Not every financial crisis arrives with a single dramatic day. The savings and loan crisis unfolded slowly over the 1980s and early 1990s, as hundreds of small and mid-sized US lenders failed. It cost American taxpayers tens of billions of dollars and offers lessons that are still relevant. In Part 10 of Great Financial Crises, we look at what went wrong.
What were savings and loans?
Savings and loan associations, also called thrifts, were specialised lenders that took savings deposits and made home mortgage loans. According to the Federal Reserve's history essay, the first thrift dates back to 1831 in Pennsylvania. By 1980, nearly 4,000 thrifts held about $600 billion in assets, roughly half of all US home mortgages.
Their business model was simple: borrow short-term from savers and lend long-term, often in 30-year fixed-rate mortgages.
The interest rate squeeze
That model worked when interest rates were stable. But in the late 1970s and early 1980s, inflation and interest rates soared (see Part 6). Thrifts were stuck with old mortgages earning low fixed rates, while they had to pay much more to keep deposits. Government caps on deposit rates meant savers moved money to higher-paying alternatives such as money market funds.
According to the Fed's essay, the fall in the value of long-term mortgages largely wiped out the industry's net worth. Many thrifts were effectively insolvent.
Deregulation and forbearance
Rather than close insolvent thrifts, which would have required large payouts from an underfunded insurance fund, policymakers tried to help them grow out of trouble.
- The Depository Institutions Deregulation and Monetary Control Act of 1980 began phasing out caps on deposit rates and raised federal deposit insurance from $40,000 to $100,000 per account.
- The Garn-St Germain Act of 1982 allowed federally chartered thrifts to make riskier loans outside home mortgages, such as commercial property and business lending.
- Regulators allowed weak thrifts to keep operating under relaxed accounting rules, a policy called forbearance. These "zombie" thrifts had little to lose.
The insurance fund, the Federal Savings and Loan Insurance Corporation (FSLIC), was badly underfunded. The Fed's essay notes that in 1983 the cost of paying insured depositors of failed institutions was estimated at about $25 billion, while the fund's reserves were only $6 billion.
Gambling for resurrection
With deposits insured by the government and owners' capital largely gone, many thrifts had strong incentives to take big risks. If risky loans paid off, owners profited; if they failed, taxpayers covered depositors. Economists call this "gambling for resurrection" and a classic case of moral hazard.
According to the Fed's essay, thrift assets grew 56% from 1982 to 1985, compared with 24% at banks. Much of the growth went into commercial real estate, construction loans and junk bonds. Some cases involved outright fraud.
The Texas epicentre
When oil prices fell in the mid-1980s, property values in Texas and other energy states collapsed. In 1988, the peak year for failures of FSLIC-insured thrifts, more than 40% of thrift failures nationwide were in Texas, according to the Fed's essay.
The clean-up
In 1989, Congress passed the Financial Institutions Reform, Recovery and Enforcement Act (FIRREA). It abolished the FSLIC and the Federal Home Loan Bank Board, created the Office of Thrift Supervision and moved thrift deposit insurance to the FDIC.
It also created the Resolution Trust Corporation (RTC) to close failed thrifts and sell their assets. The RTC closed 747 savings and loans with more than $407 billion in assets before shutting down at the end of 1995. According to the Fed's essay, the cost to taxpayers is estimated at up to $124 billion.
Wider effects
The crisis contributed to a slump in commercial real estate and a tightening of credit, which played a role in the US recession of 1990 to 1991. It also led to stronger capital requirements and supervision for depository institutions.
Lessons for investors today
- Interest rate risk is real. Borrowing short and lending long can be deadly when rates rise quickly, a lesson repeated in 2023 (Part 20).
- Delay makes losses bigger. Keeping insolvent institutions open increased the final bill.
- Moral hazard matters. When others bear the downside, risk-taking increases.
- Be wary of rapid growth in lenders, especially into unfamiliar areas.
In Part 11, we head south of the border to the Mexican peso crisis of 1994, the first big crisis of the modern globalised era.
Sources
Great Financial Crises: the full series
- Part 1: Tulip Mania (1637)
- Part 2: The Mississippi and South Sea Bubbles (1720)
- Part 3: The Panic of 1907
- Part 4: The Wall Street Crash and Great Depression
- Part 5: Weimar Hyperinflation (1923)
- Part 6: The 1970s Oil Shocks and Stagflation
- Part 7: The Latin American Debt Crisis (1982)
- Part 8: Black Monday (1987)
- Part 9: Japan's Bubble and Lost Decades
- Part 10: The Savings and Loan Crisis (you are here)
- Part 11: The Mexican Peso Crisis (1994)
- Part 12: The Asian Financial Crisis (1997)
- Part 13: Russia's Default and LTCM (1998)
- Part 14: The Dot-Com Bubble (2000)
- Part 15: Argentina's Collapse (2001)
- Part 16: The Global Financial Crisis (2008)
- Part 17: Iceland's Banking Collapse (2008)
- Part 18: The Eurozone Debt Crisis
- Part 19: The Covid Crash (2020)
- Part 20: The 2023 Banking Turmoil
This series is for education only and is not investment advice. Figures are taken from the sources listed and other commonly cited historical records, and may vary slightly between sources.
