History and Economics of the Savings and Loan Crisis

Amanda Freeman, Department of Economics, Kansas State University1

Regulation Q as Contributor

The Banking Acts of 1933 (Glass-Steagall Act) and 1935 had many components, one of which is commonly called Regulation Q. Regulation Q limited the interest rate (yield) that depository institutions (DIs—remember these are banks and thrifts) could pay on deposits, and it bears a good portion of the blame for the “savings and loan crisis” that took place in the 1980s.

The reasoning behind Regulation Q was that if DIs could give whatever yield they wanted, they would supposedly compete ruthlessly with each other. This competition would be “unhealthy,” proponents argued, because DIs would have to resort to extreme measures to offer higher and higher yields. Eventually, these DIs would have to get riskier with their uses of funds (loans, securities) to earn enough interest to pay their depositors a higher yield. This was believed to hold the potential for a collapse of the banking system.

Regulation Q didn’t create much of a fuss at the time. Why? Well, let’s simplify this by temporarily imagining that the cap was a flat 5%--in other words, that DIs couldn’t pay more than 5% interest on deposits.

Let’s also assume that a saver has two choices for what to do with his money:

1) He can deposit his money in a DI and earn up to 5% interest.2) He can invest his money in the money market (where securities with maturities less than one year are traded). There’s no limit on the interest he can earn here—it’s determined by the loanable funds framework we’ve discussed in class.

To simplify things a bit, let’s assume that neither the DI nor the market offers a special advantage over the other. In other words, DI customers didn’t get any special treatment or extra satisfaction for banking at a bank or thrift, and money market investors didn’t get any special treatment or extra satisfaction for investing there. The only thing that would make a customer decide whether she would deposit money in the DI or invest money in a

1 Address all correspondence to Amanda Freeman, Department of Economics, 327 Waters Hall, Kansas State University, Manhattan, KS 66506 or to asf9777@ksu.edu. All mistakes are my own, and the opinions expressed within do not necessarily represent those of Kansas State University.

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Something to ponder: Even though DIs couldn’t compete with each other via the yield paid on deposits, they had to find some way to get customers in the doors. This is why you sometimes saw banks offering toaster ovens or other such trinkets.

market would be the yield. Of course, a higher yield would be expected to draw more customers.

So we assume yields on bank deposits are capped at 5%. They can go no higher. And every penny the DI pays in interest to customers reduces the DI’s profits.

Even though Regulation Q came around in the 1930s, it didn’t cause problems at first. Interest rates were low, both in DIs and in the money market. Because the money market couldn’t offer a higher yield than a regular old bank or thrift could, most consumers had no special incentive to move into the money market. They kept their money in banks or thrifts as a sort of “default.” And for a while things didn’t seem anywhere near crisis levels.

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Notice that the DIs are again experiencing a problem we’ve discussed before—the need to set the interest rate “just right.” In this case, they want to pay just enough interest to make customers prefer them to the money market, but not too much—paying too much interest means lower profits.

Trouble in the Mid-1960s

In the mid-1960s, during an economic boom, everything changed. Why? The yield paid in the money market finally exceeded the Regulation Q cap.

A graph may help you picture this. Imagine yourself as a person with some savings—and you’re indifferent between putting those savings into the market or into a depository institution, because the only thing you care about is getting the highest yield possible. Therefore, if the yield offered in the market exceeds the yield offered to you by a DI for any decent length of time, you’ll take your money out of your bank or thrift and move it into the market.

Figure One: Market Yields and the Maximum DI Yields Allowed with Regulation Q

As you can see, this graph shows the relationship between the interest rate (yield) on the vertical axis and the year on the horizontal axis. We’ve had to simplify a few things to make this graph especially clear--the Regulation Q cap was a little more flexible than we’re showing, and the movements of market yields were more volatile than we’re showing, but even this simplified graph should work for now.

The graph indicates that 1965 was an important year, because this marked the first time that the market rate of interest significantly exceeded the rate DIs could offer under Regulation Q. In other words, before 1965, consumers were content to keep their money in banks or thrifts. The money market had no higher yield to offer them.

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But the vertical line at 1965 marks a change. 1965 was the first time that the market yield was higher than that DIs could offer for any significant length of time. So in 1965, many DI customers pulled their money out of banks and thrifts (a process called financial disintermediation) and invested in the money market instead.

What made the market interest rate go higher than the cap in 1965? Think about the economic conditions of the time. The country was doing well. We were in a boom period for reasons including higher government spending (Vietnam) and income tax cuts for consumers.

Figure Two: Market Interest Rates Rising in a Boom

This graph shows what happens to the market interest rate when a booming economy stimulates increases in demand for loanable funds. Because businesses want to borrow to invest and consumers want to borrow to finance large purchases, the equilibrium interest rate moves upward.

Note that the above figure shows the market yield, determined by supply and demand of loanable funds. DIs are constrained by Regulation Q and cannot let their yield payable rise, but the market can. These conditions in 1965 led to the market interest rate being higher than the yield payable by DIs.

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Recall from our discussion of the loanable funds theory of interest rates that interest rates tend to be procyclical—in other words, they tend to rise during booms and fall during recessions. This happens because, ceteris paribus, demand for loanable funds tends to increase in booms and decrease in recessions.

