MSG Team's other articles

11533 The Economics of Lawsuits

The United States of America takes pride in its judicial system. According to most American economists, the judicial system of America is the backbone of the American economy. Since property laws are rigidly enforced, and investors are sure that their economic interests will be protected they tend to invest their money in America. The number […]

12750 Chinese Walls in Investment Banking

The nature of investment banking is such that investment bankers are supposed to work very closely with their clients. In due course of their work, they are often exposed to information that is not public. This material information is not known to the larger public. Hence, this creates a situation in which investment bankers have […]

11065 The Role of Commercial Banks In Liquidity Management

Due to increasing globalization in the world economy, a lot of multinational corporations today have their businesses spread out across several geographies. This creates several management problems for multinational companies. Not only do they have to struggle with the complexity of managing personnel and operations in many countries but they also have to ensure proper […]

11548 Third-Party Risks in an Infrastructure Project

In the previous few articles, we have come across the various types of risk which are present in an infrastructure project. We have discussed the risk of cost overruns as well as the risks of revenue delays and everything in between. However, all the risks we discussed were directly applicable to the infrastructure company or […]

10430 The Need for Derivatives

In the previous article, we discussed as to how derivatives contracts can be dangerous and can pose a systemic risk. Then the question arises as to why are derivates needed at all? If they are dangerous financial instruments, that can pose a risk to the safety of the entire financial universe, then why is it […]

Search with tags

  • No tags available.

The United States banking industry and the economy in general was rocked by the Savings and Loans crisis in the 1980’s. The savings and loans associations had been an important part of the United States banking system. Hence, when one out of every four savings and loans in the US went under water, the nation panicked.

The common man was concerned about the safety of his savings. As a result of the magnitude of this crisis and the unconventional regulatory approaches followed by the regulators, the President had to intervene. The savings and loan crisis ended up growing so big that at one point it threatened to bankrupt the nation. In this article, we will look at this crisis in a bit more detail.

Primary Causes

The savings and loans crisis started with the failure of a few institutions for genuine reasons. Later, however the reasons for the growth and spread of this crisis were completely different. Hence, the reasons that caused the first few institutions to fail can be considered to be the primary causes of the failure. They are as follows

  • Deposit Insurance: The regulatory bodies increased the quantum of insurance on deposits from $40,000 to $100,000 per account. As a result, customers stopped bothering with how the savings and loans institutions invested their money. Even if these institutions lost money, the government had guaranteed the investments! As such a situation of moral hazard was created.

  • Regulatory Changes: The moral hazard situation became much more serious as a result of another law passed by the regulators. The savings and loans institutions were now subject to less stricter controls. They were now allowed to invest a larger portion of their money in commercial real estate. In fact they were even allowed to invest in risky assets such as junk bonds. Therefore, not only were the customers less likely to monitor their investments, but the banks were also willing to take much larger risks!

  • Interest Rate Spike: The savings and loans associations faced their first shock when a severe interest rate spike was declared by the Fed. The Fed raised interest rates steeply in order to rein in inflation. However, the savings and loans institutions had most of their money tied up in mortgages whose interest rates were fixed.

Therefore, these institutions had a mismatch on their balance sheet and started bleeding red ink! The most leveraged savings and loans institutions started collapsing. However, this collapse was thought of as momentary since such high interest had to be a transient phenomenon and could not last forever. Thus as interest rates reset to their normal levels, the savings and loans would be back into profitable business. This early failure of the savings and loans associations was what led to a crisis situation later.

Zombie Savings and Loans

The rising interest rates had knocked a lot of savings and loans out of business. However the regulators let them continue being in business despite the fact that they were technically insolvent. This was because of multiple reasons:

  1. First the regulators did not have the cash to make good on the deposit insurance and close off these institutions. Hence, they modified their accounting in order to make these institutions appear solvent and let them continue business.

  2. Second they believed that given enough time, these savings and loans companies would once again be profitable.

Hence, an era of living dead savings and loans institutions came into existence. These companies were called zombie savings and loans companies. Since these companies had virtually nothing to lose they started taking excessive risks. These were the companies that started offering exorbitant interest rates to depositors. They also made wild investment bets in the market particularly in the commercial real estate sector causing a small real estate crash in the process as well.

The zombies had no incentive to conduct cautious business. They only had two options, one was to be spectacularly successful and become solvent once again or the other was to be a miserable failure and leave the regulators holding the bag in the end.

Spread of the Zombie Savings and Loans

The zombie savings and loans institutions also created problems for the other members of the industry. The high interest rates that they offered drove business away from other industry members also encouraging them to undertake risky practices. The business scenario being what it was, more risk lead to increasingly large number of defaults and within a short span of time, the entire industry was in the red. Classic cases of massive bankruptcies emerged.

Vernon savings had been voted one of the most profitable institutions in the nation a couple of years back and now more than 96% of the loans it made had defaulted. Another superstar from the savings and loans associations, Lincoln savings ended up wiping more than $3 billion from its market capitalization.

It was now that the regulators had serious bankruptcies on their hands and this time the mess could not be solved by overlooking the problem in the name of regulatory forbearance!

The End

The end of the savings and loans crisis saw significant steps being taken by the President. The first was to capitalize the agencies with tax payer money so that they could pay out the depositors insurance and shut the zombie institutions for good. Also, two of the nation’s largest regulatory bodies were disbanded and powerful bureaucrats became unemployed as newer and stricter regulatory norms were created.

Article Written by

MSG Team

An insightful writer passionate about sharing expertise, trends, and tips, dedicated to inspiring and informing readers through engaging and thoughtful content.

Leave a reply

Your email address will not be published. Required fields are marked *

Related Articles

Currency Wars: “Beggar Thy Neighbor” Policy

MSG Team

Cryptocurrencies and Taxation

MSG Team

Common Terminologies Used in Forex Markets

MSG Team