Transcript Inflation, Deregulation and Recession

An Analysis of the Savings and Loan Crisis of
the 1980s:
Inflation, Deregulation and Recession
Adam D. Zubritsky
ECO 6226
Seminar in Money and Banking
Summer, 2004
Topic
This paper focuses on the Savings and Loan industry crisis in
the 1980s. A history of savings and loans, characteristics of the
industry and macroeconomic events that led to the crisis, and
the overall impact on domestic GDP are analyzed. The savings
and loan crisis required a government bailout in 1989 since
deposit insurance went bankrupt long before compensating
depositors in over 1500 failed savings institutions. According
to a report from the FDIC, the total cost of the S&L crisis in the
American economy was over $160 billion, with over $132
billion coming from taxpayers.
This topic is important because it relates to other crises in the
financial industry that required federal action. There are many
lessons to be learned from the S&L crisis including the
importance of controlling domestic inflation and interest rates,
designing deposit insurance to minimize moral hazard, and
adequate regulation to prevent such crises.
Definition:
Saving and Loan Associations (thrift institutions) are deposittaking institutions initially created for the purpose of taking in
deposits from private citizens and using them to make home
mortgage loans.
Function:
Intermediation function begins with taking in deposits and
paying interest. A higher return must come from the lending in
the form of home mortgages. This function works best when
interest rates are low and stable.
Provisions:
S&Ls offer savings accounts which earn interest, CDs, and
Negotiable Order of Withdrawal (NOW) accounts, which are
similar to checking accounts. Assets mainly consist of
mortgages, the remaining portion in consumer loans and
government securities.
Early Legislation:
Began as mutual-type or stock-type, state-chartered only.
Home Owner’s Loan Act of 1933 allowed S&Ls to have either
federal or state charters. Oversight/regulation at the federal
level from Federal Home Loan Bank Board (FHLBB).
Glass-Steagall Act of 1933/Regulation Q imposed interest
rate ceilings on deposits, but none on lending.
National Housing Act of 1934 established the Federal Savings
and Loan Insurance Corporation (FSLIC) – the insurer of
deposits in S&Ls
Timeline
1950s-1960s:
Generally stable interest rates and focus on long-term home
mortgage lending leads to successful operation and growth of
S&Ls.
1970s:
High inflation in the U.S. causes nominal interest rates to
skyrocket. Deposit funds begin to flow out of S&Ls and into
higher-earning investments such as mutual funds. S&L deposit
rate ceilings set by Regulation Q are still in place.
Late 1970s:
S&L industry starts showing first signs of buckling and
becoming insolvent.
1980:
Depository Institutions Deregulation and Monetary Control Act
(DIDMCA) Began phasing out interest rate ceilings on
deposits, increased allowance for commercial and construction
lending by S&Ls. These assets had higher returns than
traditional mortgages, but came with greater risk. Deposit
insurance was increased to $100,000 per account without
subsequent increase in insurance premiums, and the moral
hazard and adverse selection problems worsen. Commercial
deposits allowed in S&Ls. Credit cards issued by S&Ls as
another high-interest-earning (but risky) asset.
1981-1982:
Recession hits the U.S. economy. Brakes put on high inflation.
Major increases in S&L failures, but regulators grant
forebearance to institutions that may recover after interest rates
fall and avoid paying out deposit insurance.
1982:
Garn-St. Germain Act allowed S&Ls to offer money market
deposit accounts that paid market interest rates. Allowed even
greater percentage of commercial loans as assets. The FDIC
and FSLIC could now merge institutions across state lines.
This was part of a merger wave designed to avoid having to
close institutions and pay out deposit insurance.
Mid-1980s:
In order to compete for funds, S&Ls must pay higher rates to
depositors. However, due to the long-term fixed-rate
mortgages, the S&Ls are lending money at a lower rate than
they are paying to borrow. Institutions also engage in high-risk
lending and are carrying very little capital in relation to total
assets. This leads to more insolvencies among S&Ls, and also
more forebearance to avoid insurance payouts.
1987:
The FSLIC, which was undercapitalized, goes bankrupt. The
CEBA was created to recapitalize the FSLIC, but this failed.
1989:
Federal Institutions Reform, Recovery, and Enforcement Act
(FIRREA) finally eliminated the FHLBB and bankrupt
FSLIC. The FHLBB was replaced with Office of Thrift
Supervision (OTS) and savings and loans became insured by
the FDIC under the Savings Association Insurance Fund
(SAIF). Initially, they paid higher rates for insurance than
banks. S&Ls could convert their charter to become savings
banks and pay lower deposit insurance premiums. Required
that S&Ls invest a larger share in mortgages along with new
asset and capital requirements. Supervisors could intervene
sooner in cases where an institution showed warning signs of
becoming insolvent.
1989 saw the highest number of S&L failures, many being
closed by the government. The bailout costs were high, and
out of this also came unemployment. The government had to
bail out the bankrupt FSLIC and ensure all depositors received
their deposits.
1990-91:
Recession hits the U.S. economy. Data show that there is a
likely connection between failures of savings institutions and
drops in GDP. However, standard capital/asset ratios and
capital/deposit ratios, the commonly-accepted indicators of
financial solvency, do not accurately reflect the trend in
failures.
Today’s S&L industry is much different. Although both S&Ls
and banks still exist, differences between them have diminished.
Banks now provide mortgage lending, consumer loans, and
commercial loans. Banks have also engaged in many other
types of financial business. All deposits are insured by FDIC
and both banks and thrifts fall under the Deposit Insurance
Fund. This eliminated BIF and SAIF and equalized insurance
rates for all types of institutions.
