Savings and loan crisis

What Is the Savings and Loan Crisis?

The savings and loan crisis was a significant financial crisis in the United States that occurred primarily from the mid-1980s to the early 1990s, characterized by the widespread failure of savings and loan associations (S&Ls), also known as "thrifts." This event is a critical component of Financial Crisis history, involving the collapse of approximately one-third of the nation's 3,234 S&Ls between 1986 and 1995. The crisis led to a taxpayer-funded bailout and extensive regulatory reforms.

History and Origin

The roots of the savings and loan crisis can be traced back to the late 1970s and early 1980s, an era marked by high inflation and rising interest rates, a phenomenon known as stagflation.,¹⁶ Historically, S&Ls specialized in offering long-term, fixed-rate residential mortgage lending and relied on short-term deposits for funding.¹⁵ As market interest rates surged, the rates S&Ls had to pay depositors rose, while the income from their existing low-interest, long-term mortgages remained fixed. This created a significant mismatch between their assets and liabilities, severely eroding their net worth.¹⁴,¹³

In response to these financial pressures and with the aim of increasing profitability, Congress enacted deregulation measures, such as the Depository Institutions Deregulation and Monetary Control Act of 1980 and the Garn-St Germain Depository Institutions Act of 1982.¹² These acts allowed S&Ls to diversify their investments into riskier ventures, including commercial real estate and speculative investments, and offered higher interest rates on deposits to attract funds.,¹¹ However, many S&Ls lacked the expertise to manage these new, complex risks. Coupled with inadequate regulatory oversight, this led to imprudent lending practices, fraud, and excessive risk-taking, exacerbating losses when real estate markets declined, particularly in certain regions.,¹⁰ The sheer scale of failures overwhelmed the Federal Savings and Loan Insurance Corporation (FSLIC), the federal agency responsible for insuring S&L deposits, rendering it insolvent.,⁹

The ultimate legislative response to the crisis was the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA), signed into law by President George H.W. Bush on August 9, 1989.⁸ FIRREA abolished the FSLIC, transferring its responsibilities to the Federal Deposit Insurance Corporation (FDIC) and establishing the Resolution Trust Corporation (RTC) to manage and dispose of the assets of failed thrifts.,⁷

Key Takeaways

• The savings and loan crisis involved the failure of approximately one-third of U.S. savings and loan associations from the mid-1980s to the early 1990s.
• It was primarily caused by a mismatch in interest rates, followed by deregulation that permitted risky investments and poor lending practices.
• The crisis led to the insolvency of the Federal Savings and Loan Insurance Corporation (FSLIC), necessitating a taxpayer-funded bailout.
• The Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA) was enacted to address the crisis, creating the Resolution Trust Corporation and transferring deposit insurance responsibilities to the FDIC.
• The total cost of the crisis to taxpayers was estimated to be around $124 billion to $132 billion.,

Interpreting the Savings and Loan Crisis

The savings and loan crisis serves as a stark historical case study in the consequences of financial deregulation coupled with insufficient oversight and moral hazard. It highlights the importance of robust capital requirements and effective supervision for financial institutions. The crisis demonstrated how macroeconomic factors, such as high inflation and volatile interest rates, can significantly destabilize a banking sector with a structurally vulnerable business model.

Hypothetical Example

Consider a hypothetical savings and loan institution, "SafeHome S&L," operating in the early 1980s. SafeHome's primary business model relies on attracting short-term deposits from individuals, for which it pays a relatively low, regulated interest rate. It then uses these funds to issue long-term, fixed-rate residential mortgages.

In the late 1970s, the Federal Reserve begins aggressively raising interest rates to combat inflation. Suddenly, the interest SafeHome must pay on new deposits rises sharply to compete with higher-yielding alternatives like money market accounts. However, the income SafeHome earns from its existing portfolio of fixed-rate mortgages remains stagnant. This creates a severe negative spread: SafeHome is paying more to attract deposits than it is earning from its loans.

