Politics & Policy

Heads I Win, Tails You Lose

EDITOR’S NOTE: The August 31, 1992, issue of National Review, set out to set the record straight about the Reagan administration’s economic record. We reprint the content of the issue here.

No, Virginia, Ronald Reagan did not cause the savings-and-loan crisis. The time bomb that became that crisis was designed in the 1930s, tested in the 1960s, and ignited in the 1970s. A July 1981 report to the Federal Home Loan Bank Board (the federal agency that regulated the S&Ls) concluded that the industry’s net worth “was overstated by $152.3 billion, on a market-value versus book-value basis, at the end of 1980.” Since the book value of the S&L industry at the end of 1980 was only $32 billion, this implies that its market value was minus $120 billion at that time–before Reagan took office, before the deregulation of deposit rates and the types of assets the S&Ls were allowed to own.

In most industries, of course, such losses would be borne by the investors in the affected firms. As a consequence of a series of unwise policy decisions that date back to the 1930s, however, most of the losses of the S&L industry ended up as liabilities of the Federal Government, i.e., the taxpayers.

After this time bomb exploded, some negligence at damage control by the Reagan Administration and overt obstruction by several members of Congress compounded the problem, but its general nature of magnitude was a consequence of policies that Reagan inherited. As of 1992, federal taxpayers will probably be liable for about $200 billion to close or reorganize the insolvent S&Ls, about the same (adjusted for inflation) as the negative net worth of the industry in 1980. More disturbingly, the basic policies that led to the S&L crisis (and a similar but smaller problem for the commercial banks) have not yet been changed.

How did this happen?

First, the structure of the savings-and-loan industry was designed in Washington, rather than by evolutionary market processes. A 1932 act created the Federal Home Loan Bank System, with a structure much like that of the Federal Reserve System, to increase the funds available to reasonably solvent S&Ls to finance home mortgages. A 1933 act authorized the Federal Home Loan Bank Board to charter and regulate federal savings-and-loan associations; most of the loans by the member associations were initially restricted to mortgages secured by houses within fifty miles of the association’s home office. These restrictions made the assets of S&Ls unusually vulnerable to conditions in the local real-estate market.

More important, the S&Ls faced unusual interest-rate risks. Most of their liabilities were savings accounts (and later, demand deposits) with variable interest rates and subject to withdrawal on short notice. Most of their assets, however, were thirty-year mortgages at fixed rates. This made the solvency of S&Ls unusually vulnerable to an increase in short-term interest rates. No financial intermediary with these types of restrictions could survive in a free market. For several decades, however, the S&Ls were sustained by three types of preferences. Solvent associations are allowed to borrow from the Federal Home Loan Banks and securitize their mortgages through the several government-sponsored mortgage associations, each of which has an implicit federal guarantee that reduces their borrowing costs.

S&Ls were exempt from federal income taxes until 1951 (although starting them, this tax preference was gradually reduced until it was nearly eliminated by the Tax Reform Act of 1986). And from 1966 to 1984, the S&Ls were allowed to pay a slightly higher interest rate, initially half a percentage point, than commercial banks on similar accounts. The combination of the post-World War II housing boom and these several preferences sustained a rapid growth of the S&L industry through the early 1970s, despite the unique asset and interest rate risks to which these associations were subject.

Second, the unique vulnerabilities of the S&Ls would, even so, have been a problem only for their depositors and investors in the absence of another policy innovation of the 1930s. A 1934 act created the Federal Savings and Loan Insurance Corporation to insure the accounts at all federally chartered S&Ls and at those state chartered S&Ls that elected this insurance. The terms were the same as for commercial banks. The premiums were set at a low flat rate, regardless of the risks to the insurance fund from individual associations. Accounts were first insured up to $5,000, a limit that was increased in steps to $100,000 by 1980. Moreover, the typical procedure for closing an insolvent bank or S&L effectively extended this insurance to accounts of any size.

The objective of deposit insurance was to prevent the types of runs to which even solvent banks were subject in the early 1930s, and it has been effective in this regard. The problems of deposit insurance, however, were also recognized by scholars, bankers, and key public officials at that time. Both the American Bankers Association and Franklin Roosevelt, who did not agree on many issues, opposed deposit insurance for three reasons: First, it means there is no incentive for depositors to monitor the solvency of the banks and S&Ls in which their funds are deposited. Second, the flat-rate premiums provide no incentive to the owners to maintain solvency; in effect, these premiums represent a subsidy from solvent institutions to weak ones. Most important, deposit insurance creates a moral hazard for the owners of weak or insolvent banks and S&Ls, in effect setting up a one-sided bet. If they make unusually risky loans that do not later default, all the returns accrue to the owners; if these loans fail, the losses are borne by the insurance fund and, ultimately, the taxpayers. Heads I win, tails you lose. One should be surprised only that the insured depositories did not attract more crooks and frauds.

