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Too much security is a certain route to doom, and S&Ls learnt this basic truth the hard way, but not soon enough. But did America truly put the past behind it?
As said by an unknown (and most likely frustrated) philosopher, “The best way to rob a bank is to own one.” Deliberate frauds and intentional risky investments by the ‘Gucci–clad white collar criminals,’ made the Savings & Loans (S&L) institutions head towards America’s biggest and most scandalous financial crisis since the ‘Great Depression’ in 1982. This, coupled with a government, which found itself ‘singularly ill- prepared to fight the crisis’, worsened the situation, taking the final cost of resolving the failed S&Ls to over $160 billion. The estimates, as financial experts claimed, were based on the rosy picture painted by the government agencies of the economy, declining interest rates and the fast growing thrift deposits. Analysts warned that taxpayers in the future would have to pay tens of billions of dollars more than expected. President Bush, the chief architect of the final bailout commented, “Nothing is without pain when you come to solve a problem of this magnitude.” But what led to the sorry state of the once successful S&Ls?
Well, perhaps the answer lies in the lack of preparedness and strategy on the part of the institutes and the government policy. S&Ls like Lincoln Savings & Loan Association, Atlanta Mortgage Consortium & Silverado Savings & Loan (of which Neil Bush, son of Sr.George Bush was Director) were specialised financial instruments using federally-insured low-interest rate deposits. Under strict government regulation, they ran on the philosophy of paying depositors 3% and lending at 6% and reaching the golf course by 3 p.m. (denoted as the infamous 3-6-3 rule in those times)! The system worked perfectly well till the late 70’s, till the thrifts started losing depositors to the new money market funds. Control on interest rates charged by them was a major impediment. During the late 70s, US was still recovering from the wounds of the 1973 oil crisis and the 1979 energy crisis. A mild recession pushed up the inflation, forcing the Fed to increase the rates.
The fed-rate grew and touched a high of 20% in June 1980. Post the increase, the S&Ls had to increase the rates and launch commercial and consumer loans and also remove some restrictions. They saw a major outflow of low-cost capital, as people took out their money from SLs and invested them in high rate yielding banks. Besides this, they found their money tied up in fixed-rate long-term mortgages with returns less than existing market returns. This made S&Ls uncompetitive. The then President Jimmy Carter, during the last days of his presidency, removed restrictions on the amount to lend and interests to charge by S&Ls. Federal Savings and Loan Insurance Corporation (FSLIC) further insured 100% (earlier only 70%) of the deposit amount of all S&Ls, thus making them risk-averse. During 1980, the FSLIC had insured approximately 4,000 S&Ls with total assets of $604 billion. Subsequently, they went ahead with highly risky projects like speculative real estate & commercial loans.
By the time Carter vacated office in 1981, many S&Ls had already started losing money. Net S&L income, which totaled $781 million in 1980, fell to a negative $4.6 billion and $4.1 billion in 1981 and 1982 respectively. When Ronald Regan came to office, he enforced Garn-St Germain Depository Institutions Act in 1982. S&Ls could now pay higher market rates for deposits, borrow money from the Federal Reserve, issue credit cards, make commercial loans and do almost everything to stay in the market.
James R. Barth Lowder, Eminent Scholar in Finance at Auburn University and Senior Fellow at the Milken Institute, calls it “an ill-advised government rule.” With almost no proper regulation, the S&Ls started mushrooming and becoming insolvent. Corrupt management, fraudulent practices and too many risky projects made them vulnerable.
An estimate by the Fed shows that fraud and insider transaction abuses were the principle cause for some 20% of savings and loan failures and a greater percentage of the dollar losses borne by the FSLIC. Besides, lowering of house prices and considerable fall of inflation in later part of 1980s led FSLIC to close down or resolve 296 institutions with total assets of $125 billion within just three years (1986-1989). In 1989, the US Congress passed Financial Institutions Reform, Recovery and Enforcement Act (FIRREA) and forced S&Ls to go back to home-lending. The effect was so large that Texas almost went into recession due to Texas-based S&Ls.
Greenspan, Bush & crisis have been inextricably linked to US since most of the last three decades. Of course, S&Ls do not exist and even Junior Bush is on his way out. But still, American banks could hardly avert the current mortgage crisis. The 3-6-3 rule may be there no more, but perhaps the cultural legacy it represented lives on!
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Source : IIPM Editorial, 2008
An Initiative of IIPM, Malay Chaudhuri and Arindam chaudhuri (Renowned Management Guru and Economist).
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