Once the regulations were loosened, S&Ls began engaging in high-risk activities to cover losses, such as commercial real estate lending and investments in junk bonds. Depositors in S&Ls continued to funnel money into these risky endeavors because their deposits were insured by the Federal Savings and Loan Insurance Corporation (FSLIC).
Widespread corruption and other factors led to the insolvency of the FSLIC, the $124 billion bailout of junk bond investments and the liquidation of more than 700 S&Ls by the Resolution Trust Corporation.
The S&L Crisis is arguably the most catastrophic collapse of the banking industry since the Great Depression. Across the United States, more than 1,000 S&Ls had failed by 1989 essentially ending one of the most secure sources of home mortgages.
The Texas Situation
The crisis was felt twice over in Texas where at least half of the failed S&Ls were based. The collapse of the S&L industry pushed the state into a severe recession. Bad land investments were auctioned off, causing real estate prices to plummet. Office vacancies rose significantly, and the price of crude oil dropped by half. Texas banks, such as Empire Savings and Loan, took part in criminal activities that further caused the Texas economy to plummet.
The Federal Savings and Loan Insurance Corporation and State-run Funds
The FSLIC was established to provide insurance for individuals depositing their hard-earned funds into S&Ls. When S&L banks failed, the FSLIC was left with a $20 billion debt that inevitably left the corporation bankrupt. The defunct company is similar to the Federal Deposit Insurance Corporation (FDIC) that oversees and insures deposits today.
During the S&L crisis, which did not effectively end until the early 1990s, the deposits of some 500 banks and financial institutions were backed by state-run funds. The collapse of these banks cost at least $185 million and demolished the concept of state-run bank insurance funds.
The Keating Five Scandal
During this crisis, five U.S. senators – the Keating Five – were investigated by the Senate Ethics Committee due to the $1.5 million in campaign contributions they accepted from Charles Keating, the head of the Lincoln Savings and Loan Association. These senators also pressured the Federal Home Loan Banking Board to overlook suspicious activities in which Keating had participated.
The Savings and Loan Crisis was the most significant bank collapse since the Great Depression of 1929. By 1989, more than 1,000 of the nation’s savings and loans had failed. Between 1986-1995, more than half of the nation’s S&Ls had failed.
The crisis cost $160 billion. Taxpayers paid $132 billion, and the S&L industry paid the rest. The Federal Savings and Loan Insurance Corporation paid $20 billion to depositors of failed S&Ls before it went bankrupt. More than 500 S&Ls were insured by state-run funds. Their failures cost $185 million before they collapsed.
The crisis ended what had once been a secure source of home mortgages. It also destroyed the idea of state-run bank insurance funds.
The Senate Ethics Committee investigated five U.S. Senators for improper conduct. The “Keating Five” included John McCain, R-Ariz., Dennis DeConcini, D-Ariz., John Glenn, D-Ohio, Alan Cranston, D-Calif., and Donald Riegle, D-Mich.
The Five were named after Charles Keating, head of the Lincoln Savings and Loan Association. He had given them $1.5 million total in campaign contributions. In return, they put pressure on the Federal Home Loan Banking Board to overlook suspicious activities at Lincoln. The FHLBB’s mandate was to investigate possible fraud, money laundering, and risky loans.
Empire Savings and Loan of Mesquite, Texas was involved in illegal land flips and other criminal activities. Empire’s default cost taxpayers $300 million. Half of the failed S&Ls were from Texas. The crisis pushed the state into recession. When the banks’ bad land investments were auctioned off, real estate prices collapsed. That increased office vacancies to 30 percent, while crude oil prices fell 50 percent.
The Federal Home Loan Bank Act of 1932 created the S&L system to promote homeownership for the working class. The S&Ls paid lower-than-average interest rates on deposits. In return, they offered lower-than-average mortgage rates. S&Ls couldn’t lend money for commercial real estate, business expansion, or education. They didn’t even provide checking accounts.
In 1934, Congress created the FSLIC to insure the S&L deposits. It provided the same protection that the Federal Deposit Insurance Corporation does for commercial banks. By 1980, the FSLIC insured 4,000 S&Ls with total assets of $604 billion. State-sponsored insurance programs insured 590 S&Ls with assets of $12.2 billion.
In the 1970s, stagflation combined low economic growth with high inflation. The Federal Reserve raised interest rates to end double-digit inflation. That caused a recession in 1980.
Stagflation and slow growth devastated S&Ls. Their enabling legislation set caps on the interest rates for deposits and loans. Depositors found higher returns in other banks.
At the same time, slow growth and the recession reduced the number of families applying for mortgages. The S&Ls were stuck with a dwindling portfolio of low-interest mortgages as their only income source.
The situation worsened in the 1980s. Money market accounts became popular. They offered higher interest rates on savings without the insurance. When depositors switched, it depleted the banks’ source of funds. S&L banks asked Congress to remove the low interest rate restrictions. The Carter Administration allowed S&Ls to raise interest rates on savings deposits. It also increased the insurance level from $40,000 to $100,000 per depositor.
By 1982, S&Ls were losing $4 billion a year. It was a significant reversal the industry’s profit of $781 million in 1980.
In 1982, President Reagan signed the Garn-St. Germain Depository Institutions Act. It solidified the elimination of the interest rate cap. It also permitted the banks to have up to 40 percent of their assets in commercial loans and 30 percent in consumer loans.
In particular, the law removed restrictions on loan-to-value ratios. It permitted the S&Ls to use federally-insured deposits to make risky loans. At the same time, budget cuts reduced the regulatory staff at the FHLBB This impaired its ability to investigate bad loans.
Between 1982 and 1985, S&L assets increased by 56 percent. Legislators in California, Texas, and Florida passed laws allowing their S&Ls to invest in speculative real estate. In Texas, 40 S&Ls tripled in size.
Despite these laws, 35 percent of the country’s S&Ls still weren’t profitable by 1983. 9 percent were technically bankrupt. As banks went under, the FSLIC started running out of funds. For that reason, the government allowed bad S&Ls to remain open. They continued to make bad loans, and the losses kept mounting.
In 1987, the FSLIC fund declared itself insolvent by $3.8 billion. Congress kicked the can down the road by recapitalizing it in May. But that just delayed the inevitable.
In 1989, the newly-elected President George H.W. Bush unveiled his bailout plan. The Financial Institutions Reform, Recovery and Enforcement Act provided $50 billion to close failed banks and stop further losses. It set up a new government agency called the Resolution Trust Corporation to resell bank assets. The proceeds were used to pay back depositors. FIRREA also changed S&L regulations to help prevent further poor investments and fraud.