The Savings and Loan Crisis, or commonly known as S&L, is termed as one of the largest financial crisis in the United States history. The crisis began in the late 1970s, and its impacts on the economy were felt in the 1980s and ended in the early 1990s. Various sources have indicated the causes of the S&L crises. Some of the documented reasons include high and volatile interest rates during the period, the phase-out and its elimination, negative regional economic conditions, and federal and state deregulation of depository institutions. Other reasons include deregulation of the thrift industry, declining regulatory capital requirements, the excessive chattering of emerging thrifts, the withdrawal of federal tax laws in 1986, the emergence of the brokered deposit market, and delay in identifying the thrift insurance funds (Curry and Shibut 27). These factors, especially the volatile interest rates, influenced the depositors to shift to the money market in search for high-interest rates, and hence adversely affecting the S&Ls. After the regulations in S&L had been loosened, the S&L started participating in risky activities such as investments in unwanted bonds and lending in commercial real estate (Federal Deposit Insurance Corporation 180).
The root of the crisis
The financial innovation was seen as the main predictor of the savings and loans crisis. The financial innovation worsened the situation by introducing the new financial instruments that facilitated the risk-taking activities. For instance, the junk bonds, financial futures, and swaps among other instruments enhanced the risk-taking activities of banks and consequently broadened the scope of the moral hazard problem. New legislation such as Depository Institutions Deregulation and Monetary Control Act (DIDMCA) allowed the Savings and Loans institution and mutual saving banks to participate in risky activities (44). By 1980, the FSLIC (Federal Savings and Loan Insurance Corporation) has insured about 4,000 federally and state chartered saving and loan institutions that had accumulated total assets of $604 billion. Similar to the mutual savings banks, the savings and loan institutions were incurring losses because of the liability/asset mismatch and upwardly spiraling interest rates. The savings and loan's income decreased sharply from $781 million in 1980 to negative $4.1 billion and $4.6 billion in 1982 and 1981 respectively (Federal Deposit Insurance Corporation 168).
During the Reagan administration, the financial deregulation and innovation contributed to power expansion for the savings and loan industry, which consequently led to several issues in the industry. According to Mishkin, "many S&L managers did not have the required expertise to manage risk appropriately in these new lines of business" (45). In addition, the expansion of power among the S&L contributed to the prompt growth in new lending, especially in the real estate industry. Even if some managers were proficient in S&L industry, the growth of credit in the sector outweighed the available information resources to manage the banking institutions. The other emerging problem was that the rapid growth of the S&Ls and the lending activities become complex, and hence required effectively regulatory system to monitor such activities appropriately. However, the main regulator of S&L institutions, FSLIC did not have adequate resources and expertise to monitor the activities appropriately. Consequently, the inadequate regulatory apparatus, the risk for moral hazard incentives exacerbated, and this led to the excessive risks in the S&Ls, which contributed to bad loans and huge loans in the industry (Federal Deposit Insurance Corporation 168).
Reforms to Help the United States survive the crisis
For the United States economy to survive, the Congress identified the resolution to mitigate the thrift industry's problem in the late 1980s. The Congress enacted the Financial Institutions Reform, Recovery and Enforcement Act (FIRREA) in 1989 and involved the taxpayers in mitigating the problem (Curry and Shibut 28). This institution established many reforms to clean up the industry. During the same period, the Federal Home Loan Bank Board, the key S&L regulator, was demolished, and Congress replaced it with the Office of Thrift Supervision (Robinson). The Congress also retained the thrifts' insurance on the Federal Deposit Insurance Corporation (FDIC). Additionally, the RTC (Resolution Trust Corporation) was developed and funded to mitigate the remaining issues in the S&L industry. One of the significant moves of cleanup in the industry involved closing about 747 Savings and Loans that had assets worth $407 billion (Robinson). The crisis ended December 31, 1995 when the RTC was closed. The thrift crises cost the taxpayers around $124 billion and $29 billion to the thrift industry (Curry and Shibut 33). The crisis also acted as a cornerstone of reform legislation that enhanced profitability and stability.
The Federal Deposit Insurance Corporation Improvement Act (FDICIA) covered several reforms that were aimed at regulating and supervising banks, and the FDICIA allowed the Federal Reserve to be involved in the earlier mitigation of bank failure. In addition, the FDICIA ordered the closure of the failing banks using the least-cost method. FIRREA also allowed the regulators to limit the institution's activities and growths as a way of enhancing the powers of the banking regulatory agencies. These and other measures allowed the crises to end after lasting for almost 25 years. In 1982, the effect of crisis was reflected by the negative economic growth rate of -1.9, which was relatively worse compared to -0.3 in 2008 (The World Bank).
