February 8, 1989
"Don't Feed 'Zombie' Thrifts"
San Jose Mercury News
By Timothy Taylor
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IF you've seen Jimmy Stewart in "It's a Wonderful Life," you know what a savings and loan is supposed to be. People from a community put in their money, and the S&L loans it out so houses can be built in that community. The very definition of "savings and loan association" in Webster's dictionary is "a cooperative association organized to hold savings of members in the form of dividend-bearing shares and to invest chiefly in home mortgage loans."

Laws were passed to require that savings and loans would not pay more than 5 1/4 percent or so in interest payments, which meant that they could loan out the money for a home mortgage at, say, 6 percent, and still make a quiet profit. The joke about the sleepy business of savings and loans used to be: "Loan at 6, pay at 5, the golf course at 4." Percent, percent and o'clock, you understand.

But dramatic economics changes have rocked the savings and loan industry.

When inflation and interest rates shot up in the late 1970s, many people took their money out of the savings and loans, which were limited in the interest they could pay, and put it into higher-paying accounts like money market funds. A second major change is that the home mortgage market has been taken over by "securitization," a word that only a high financier could love. It means that instead of mortgage money coming from individual deposits, Jimmy Stewart-style, the money for mortgages now comes from new securities like "Collateralized Mortgage Obligations" and "Real Estate Mortgage Investment Conduits," which are owned by banks and other large investors.

Because of securitization, the defining legal purpose of savings and loans -- to provide money for home mortgages -- is diminishing. In the 1970s, S&L's originated over half the new mortgages in the country; more recently, they originate less than a quarter. Mortgages were 86 percent of the assets of S&Ls a decade ago; today, the share is less than 70 percent.

Dramatic changes in technology have given the savings and loans nowhere to hide from the first two trends. Modern investors can switch money from savings and loans to banks, the stock market, investment funds, government and corporate securities, and any other investments, literally at a moment's notice.

These changes practically forced government regulators to give savings and loans the freedom to make different investments and offer higher interest rates. Many S&Ls used that new freedom to make themselves competitive in the modern financial markets; although you don't often read about them, 90 percent of the S&Ls are financially solid.

But the problem with the current regulatory system is that it encourages weak savings and loans to make themselves still weaker. Here's how:

Imagine that you're a manager of a savings and loan, you've been whipsawed by economic change in the late 1970s and early 1980s, and your institution is either technically bankrupt or close to it. How can you bring in more deposits to avoid bankruptcy?

One obvious answer is to offer a higher rate of interest; since depositors know that their money is guaranteed by the federal government up to $100,000, as every bank advertisement tells you, they are willing to deposit money even in a bankrupt institution. To pay off that high rate of interest, though, the savings and loan will have to make some riskier-than-usual investments. If the high risk strategy pays off, it will be sitting pretty, out of the red.

However, risky investments have a way of not paying off, and so the S&L is likely to end up in an even deeper financial hole. But because of federal bank insurance, the cycle can be repeated over and over, at least until the institution gets lucky or runs out of funds altogether.

Savings and loans that fall into this destructive cycle are called "zombie thrifts" by Edward Kane of Ohio State University. They suck the deposits away from other, healthier institutions, and they push up the cost of regulating the system for everyone. Recent estimates from the GAO hold that nearly 60 percent of the $100 billion in total S&L losses can be traced to a mere 26 thrifts.

The plan just announced by President Bush for bailing out the savings and loans does not deal with these systematic problems. That means his proposals are a decent stopgap, but not really a solution.

For example, a solution to the savings and loan problem would recognize the changes in the home mortgage market and financial technology, and allow S&Ls more freedom to compete. But while the Bush plan requires the savings and loans to pay higher premiums to the federal government for deposit insurance and to increase their capital holdings for greater safety, they will apparently have to do so under current regulatory constraints. That double-bind will probably create some additional S&L failures.

A systematic reform would change federal deposit insurance, too. Under current rules, savings and loan institutions pay the same insurance premiums to the federal government whether they are in financial trouble or not, which is like letting reckless and accident-prone drivers pay the same auto insurance premiums as safe and cautious ones. If riskier institutions had to pay higher insurance premiums, they would have a financial incentive not to become zombie thrifts. But under the Bush plan, deposit insurance remains the same for all S&Ls, regardless of whether they are prudent and healthy or sick and reckless.

Finally, if the Bush proposal is to work, the bank regulators will have to be more active. Under the pressure of higher insurance premiums and higher capital requirements required by the Bush plan, a number of S&Ls that are close to bankruptcy will face a temptation of becoming zombie thrifts. If a savings and loan begins to look like the living dead, a stake should be driven through its heart before it gambles itself into financial oblivion.

Bush's proposal to bail out the savings and loans is all right, but it's only a starting point for reform. Unless he or the Congress moves to deal with the systemic problems of the savings and loans industry, they are likely to be bailing out a leaky boat, and spending taxpayer money to do it over and over again.

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