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August 26, 1990
"S&L Primer - Bad Assets, Not Bandits, Led to Thrift Collapse"
San Jose Mercury News
By Timothy Taylor
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WHEN people hear of a savings and loan losing all its money, the first association they seem to have is with bank robbers, like Jesse James. Someone must have taken that money, they think. So if we just round up a posse and ride out after those bandits, we can bring the money back.

It's a tempting vision. It offers taxpayers the hope that they won't have to pay $150 billion or so to bail out S&L depositors. It also offers absolution to legislators, since it puts all the blame on those nasty S&L wheeler-dealers, and none on Congress's inability and unwillingness to monitor the industry.

However, the Jesse James mindset is ignorant of how an S&L actually works. Set aside your 19th century bank robbers, and consider the modern mysteries of assets and liabilities.

An S&L receives money from loans it has made; those loans are its assets. The institution owes money to depositors; deposits are its liabilities. If the value of its loan payments falls, then the liabilities of the institution may exceed the value of its assets. Or to put it another way, if all depositors wanted their money, the S&L wouldn't be able to pay off, not even after selling all its loans to other banks. It is bankrupt.

The value of loans can fall in at least two ways. First, borrowers can fail to repay. For example, maybe it was a good idea to loan money to oil drillers and home builders and office complexes in Texas when the price of a gallon of gasoline was up near $1.40 in 1981. But when a gallon of gas cost less than a dollar in 1986, borrowers who had counted on high oil prices could not repay. A second way the value of loans declines is a bit trickier. The value of a loan is determined both by how much will be received in payments, and by how much other investments in the market are paying. Consider an (oversimplified) example of a loan for $100,000 at 6 percent interest, where the borrower pays $6,000 in interest every year, and then repays the $100,000 after 30 years. If interest rates double to 12 percent, then any investor can receive $6000 a year by investing only $50,000, or half as much. As a result, the loan which was originally worth $100,000 might now fetch only $50,000 if the bank had to sell it.

The S&L industry ran headlong into this fix in the early 1980s. S&Ls had been required by law to loan out most of their funds for home mortgages, generally at low fixed rates of interest like 6 percent. Double-digit interest rates in the early 1980s cut the value of those loans in half. If S&Ls had been forced to sell off their loans and pay off their depositors in the early 1980s, virtually every one of them would have been broke.

When an S&L goes broke in either of these ways, the lost money isn't sitting in some robber's saddle bags, waiting to be seized. Either it was spent years ago in paying wages and materials for projects that turned out to be worth less than expected, or it was lost to higher interest rates.

Now, I'm all for prosecuting any and all cases of fraud in the S&L industry. By all means, chase down the bandits and hang them by their toes. Seize their assets and auction off their families and household pets. Force them to wear green dollar signs of shame in the middle of their foreheads. It feels good, doesn't it? Prosecution does send an unmistakable message.

But when all the trials are done, you still haven't retrieved most of the money, because the overwhelming amount of the money simply wasn't lost by fraud. Getting back a few million dollars, or a few hundred million, or even a few billion dollars by seizing the assets of white-collar criminals just won't go very far toward raising the $150 billion or so that will be needed to clean up the S&L industry.

So if prosecution isn't the answer, what is? In two words, payment and prevention.

With all the talk over paying for an "S&L bailout," it's easy to forget the purpose is to protect people's savings. As Treasury Secretary Nicholas Brady said in recent congressional testimony:

"It is important to bear in mind that money spent on the savings and loan crisis is spent with a single purpose in mind. The United States government made a promise to millions of Americans. We promised to protect their savings if deposited in a federally insured savings and loan. Now we make good on that promise... While comparisons with other government rescues are inevitable, this is not a bailout. We are not bailing out shareholders. We are not bailing out management. We are not in this to preserve institutions. In fact, many will be lost. It bears repeating that monies spent are to protect depositors."

