(Reprinted from HKCER Letters, Vol. 10, September 1991) 


The U.S. Savings and Loan Debacle

David I. Fand


Editor's Note: The U.S. savings and loan associations, which are depository institutions granting mainly mortgage loans, had been facing tremendous problems which precipitated into the final crisis of 1989. An Act had to be enacted by the U.S. Congress which provided US$115 billion to bail out the failing institutions, despite the existence of a deposit insurance scheme. This was the largest single government financial assistance to any economic sector in the U.S. Professor David I. Fand explained the ideological background and the causes of this phenomenal crisis in his talk at the Hong Kong Centre for Economic Research, which is reproduced below.

On the other hand, the Hong Kong banking system has recently gone through a period of turbulence initiated by the BCCHK incident. As a result, much attention has been given to the debates on the soundness of the system and its vulnerability to outside shocks, the adequacy of the existing regulatory framework, the protection of small depositors, and so on. The views of Professor Fand on the U.S. case provide a useful reference for the local controversies.

Extent of the Problem

The U.S. thrift industry experienced the worst performance of its entire history in the 1980s. Over 500 insolvent institutions were liquidated at an estimated cost of about $50 billion. Another 18 institutions were stabilized at a cost of about $7 billion. Over 500 institutions were reporting insolvency but still operating. It was estimated in the spring of 1990 that the remaining candidates for closure would cost approximately $100 billion. Furthermore, around 1,000 thrifts began the decade of 1990s troubled and seeking to survive the consolidation and restructuring that was sweeping the industry.

Immediate Causes of the Debacle

In retrospect we can identify several factors as the main causes of the savings and loan debacle:

Unbalanced Portfolios and Disintermediation. Public policy elected to ignore a fundamental problem with the thrift intermediaries and the mortgage market for about three decades. A savings and loan association typically made long-term mortgage loans--usually at a fixed interest rate--for a period up to thirty years. This long-term loan was usually financed with deposits which could be withdrawn the next day.

For an intermediary to specialize in financing long-term mortgages (at fixed rates) with short-term depository funds (whose interest costs could rapidly escalate) may not be appropriate in an economy with free capital and money markets. In any event, funds will hemorrhage from the intermediaries--on a massive scale--when short-term interest rates rise sufficiently and Regulation Q does not permit the rate paid on saving deposits to move with market rates.

This potential problem of disintermediation did not manifest itself until the mid-1960s. So long as inflation was moderately low, say less than 2 to 3 percent, nominal interest rates did not diverge too far from real interest rates, and short term rates did not move significantly above the Regulation Q ceilings. However, as inflation began to rise, and especially when short rates moved over two points above the Regulation Q ceilings of 5 to 5.5 percent, disintermediation developed on a massive scale. Disintermediation first emerged during the Vietnam War and became acute in the 1970s inflation.

High, Exploding, and Volatile Interest Rates. In the late 1970s and early 1980s, interest rates accelerated to unexpectedly high and volatile levels. When interest rates skyrocketed in late 1979 and the early 1980s, net operating income of the savings and loans plummeted. It is estimated that 85 percent of all thrifts were unprofitable in 1981, and virtually all were insolvent if their mortgage portfolios were marked-to-market. On a market-value basis, the entire industry was deeply insolvent in 1981, and probably in 1980. The market value of capital became positive in 1985 and remained so into 1988. Substantial increases in interest rates can clearly devastate thrifts since the cost of short-term deposits rises faster than the income on the fixed rate long-term mortgages.

Egalitarian Insurance and Moral Hazard. The Federal Savings and Loan Insurance Corporation (FSLIC) deposit insurance was disaster prone and the moral hazard it created was an important, and powerful, contributor to this debacle.

Federal deposit insurance was established after the widespread failure of financial institutions during the Great Depression. The rationale for such insurance is that depositors may withdraw their funds whenever a financial institution was believed to be insolvent, and the withdrawals might spread to solvent institutions. Federal deposit insurance assures depositors that their funds are safe and thereby eliminates runs on depository institution.

Unfortunately, once depositors believe their funds are totally secure, they have no incentive to monitor the institutions. A financial intermediary can therefore invest federally insured deposits in riskier activities than would otherwise be possible. The government is supposed to minimize this "moral hazard" problem by doing what depositors at risk would do. But if the regulator does not properly control the risk-taking behavior of institutions, more failures and greater costs are likely.

To make things worse, under the FSLIC scheme, a healthy savings and loan institution and a weak, or insolvent, institution paid the same "insurance" fee. This "egalitarian" schedule of rates is equivalent to a life insurance company charging the same premium to a healthy athlete who has just completed a marathon and a sickly individual who has just been through triple bypass surgery. Only a government-sponsored insurance corporation could operate in this manner.

Deposit insurance permits an inadequately capitalized institution to retain access to funds by offering high rates and thus continue operating in a gambling or go-for-broke manner. If the gamble succeeds, the institution willgain; and if it fails, the institution loses nothing since it was already insolvent. The value of insurance to an institution and its attitude towards very risky ventures varies inversely with the stockholder equity at risk. The operating procedures of FSLIC created a moral hazard by socializing the losses and privatizing the gains.

Increased Competition in the Financial Services Industry. Substantial improvements in informational technology, rapid growth in mortgage loan securitization, and greater competition among financial service firms in the 1970s and 1980s significantly narrowed the net interest margins for savings and loans. As a consequence, only the lowest-cost providers of services and products have been able to remain relatively profitable.

