Before the subprime mortgage crisis, there was the savings and loan crisis. Between 1986 and 1995, almost a third of all S&Ls in the U.S. failed. It is a story of poor regulation, mismanaged incentives and a real estate bubble -- in short, all of the same ingredients that caused the financial crisis just over a decade later. Here is why this is still relevant to investors today.
What are S&Ls?
Savings and loan associations accept deposits and makes loans, especially mortgages. They are often mutually owned by their depositors. In the first half of the 20th century, S&Ls played an important role in expanding home ownership to more Americans. In order to facilitate their role as a provider of such a public good, S&L deposits of up to $40,000 were insured by the government. They were also tightly regulated: They could only lend money to property buyers within a 50-mile radius of their main office. Their activities were largely limited to home buying. In 1966, Regulation Q imposed a 5.5% ceiling on the rate that could be paid out to depositors.
What went wrong?
In the late 1970s, S&Ls were suffering from a combination of high inflation and high interest rates. High inflation eroded the value of the long-term loans on their balance sheets, while the ceiling imposed by Regulation Q made it difficult for S&Ls to attract deposits, as they were being outcompeted by other types of financial institutions.
To save the industry, both the Carter and Reagan administrations decided that deregulation was the way to go. Tax breaks came in, and the restrictions on what S&Ls could invest in were lifted. The deposit ceiling was removed. However, federal deposit insurance was kept, and was even expanded to cover $100,000 of individual deposits. So all of a sudden, the people running S&Ls were essentially playing with free money.
With their hands untied and their deposits federally insured, the previously staid and conservative S&Ls were able to write loans for any number of dubious real estate ventures. Unscrupulous real estate developers would buy cheap land and flip it to investors who received easy loans from the S&Ls, leading to a property boom that had no organic demand to support it. Of course, none of this was sustainable in the long term and by the late 1980s, hundreds of S&Ls were insolvent. The total cost of sorting out the mess was estimated to total $160 billion, with over $132 billion coming out of taxpayers' pockets.
What can investors learn from the crisis?
I think the lesson from the S&L crisis is that mismanaged incentive structure will cause excesses and bubbles whenever they are allowed to exist. And while the greed of real estate developers and S&L managers undoubtedly played a role in the crisis, a large portion of the blame must go to the government for essentially eliminating risk from the calculus faced by the S&Ls, by creating enormous moral hazard.
Everyone wants a free lunch, and if you give it to them, they will come. However, giving things away for free is a recipe for crisis. Whenever the next meltdown happens, I am sure that moral hazard will play a role in it too.
Disclosure: The author owns no stocks mentioned.
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