The savings and loan crisis of the 1980s and 1990s (commonly dubbed the S&L crisis) was the failure of approximately a third of the savings and loan associations (S&Ls or thrifts) in the United States between 1986 and 1995. These thrifts were banks that historically specialized in fixed-rate mortgage lending. The Federal Savings and Loan Insurance Corporation (FSLIC) closed or otherwise resolved 296 thrifts from 1986 to 1989, whereupon the newly established Resolution Trust Corporation (RTC) took up these responsibilities. The two agencies closed 1,043 banks that held $519 billion in assets. The total cost of taxpayers by the end of 1999 was $123.8 billion with an additional $29.1 billion of losses imposed onto the thrift industry.
Starting in 1979 and through the early 1980s, the Federal Reserve sharply increased interest rates in an effort to reduce inflation. At that time, thrifts had issued long-term loans at fixed interest rates that were lower than prevailing deposit rates. Thrifts were forced to increase interest rates on deposits to retain them; this had, however, the effect of squeezing their net interest margins and creating large losses. Nor could outflowing deposits simply be paid out by sale of now less-valuable assets. The result was that about one third of S&Ls became insolvent, causing a first wave of failures in 1981–83.
When the problem became apparent, Congress acted to permit thrifts to engage in new lending activities with the hope that they would diversify and become more profitable. This included issuance of adjustable-rate mortgages and permission to enter into commercial real estate lending. Lower capital requirements and permissive accounting standards also allowed weaker thrifts to continue operating even though under the old rules or US GAAP they would have been insolvent. These changes allowed for substantial risk-taking and thrift industry growth. Many new thrifts were formed in the American southwest and levered themselves to substantial size rapidly. The regional concentration of thrift investments there, along with thrifts' inexperience in the new types of lending they had entered, proved highly fragile. When property prices in those regions dropped in 1986, a second and larger wave of failures started.
The thrift deposit insurer, the FSLIC, was unable to pay for all these failures and became insolvent. The FSLIC's financial weakness, along with congressional pressure, also forced regulators to engage in regulatory forbearance. This allowed insolvent thrifts to remain open and tied FSLIC to capital injections. Attempts to recapitalize the FSLIC arrived both too late and in insufficient amounts. Failures continued to mount through 1988 and by February 1989, congressional legislation – the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 – was brought to establish the Resolution Trust Corporation to wind down all remaining insolvent thrifts. The law also brought more stringent capital regulations for thrifts and an increase in supervisory resources. Responsibility for thrift supervision and thrift deposit insurance were also transferred, respectively, to the then-new Office of Thrift Supervision and the Federal Deposit Insurance Corporation.
Causes
Thrift institutions originated in the 19th century with the goal of pooling resources among members to make loans with which to purchase residential properties. The industry grew rapidly at over 10% annually in the postwar period amid government support for home financing. At the time, thrifts were regulated by two – or three, if state regulators are included, – institutions. Examinations were conducted by the Federal Home Loan Bank Board (FHLBB); but supervisory authority was separate and resided in regional Federal Home Loan Banks. Conflict of interest concerns also existed in the privately owned home loan banks, leading to poor working relationships between federal employee examiners and the private supervisors. Delays between examinations and their reports arriving to supervisors also meant that supervisory action, if it were to be taken, would be months late. Weak enforcement powers, along with thrifts' rights to contest unfavourable reports, meant the Federal Home Loan Bank Board was highly deferential to bank management.
Interest rate increases
The early 1980s saw a recession along with high interest rates, which stressed both thrift and other banking institutions considerably. Negative net interest margins, due to the low interest earned on assets with high deposit interest expenses needed to retain deposits, caused a wave of thrift failures between 1981 and 1983. Federal regulations, especially Regulation Q, placed caps on deposit interest rates. Depositors responded by withdrawing their cash and depositing them in money market mutual funds. In response to these outflows, Congress passed the Depository Institutions Deregulation and Monetary Control Act of 1980 which phased out Regulation Q interest rate caps and expanded thrift lending powers to include construction loans. The deposit insurance limit was also raised from 40,000 to 100,000 dollars per account. The phase-out of deposit interest rate caps, however, caused thrifts' deposit interest expenses to increase substantially as they scrambled to retain depositors. The resulting decline in profitability led to a wave of thrift failures in 1981–83.
Many of these failures were outside of their managers' control. The high and volatile interest rates in the early 1980s meant that even thrifts with diversified residential mortgage portfolios, constrained by existing price caps, became unable to meet their obligations. The historical institutional characteristics of thrift institutions – low loss rates accompanied by low earnings and capital – were stable but severely challenged by these market conditions.
Deregulation and commercial lending
The 1982 Garn–St. Germain Depository Institutions Act completed a process of deregulation that provided relief to weak thrifts by allowing their deposit insurer, the Federal Savings and Loan Insurance Corporation (FSLIC), to provide direct capital injections through "net worth certificates". The Garn–St. Germain Act also hugely expanded thrift lending powers, allowing them to engage in commercial real estate and line-of-credit lending, which many thrifts eagerly exploited. Between 1980 and 1986, thrifts' residential mortgage holdings as a proportion of assets fell from over 80 percent to less than 60.
These new lending powers were not accompanied by any increase in supervisory resources or powers. The view at the time was that the interest rate environment would quickly ease, allowing for thrifts to restructure their asset portfolios, and that expanded lending powers would allow for thrifts to diversify their portfolios and engage in more profitable lending activities. It was expected that thrifts would continue being the relatively docile institutions they had then always been and diversify their portfolios prudently; few believed at the time that these deregulatory episodes would allow thrifts to engage in excessively risky lending.