Federal and State Deregulation. Thrifts were heavily regulated for many years, and these regulations generated monopoly rents, enhancing the value of the thrift charter. These regulated institutions could not readily adapt to changing technological developments dramatically affecting the ability to obtain and monitor information. The 1980s deregulation came after the industry was in serious trouble, but it nonetheless increased competition among thrifts and other financial institutions throughout the 1980s.

Interest Rate Risk and Credit Risk. The risk in the early 1980s was primarily one of interest rates. But the risks in later years were associated with asset quality. While interest rate risk will affect all thrifts, credit risk is primarily local or regional and does not necessarily move with national factors. Thrift industry losses were increasingly concentrated in Texas after 1984, due to the plunging oil prices and real estate values.

More Deep-Seated Causes

The above events, true and influential as they were, could not by themselves have produced a debacle of such gigantic proportions. On a more abstract level, the extraordinary U.S. savings and loan debacle, while unique in its duration and singular in its magnitude, is nevertheless the result of quite ordinary forces that are nearly always present. The first is an activist, constructivist, social engineering philosophy. The second is a special standard, partially rose-colored, to value non-bank depository institutions. The third is a positive affirmation that residential construction must be maintained--almost at all costs. The fourth concerns rent-seeking politicians and opportunistic bureaucrats that normally operate in the corridors of power.

The special standard postulated that the thrift intermediaries, in contrast to the commercial banks, were progressive institutions serving important social needs, and were therefore entitled to special consideration. The positive affirmation, accorded to housing, postulated that there were important macroeconomic reasons for maintaining the volume of residential construction in order to avoid a decline in the GNP and a possible recession. This was coupled with another widely held view that homeownership helps create more responsible citizens.

Two Postulates

In the late 1950s and early 1960s, a significant body of policy opinion viewed the thrifts and the other non-bank financial intermediaries as progressive and modern institutions representing the future; commercial banks, they believed, were becoming a smaller component of a larger, more complex, and more innovative financial structure. They concluded that monetary policy, which operated, in the first instance, on the commercial banks, was more like a selective control; and as a selective control it lost out to fiscal policy, which was, in any event, their preferred macroeconomic policy and which could now be rationalized as a more general control. Given this ideological perspective, the banks were seen as the "reactionaries" and the thrifts were seen as the "progressives." Having thus concluded, these economists did not examine the nuts and bolts of thrift operations.

As an illustration, in the 1970s, short-term market interest rates were running over 10 percent. Yet our monetary officials did not allow the rate of passbook savings to rise above 5 to 5.5 percent. The public investing in passbook savings was therefore being punished. To add insult to injury, the public was expected to pay tax on the nominal return which constituted a loss in real terms.

Under the influence of this rose-colored special standard, the economists who normally associate themselves with the small investor--the passbook owner--somehow failed to challenge this. They overlooked the short-changing of the passbook depositor primarily because it was being done, among others, by the "progressive" thrift institutions. Thus, the short-changing of the public was being condoned, if not justified, because the thrifts wanted the Regulation Q ceilings. These economists saw the thrifts as "progressive" institutions; and good guys, by definition, do not do bad things.

Finally, the positive affirmation accorded to housing--the other postulate--had a powerful impact in generating an environment which sought to insulate the thrifts and protect residential homebuilding. Some macroeconomists came to believe that in order to prevent recession, one must avoid a downturn in residential housing construction. In the 1960s and 1970s, as interest rates rose, disintermediation followed, with a subsequent downturn in housing followed by a decline in the economy, and then, possibly a recession. Unfortunately, these economists were not prepared to eliminate the disintermediation threat by removing Regulation Q and deregulating the thrift institutions. Insulating the thrifts, avoiding disintermediation, and protecting housing (without deregulation) became almost unquestioned absolutes. This point of view partially explains why the regulators who were supposed to protect the public-created so-called new "accounting" rules--which some have called officially sanctioned fraud--permitted insolvent thrifts with negative capital to continue operations and, in effect, gamble with taxpayers money.

These two postulates together provided a protective shield for the rent seekers and the opportunists who habituate the corridors of regulatory and administrative power. Questionable policies, regulations, and actions were rationalized as serving a greater good. Such a protective shield, together with the "egalitarian" insurance system, combined in a critical mass to produce the savings and loan debacle.


Market forces were not responsible for the heavy investment by thrifts in fixed rate mortgage loans. The government influenced thrift behavior by providing tax incentives to use deposits to fund mortgages, and by prohibiting institutions from diversifying their portfolios. The thrifts were even prohibited from offering adjustable rate loans until the early 1980s.

The underlying reason for the U.S. savings and loan debacle of the 1980s lies in the facilitating role of activist ideology. During the 1970s, there was a general feeling that housing was hit unfairly by monetary policy, that the thrift institutions were encouraging residential construction, homebuilding, and homeownership, that this was both desirable and important, and that public policy should try to protect both the thrifts and housing. Many people apparently believed that these questionable policies were necessary to insulate the thrifts, protect housing, prevent a downturn in the economy, and avoid a recession.

The real crisis did not start, however, until interest rates exploded in 1979 and 1980. The super-high interest rates, in conjunction with the structural deficiencies of the thrifts and the regulatory and information system, laid the groundwork for the savings and loan debacle which developed in the 1980s. The government did respond by enacting legislation granting thrifts new and expanded powers to engage in activities similar to those of commercial banks. The broader powers, however, came far too late to undo the damage already done. Unfortunately, taxpayers will bear the major cost of the cleanup of this private industry.

Professor David I. Fand has been with the Department of Economics at Wayne State University for over twenty years. He is currently a visiting scholar at the Center for the Study of Public Choice at George Mason University. He has served as an advisor to various government institutions and agencies, including the Federal Reserve Board, the U.S. Treasury, and the Department of Commerce.


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