Muchen Liu The Savings and Loans Crisis BA 543 04/16/2013 1 S&L Crisis SCENE 1 The Savings and Loans Crisis Muchen Liu Good evening, ladies and gentleman, my name is Muchen Liu. Welcome to our lecture today. The topic is about the Savings and Loans crisis in 1980’s. BA 543 04/16/2013

S&L : Financial Intermediation S&L Crisis SCENE 2 S&L : Financial Intermediation First of all, I will give you an overview of this Industry. Savings and Loans is a special type of Depository Institution that provided various services aimed at promoting home ownership. It is a Financial Intermediation between demand deposits and Mortgages Demand Deposits S&Ls Mortgages

S&L : Operation Mechanism S&L Crisis SCENE 3 S&L : Operation Mechanism Premium Briefly speaking, S&Ls institutions raise funds via deposits that have a maturity of one year or less and invest in mortgages that mature in 15-20 years. When competing with other financial institutions, such as commercial banks and credit unions, S&Ls were given a competitive advantage over others. They were permitted to pay a higher interest rate than commercial banks. This premium makes S&Ls more attractive than other financial institutions at that time. Demand Deposits 1 year S&Ls Mortgages 15-20 years

S&L : Equilibrium Spread +3% 105% 8% Demand Deposits 1 year $1 M $1 M S&L Crisis SCENE 4 Spread +3% 105% 8% For instance, suppose that an S&Ls institution raised $1 million deposits that has a maturity of one year by agreeing to pay an interest rate of 5%. Then, they invested this $1 million into mortgages or U.S. government securities that matures in 20 years, paying a fixed interest rate of 8%. The spread of +3% is the profit that S&Ls earned for the first year. Here is one thing I want to you remember before we move on. The 8% here is fixed, however the spread in future will depend on the interest rate that S&Ls will have to pay depositors in order to raise $1 million after the one-year time deposit matures. In other words, it must borrow at least $1 million per year to maintain the equilibrium. If the short term interest rates are stable or declining, there is no problem and S&Ls could make positive spread continually. Demand Deposits 1 year $1 M $1 M S&Ls Mortgages 15-20 years

S&L : Disequilibrium Spread % 8% Demand Deposits 1 year $1 M $1 M S&Ls S&L Crisis SCENE 5 Spread % 8% However, if the short term interest rates keep rising, the spread will decline. When it must pay more than 8% to depositors for the next 19 years, the spread will be negative and the system will be in Disequilibrium. Demand Deposits 1 year $1 M $1 M S&Ls Mortgages 15-20 years

ˣ S&L : Collapse Spread % 8% Demand Deposits 1 year $1 M $1 M S&Ls S&L Crisis SCENE 6 Spread % 8% Once, if S&Ls could not afford the increasing interest rates, depositors will unhappy and invest their money to other financial institutions, such as money market funds, which could provide them 10% short term interest rate instead of 5% or less. ˣ Demand Deposits 1 year $1 M $1 M S&Ls Mortgages 15-20 years

ˣ ˣ S&L : Collapse Spread % 8% Demand Deposits 1 year $1 M $1 M S&Ls S&L Crisis SCENE 7 Spread ˣ % 8% That makes S&Ls could not raise funds to pay for their existing depositors. What’s more, the mortgage rates also increased at that time, which means S&Ls could not get enough funds back from here. ˣ Demand Deposits 1 year $1 M $1 M S&Ls Mortgages 15-20 years

S&L Crisis SCENE 8 Actually, both short interest rates and Mortgage rates increased significantly from late 70s to early 90s. That made large numbers of depositors removed their funds from savings and loan institutions (S&Ls)

ˣ ˣ S&L : Collapse 15%-25% Spread % 8% Demand Deposits 1 year $1 M S&L Crisis SCENE 9 15%-25% Spread ˣ % 8% As I talked before, S&Ls were largely making their money from mortgages, they did not have the means to offer higher interest rates until S&L regulations loosened, In order to avoid insovency, many troubled S&Ls engaged in increasingly risky activities , including commercial real estate lending and investments in junk bonds. in the hope of recovering if these high return but high risky strategies worked out. ˣ Demand Deposits 1 year $1 M $1 M S&Ls Mortgages 15-20 years

ˣ ˣ ˣ S&L : Defaults 15%-25% Spread % 8% Demand Deposits 1 year $1 M S&L Crisis SCENE 10 15%-25% ˣ Spread ˣ % 8% Unfortunately, these gamble behaviors resulted eventually in defaults due to the falling home prices which crushed the last resort of S&Ls. ˣ Demand Deposits 1 year $1 M $1 M S&Ls Mortgages 15-20 years