Many of the loans made under expanded lending powers were concentrated in rapidly-growing states such as California, Florida, and Texas. Lax state supervision and highly permissive leverage restraints allowed thrifts in these states to expand rapidly, taking on considerable risk concentrated in these business lines and geographic regions. The highly-sensitive nature of commercial real estate values to local economic conditions made these thrifts highly sensitive in turn to those local economic conditions. These issues were compounded by the relative inexperience of thrift staff in evaluating risks of commercial lending and equity investments.
The deregulatory policy of the Reagan administration, enforced by its appointment of thrift executive Edwin J. Gray, reduced thrift examinations between 1981 and 1984 by 26 percent. Normalized per institution or by assets held, FSLIC-insured institutions' supervisory resources were stretched. However, Gray's position reversed after the fraud-induced failure of Texas-based Empire Savings and Loan: he spent the next two years increasing examination resources and tightening financial regulations. Such efforts were, however, not supported by industry groups or the Reagan administration.
Forbearance
Attempts to smooth over rough market environments included considerable regulatory forbearance: when a regulator decides not to apply regulations that normally would disrupt the operation of a bank. The FHLBB therefore progressively lowered net worth requirements from five percent in 1980 to three percent in 1982. Lax phase-in rules also meant that many newer savings and loan institutions could be required to have net worth requirements lower than three percent; in fact, new institutions could be levered from two million dollars in capital to $1.3 billion in assets (a multiple of 650) in about a year.
FHLBB also chose to adopt regulatory accounting principles which allowed institutions to defer reporting of losses and treat more instruments as capital. Accounting rules over supervisory goodwill (a type of intangible asset) were also liberalized, making it easier for thrifts to purchase insolvent thrifts. Since this substituted for the normal cash injections from FSLIC due to the insurer's limited financial resources, this utilised such goodwill as essentially an accounting fiction. Such lenient accounting rules, however, also had the effect of preventing the FHLBB from intervening against thinly capitalised institutions whose balance sheets were supported by intangibles. Policy responses chosen by the Reagan administration, and adopted by the FHLBB under pressure, also led to demands not to use taxpayer money. Along with political demands not to alarm the public by closing institutions, these constraints forced FHLBB into a policy of "hiding the poor condition of [thrifts] behind accounting gimmicks".
By 1983, even though the interest rate environment had substantially eased, a tenth of thrifts were insolvent on a GAAP basis, with those institutions controlling 35 percent of thrift industry assets. Even so, such institutions were allowed to continue operating and thereby exposed taxpayers to eventual losses through their failure and following deposit insurance claims.
Fraud
Several high-profile casualties of the crisis involved fraud. A variety of methods were identified. For example, a thrift officer could extract compensation and other benefits from origination fees on low-quality loans. Alternatively, they could collude with developers to book paper profits that were extracted and eventually placed on the government, or simply pay themselves high compensation until the thrift became bankrupt, and place the responsibility for paying off depositors onto FSLIC. William K. Black gained considerable notoriety for his leadership in prosecuting Charles Keating, who was temporarily successful in blocking Black's investigations, because campaign contributions coordinated by Keating had saved Jim Wright from financial ruin and elevated him to the Speaker of the House. Keating also had bought support from five US Senators, but it was not enough to keep him out of prison. Black said that many senior executives can find accountants and auditors willing to conspire to commit fraud; he coined the term "control fraud" to describe this phenomenon.
However, such fraud was not the core reason for the crisis. Estimates of the number of failures that involved fraud or insider abuse ranges considerably due to the difficulty in detecting fraud and distinguishing it from bad business judgment. An Office of the Comptroller of the Currency study in 1988 indicated fraud in 11 percent of failures between 1979 and 1987; a Federal Deposit Insurance Corporation study indicated involvement in 25 percent of failures in 1989; a Resolution Trust Corporation study in 1992 found fraud in 33 percent of its cases; and a 1994 General Accounting Office study reported 26 percent of banks that failed in 1990–91 had issues with fraud. The most clear cases of fraud both within and without of the thrift system were concentrated in a few large institutions that had grown substantially and were alleged to have conspired to manipulate junk bond markets with thrift directors for personal gain.
Regardless, there was fraud and insider abuse in many cases. The Crime Control Act of 1990, after the crisis, established a special counsel to investigate and prosecute fraud in financial institutions. Between 1988 and 1992, the Department of Justice sent 1,706 bankers to prison and found guilty verdicts in 2,603 cases. Expert estimates as of a Congressional Budget Office report in 1992 as to the proportion of losses due to fraud eventually borne by the government range from three to 25 percent, with a more narrow consensus estimate in the range 10–15 percent (corresponding to taxpayer losses of 16–24 billion dollars).
Thrift failures
Realisation of interest-rate risk in the early 1980s led to a short series of failures that impelled a deregulatory episode from 1980 to 1981. The failure of Empire Savings and Loan in 1984 also drove the FHLBB to reverse course and tighten regulations on thrifts. Such actions were too late, however, since the poor loans had already been made and were already on thrift balance sheets.
The condition of the banking system as a whole was also not entirely solid. The rapidly changing legal environment, along with new financial technologies, also destabilised commercial banks. 1984 saw the largest commercial bank failure to date, that of Continental Illinois, which was infamously branded "too big to fail". The bank failed amid a rise in foreign non-performing loans (mostly in Latin America) and an electronic bank run. The FDIC stepped in to prevent the failure of almost 2,300 smaller banks which had their money in Continental and a general panic.
Moreover, even by 1983, FSLIC's reserves were clearly inadequate for the thrifts that had already by that time failed: with just a bit more than six billion dollars in reserve, outstanding claims by that point already totalled $25 billion.