How did regulators exacerbate the Savings and Loan Crisis of
the 1980s?
Although the economy improved after 1933, regulatory regimes
did not. Ever fearful of a repeat of the Great Depression,
U.S. regulators sought to make banks highly safe and highly
profitable so none would ever dare to fail. Basically, the
government regulated the interest rate, assuring banks a nice
profit—that’s what the 3-6-3 rule was all about.
Regulators also made it difficult to start a new bank to keep
competition levels down, all in the name of stability. The game
worked well until the late 1960s, then went to hell in a handbasket
as technological breakthroughs and the Great Inflation conspired to
destroy traditional banking.
Here’s where things get interesting. Savings and loan
associations were particularly hard hit by the changed financial
environment because their gaps were huge. The sources of their
funds were savings accounts and their uses were mortgages, most of
them for thirty years at fixed rates. Like this:
Typical Savings and Loan Bank Balance Sheet
(Millions USD)
Assets
Liabilities
Reserves $10
Deposits $130
Securities $10
Borrowings $15
Mortgages $130
Capital $15
Other assets $10
Totals $160
$160
Along comes the Great Inflation and there go the deposits. Then
S&L’s balance sheets looked like this:
Typical Savings and Loan Bank Balance Sheet
(Millions USD)
Assets
Liabilities
Reserves $1
Deposits $100
Securities $1
Borrowings $30
Mortgages $130
Capital $10
Other assets $8
Totals $140
$140
This bank is clearly in deep doodoo. Were it alone, it soon
would have lost its remaining capital and failed. But there were
some 750 of them in like situation. So they went to the regulators
and asked for help. The regulators were happy to oblige because
they did not want to have a bunch of failed banks on their hands,
especially given that the deposits of those banks were insured.
So regulators eliminated the interest rate caps and allowed
S&Ls to engage in a variety of new activities, like making
commercial real estate loans and buying junk bonds, hitherto
forbidden. Given the demise of traditional banking, that was a
reasonable response. The problem was that most S&L bankers
didn’t have a clue about how to do anything other than traditional
banking. Most of them got chewed. Their balance sheets then
began to resemble a train wreck:
Typical Savings and Loan Bank Balance Sheet
(Millions USD)
Assets
Liabilities
Reserves $1
Deposits $120
Securities $1
Borrowings $22
Mortgages $130
Capital $0
Other assets $10
Totals $142
$142
Now comes the most egregious part. Fearful of losing their
jobs, regulators kept these economically dead (capital < $0)
banks alive. Instead of shutting them down, they engaged in what is
calledregulatory forbearance. Specifically,
they allowed S&Ls to add “goodwill” to the asset side of their
balance sheets, restoring them to life—on paper. (Technically, they
allowed the banks to switch from generally accepted accounting
principles [GAAP] to regulatory accounting principles [RAP].) Seems
like a cool thing for the regulators to do, right? Wrong! A teacher
can pass a kid who can’t read, but the kid still can’t read.
Similarly, a regulator can pass a bank with no capital, but still
can’t make the bank viable. In fact, the bank situation is worse
because the kid has other chances to learn to read. By contrast
zombie banks, as these S&Ls were called, have little hope of
recovery. Regulators should have shot them in the head instead,
which as any zombie-movie fan knows is the only way to stop the
undead dead in their
tracks.www.margrabe.com/Devil/DevilU_Z.html;www.ericlathrop.com/notld
Recall that if somebody has no capital, no skin in the game, to
borrow Warren Buffett’s phrase again, moral hazard will be
extremely high because the person is playing only with other
people’s money. In this case, the money wasn’t even that of
depositors but rather of the deposit insurer, a government agency.
The managers of the S&Ls did what anyone in the same
situation would do: they rolled the dice, engaging in highly risky
investments funded with deposits and borrowings for which they paid
a hefty premium. In other words, they borrowed from depositors
and other lenders at high rates and invested in highly risky loans.
A few got lucky and pulled their banks out of the red. Most of the
risky loans, however, quickly turned sour. When the whole thing was
over, their balance sheets looked like this:
Typical Savings and Loan Bank Balance Sheet
(Millions USD)
Assets
Liabilities
Reserves $10
Deposits $200
Securities $10
Borrowings $100
Mortgages $100
Capital −$60
Goodwill $30
Crazy, risky loans $70
Other assets $20
Totals $240
$240
The regulators could no longer forbear. The insurance fund
could not meet the deposit liabilities of the thousands of failed
S&Ls, so the bill ended up in the lap of U.S.
taxpayers.
Stop and Think Box
In the 1980s, in response to the Great Inflation and the
technological revolution, regulators in Scandinavia (Sweden,
Norway, and Finland) deregulated their heavily regulated banking
systems. Bankers who usually lent only to the best borrowers at
government mandated rates suddenly found themselves competing for
both depositors and borrowers. What happened?
Scandinavia suffered from worse banking crises than the United
States. In particular, Scandinavian bankers were not very good at
screening good from bad borrowers because they had long been
accustomed to lending to just the best. They inevitably made many
mistakes, which led to defaults and ultimately asset and capital
write-downs.
The most depressing aspect of this story is that the United
States has unusually good regulators. As
Figure 11.3 "Banking crises around the globe through
2002" shows, other countries have suffered through far
worse banking crises and losses. Note that at 3 percent of U.S.
GDP, the S&L crisis was no picnic, but it pales in comparison
to the losses in Argentina, Indonesia, China, Jamaica and
elsewhere.
KEY TAKEAWAYS
First, regulators were too slow to realize that traditional
banking—the 3-6-3 rule and easy profitable banking—was dying due to
the Great Inflation and technological improvements.
Second, they allowed the institutions most vulnerable to the
rapidly changing financial environment, savings and loan
associations, too much latitude to engage in new, more
sophisticated banking techniques, like liability management,
without sufficient experience or training.
Third, regulators engaged in forbearance, allowing essentially
bankrupt companies to continue operations without realizing that
the end result, due to very high levels of moral hazard, would be
further losses.