What Exactly Was the Savings and Loan Crisis?

The Savings and Loan Disaster (S&L) was a long-term financial crisis. Between 1986 and 1995, more than three-quarters of the 3,234 savings and loans companies across the United States failed, bringing the crisis to a close.

The problem arose during the volatile interest rate environment, stagflation, and poor growth in the 1970s. It totaled $160 billion, of which $132 billion was paid by taxpayers. 1 The lack of a proper match between regulations and markets, market fluctuations, and moral risk posed by the combination of taxpayer guarantee in conjunction with regulation, as well as outright fraud and corruption, as well as the introduction of relaxed and expanded lending rules that forced desperate banks to take on too much risk, were all key factors in the S&L problem, which were counterbalanced by insufficient capital in reserve.

The Savings and Loan Crisis: An Overview

When the economy tanked and inflation rose, the limits placed on S&Ls by legislation like the Federal Home Loan Bank Act of 1932–such as the limiting of interest rates offered on deposits and loans—significantly limited their ability to compete with other lending organizations. S&Ls, for example, couldn’t compete with traditional banks due to lending limits when depositors piled money into newly founded funds called money market funds in the early 1980s.

In addition to a recession brought on by the Fed’s decision to raise interest rates in order to combat double-digit inflation, the S&Ls were left with an ever-dwindling portfolio of mortgage loans. Their cash flow has been exceedingly limited.

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How the Crisis Played Out

In 1982, President Ronald Reagan signed Garn-St. The Germain Depository Institutions Act abolished loan-to-value ratios and interest rates for S&Ls. It also permitted them to maintain 30 percent of their money in consumer loans and 40 percent in business loans. They were no longer subject to Regulation Q, which caused the spread between the cost of borrowing money and the returns on assets to reduce.

Because the reward was not linked to the risk, zombie thrifts began providing higher and higher rates to attract capital. S&Ls began to invest in commercial real estate and, more dangerously, junk bonds. The premise behind the strategy of investing in more risky and riskier projects and products was that they would yield larger yields. If these profits do not materialize, taxpayers – through their participation in the Federal Savings and Loan Insurance Corporation (FSLIC)]—rather than S&L officials or banks]—will bear the brunt of the cost. This is precisely what occurred.

The combination of unregulated capital and lending regulations, as well as a taxpayer-funded guarantee, created a significant moral risk for the S&L business. S&Ls were allowed to take on more risk and were rewarded for taking excessive risks. This resulted in the industry’s rapid expansion as well as an increase in the risk of speculative speculation.

At first glance, the steps appeared to be working, at least for some S&Ls. S&L investments had increased by more than 50% in 1985, and they were increasing at a considerably faster rate than bank assets. In Texas, S&L growth was exceptionally significant. S&Ls were allowed to grow their operations by allowing them to invest in speculative real estate by certain state legislators. However, roughly one out of every five S&Ls was losing money in 1985. 1

Meanwhile, despite mounting pressure on FSLIC’s bank accounts, even failed S&Ls were allowed to continue lending. The FSLIC was declared bankrupt in 1987. They reconfigured the FSLIC and exposed taxpayers to more risk, rather than allowing it and S&Ls to fail as they were sure to do, and then recapitalizing the federal government. Meanwhile, the S&Ls were allowed to keep increasing risk.

Fraudulent S&L

Certain S&Ls have adopted a “Wild West” mentality, with insiders openly committing fraud. A popular fraud comprised two partners working with an appraiser to buy land using S&L loans and then flipping the property for a large profit. Partner 1 would pay the assessed market value for the land. After that, the two would work with an appraiser to have it reapplauded at a higher value. The property would then be transferred to Partner 2 in the name of an S&L loan that was never paid. The proceeds were to be split between the appraiser and both partners. Certain S&Ls were aware of the frauds and enabled them to happen.

Law enforcement officers were hesitant to pursue incidents of fraud, even when they were aware of them, due to staffing and workload issues, as well as the intricacy of these cases.

Resolution to the Savings and Loan Crisis

Congress passed the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA) in the aftermath of the S&L crisis, which amounted to a significant revamp of S&L industry laws. The establishment of the Resolution Trust Corporation, which had the goal of removing the failed S&Ls that regulators had taken over, was one of FIRREA’s main and critical moves.