The Savings and Loan and Banking Crisis

of the Early 1980s

1929 and 1950: Financial System Frozen by the New Deal

The New Deal Banking Cartel:Banks Protected and Profitable

But Costly to Consumers• Limits on Price Competition:

– Regulation Q: • 0% interest on demand deposits• Ceilings on interest for savings and time deposits

– “Free Toaster”• Limits on Geographic Competition:

– Restrictions on Branching and Mergers• Limits on Product Competition:

– Narrowly Defined Banking---new products limited

Inflation and Its Effects on New Deal Banking

• Real Rate=Nominal Rate – Inflation• InflationBonds pay fixed interestBond

Prices Fall & Nominal Yields Rise (and Real Yields Recover)

• If unexpected inflationEffects on Creditors and Debtors?

Regulation Q and the Funding Squeeze

• InflationNominal Yields Rise • The “Funding Squeeze”

– Nominal (Market) rates exceed Regulation Q Ceilings and no interest on demand deposits

– Business and then Household seek places to get a real return

Regulation Q and the Emergence of the Funding Squeeze—Effects of Inflation

Interest Rate (%)

Loanable Funds

Demand 2

Supply 2

Regulation Q Ceiling

Demand 1

Supply 1

Huge losses to households and businesses

Interest Rates and Inflation

0

2

4

6

8

10

12

14

16

10 Year US Bond Rate Inflation Rate (CPI)Regulation Q Ceiling on commercial bank savings deposits

Can Banks Compete?--Funding• To keep public from escaping---minimum

denomination on Treasury bills raised from $1,000 to $10,000

• Businesses are hard to keep because they can buy Treasury bills and commercial paper

• How can banks meet up with “loss of funds”• 1961 The First National City Bank of New York

(Citibank) creates the “negotiable certificate of deposit” or CD in minimum units of $ 1million. No restrictions.

New Competitor: Rise of the S&Ls

• Savings and Loans or “Thrifts”: Take savings deposits and make mortgage loans.

• Fast-growing competitors to banks 5.7%12.7% of all intermediaries assets 19501970

• Under Regulation Q, S&Ls allowed to offer higher interest on accounts than commercial banks—0.75% in 1966

• FSLIC insurance---coverage raised• Federal government encourages them to make

mortgages to stimulate home ownership. FHA insurance. Fannie Mae and Freddie Mac

• Easy going days of “3-6-3” lending.

MORAL HAZARD?

The Collapse of the S&Ls • Inflation jumps 1969, 1973, 1979—When

Fed Attacks inflation– Maturity mismatch for Thrifts. Locked into low

interest long-term mortgages while costs of funds rise. Can’t make money if mortgage rate is 6% and funding costs 8%!

– Value of mortgages fallAssets Value declinesInsolvency

• Unprofitable thrifts (S&Ls) rise from 7% in 1979 to 85% in 1981. Most are insolvent. Market evaluation of thrifts shows whole industry insolvent by $100 billion

• BUT NOT CLOSED: FORBEARANCE

S&L Collapse• Depository Institutions Deregulation and

Monetary Control Act of 1980 and Garn-St. Germain Act of 1982– Phase out of Regulation Q ceiling—Allows

them to raise funds but at higher rates – But higher cost of funds---need to earn higher

rates---so allow banks to take more risks and they can now invest in consumer loans, commercial real estate mortgages, and business loans.

– Raise insurance to $100,000 per account—so public does not flee

S&L Collapse• S&Ls---they are “zombies”

(insolvent) allowed to gamble on recovery.

• Gamble fails. Interest rates stay high and economy is in recession. Huge number of failures.

• The FSLIC is closed as insolvent and a new agency the Resolution Trust Corporation is begun to close insolvent thrifts---cost is $74 billion by this agency alone. Far greater than cost of bank failures in Great Depression!

Summary: Collapse of the S&Ls 1979-1984• S&Ls are 13% of the financial system• Big maturity mismatch—savings deposits and 30 year

mortgages• Rising inflation 1970s and then 1979 “Volcker Shock”• S&Ls: Most are Unprofitable and Insolvent• Not closed down because this would bankrupt FSLIC and

require taxpayer bailout, otherwise depositors lose• Second chance: “Zombies”• Deregulate interest rates so can get funds to

investhigher cost funds require higher returnsDeregulate controls on loans so can earn higher returns + Higher deposit insurance so depositors don’t flee

• Risky investments failBigger losses• S&Ls closed by RTC (Resolution Trust Corporation) and

government issues off-budget bonds to raise money to pay…i.e. taxpayers pay later rather than now.