Despite some deregulation allowing it to seek higher returns, SafeHome S&L is unable to quickly replace its low-yielding assets with profitable new ventures or manage the risks associated with new, riskier investments. As a result, its net worth diminishes rapidly, leading to insolvency. Depositors, concerned about the solvency of SafeHome, begin to withdraw their funds, further accelerating its collapse and requiring intervention from the federal deposit insurance system.

Practical Applications

The savings and loan crisis had profound and lasting effects on the U.S. financial system and continues to be studied for its lessons in financial regulation and risk management.

• Regulatory Reform: The crisis directly led to the passage of FIRREA, which fundamentally restructured the regulatory framework for thrift institutions, establishing new agencies and increasing regulatory oversight. This act strengthened capital requirements for S&Ls, prohibited investments in speculative assets like junk bonds, and imposed stricter rules for real estate appraisal to prevent inflated asset valuations.,⁶
• Deposit Insurance System: The crisis exposed weaknesses in the deposit insurance system, particularly the insolvency of the FSLIC. FIRREA merged the FSLIC with the stronger FDIC, consolidating federal deposit insurance under a single agency and bolstering its financial capacity.
• Government Intervention: The establishment of the Resolution Trust Corporation (RTC) demonstrated a direct, large-scale government intervention to liquidate assets of failed financial institutions, a model that informed later responses to financial distress.,⁵ By the time the RTC closed operations in 1995, it had resolved 747 S&Ls with assets exceeding $407 billion.⁴

Limitations and Criticisms

While FIRREA aimed to resolve the savings and loan crisis and prevent future occurrences, the event itself and the response faced criticisms. One limitation identified in the aftermath was the initial reluctance and delay by policymakers to acknowledge the full extent of the problem and take decisive action. This "regulatory forbearance" allowed many insolvent S&Ls to continue operating, accumulating greater losses and significantly increasing the ultimate cost of the bailout to taxpayers.,³

Another critique revolved around the extent of deregulation itself, which some argued was too permissive without adequate simultaneous strengthening of regulatory frameworks and oversight. While the intent was to foster competition and profitability, it inadvertently created an environment ripe for excessive risk-taking and fraudulent activity. The crisis also highlighted the potential for moral hazard when deposit insurance removes market discipline, as insured depositors have less incentive to monitor the health of their financial institutions. Furthermore, the crisis resulted in a significant contraction of the S&L industry, with the number of operational S&Ls drastically reduced, and their role largely absorbed by commercial banks and other financial entities.

Savings and Loan Crisis vs. Subprime Mortgage Crisis

The savings and loan crisis and the subprime mortgage crisis both represent periods of significant financial distress in the United States, rooted in issues within the housing and lending sectors, but they differ in their scope, primary causes, and the nature of the institutions involved.

While both crises involved failures stemming from poor lending and asset bubbles, the savings and loan crisis was largely contained within a specific type of financial institution and predated the complex financial instruments that characterized the subprime mortgage crisis, which had a far more systemic and global impact.

FAQs

What caused the savings and loan crisis?

The crisis was initially caused by a mismatch between the fixed, low-interest mortgages held by S&Ls and the rising interest rates they had to pay to attract deposits. Subsequent deregulation allowed S&Ls to make riskier investments without sufficient oversight, leading to widespread losses and fraud.,¹

How much did the savings and loan crisis cost taxpayers?

The total cost to taxpayers for resolving the savings and loan crisis was estimated to be between $124 billion and $132 billion.,

What was the Resolution Trust Corporation (RTC)?

The Resolution Trust Corporation (RTC) was a government-owned corporation created by the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) in 1989. Its purpose was to manage and sell the assets of failed savings and loan institutions that were taken over by the federal government.

What was the main long-term consequence of the savings and loan crisis?

The primary long-term consequence was a significant restructuring and consolidation of the U.S. banking industry, with many S&Ls either failing or being acquired by larger commercial banks. It also led to fundamental changes in financial regulation, particularly through the strengthening of deposit insurance and increased oversight over financial institutions.