The savings and loans crises did not occur until the 1980’s. Sudden deregulation, competition and market volatility in the late 1970’s started the crises. In 1979 there were sudden changes to traditionally low interest rates because the Federal Reserve doubled the interest rate to combat inflation. The savings & loans associations (S & Ls) made most of their money from low interest mortgages and tried to increase their interest rates to make up the shortfall. Furthermore, The S & Ls was restricted by regulation Q that capped the amount of interest that they could pay to depositors; they could not offer short term deposits with high interest rates. Depositors wanted to make more money from the high interest rates and took their money from S & Ls and invested into money market funds. Such funds were not governed by regulation Q.
Regulations that restricted the profits of S & L’s decreased in the early 1980’s as a result of the market conditions and impending failure of many banking institutions. The deregulation should have helped banks retain their profits. Instead they engaged in risky investments like junk bonds and real estate while not being effectively regulated for the amount of capital that they should hold against bank losses. The high risk investments continued because they were insured by the Federal Savings and Loans Insurance Corporation (FLIC) spreading the risk and arguable causing a moral hazard. Corrupt practices and a complex web of political and banking failures resulted in FLIC becoming insolvent and a government bailout of 124 billion dollars was issued. 700 S & Ls had to be liquidated by the Resolution Trust Corporation in the U.S making the crises one of the worst in its financial history.
The 2008 crises began when investors stopped taking out treasury bonds from the Federal Reserve because they could not make sufficient capital off the low interest rates. Instead investors took advantage of the low rates and borrowed cheap credit from the Federal Reserve. They used leverage to borrow even more money and made investments to pay off the interest and loans. Investors looked to make more money from rising house prices by using housing mortgages serviced by mortgage brokers. Lenders such as banks sold the mortgages to investors that now received a monthly profit from the mortgages. The mortgages bought by investors were categorised into investments called safe, ok and risky collateral debt obligations (CDOs). Investors received higher returns on higher risks mortgages and safer investments that were low risk like AAA became the most popular investments. The investors paid their loans and made millions from CDOs which are more attractive than low return treasury bills. The sudden attractiveness of CDOs sets off a huge demand for more mortgages from brokers and lenders however there was a shortage of people willing to take out mortgages.
Investors and lenders realised that it didn’t matter if mortgages failed because banks kept the asset and house prices would also continue to increase. So lenders failed to assess risk like proof of income and down payments on mortgages. They invested in subprime mortgages and people that shouldn’t buy large houses, took out mortgages thinking that their investment will increase. Many subprime mortgages defaulted and there was an overabundance of houses owned by lenders. There was more supply than demand of houses, prices plummeted and mortgages were foreclosed by the banks. Other people who continued paying for their loans also walked away from their investments because they were making large payments on mortgages that were now almost worthless in some areas. CDO’s become less attractive because the safer one’s were replaced with high risk CDOs. Investors were also unable to pay back their loans because no other investors want to buy high risk CDOs. Everyone started going bankrupt because of the reliance of home owners, brokers, lenders and investors on each other.
Moral hazard played a big part of both crises as a result of deregulation. The repeal of the Glass Steagall Act 1999 may be partly to blame for the 2008 crisis just like banking deregulation had an effect on the S & L crisis. Lenders and investors leverage was not capped as a result of the Steagall Act 1999 resulting in cheap credit that was passed down from mortgage holders to investors. Deregulation resulted in risky investments by banks and investorswithout many implications for anyone during the S & L crises because of the role of the FLIC. The biggest difference between the 2008 and S & L crises was the sheer enormity of the deficit. The 2008 crises resulted in trillions as opposed to billions pumped into the economy during the S & L crises. The overall effect on the economy was much more extensive as a result of the 2008 crises.
The Federal Government pumped trillions into the economy to stop the economy collapsing probably mitigating the effects of bank foreclosures in 2010. Between January 2007 to December 2011. There were more than 4 million foreclosures and 8.2 million starts at foreclosures. There were 3.5 % of homes in the national foreclosure inventory in May 2011 with the number increasing. From 1931 to 1935 foreclosures exceeded 1 %. Despite the larger percentage of mortgages effected in 2010, there were far less effects on the banking industry and homeowners. The depositors were covered by the Federal Deposit Insurance Corporation (FDIC) in the event of bank failure. Banking foreclosures were almost unfounded because of better government regulation, automatic stabilizers and discretionary fiscal or monetary policy. The insurance limit for depositors was also raised from $100, 000 to $250, 000 helping to prevent any depositor panic. There was a better safety net for those that lost their houses such as welfare, food stamps and ‘extended benefits of 99 weeks’ during the recession. None of these existed during the depression causing a much more stable market despite the bad economic downturn.
References
Blomquist, D. (2012). 2012 Foreclosure Market Outlook. Retrieved from http://www.realtytrac.com/content/news-and-opinion/slideshow-2012-
CoreLogic. (2012). CoreLogic Reports 63,000 Completed Foreclosures in May. Retrieved from http://www.corelogic.com/about-us/news/corelogic-reports-63,000-completed-foreclosures-in-may.aspx
Effros, R. (1997). Current Legal Issues Affecting Central Banks. Washington: International Monetary Fund.
Investopedia. (2016). Macroeconomics - Discretionary Fiscal Policy and Automatic Stabilizers. Retrieved from http://www.investopedia.com/exam-guide/cfa-level-1/macroeconomics/discretionary-fiscal-policy-stabilizers.asp
Office, U. G. (1996). Financial Audit: Resolution Trust Corporation's 1995 and 1994 Financial Statements.
Wheelock, D. (2008). The Federal Response to Home Mortgage Distress: Lessons from the Great Depression. Federal Reserve Bank of St Louis Review , 133-48.