The Principal-Agent Problem
In the process of solving the crisis, the involvement of the politicians and regulators led to the principal-agent problem. The politicians and regulators were the ultimate agents for the principles (voter-taxpayers) because it turned out that the taxpayers were bearing the cost attributed to losses in the deposit insurance agency. In other words, the political system in the United States created a serious issue of the principle-agent problem. The politicians were strongly inclined to create the incentives that favored their own interest instead of the interests of the taxpayers. Given that the increasing cost of the political campaigns in the United States, the politicians strived to raise substantial funds for their campaigns instead of focusing on the public interest (Mishkin 49). Consequently, "lobbyist and other campaign contributors with the opportunity to influence politicians to act against the public interests" (Mishkin 49). For instance, scandal related to Lincoln Savings and Loan Association and Charles H. Keating, Jr. provides a good example of the principal-agent problem. The scandal of Lincoln Savings and Loan cost the taxpayer approximately $2 billion and was coined as the most costly savings and loan institution of that time (Mishkin 48).
Strategies to mitigate the situation
However, despite the agent-principal problem, various strategies were formulated to mitigate the crisis. After George W. Bush had resumed the office, the new legislation was proposed to offer adequate funding to eliminate the insolvent S&Ls in the industry. It is during this period that the FIRREA to conduct major provisions. These provisions included restructuring of the regulatory apparatus to eliminate the FSLIC and Federal Home Loan Bank Board (FHLBB) that failed to regulate the sector. The Office of Thrift Supervision (OTS) resumed the roles of the FHLBB, and the OTS has the similar responsibilities to the Office of the Comptroller of the Currency. On the other hand, the FSLIC responsibilities were relegated to the FDIC, which became the administrator of Federal Deposit Insurance system. This was facilitated through two main insurance funds: Savings Association Insurance Fund (SAIF) and Bank Insurance Fund (BIF) (Mishkin 49).
The most significant feature of the FDICIA is the corrective action provisions that demanded the FDIC intervene vigorously and on time when the bank experiences the problem. To prevent such problem to happen in the future, the banks have been categorized into five distinct groups with respect to the bank's capital. The first group was known as "well capitalized," because banks in this group exceeded the minimum capital requirements. The group 2 was recognized as "adequately capitalized" because the banks in this group satisfied the minimum capital requirements and were subjected to correcting action. Banks categorized group 3 were recognized as "undercapitalized" because they failed to meet the minimum capital requirements. The other categories, group 4 and 5 were recognized as "significantly undercapitalized" and "critically undercapitalized," and were not permitted to give interests on their deposits that exceeds the average (Mishkin 50).
Description of a Savings and Loan Institution
Saving and Loan Institution is a financial association that deals with deposits, mortgage loans, and savings and is one of the fundamental sources of mortgage loans in the United States today. The borrowers and depositors are members of the institution, and they have voting rights and can direct the managerial and financial goals of the institution. They are characterized by locally or privately managed financial organizations and disperses loans for refinancing, construction, and home repairs. In 1965, before the crisis, the S&Ls were 6,071, and they have reduced to 327 by 1989. The decrease because of the high-interest rates that continue to increase the borrowing costs hence discourage the mortgage business. In addition, the stiff competition emerged and hence limited the S&Ls from making the profits that they used to make. However, the numbers have increased to 1,103 at the start of the 21st century, and they retain the second position in the repository for consumer savings (Economic History Services).
Comparing the S&L crisis and the 2008 financial crisis, both crises shares the same root causes indicating that the S&L crisis did not provide a substantial message on how to avoid such crisis in the future. For the S7L crisis, the principal-agent problem revealed how the politicians concentrated on their own interests rather than the interests of the public in the United States. Similarly, the financial crisis is attributed to the failure of the government to regulate and limit Wall Street borrowing. The bank also failed to limit the financial ties between the investment banks and the rating agencies and failed to develop a system to punish and reward based on their long-term performance. In addition, similar to commercial real estate in the S&L crisis, the securitization was perceived as the safest way to obtain high returns. However, things went wrong, and the value of securities plunged to a level below what the bankers had anticipated (Cohan).
Works Cited
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Curry, Timothy, and Lynn Shibut. "The Cost of the Savings and Loan Crisis: Truth and Consequences." FDIC Banking Review (1986).
Economic History Services. "Savings and Loan Industry (U.S.)." Economic History Services, Web. 27 Apr. 2016. <https://eh.net/encyclopedia/savings-and-loan-industry-u-s/>.
Federal Deposit Insurance Corporation. History of the Eighties: Lessons for the Future. An Examination of the Banking Crises of the 1980s and Early 1990s. Washington: Federal Deposit Insurance Corporation, 1997. Print.
Mishkin, Frederic S. The Economics of Money, Banking, and Financial Markets. 7th ed. Harlow: Pearson, 2004. Print.
Robinson, Kenneth J. "Savings and Loan Crisis - A Detailed Essay on an Important Event in the History of the Federal Reserve." The Federal Reserve History Gateway Provides Historical Materials That Illustrate How the Fed Has Changed over Its First 100 Years. The Federal Reserve History, 22 Nov. 2013. Web. 27 Apr. 2016. <http://www.federalreservehistory.org/Events/DetailView/42>.
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Wadhwani, R. Daniel. Why does the US have a weak mutual savings bank sector? World Savings Banks Institute/European Savings Banks Group, 2011. Print