The next question may sound heretical, but it needs to be asked: What's wrong with breaking the government's word and having some depositors lose at least some of their savings?

The hard-headed reason not to take such a step harks back to the original reason for government deposit insurance, which was to prevent bank runs. In a bank run, people rush down to a bank that might be failing and take out their money. The bank can only give depositors their money by selling off its loans at bargain basement rates to suspicious buyers, and so a bank run can push a healthy bank into bankruptcy.

Federal deposit insurance has assured depositors that they won't lose their money, and has succeeded in making bank runs obsolete. Clearly, it is counterproductive for the government to limit deposit insurance, give depositors a reason to start bank runs again, and then have to pay off the depositors who got left behind. Remember that in the modern world of computerized high finance, a bank run could be nearly instantaneous.

It's time to face reality. The overwhelming bulk of the money lost is really lost, because the value of the loans really did decline. Paying off the depositors and closing down the bankrupt S&L's is the right and proper and sensible thing to do.

Congressmen who complain over the cost should be asked: If $150 billion to pay off S&L depositors is an unbearably large amount to pass along to future generations, what does that say about the budget deficits during most of the 1980s, not to mention next year's expected budget deficit of $170 billion or so? The question Congress should be asking is how to prevent this from ever happening again.

Before the 1980s, if you had taken a survey to find out what profession had the highest percentage of uncharismatic, buttoned-down, safety-first geeks, savings and loan managers might have won. But today, it seems like the savings and loan industry is full of swashbuckling financial daredevils and brilliant con men. Where did these desperadoes come from? Or, in what phone booth did their transformation take place?

Most economists would say that the answer lies in a perverse consequence of deposit insurance itself. If owners of savings and loans have their own capital at risk, they are likely to be cautious and prudent in making loans. After all, they will lose money if they judge risk poorly.

But if the economy takes a swing for the worse, as it did with rising interest rates and bankruptcies in the late 1970s and early 1980s, the incentives shift. S&L operators know that their capital is already gone, even if the accounting doesn't actually show it yet. But if the S&L makes a series of high- risk loans at high interest rates, it has a slim chance of making enough money to become solvent again. It's like a football team that is behind throwing long passes at the end of a game. If time is running out and you're already behind, a high-risk strategy makes sense.

It's vital to understand that a certain amount of this risk- taking behavior is not illegal, nor should it be. Bankers are in the business of deciding which loans are worth making; you can't lock up people for misjudging whether interest rates would stay low or oil prices would stay high.

Nonetheless, from a taxpayer's point of view, the situation was similar to offering someone $10,000 if they would hit you in the head with a brick. If you make it their financial interest to slug you, then you should expect to get slugged. S& L operators were in a position where a high-risk strategy might make them profitable, while any losses would be paid off by government deposit insurance.

If the S&Ls that were bankrupt in 1985 had all been closed down that year, and all the depositors paid off, it probably would have cost about $20 billion. But the regulators weren't especially vigilant, and when they tried to be, Congressmen had a way of popping up and stopping them. The high-risk strategy was continued; the value of loans fell still further; and the government responsibility to depositors increased.

Obviously, the government has to shut down and take over all bankrupt or near-bankrupt S&Ls as soon as possible, so they don't enter that vicious circle of high risks and high losses. This task has meant creating, in the last year, a government organization the size of Citicorp that is chock-full of bad debts, and then trying to sell off those bad debts for whatever the market will bring. It's a very tough job.

To avoid this pattern in the future, the government must assure that the books of all S&Ls (and banks, too) are quickly adjusted for changes in economic conditions, that owners have plenty of their own capital at stake, and that high-risk loan strategies are nipped in the bud and that political influence on this process is minimal.

Legislators love to criticize private insurance companies for rising auto and health and liability and malpractice premiums. Well, the legislators have their chance to run an insurance company -- federal deposit insurance -- and they've mucked it up horribly. Even now, they haven't put the mechanisms in place to assure that this debacle won't happen again.

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