Savings and Loan Crisis Explained

The Savings and Loan Crisis was the most significant bank collapse since the Great Depression of 1929. By 1989, more than 1,000 of the nation's savings and loans had failed.

The crisis cost $160 billion. Taxpayers paid $132 billion, and the S&L industry paid the rest. The Federal Savings and Loan Insurance Corporation paid $20 billion to depositors of failed S&Ls before it went bankrupt. More than 500 S&Ls were insured by state-run funds. Their failures cost $185 million before they collapsed.

The crisis ended what had once been a secure source of home mortgages. It also destroyed the idea of state-run bank insurance funds. 

Causes

The Federal Home Loan Bank Act of 1932 created the S&L system to promote homeownership for the working class. The S&Ls paid lower-than-average interest rates on deposits. In return, they offered lower-than-average mortgage rates. S&Ls couldn't lend money for commercial real estate, business expansion, or education. They didn't even provide checking accounts. 

In 1934, Congress created the FSLIC to insure the S&L deposits. It provided the same protection that the Federal Deposit Insurance Corporation does for commercial banks. By 1980, the FSLIC insured 4,000 S&Ls with total assets of $604 billion. State-sponsored insurance programs insured 590 S&Ls with assets of $12.2 billion. 

In the 1970s, stagflation combined low economic growth with high inflation. The Federal Reserve raised interest rates to end double-digit inflation. That caused a recession in 1980.

Stagflation and slow growth devastated S&Ls. Their enabling legislation set caps on the interest rates for deposits and loans. Depositors found higher returns in other banks.

At the same time, slow growth and the recession reduced the number of families applying for mortgages. The S&Ls were stuck with a dwindling portfolio of low-interest mortgages as their only income source. 

The situation worsened in the 1980s. Money market accounts became popular. They offered higher interest rates on savings without the insurance. When depositors switched, it depleted the banks' source of funds. S&L banks asked Congress to remove the low-interest rate restrictions. The Carter administration allowed S&Ls to raise interest rates on savings deposits. It also increased the insurance level from $40,000 to $100,000 per depositor.

By 1982, S&Ls were losing $4 billion a year. It was a significant reversal of the industry's profit of $781 million in 1980.

In 1982, President Reagan signed the Garn-St. Germain Depository Institutions Act. It completely eliminated the interest rate cap. It also permitted the banks to have up to 40% of their assets in commercial loans and 30% in consumer loans. 

In particular, the law removed restrictions on loan-to-value ratios. It permitted the S&Ls to use federally-insured deposits to make risky loans. At the same time, Reagan cut the budgets of the regulatory staff at the FHLBB. This impaired its ability to investigate bad loans.

Between 1982 and 1985, S&L assets increased by 56%. Legislators in California, Texas, and Florida passed laws allowing their S&Ls to invest in speculative real estate. In Texas, 40 S&Ls tripled in size.

Banks also used historical accounting. They only listed the original price of real estate they bought. They only updated this price when they sold the asset. 

When oil prices dropped in 1986, the property held by Texas S&Ls also fell. But the banks kept the value on their books at the original price. That made it seem the banks were in better financial shape than they were. Banks hid the deteriorating state of their declining assets.

Today, banks use mark-to-market accounting. They regularly update the value of their real estate assets.

Despite these laws, 35% of the country's S&Ls still weren't profitable by 1983. Nine percent were bankrupt. As banks went under, the FSLIC started running out of funds. For that reason, the government allowed bad S&Ls to remain open. They continued to make bad loans, and the losses kept mounting.

In 1987, the FSLIC fund declared itself insolvent by $3.8 billion. Congress kicked the can down the road by recapitalizing it in May. But that just delayed the inevitable. 

In 1989, the newly-elected President George H.W. Bush unveiled his bailout plan. The Financial Institutions Reform, Recovery and Enforcement Act provided $50 billion to close failed banks and stop further losses. It set up a new government agency called the Resolution Trust Corporation to resell bank assets. The proceeds were used to pay back depositors. FIRREA also changed S&L regulations to help prevent further poor investments and fraud. 

Scandal

The Senate Ethics Committee investigated five U.S. Senators for improper conduct. The "Keating Five" included John McCain, R-Ariz., Dennis DeConcini, D-Ariz., John Glenn, D-Ohio, Alan Cranston, D-Calif., and Donald Riegle, D-Mich.

The Five were named after Charles Keating, head of the Lincoln Savings and Loan Association. He had given them $1.5 million in total in campaign contributions. In return, they put pressure on the Federal Home Loan Banking Board to overlook suspicious activities at Lincoln. The FHLBB's mandate was to investigate possible fraud, money laundering, and risky loans.

Empire Savings and Loan of Mesquite, Texas was involved in illegal land flips and other criminal activities. Empire's default cost taxpayers $300 million. Half of the failed S&Ls were from Texas. The crisis pushed the state into recession. When the banks' bad land investments were auctioned off, real estate prices collapsed. That increased office vacancies to 30%, while crude oil prices fell 50%. (Sources: "The S&L Crisis: A Chrono-Bibliography," FDIC.  "The Savings and Loan Crisis and Its Relationship to Banking," FDIC.gov.)