S&L Crisis SCENE 11 From 1986 to 1995, the number of federally insured savings and loans in the United States declined from 3,234 to 1,645. One of the largest S&L failures was that of Lincoln Savings & Loan, part of the Keating Five scandal which exposed the political corruption that was part of the S&L Crisis. Because S&L deposits were insured by the Federal Savings and Loan Insurance Corporation (FSLIC), depositors continued to put money into these risky institutions. A complex web of these factors and others, combined with widespread corruption, led to the insolvency of the FSLIC. The S&Ls Crisis ended up cost U.S government a staggering $124 billion over more than 1000 savings and loans institutions since 1980’s

S&L Crisis SCENE 12 References Reggie Middleton . (2008). Don't believe Paulson: S&L 2.0, the Bank Failure Redux http://seekingalpha.com/article/77584-don-t-believe-paulson-s-l-2-0-the-bank-failure-redux/ Unsigned (2013). Savings and Loan Crisis Timeline http://savingsandloancrisis.com/ Bill McBride (2009). FDIC Bank Failure Update http:// www.calculatedriskblog.com/2009/08/fdic-bank-failure-update.html

Thanks for your attention! Any Questions? S&L Crisis SCENE 13 Thanks for your attention! Any Questions? Some commentators believe that a taxpayer-funded government bailout related to mortgages during the savings and loan crisis may have created a moral hazard and acted as encouragement to lenders to make similar higher risk loans during the 2007 subprime mortgage financial crisis

Brainstrom What is the root cause of the S&Ls crisis？ M&A SCENE Brainstrom 1 What is the root cause of the S&Ls crisis？ 2 After talking about the S&Ls crisis, I come up with two questions that I want to ask you guys. One of the largest financial scandals in U.S. history, the Savings and Loan Crisis emerged in the late 1970s and came to a head in the 1980s, finally ending in the early 1990s. In the volatile interest rate climate of the '70s, large numbers of depositors removed their funds from savings and loan institutions (S&Ls) and put them in money market funds, where they could get higher interest rates since money market funds weren't governed by Regulation Q, which capped the amount of interest S&Ls could pay to depositors. S&Ls, which were largely making their money from low-interest mortgages, did not have the means to offer higher interest rates, though they tried to once interest rate ceilings were dropped in the early '80s. As S&L regulations loosened, they engaged in increasingly risky activities, including commercial real estate lending and investments in junk bonds. Because S&L deposits were insured by the Federal Savings and Loan Insurance Corporation (FSLIC), depositors continued to put money into these risky institutions. A complex web of these factors and others, combined with widespread corruption, led to the insolvency of the FSLIC, the government bailout of the thrifts to the tune of $124 billion in taxpayer dollars and the liquidation of 747 insolvent S&Ls by the U.S. government's Resolution Trust Corporation. Federal Deposit Insurance Premium Policy. One of the contributing factors that led to the savings and loans crisis was the federal deposit insurance corporation or FDIC. This insurance was offered to savings and loans institutions in 1934. It stated that the same premium be given to all S&L members no matter how risky the transaction might be. The government continued to provide deposit insurance to any S&L transactions despite it being unstable. In 1991, the government tried to correct this problem by asking the FDIC to increase the premiums for those transactions that were likely to be risky and unsafe. However, the FDIC did not take heed of this amendment since it feared tremendous complaints, criticisms, and great loss of members who have made these types of transactions. As a result, the same amount of premium was paid for by members regardless of the risks involved. Regulation Q This is part of the banking act imposed by the law of federal regulations. It stated that any financial institutions, including banks and S&L companies, were prohibited to provide any interest on demand deposits or checking accounts. It also stated that financial institutions give higher interest rates on other kinds of banking transactions such as time deposit and savings account. In 1966, Regulation Q was extended to all S&L companies. The fixed amount of interest imposed by this policy enabled S&L companies to continue on for a few more years. The deposits made by members were actually used to cover loan and mortgages transactions. Expansion and Branches Restrictions A law was imposed preventing banking institutions as well as S&L companies to expand or put up branches. This made S&L institutions more susceptible to risks and downturns. Regional crisis greatly contributed to the decrease in real estate value. Some of these properties were made as collateral by most savings and loans members. Resuscitation of S&L Because of the impact brought on by the savings and loans crisis, the government approved a bill that would help change the banking industry, the federal rules that went with it and help people avoid bad credit loans. In 1989, most of the savings and loans companies were merged with larger commercial banking institutions. The federal regulations that governed all banking and financial institutions have also been modified to answer to the needs of the industry. In 2004, more than 800 S&L institutions made around one trillion dollars in assets. There are also bank holding institutions that possess two of the biggest S&L companies, namely, World Savings Bank and Washington Mutual Bank. These two major S&L companies made a hundred billion dollars in assets. While some independent S&L companies have assets that are more than a billion dollars. With the implementation of the financial reform law, S&L companies continue to thrive despite the continuous economic recession. Although the number of these companies is decreasing, people will not feel any of the effects since there are a lot of banking institutions nowadays that provide the same service and follow the same regulations of savings and loans companies. The government continues to monitor and observe the regulations as well as the finance and banking policy implementation in order to ensure the stability of the industry. What is the similarity between S&L Crisis and Subprime Mortgages Crisis in 2008?