A Mid-’70s ‘Reform,’ an S & L Debacle Today

The search for scapegoats over the thrift industry debacle has targeted current and previous federal and state regulators, greedy acquirers of insolvent thrifts, incompetent and/or criminal S&L; managers, Congress and the President. While there certainly is enough blame to go around, nowhere does one see any references to what started the slide down: the banking industry “reforms” of the mid-1970s.

The modern savings-and-loan industry was created as a source of relatively cheap loans to enable the average person to own a home. The benefits of homeownership to the owner, the building industry, the building-trade unions and the scores of businesses that thrived on it are too obvious to describe at length. But it is important to understand the fundamental reasons the industry did such a good job for so long. In addition to account insurance by the Federal Savings and Loan Insurance Corp., regulation by the Federal Home Loan Bank Board and the states, federal regulations prevented banks as well as S&Ls; from paying market rates of interest on their deposits. This enabled S&Ls; to offer mortgage loans at lower rates than would have been possible in a freer market. In other words, predominantly older, well-to-do account holders subsidized mostly younger homeowner/borrowers.

In the wake of post-Vietnam inflation, short-term interest rates soared over 20%--consistently well above what banks and S&Ls; were legally able to pay to most depositors. Billions flowed out of these financial intermediaries into direct market instruments, such as bonds and T-bills, and into money-market funds, which combined high rates and easy accessibility. When these funds were paying over 15%, little wonder that the smart money deserted the intermediaries, then paying little more than 5% to most depositors.

At the same time, Congress and the Carter Administration came under increasing pressure to lift the ceilings on interest rates that could be paid to small accounts in banks and S&Ls.; This pressure came significantly from the elderly, who often maintained substantial balances in federally insured accounts but could not qualify for the market rates being paid by banks to depositors with more than $100,000 in their accounts. Doctrinaire economists within and outside the Administration added their voices, arguing that the “free market” should decide levels of interest rates. Controlling the rates paid by money-market accounts to ease the outflow from banking institutions was considered as a strategy and abandoned.

The sequel was predictable. Gradually interest ceilings were taken off banks and savings and loans. Banks, with sources of income (mainly short-term commercial loans) that could quickly adapt to their changing cost of funds, survived. Savings and loans, with long-term fixed-rate mortgages as their main asset base, had to change. Faced with paying higher interest or losing their depositors, they had to increase their income. Part of the problem was addressed by a gradual switch to variable-rate mortgage loans, which allowed their income from such loans to slowly and imperfectly track interest rates as they rose and fell. But eventually, S&Ls; had to move away from what they knew--mortgage lending--and what justified their existence in the first place, into areas that offered higher returns faster.

Is it so surprising that these higher returns involved higher risk, made even riskier by the fact that the lenders were often not experienced in these types of loans? When you add to this what seems to have been an extraordinary amount of chicanery and an unwillingness on the part of both federal and state administrations to allow regulators to hire the staff requiredto police this dramatically changed industry, a collapse of some dimensions should have been no surprise. This regulatory myopia is all the more reprehensible because the funds to hire staff are 100% industry-financed.

Widespread criticism of the FSLIC’s year-end sales of insolvent S&Ls; usually focused on the tax write-offs and commitments of FSLIC funds to purchasers with little at risk. The fact is, however, that the losses exist. They are merely being recognized. The alternative to transactions such as occurred last month would be huge payments of federal cash, instead of the FSLIC notes that were issued with little or no backing. In a year where extremely optimistic projections of interest rates and economic growth were necessary to project meeting the Gramm-Rudman deficit-reduction requirements, one cannot criticize the Administration too harshly for seeking an alternative to a pay-out of $100 billion or more in this budget year. In fact, no knowledgeable lawyer would risk his malpractice coverage on an opinion that the FSLIC notes are backed by the U.S. government. It may be that the “rescuers” are the ones who will be left holding the bag when Congress declines to honor the FSLIC funny money at face value.

In the rush to pillory the Federal Home Loan Bank Board’s chairman, M. Danny Wall, for making a valiant attempt to bail out insolvent institutions, we should not forget how it was that he was stuck with the current mess.