• S&Ls vanish---this part of financial system—gone.

Crisis of the Commercial Banks• Commercial Banks are 35% of financial system, largest

type of institution, but regarded as “special” because provide means of payment and credit to many

• For the first time since the depression commercial banks begin to fail in large numbers in the early-mid 1980s

• Same problems as S&Ls—inflation jump and maturity mismatch but not as bad as average maturity of loans is shorter

• Bad real estate loans—New England, Oil States and California

• Bad loans to Less Developed Countries and Collapse of Oil Prices

• Penn Square Bank---sells off oil loans; Continental Illinois (8th largest bank) buys them---most are worthless.

Huge losses to the FDIC---nearly bankrupted

Crisis of the Commercial Banks• In 1980 the FDIC does not close First

Pennsylvania Bank when it fails but recapitalizes it in a bailout

• Applied new doctrine of “Too Big to Fail.”• Followed by the bailout of Continental Illinois. • Between 1981 and 1994, 1,455 banks fail at a

cost of $52 billion to the insurance fund.• Increase in assessments to pay.• Weak banks gone• New regulations but also collapse of New Deal

– Geographic Restrictions– Product Restrictions

Before the Banking Crisis--Resilient Geographic Restrictions

• Limits on Geographic Competition, keeps up bank profits (at expense of public and risk of undiversified banks)

• Branching---Slow Change– In 1951 only 17 states permit branching– In 1967 only 19 states permit branching– Only within state branching; sometimes less

• Mergers: Hold the Line– 1960 Bank Merger Act gives federal bank regulators

power to block mergers– U.S. v. Philadelphia National Bank 1964, Supreme

Court forbids mergers if they “substantially lessen competition.”

– Department of Justice challenges any bank merger where one bank has more than 5% of local market.

Before the Banking Crisis Resilient Product Line Restrictions

• Commercial banks try to expand into business of travel agencies, insurance, armored car services, investment advisors---courts deny them.

• Single bank holding company to get around—by 1976, 26 of all banks owned by holding companies and they control 50% of bank offices and 66% of deposits.

• Thus Citigroup owns Citibank and all of its affiliates

• Bank Holding Company Act of 1970 subjects one bank holding companies to Board supervision as well.

The Collapse of the New Deal• Bank failures brings demand of ‘white knights’

and states begin to permit mergers to save banks and S&Ls

• Need to have takeovers to prevent losses to FDIC and taxpayers

• Reagan administration ceases to block mergers. • States begin to allow out-of-state banks to enter

their markets. • 1994 Riegle-Neal Interstate Banking and

Branching Efficiency Act starts nationwide branching in 1997.

The Collapse of the New Deal• Commercial banks are given permission to have

new securities and investment affiliates.• In 1990, J.P. Morgan becomes the first bank to

receive permission from the Federal Reserve to underwrite securities, so long as its underwriting business does not exceed the 10 percent limit.

• Evidence that no economic evidence behind Glass-Steagall Act of 1933

• Bank holding companies move into investment banking

• Financial Services Modernization Act of 1999 allows the full merger of banks, securities firms, and insurance companies into huge financial conglomerates. Overturns Glass-Steagall Act of 1933

Never Again—New Rules

• FDIC is given power to raise premiums to replenish the insurance fund.

• 1991 Federal Deposit Insurance Improvement Act– ”Prompt Corrective Action” – No more forbearance, (and no more bailouts).– Declines in bank capital (from losses) met

with severe penalties until it is increased.

Where is my checking account?

Bank of America 2004

Fleet Bank 1996

National Westminster Bank of New Jersey 1991

First National Bank of Central Jersey 1988

Peoples National Bank of Central Jersey 1980

By 2000……..• Full Price Competition Permitted• Full Geographic Competition Permitted• Full Product Competition Permitted• Many new markets and products• ------in these respects they become like

Canadian or European banks----• Deposit Insurance and “Too Big to Fail” create

moral hazard to take risk. Capital requirements thought to control.

• Huge growth of mortgage market beginning in late 1990s and huge promotion of mortgage loans