S&L; Regulatory System Still Flawed
Congress has finally completed legislation to stop the losses in the thrift industry. The taxpayers will pick up a bill for $150 billion, give or take $20 billion or so. The failing thrifts are being taken over by the government. The worst will be liquidated; most of the others will be sold for their salvage value.
Another crisis surmounted by wise public policy? Hardly. Some useful steps have been taken, but we have not seen the end of thrift industry problems. And not enough has been done to change the incentives that were the cause of past failures.
Thrift industry failures and losses did not occur suddenly in 1989. For 20 years, books and papers have warned about the industry’s weaknesses. Most of this material was not hidden in obscure academic journals. It was known to congressmen, Treasury officials, Federal Reserve governors, presidential counselors and to the officials responsible for supervising and regulating the thrift industry.
The basic problem is neither obscure nor arcane. Deposit insurance gives owners of thrift institutions (and banks) an opportunity to take a one-way gamble. Heads they win; tails the taxpayers lose. The gamble only takes that form when the savings and loan or bank is insolvent or has very little net worth. That’s why the problem didn’t become serious until years after academic researchers first spotted it.
Here’s why the failures grew. Inflation eroded the net worth of the thrift industry by lowering the value of the mortgages that they held. Everyone who took a fixed-rate mortgage in the 1960s or 1970s knows that he gained. The losers were the lenders--the savings and loans that owned the mortgages. The end of high inflation in the early ‘80s and the collapse of the oil boom lowered the value of the mortgaged property and led to defaults. The accumulated losses wiped out the net worth of many thrifts. They were bankrupt. They remained in business, however, because deposit insurance protected them from bank runs. The customers had no reason to worry about the safety of their deposits. They were guaranteed by the government or, more accurately, by the taxpayers.
Bankruptcy changed the incentives for the managers and operators. Risky investments became more attractive--so attractive that they flocked to them with open pocketbooks. Alas, many of these investments didn’t pay off. That’s the way it is with risky gambles. Did the operators shut down? Not at all. Many paid above-market interest rates to attract large deposits and invested in other risky ventures. The depositors had little to fear. They were insured, so losses rose and the problem grew.
Plenty of Blame to Go Around
The losses became so large that they wiped out the reserves set aside by the government’s insurance fund. The government’s insurer, the Federal Savings and Loan Insurance Corp., known as FSLIC, was itself bankrupt. By the 1980s, many thrifts, with government approval, were using accounting gimmicks to hide the losses.
The regulators mostly dithered. The Reagan Administration made a few unimpressive attempts to shut down the worst offenders. Congress looked the other way or, in some cases, pushed the regulators toward greater laxity. There is so much blame to go around that nothing much is said.
This is a scandal, a government regulatory failure. The costs to the taxpayer are far larger than the headline-grabbing mismanagement of defense contracting or the Department of Housing and Urban Development. The public picks up a bill for $600 or more per person, or $1,500 per taxpayer. And no one seems interested enough to take a thorough look at what can be done to prevent additional scandals and more losses to the taxpayers.
Deposit insurance has not been reformed. A few modest changes have been made, but a bankrupt thrift (or bank) still has an incentive to take large risks. And, once memories of the scandal fade, some will do so.
Deposit insurance makes sense for small depositors, or small amounts, as originally intended, but not for large. The system started with a maximum of $2,500 per account in 1934. Adjusting for inflation, today’s equivalent would be about $25,000. This is sufficient to protect small depositors. In 1980, Congress expanded deposit insurance, however, to cover deposits of up to $100,000. In practice, even accounts above $100,000 are often protected in case of failures.
This system removes any incentive that large depositors have to keep track of the safety and soundness of their bank or thrift. They know that if the bank or thrift fails, their deposits are secure. Large firms are accustomed to monitoring the position of people who owe them money.
Lower Ceiling Needed
A ceiling on deposit insurance at $25,000 would give large depositors an incentive to shift deposits to strong banks. Knowing that large withdrawals can occur would spur the manager of the bank or thrift to avoid those one-way gambles. Market discipline creates incentives for responsible management even where net worth is low.
An alternative, favored by many observers, would have deposit insurance protection decline with the size of the deposit. Deposits could be fully insured up to $25,000, then 80% insured from $25,000 to $50,000, with lesser percentages on larger amounts. Or, Congress could increase incentives for management by raising insurance fees at risky banks. Most important of all, regulators should require banks to price assets at market value to the fullest extent possible instead of hiding losses from sight.
Congress and the Bush Administration have ignored these and many other proposals. Some increase in capital requirements and higher average fees for deposit insurance at all thrifts, whether safe or risky, and modest changes to encourage self-regulation are about all that the taxpayers got for their money. It’s not enough.
In fact, the government bailout creates a new risk. When the bankrupt thrifts are taken over by the government, the land and buildings that have been foreclosed become public property. Someone has to decide when to sell, to whom and at what price. The opportunities for political favors are large. A government decision to sell creates problems for any local developer of competing properties, so he will have an interest in encouraging a delay in the selling of the foreclosed properties when he has his own properties up for sale.
Problems of this kind are not new, but the magnitude of the problem is unprecedented. In parts of California, Arizona and Texas especially, government has a lot of property to sell.
How can the public recover the remaining value of these assets and reduce opportunities for more raids on the taxpayers’ pocketbooks? I believe that the best solution is for the government to sell the foreclosed properties at public auction within a fixed period, say six months or a year from the time that they are acquired. Unless there is a fixed time schedule for sales, pressures for delay will be powerful. Unless properties are sold at public auction, opportunities for favoritism will be difficult to overcome.
