia.org/pdf/Case_Studies/US_S&L.pdf
[Accessed 31 October 2010 to 18 November 2010]
8. Savings and Loans Crisis, FDIC Report Vol. 1
http://www.fdic.gov/bank/historical/history/167_188.pdf
[Accessed 31 October 2010 to 18 November 2010]
9. The Economic Effects of the Savings and Loans Crisis, Congressional Budget Office http://www.cbo.gov/ftpdocs/100xx/doc10073/1992_01_theeconeffectsofthesavings.pdf [Accessed 31 October 2010 to 18 November 2010]

10. The Cost of Savings and Loans Crisis: Truth and Consequences, FDIC Banking Review http://fcx.fdic.gov/bank/analytical/banking/2000dec/brv13n2_2.pdf [Accessed 31 October 2010 to 18 November 2010]


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