Savings and Loan Crisis

Savings and Loan Crisis
Savings and Loan Crisis

When a trickle of failed savings and loan (S&L) institutions in the 1970s turned into a torrent by the end of the decade, blame was apportioned everywhere. More than a few prominent politicians found themselves implicated in the collapse—some through direct ownership, such as Neil Bush, the son of then-Vice-President George H.W. Bush—and some through investments “placed” by others, such as Bill and Hillary Clinton.

Before the scandal was over, five politicians were investigated on charges of peddling their influence on behalf of Charles Keating. Although none were indicted, the “Keating Five” sparked calls for renewed campaign finance laws.

The S&L crisis had its origins in the laws under which S&Ls operated. Early S&Ls were intended to finance mortgages, and to do that they needed a more stable deposit base than commercial banks (which made loans to individuals and businesses).

Congress therefore allowed S&Ls to pay slightly higher interest rates for deposits, but in turn restricted their lending, prohibiting them, for example, from having checking accounts or lending on consumer items, such as cars or appliances.

This strategy worked well for S&Ls in the 1950s and early 1960s, when interest rates were stable or moved slowly. As long as the S&L had a chance to adapt its new mortgage structure to higher interest rates over time, it could remain stable. What threatened the existence of the entire industry, however, was rapid inflation.

In the early 1970s, the combination of federal deficits, union wage increases, and oil price increases sent prices skyrocketing, reaching levels nearing “hyperinflation” by the end of the decade. To obtain funds, S&Ls had to pay increasingly higher interest on deposits.

After 1973, regulators permitted S&Ls to offer “Jumbo Certificates of Deposit.” But with their loans tied up in long-term (fifteen- to thirty-year) mortgages, the institutions experienced “disintermediation”—a term that describes a gap between the deposit interest paid and the loan interest received.

In short, the S&Ls were “selling” their product—their mortgages—for far less than they were paying for the money to finance new mortgages, and the long-term nature of the thirty-year fixed mortgages meant that there was no way for the S&Ls to adjust. “Variable rate” mortgages appeared, but that did nothing to address the immediate shortfalls.

Another factor, traced back to Franklin Roosevelt’s New Deal, came into play. During the banking “reforms” of the Great Depression, Congress had established deposit insurance for banks (the Federal Deposit Insurance Corporation, or FDIC) and for S&Ls (the Federal Savings and Loan Insurance Corporation, or FSLIC).

These “corporations” provided government funds to insure depositors against losses in their accounts should the banks or S&Ls fail. (Many observers of the day had credited the creation of the FDIC with shoring up the banks in the 1930s, but in fact the key policy move involved Roosevelt’s decision to take the United States off the gold standard.)

No substantial runs had threatened either system since the 1930s, and thus little attention was paid to the “moral hazard” posed by, in essence, separating the welfare of the depositors from the health of the institution itself. Put another way, with the government insuring deposits, potentially corrupt bank managers or owners had an incentive to take risks they would not otherwise take.

Until the disintermediation crisis occurred, S&L owners and managers had no need to engage in particularly risky operations. But faced with a sudden shortfall in profits that could not be met through normal means, they pursued two avenues of escape.

One involved the time-tested appeal to Congress for special assistance. In 1982, the Garn-St. Germain Act expanded the power of S&Ls by allowing them to pursue investments aggressively in a variety of areas previously denied them, such as offering checking accounts. S&Ls, in short, were permitted to act like banks.

That did little to stop the hemorrhaging, and between 1981 and 1982, the S&Ls lost between $11 and $12 billion. Worse, seeing that their customers were “protected” by deposit insurance, many S&L owners sought quick fixes by investing in highly speculative ventures, especially land.

Critics of the day claimed that the S&L industry’s collapse was tied to “junk bonds,” as in the case of Michael Milken and his placement of junk bonds with Columbia Savings and Loan in Beverly Hills.

A more important connection of wheeler-dealers came when Milken hooked up with Charles Keating of Cincinnati who received $119 million in Drexel Burnham Lambert–underwritten bonds to finance the American Continental Corporation, a real estate development firm that Keating tapped to purchase Lincoln Savings and Loan in Irvine, California. Keating then used the S&L money to purchase more junk bonds.

When these investments collapsed, Keating was investigated by the Securities and Exchange Commission. During the investigation, Keating met with five senators, John McCain (R-AZ), Dennis DeConcini (D-AZ), John Glenn (D-OH), Alan Cranston (D-CA), and Don Riegle (D-MI), each of whom had received $1 million in campaign contributions from Keating.

The Senate Ethics Committee found that Cranston, DeConcini, and Riegle had interfered with the investigation, but only Cranston was censured. (McCain later made a political career out of calling for “campaign finance reform”—after he had benefited from the largesse!) Lincoln lost $3.4 billion, and Keating served time in jail for fraud.

Despite these examples, most of the failed S&Ls had their money in land and development projects. The worst of these were “daisy chains,” in which one piece of speculative property was used as collateral for a loan at another S&L, whose loan was then used to purchase another piece of speculative land, and so on.

It was no surprise that the states with the largest numbers of S&L failures were those states with plenty of land yet to develop—Texas, Florida, California, and Arizona. After the government shut down the S&Ls in a series of acts aimed at dealing with the failed institutions, Uncle Sam acquired their land assets. Wisely, the government held on to most of the land and, over time, land values returned.

The “bill” for the S&L crisis was never as high as had been predicted in the 1980s (the Office of Management and Budget, in 1989, estimated $257 billion would be needed), although fixing a final cost of the debacle is still an exercise in futility depending on which dates are used.

Conspiracy literature attempting to link the “Reagan-Bush” administrations to the “looting” of the S&Ls claimed that the final tab would be $400 billion to $500 billion, an amount that is wildly exaggerated by any evidence provided from either the banking industry or the government.

From 1960 to 1990, the number of S&Ls fell from 6,000 to about 3,000, and even as conditions improved, the government changed both the examination procedures and the capital requirements, which further reduced the number of troubled institutions.

By the time the S&L debacle was over, well-known celebrities such as Keating, Milken, and several politicians had been investigated. President George Bush’s son, Neil, who was a director of Silverado Savings and Loan in Colorado, was the target of ethics charges for his defaults in that S&L, while his brother Jeb was loosely associated with Broward Savings and Loan in Florida.

Publications such as Mother Jones railed about the “involvement” of the Bushes, yet no evidence has yet shown them to have been directly involved in any malfeasance.

Quite different was the involvement of Bill and Hillary Clinton in the infamous “Whitewater” scandal, in which the Clintons, with Arkansas developer James McDougall, the owner of Madison Guaranty and Loan in Arkansas, purchased ownership in a development project called Whitewater.

Madison was investigated, and put into conservatorship as insolvent after lending considerable money through Susan McDougal, James’s wife, to Whitewater and other development projects. Hillary Clinton, through her position at the Rose Law Firm, was the primary attorney preparing all the documents and signed them all (as well as billed her hours based on that work), although she later claimed that she did none of the work.

By the time Bill Clinton became president, the Whitewater scandal demanded the appointment of a special prosecutor, Robert Fiske, who soon was replaced by Judge Kenneth Starr. Ultimately, the failed Arkansas S&L would lead to Clinton’s impeachment in 1999.