Minus The Nemesis
A Collaboration of Some of the Finest Thought on Today's World


Wednesday, October 01, 2008
The Savings and Loan fiasco, and what we can learn from it.  Much credit to Cato Institute's Savings and Loan Lessons Learned report.

First...what happened?

S&Ls were institutions that were required, by law, to take in savings accounts, then re-invest the money in 30 year fixed rate mortgages, at an interest rate cap, within a 50 mile radius of their institution. The situation was that the SL was solvent as long as savings accounts remained viable investments, and the bank was allowed to make money by recouping the mortgage investment as people bought new homes—hence new mortgages--,and re-financing old mortgages-hence paying off the original debt.

The problem began when inflation began to rise, and the returns on savings accounts no longer were viable investments. So, people pulled their money from savings accounts, and put them elsewhere. Additionally, the housing market slowed. First time buyers held off on purchasing new homes, and people were afraid to re-finance. As the industry was severely hand-tied with the aforementioned regulations, it was not in a position to react and re-capitalize. Quickly SLs owed more money than they owned.

The government recognized this problem, and decided to act. They increased the insurance on deposits to 100,000 from 40,000, and allowed the SLs a degree of freedom in their investments—specifically allowing ARM loans, issue credit cards, etc—in an attempt to let the SLs become solvent again.

The first step was a serious mistake, the second too little too late.

In a normal, non-regulated, industry when a company is no longer solvent, its creditors recognize this and stop extending credit to that company. The company then is forced to declare bankruptcy, the creditors take over the company, sell what isn’t profitable and keep what it is. Eventually, and painfully, the company is rebuilt and the market is stronger.

However, the increase in the FDIC amount meant that the company could continue to rely on additional credit—propping up an already dead company—and eventually making the inevitable collapse that much more expensive.

Also, as the Fed continued to loan money to these companies, coupled with the industry’s new freedom to invest in additional areas, put the presidents in a position to have nearly unlimited access to taxpayer money, while risking very little, if any, of their own.

At first, most accept that the owners of SLs set out with the best of intentions. They took the money from the government and, in a desperate hope to recapitalize their banks, made increasingly high payoff, and risky, investments. They didn’t have the normal investor’s risk aversion, thanks to the government’s backing, and little knowledge of the new markets in which they were investing. Simplified, the SL owners could make money and save their banks if the investments paid off or, if the investments didn’t, they knew the government would back them. This turned out to be catastrophic for the US taxpayer.

Of course the new, high yield investments of the SL owners didn’t pay off, so in turn they borrowed more money from the government to re-invest in other high risk investments—increasing their debt and severely limiting their credit quality.

Weak institution needed continued infusions of funds to pay operating expenses and to support increased investments. Meanwhile, federally insured depositors were largely unconcerned about the health of the institutions in which they placed their money.
-Cato Institute’s Lessons Learned

The market would normally destroy firms in such a situation because, again, people won’t invest in failed companies. But, because of government backing, this constraint didn’t apply to the SLs. As such, these SLs were nicknamed zombies, or dead men walking.

Perversely, the few healthy and solvent SLs were being punished by the government. Because the government was handing out these large sums of money to SLs, and insuring an increased amount of deposits, the government increased insurance premiums. The poorly managed SLs could afford this, because of their high-risk, on paper profitable, investments. The conservatively managed ones already operating on a razor thin profit margin could not.

Additionally, the “zombie” SLs would be able to steal business from the healthy SLs, as they didn’t have anything to lose—further weakening their healthier brethren.

The investor didn’t care, because their 100,000 was secured, whether they put it in a healthy bank or a zombie. And as the zombie frequently promised higher returns, what was left of the market was quickly killed.

Eventually, when the system collapsed, it cost taxpayers 200 billion dollars to cover the costs of deposits—not counting the billions of bad money already sucked up by the SLs.

If the market was allowed to act, without government interference, the crisis would have been avoided. SLs wouldn’t have faced the restrictions which forced them into poor capitalization from the get-go, and poorly managed SLs would have become bankrupt—thereby not destroying other healthy SLs in the industry. Investors would have been forced to research banks prior to investing, or depositing, money in them, thereby capitalizing solvent, profitable SLs and punishing bad ones. Lastly, the corruption among SL leaders could not have happened at the level it occurred if these individuals did not have nearly limitless access to taxpayer money.

The risk of failure forces companies to behave responsibly, and punishes those that don’t. Government interference prevents this from happening.

Well intentioned government action, i.e. the FDIC, severely distorted the normal market mechanisms—as investors in the bank didn’t have to concern themselves with risk.

It is now a myth that deregulation of the SL industry is what caused the crisis. This is not true. The over regulation of the industry prior to the 1980’s deregulation is what put the SLs in such a poor position. Then, the government “deregulated” the industry by allowing it to make additional investments, but still didn’t allow the market to function normally thanks to its provision of unlimited funds and the FDIC. Deregulation works only when the government takes itself out of the picture—otherwise artificial prices and risks are created which, ultimately, lead to disaster.

The quick pull of the band-aid in the early 80s—i.e. allowing some banks to fail and some investors to lose their money—would of, in the long run prevented the prolonged, and ultimately multi-billion dollar collapse that occurred.

Sound familiar? As the government considers propping up another failed banking industry with 700 billion dollars, it’s unfortunate to know that our congressmen and executives are totally incapable of learning from even a painful and recent experience.

How many more trillions of dollars must we waste until we allow the market to function? Or will this gross mismanagement continue until the dollar is utterly worthless and we find ourselves in a problem too big to throw money at?

My prediction—people will lose faith in the dollar, gold will soar above 1000 dollars an ounce, and we will slide into a painful, prolonged, and devastating recession.

Thanks, Congress.


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