The collapse of the S&L’s
The strength of the S&L’s and their mortgage lending market share soared from post-World War II until 1965. The National Housing Act was a crucial first step to turning the Liquidity Factor from local markets to national markets, but the transition was extremely slow. When WWII ended, and millions of servicemen returned home, a housing boom ensued, caused mainly by a baby boom. The post-war housing expansion was primarily funded by the S&Ls. S&L’s continued to grow in numbers and worth by offering saving rates that typically were higher than banks. By 1965, the S&L’s had over 26% of the savings customers and a historic high of 46% of the mortgage lending market. Banks and S&L’s were battling for savings account customers, but the S&L’s were winning the rate war. Customers took advantage of the fight until the government thought it necessary to step in and end the rate war in 1966. Regulation Q was passed to limit the rate of returns these institutions could pay to their customers. But, as stated in Part I, the government gave the S&L’s a 50 basis points rate advantage over the banks. This advantage enabled the S&L’s to maintain their dominance, particularly in the mortgage lending market. Yet, there was a deliberate limiting feature to Regulation Q and it had an effect on the number of S&L’s from 1965-1979, dropping the actual numbers of institutions from approximately 6000 to 4700. However, innovative business practices caused the assets of the S&L’s to grow.
But change was coming. Inflation was on the rise, causing stress in the S&L’s by the mid-’70s. Inflation erodes the interest returns on fixed savings accounts and other fixed investments, like the below-market fixed rate mortgages that the S&L’s were holding. Those savings customers, for whom the S&L’s had fought so hard for during the rate wars, were now looking for other methods of interest income. The locked in nature of the Certificates of Deposits which were the bread and butter of the S&L’s for the past 20 years were now prison cells to consumers, as high inflation rates stripped them of interest income and Regulation Q prevented the S&L’s to renegotiate the savings rates. The S&L’s found themselves, for the first time in their history, trapped by the very regulation that they had profited from in the past.
Additionally, there was more distressing news on the horizon for the S&Ls. As inflation started to appear, so did a new type of investment institution, the investment bank. A new investment product came to the attention of savings customers, the Money Market Mutual Funds (MMMF). The MMMF’s were highly liquid, paying current market rates with no early withdrawal penalties and they were all outside the control of Regulation Q. The S&L’s were caught flat-footed. The investment banks were now able to offer market-rate returns to their customers by taking full advantage of the high-interest rate market caused by inflation. When asked the question, ‘What, in your opinion, caused the collapse of the S&L’s?’ Stephen (Steve) R. Smith, CMB, Executive Vice President, Retail Sales & Production with Mortgage Investors Group and former top executive of an S&L in the ’80s replied, “In a word, disintermediation.” Smith went on to explain what disintermediation meant, “….saving account customers poured out of the S&L’s and into the investment banks. The effects were devastating and in the end, insurmountable.”
The dominoes of the S&L’s slowly began to fall. In Part II, the point was made that the S&L’s did not participate in selling their mortgage loans to FNMA but chose to keep them, as assets, on their books. If they needed to free up money or liquidity, they sold to other S&L’s. But as a result of disintermediation, no S&L had any cash to buy, they were suffering the same fate: the threat of insolvency.
The only thing to stem the tide was deregulation, but it came too late and it came in pieces. There were numerous attempts by the government to help supply ballast for the listing S&Ls. In the early to mid-1970s, the S&L’s were allowed to offer checking accounts, engage in commercial lending, make limited investments in land development and construction as well as educational type loans. These changes helped the S&L’s to develop diversified business practices, but Regulation Q was still the governing burden. The main source of their solvency continued to be the savings account customers and mortgage holdings, and by 1979, double-digit inflation was wreaking havoc on these fixed-rate investments.
Renewed hope appeared in March of 1980 with the first deregulation attempt to save the S&L’s, Deregulation and Money Control Act. The Act allowed the S&L’s to pay market interest rates to their savings customers in hopes to curb their moving to the investment banks. The act restored some confidence, but it only addressed half the issue, it did not address all those millions of dollars of under-performing fixed-rate loans that were still on the S&L’s books. There was certainly no hurry for homeowners to pay off these low-interest rate loans and there were no commercial buyers to purchase the mortgage paper from the S&Ls. Steve Smith supplies an anecdotal example of the dilemma the S&L’s faced, “…we used to joke that our business plan was based on 3-2-1, we loan money at a rate of 3, we pay savers at a rate of 2 and go play golf at 1, but when inflation hit and then deregulation, our model changed to 3-9-0, we were bleeding badly and couldn’t afford to play golf.”
It took 2 years for the government to deregulate the lending restrictions for the S&Ls. Reagan signed a new law giving the S&L’s additional flexibilities, namely the much needed adjustable rate mortgage. This type of mortgage allows the lender to move the interest rate to match market conditions, such as inflationary pressures, protecting the lender from a below-market fixed rate investment. However, there was still no help for thousands of fixed-rate loans that were trapped on the S&L’s books. But the new law gave the S&L’s ability to expand into more speculative business enterprises. By the mid ’80s, the speculative nature of the S&L’s along with poor business decisions and fraud sealed the inevitable collapse of the S&Ls. “The fraud was symptomatic of an existing systemic problem….” explains Smith, “…by the early to mid ’80’s we were trying to create revenue given the new advantages offered by deregulation. Certainly, some didn’t play by the rules, but there was desperation throughout the industry. Inflation and the inability to react to it was an unintended consequence of government regulation and ultimately, in my opinion, the cause of the collapse. ”
Although the S&L collapse caused great financial hardships, including the use of US taxpayer’s money for bailouts, it did not create liquidity void for mortgage lending markets. The expansion of the GSE’s, FNMA and the newly created Freddie Mac in 1970s, allowed the vision of Roosevelt to finally be realized, the switch from local liquidity markets to a nationally controlled market.
Next: Mortgage Lending: Part IV, The rise of the GSE’s