One consequence of these problems is perverse runs from solvent banks to insolvent banks, until the solvent banks increase their deposit rates to match those set by the insolvent banks. The most dramatic consequence, of course, is that the taxpayers have now been left with the bill for the insolvent S&Ls.

Ticking Away

All right, smart aleck, you may be asking, if these problems were so clear, why didn’t this time bomb explode until the 1980s? The primary reason was that inflation and interest rates were low and stable until the late 1960s. In fact, this time bomb was severely tested (without exploding) by increases in short-term interest rates in 1966, 1969-70, and 1973-74. The first policy response to the interest-rate squeeze of 1966 was to establish controls on the deposit rates of the S&Ls, only compounding the longer-term problem. A 1968 act permitted the S&Ls to issue longer-term liabilities but allowed only minor diversification of their assets. These episodes of rising short-term interest rates reduced the earnings of the S&Ls but were too brief to induce many insolvencies or a major policy response. In the meantime, the controls on deposit rates contributed to a loss of deposits to the new (unregulated and uninsured) money-market mutual funds created by securities firms in the 1970s.

The spark that finally ignited this time bomb was the rapid increase in inflation and interest rates from 1978 through 1981. In this period, the typical S&L found itself with a portfolio of mortgages yielding 8 per cent, at a time when the inflation rate was 10 per cent and the smart money was going into money-market funds at 14 per cent. Most S&Ls were effectively insolvent, even if their books showed some positive net worth.

For the most part, the policy responses to this episode were correct. The S&Ls were authorized to issue variable-rate mortgages in 1979. A 1980 act phased out the deposit-rate controls and broadened the range of assets that an S&L could own; the one major mistake in this act, a last-minute decision of the conference committee, was to increase the limit on insured deposits from $40,000 to $100,000. A 1982 law further broadened the asset powers and enforced the due-on-sale clauses in existing mortgages. This deregulation of deposit rates and asset powers was necessary to avoid a precipitous collapse of most of the S&L industry.

As it turned out, however, such measures only delayed the day of reckoning. The S&Ls then faced a series of asset shocks, the most important of which were due to the 1981-82 recession, the collapse of oil prices in 1986, and the general weakness in real estate markets following the Tax Reform Act of 1986. Some of the insolvencies were due to irresponsible loans of the types recently authorized; most were not. In fact, two of the newly authorized assets, credit cards and high-yield “junk” bonds, had the highest net yield in the S&L portfolios. Deregulation gave the S&Ls greater opportunity for both irresponsible and prudent behavior. The incentive for irresponsible behavior, however, was (and remains) attributable to the combination of deposit insurance and inadequate private capitalization of the depository institutions.

As part of the general assault on the Reagan years, a Washington Post editorial (April 28, 1992) concluded that “Deregulation, combined with the egregious failure to enforce the remaining rules, led to the gigantic costs of cleaning up the failed S&Ls.” Some people never learn! The failure of the S&Ls was primarily due to the combination of the excessive regulation and the increase in inflation prior to 1981. The cost of this failure to the taxpayers is entirely attributable to the flawed system of federal deposit insurance. The policy of general reluctance to close the failed S&Ls in the 1982 act was wise, based on a correct expectation that the interest-rate problem would soon be resolved. The later forbearance toward specific S&Ls, usually in Texas and California, was primarily due to strong pressure from leading members of Congress, such as House Speaker Jim Wright and the Keating Five. Management of the savings-and-loan crisis by the Reagan Administration was faltering but not egregious, given the overwhelming burdens on regulators working for an agency that reported to Congress and was unusually responsive to industry concerns.

The appropriate charge against the Reagan Administration and Congress was that they failed to change the major policies that led to the S&L crisis. Unfortunately, these still have not been changed. A 1989 act authorized funds to close many of the insolvent S&Ls and reassigned the regulators to the Treasury but did not change the deposit-insurance system. Capital standards were increased but the asset powers of the S&Ls were reduced. This act reflects a misperception that some of the effects of deregulation, such as brokered deposits and investment in “junk” bonds, were the primary cause of the S&L crisis. The premise of this act is that conscientious regulators can identify and close weak S&Ls before they become insolvent. Maybe so, but I doubt it. This patchwork of policies may be sufficient in the absence of another surge of inflation. In the meantime, however, the Bush Administration has persistently (and recently) pressured the Federal Reserve for a more expansive monetary policy.

Stay tuned for another episode in the continuing saga of your friendly neighborhood S&L.

Mr. Niskanen, who served on the Council of Economic Advisors from 1981 to 1985, is currently the chairman of the Cato Institute.

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