The Savings and Loan Crisis

1) Role players and their actions:

Primary role players involved in Savings and Loan Crisis were:

- Congress/Government
- Savings and Loan companies
- Federal Reserve Board
- Lobbyists for Savings and Loan industry
- Governmental enacted agencies like Federal Deposit Insurance Corporation (FDIC) and
Federal Savings and Loan Insurance Corporation (FSLIC)

Post the Great Depression, “Regulation Q” was implemented by Federal Reserve Board on
August 29, 1933 which prohibited payment of interest by Bank on customer’s demand deposit
accounts (Checking/Savings bank accounts). In addition to that, it imposed a ceiling on interest
rates, Banks can pay to its customers on savings and time deposits to discourage excessive
competition for deposit funds by Banks and subsequently leading Banks to invest in risky assets
to earn more returns.

Interest rates rose to double digits as a result of high rates of inflation in 1970s. However, due to
ceiling imposed by “Regulation Q”, Savings and Loan companies could not offer competitive
rates to attract savings deposits from customers. Also, S&Ls primarily used to lend long term
fixed mortgage loans. So rising interest rates hit S&Ls very hard. So in order to rescue S&Ls
industry and also due to tactful lobbying by S&Ls, policymakers passed “Depository Institutions
Deregulation and Monetary Control Act of 1980”, whose main purposes were to phase out the
ceilings imposed on interest rates Banks can offer on customer’s deposits and have more control
on the money supply in the economy by bringing S&Ls under Fed’s reserve requirements. In
1982, “Garn-St. Germain Depository Institutions Act” was instituted, which completely
eliminated the interest rate cap and also permitted the banks to have up to 40% of their assets
in commercial loans and 30% in consumer loans (Commercial and Consumer loans are riskier
assets compared to mortgage loans as the underlying assets of these loans tend to depreciate
more than appreciate and also depreciate at a very high pace). The limit on deposit insurance
coverage was also raised from $40,000 to $100,000.

Due to said regulations, S&L assets increased by 56% between1982 and 1985**. This growth was
primarily due to S&Ls ability to attract deposits by paying higher interest rates. However, S&Ls
continued to make losses as they were paying higher interest rates to attract deposits now but
the amount they earned on long-term fixed-rate mortgages didn’t change. So, losses began to
mount. Hence, to generate higher returns and offset losses, S&Ls started to invest in riskier and
riskier assets. Many of the S&Ls were already bankrupt by 1985, but S&L’s insurance fund known
as Federal Savings and Loan Insurance Corporation (FSLIC) did not have enough funds to pay off
the depositors of those insolvent S&Ls, hence, they were allowed to remain open.

Year 1986’s Oil price collapse gave a final blow to this financial crisis. Oil price collapse lead to
sharp decline in value of real estate assets leading to acceleration in defaults of S&Ls mortgage
loans.

In 1987, the FSLIC fund declared itself insolvent by $3.8 billion and in year 1989, as a final action
to many financial crises, Congress stepped in and used taxpayer’s money to bail out the fund.
Congress also passed the “Financial Institutions Reform, Recovery and Enforcement Act of
1989”. This act provided $50 billion to close failed banks and stop further losses and also
instituted a number of reforms in S&L industry.
 2) Causes of S&L crisis (Shortfalls of regulations implemented, leading to S&Ls crisis):

- Fixed interest rate ceilings on deposits, imposed as part of “Regulation Q” was bounded for
failure. Interest rates are very dynamic and are dependent on various factors like inflation,
unemployment, currency values etc. So, given the dynamic nature of interest rates,
government/policymakers should have kept the ceiling on interest rates on deposits flexible
and the same was needed to be revised monthly or quarterly by accessing various economic
indicators.
- “Asset Liability Mismatch” risk went unchecked. Asset liability mismatch in Banks may occur
due to many reasons. Primary causes being maturity dates mismatch i;e using short terms
deposits to advance long term loans and secondly, interest rates mismatch i;e to pay floating
rate on deposits but charging fixed rates on loan advances or vice-versa. None of the
regulations implemented by policy makers tried to address or constrain this issue.
- Indirect consequences within the same industry were not examined in detail. Policy makers
established “Depository Institutions Deregulation and Monetary Control Act of 1980” to
phase out ceilings on interest rates, enabling S&Ls to offer competitive interest rates to
attract more deposits. The Act achieved this primary objective but consequences of raising
interest rates on deposits by S&Ls on their financial conditions were not examined. A simple
stress test on financial statements of S&Ls by considering various interest scenarios would
have given a clear picture to regulators.
- S&Ls insurance fund, FSLIC not having sufficient funds to dissolve insolvent S&Ls was a
major oversight from the Congress and policy makers. This explains the extent to which
policy makers or regulators were under informed about Industry’s financial condition.

3) “Garn-St.Germain Depository Institutions Act” was a Domestic, Governmental, Industry-

specific and a Direct regulation.

Following points were stated by Professor Bryony Ortlepp in Module 2, Unit 2 video:
- “Domestic regulation is applied to a specific country.”
- “Governmental regulation is implemented by government agents within a particular
country’s borders.”
- “Industry-specific regulation is necessary to address specific issues within a certain sector
that may not be applicable to other sectors of trade.”
- “Direct regulation involves the application of regulation to a particular industry or
environment with the specific aim of enacting change or oversight within that
environment.”

Garn-St.Germain Depository Institutions Act was instituted and signed by US President

Reagan. It was applicable only within U.S borders. This act was aimed particularly at
improving the competitiveness of U. S’s Savings and Loans industry by eliminating the
interest rate ceiling on deposits, to be paid by S&Ls.

References used:

* https://www.federalreservehistory.org/essays/savings_and_loan_crisis

** https://www.thebalance.com/savings-and-loans-crisis-causes-cost-3306035