What was the Savings and Credit Crisis? How did it affect investors?
What was the Savings and Credit Crisis?
The 1980s saw a financial crisis in the United States, fueled by skyrocketing inflation and the rise of high-yield debt, known as junk bonds, which led to the collapse of more than half of the country’s savings and loans (S&Ls) .
A savings and loan institution, also known as a savings bank, is a community-based bank. It offers consumers checking and savings accounts, as well as loans and mortgages.
The concept of the S&L began in the 1800s. They were founded with a mission to help the working class get cheap mortgages so they can afford homes. The most famous example of thrift appeared in film It’s a beautiful life. In the 1980s there were more than 3,200 S&Ls in the United States; today it’s fewer than 700 — and it’s estimated that the S&L crisis cost taxpayers as much as $160 billion.
What Caused the Savings and Credit Crisis?
The savings and loans crisis was due to a variety of factors, but none contributed more than inflation. The early 1980s were a difficult time for the United States as consumers faced rising prices, high unemployment and the effects of a supply shock – an oil embargo – that sent energy prices skyrocketing. The result was stagflation, a toxic environment of rising prices and falling growth that plunged the economy into recession.
In order to combat inflation, the Federal Reserve had to take aggressive action, and so it raised the fed funds rate steeply. This impacted all other short- and long-term interest rates – peaking at 16.63% in 1981 – and made the “American Dream” of home ownership all but impossible.
That is, until a “revolution” in home finance was introduced: mortgage instruments that reflected changing interest rates, called rollover or adjustable rate mortgages. These would make the homeowner responsible for taking on some of the risk if interest rates ever spiked again – and hit global markets again during the 2007-2008 financial crisis.
How were S&Ls affected by inflation in the 1980s?
Inflation didn’t just hit homebuyers in the 1980s. Bonds have long been a way for companies to raise cash, but during the recession, many companies that had previously issued investment-grade bonds received credit downgrades, reducing their bonds to riskier, speculative, or junk status, reducing their likelihood meant because the delay had increased. That didn’t stop big business in the 1980s, however. Companies simply started using junk bonds to finance their activities such as mergers or leveraged buyouts – as did thrifts and credit institutions.
The Savings and Credit Crisis Explained
The problem for S&Ls was that many of the loans they made were long-term and fixed-rate. When the Fed raised interest rates sharply, S&Ls could not raise enough capital from existing depositors to meet their liabilities. In addition, restrictions imposed by laws such as the Federal Home Loan Bank Act of 1932 placed limits on the amount of interest a bank could charge its account holders, effectively tying their hands. S&Ls earned less interest on their loans than they paid on their deposits. The phrase “borrowing short to lend long” was coined.
New consumer account holders were lured to other banks offering vehicles such as money market accounts that had better, higher savings rates; As a result, many S&Ls went bankrupt.
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The federal government, itself faced with the negative effects of the recession such as a hiring freeze in 1981, did not have the manpower to oversee the S&L industry as it became increasingly volatile. Instead, officials made the head-scratching decision deregulate the industry in the hope that it would regulate itself. But less oversight led to even more outrageous things happening.
How were S&Ls linked to junk bonds?
Deregulation allowed S&Ls to invest in even riskier instruments that offered the high returns they needed: junk bonds became the speculative vehicle of choice for financiers behind S&Ls hoping to reverse the damage done by fixed-rate mortgages. Amazingly, the government did not charge S&Ls that made these investments premiums for their deposit insurance; in fact, all S&Ls paid the same premium.
S&Ls also took advantage of other regulatory loopholes designed to delay their bankruptcy and cost taxpayers years and billions more. For example, they invested heavily in speculative commercial real estate, particularly in Texas. They also did “brokered deposits,” where client funds were broken up into $100,000 increments that could then be deposited into various S&Ls in search of the highest interest rates, leaving quite a paper trail. The S&L financiers also flagrantly flouted generally accepted accounting principles by posting losses on their balance sheet as “goodwill.”
One example was investor Charles Keating, who bought up to $51 million worth of junk bonds for his S&L, Lincoln Savings & Loan, even though it technically meant a net loss of $100 million. These junk bonds came from Michael Milken’s Drexel Burnham company; Both men were convicted of securities fraud and extortion and sentenced to prison terms.
But Keating’s actions didn’t stop there. Even more incredible, Keating was also responsible for sending $1.5 million in campaign funds to five US Senators. The incident became a political scandal known as Keating Five and involved Senators John Glenn (D-Ohio), Alan Cranston (D-California), John McCain (R-Arizona), Dennis DeConcini (D-Arizona), and Donald Riegle (D-Michigan).
Keating’s bribes were an attempt to keep the Federal Home Banking Board from investigating his S&L, but in 1991 the Senate Ethics Committee found that Cranston, DeConcini, and Riegle all unduly interfered in the Lincoln Savings investigation, while Glenn and McCain did turned off. All five were allowed to complete their Senate terms, but only Glenn and McCain were reelected.
What are the consequences of the savings and credit crisis?
In 1989, President George HW Bush introduced the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA), which reformed the S&L industry by providing $50 billion to close or “bail out” failed S&Ls and further losses curb, as another 747 S&Ls declared bankruptcy between 1989 and 1995.
In addition, FIRREA has ordered all S&Ls to sell their junk bond investments and implement stricter capital maintenance requirements. New penalties for fraud within government-insured banks were also created. A new government agency, the Resolution Trust Corporation, was formed to resolve the remaining S&Ls. It operated under the Federal Deposit Insurance Corporation (FDIC) until it was finally dissolved in 2011.
The S&L crisis is one of the causes of the US recession of 1990, which lasted 8 months. During this time, home buying fell to its lowest level since World War II.
Are there still S&Ls?
Yes, but today’s S&Ls have merged or been acquired by bank holding companies. They are managed with much stricter regulations that dictate that, for example, 60% of their assets must be invested in residential mortgages and other consumer goods.
Are savings safe in a recession?
While a recession can be a natural part of the economic cycle, TheStreet.com’s Roger Wohlner believes multiple categories of bonds and bond funds can help keep your portfolio more resilient.