Book summary: The Savings and Loan Crisis – Lessons from a regulatory failure

This book documents the series of regulatory missteps from the 1980s to the 1990s that lead 50% of savings and loans in the US to insolvency. During this period the total number of savings and loans decreased from 3,234 to 1,645.

Operating mechanism

The savings and loans are a special group of banks that are encourage to grow by the US government to enable affordable housing after the world depression.

They take in short term savings deposits at lower interest rates and lend out long term mortgages at higher interest rates. They profit through the net interest income generated between the short term interest rates and the long term interest rates.

Events leading to massive failure

  • During the Vietnam war, inflation which drove short term interest rates increase. This cannibalized SnLs’ profit margins.
  • De-regulation of short term interest rates which lead to increased competition by other banks for deposits.¬† This lead to the inability to attract deposits at feasible rates to finance SnL’s long term illiquid mortgage loans.
  • The US government instead of recapitalizing these insolvent SnLs opted to de-regulate by allowing them to enter into other high yield investment instruments. This is in hopes of they will be able to rebuild the capital and thus minimize the amount of burden to be imposed on tax payers
  • Entrance of new entities
    • mutual funds competed for deposits
    • Freddie Mae and Freddie Mac competed for mortgages
  • SnLs ventured out of their areas of expertise and started buying into high yield corporate junk bonds and unsecured commercial loans.
  • With minimal equity stake in the game due to years of erosion and an implied government guarantee for a bail out in case things go south, SnLs began aggressive leveraged into these positions.
  • The US government reversed it stance and past regulation against SnLs holding high yield investment instruments. The forced liquidation of relatively illiquid positions further exacerbated the situation.

Lessons learned

  • Government meddling in market mechanism to further political agenda is generally a recipe for disaster
  • Venturing beyond circle of competence in search of high yield is generally a recipe for disaster
  • Overt or implied¬†guarantee of government bail out is a source of moral hazard that leads to excessive leverage by operators which is definitely a recipe for disaster

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