Other Literature on the S&L Crisis
Papers and books regarding the savings and loan crisis are
overwhelming. This was a major topic of discussion among
academic economists and Federal Reserve researchers in the
late 1980s and early 1990s. The major force was on
identifying the causes of the crisis, what was done wrong, and
how to prevent future collapses in the financial industry. The
overall impact on the U.S. economy was not completely
described in prior analyses.
1.
George Kaufman and Steven Seelig at Loyola University
discuss the costs of the crisis. They conclude that in dollar
terms only 3% of the variance of GDP in the 1980s was
caused by fluctuations in the S&L industry. They do not offer
statistical analysis to back up their claim.
2.
The FDIC collects data on bank and thrift failures. They cite
a connection between low capital/asset ratios and S&L failures
between 1980 and 1988. They also state the cost of the entire
crisis in dollar terms.
3.
Arturo Estrella et. al. at the Federal Reserve Bank of New
York discuss capitalization ratios as predictors of deposit
institution failures. They find that risk-based ratios are no
better at predicting failures than standard ratios, but it is hard
to obtain aggregate measures relating to the default risk of
assets held by institutions.
1.
Christopher Neely of the St. Louis Federal Reserve and
Elijah Brewer and Douglas Evanoff of the Chicago Fed
present papers discussing the role of deposit insurance, moral
hazard creation, and financial crises that require government
bailouts. Neely compares the S&L crisis and subsequent
insurance bailout to the events following September 11, 2001.
2.
R. Alton Gilbert of the St. Louis Fed wrote 2 papers. The
first presents an argument for risk-based capitalization ratios
and risk-based deposit insurance premiums to alleviate the
moral hazard problem. The second paper presents an argument
for shutting down undercapitalized S&Ls and the need for
stronger government supervision to minimize crises.
3.
David C. Wheelock and Philip Dybvig of the St. Louis Fed
also discuss the role of deposit insurance, moral hazard, and
regulations.
Analysis of Paper
Data show that S&L failures precede both recessions. There is
likely causality of as much as 23% of the variation in GDP.
While FSLIC went bankrupt, the government eventually
depositors their lost amounts, preventing widespread bank
panic. This was a transfer of capital. However, time delay
between failure and payout, lost faith in financial institutions,
high government bailout costs that could have been used for
other purchases, and unemployment caused by the closing of
over 1500 institutions led to economic downfall.
Annual Data on S&L Failures
Year
S&L Failures
Year
S&L Failures
1980
11
1992
60
1981
28
1993
7
1982
76
1994
2
1983
51
1995
2
1984
24
1996
1
1985
60
1997
0
1986
59
1998
0
1987
60
1999
1
1988
190
2000
1
1989
327
2001
1
1990
214
2002
1
1991
146
Source: FDIC Web
Site
Estimated Regression:
lnYt* = β1 + β2(lnFAILt*) + β3(lnFAILt-1*) + β4(lnFAILt+1*) + ε
note: lnYt represents detrended real GDP.
* All data is adjusted for serial correlation using the quasifirst differencing procedure.
Variable
Constant
Description
Mean
lnFAILt
S&L failures coincident
1.1045
lnFAILt-1
S&L failures lag
1.1045
lnFAILt+1
S&L failures lead
1.0003
n = 23
R2 = .2296
DW = 1.5341
OLS
-0.00007
(-.016)
-0.01047
(-1.792)
-0.0001587
(-.038)
0.012326
(2.3730)
p = .23293
Real GDP and S&L Failures
Trend GDP and Lead Failures
343
FAILLEAD
GDPFLUC
Variable
266
189
112
35
-43
1975
1980
1985
1990
YEAR
1995
2000
2005
Similar analyses were run to determine the effectiveness of
standard capital/assets and capital/deposits ratios in
predicting S&L failures. The results show that these ratios
are poor indicators of S&L failures. A possible reason for
the lack of correlation could be that forebearance actually
tended to reduce the number of failures despite the low
amount of capital held in so many institutions.
Forebearance was only granted when capital/asset ratios
were generally low. Institutions that were allowed to remain
open and survived into the early 1990s enjoyed low interest
rates. This and tighter regulations made failures extremely
rare after 1993.
What Have We Learned from the S&L Crisis and this Analysis?
1.
We have learned the damaging effects of high inflation and
interest rates on financial intermediaries, an obvious argument
for controlling domestic inflation.
2.
We have learned the negative effects of quick deregulation and
lack of oversight as well as the moral-hazard and adverseselection problems caused by deposit insurance. Also, the lack
of depositor oversight caused by insurance cannot be ignored
either. Deposit insurance should be established so that it
minimizes these problems and yet provides the stability and
protection needed by small depositors.
3.
This analysis has presented evidence that S&L failures were a
leading cause of the recessions of the early 1980s and early
1990s. The failed institutions may have had as much as a 23%
effect on GDP. This is much greater than previously believed.
The recessions partially caused by the S&L crisis were from
deadweight losses, slow payouts to depositors, and
unemployment. Also there was a general loss of faith in
deposit institutions.
4.
We have learned from this analysis that standard capitalization
ratios in general do not go far in determining savings and loan
failures. Risk-based ratios may be more reliable indicators, but
we do not have adequate data at this point for a comprehensive
analysis on this, especially since risk assessments were not
required during the period of the savings and loan crisis.
Questions…
Comments…
Concerns…
Have a great evening!