Regulation Q as a Price Control in the Loanable Funds Market

Any control on prices—remember, the interest rate is just the price of loanable funds—can be analyzed as we did earlier in our discussion of price controls. We further simplify the graphs by ignoring the fact that the Regulation Q cap on yields was periodically adjusted upward. Instead, we imagine that we “freeze time” for a moment and examine Regulation Q from the point of view of the loanable funds market.

Figure Three: Regulation Q as a Price Control

Because the market for loanable funds is a microeconomic market like any other, in equilibrium the quantity of loanable funds supplied equals the quantity of loanable funds demanded as long as there is no cap on the interest rate (control on the “price”). With Regulation Q limiting the yield that DIs can pay, this equality no longer holds up.

We have the same rightward shift in demand for loanable funds we discussed earlier, but now let’s turn our attention from the money market (flexible enough to change the yield) to DIs (unable to move their yield higher than the Regulation Q level). The horizontal line from “maximum DI yield” on the vertical axis represents the Regulation Q cap on interest rates.

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With the introduction of the “price control” Regulation Q, the quantity demanded of loanable funds is no longer equal to the quantity supplied of loanable funds—in fact, the quantity demanded of loanable funds exceeds the quantity supplied, creating a shortage.

This analysis seems consistent with our discussion of the mid-1960s. Many people wanted loans, but DIs struggled to find the funds to give out. When the yield they offered couldn’t adjust because of Regulation Q, all the toaster ovens and giveaways in the world couldn’t convince many customers to stay.

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Borrowers (who demand loanable funds) are glad to pay the interest rate held low by Regulation Q. Savers (who supply loanable funds) are unhappy with the situation. The yield received from DIs is too low for them, so they move to the money market. Therefore, a shortage exists—the quantity demanded of loanable funds is greater than the quantity supplied.

Big Savers, Small Savers, and the MMMF

DIs had one last thing to be grateful for. Sure, all customers, desiring higher yields, would have preferred to take their money out of banks and thrifts and put it in the money market. The problem was, however, that not all of them could. For a while, not all customers could leave to put their funds into the money market. Most money market instruments at the time came in very large denominations—in other words, there was a minimum investment of something like $100,000 to buy them. And many savers didn’t have anything near $100,000 in their accounts, so they were stuck.

Eventually, financial innovation targeted this problem when the money market mutual fund (MMMF) was created in 1971. A MMMF is a mutual fund broken up into smaller one-dollar portions for those with less than $100,000 to invest (recall that a mutual fund is just a diversified group of securities selected around a common theme). And although a MMMF may require you to buy a certain quantity of one-dollar portions (typically one thousand minimum, although this varies), $1,000 in savings is much easier to come by than the $100,000 needed to invest in a mutual fund. Now finally even the small savers could move into the money market and get a higher yield on their savings.

Great news for everyone—except for DIs, of course, who fared worse than ever. The small savers they’d had as a captive customer base left to get a higher yield in the market, and there was little the DIs could do to keep them around.

So DIs and politicians worked toward eliminating Regulation Q. Suddenly the “unhealthy competition” Regulation Q was created to avoid didn’t seem like such a bad situation after all, compared to having no sources of funds whatsoever.

Eventually Regulation Q was gone, thanks to DIDMCA (the Depository Institutions Deregulation and Monetary Control Act of 1980). DIs could pay an interest rate higher than the cap previously in force. And some customers left the money market and went back to banks. But the problem still wasn’t over, especially for thrifts. (Recall—a thrift is a type of DI, for all purposes today very similar to a bank. One type of thrift, which makes mostly home loans, is called a savings and loan (S&L).

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The big savers (people with more than $100,000 put away) were happy . They moved out of DIs, put their savings in the money market, and enjoyed the higher yield.

The DIs weren’t happy at all . Their big savers were leaving them, and all the demand for loanable funds in the world didn’t mean a thing if the banks and thrifts had no source of funds to make loans with.

The small savers (with less than $100,000) weren’t happy either . They stayed with DIs, but it wasn’t by choice. They would have gladly left and gotten a higher yield in the money market, but they were stuck.

Hard Times for Savings and Loans

Savings and loans were hit especially hard by the situation, even after Regulation Q was removed. One of the main reasons for this was that savings and loans tended to rely almost exclusively on mortgages as a use of funds (an earning asset). This was no simple matter of choice—S&Ls were bound to this choice of earning asset by law, while banks were able to invest in more diverse uses of funds.

Why was this a problem? Well, we know a couple of things about mortgages from class, and a few more facts should clarify the issue.

But ARMs didn’t exist during this crisis. These mortgages were fixed-rate loans, and that fixed rate was set long before the market interest rates rose.

That last point is especially important. It means that for the average family who bought a nice little house with a picket fence in 1958, market interest rates were low, and Regulation Q was still in effect. Because interest rates tend to rise and fall together, this family probably paid a pretty low interest rate on their home loan, so the S&L didn’t make very much interest income from them. But that was okay, because with Regulation Q the interest the S&L paid out on deposits was low too. So we might have had a hypothetical situation like this one:

The Smith family buys a house and pays 6% interest on their mortgage (home loan) from Good Times Savings and Loan. This 6% interest rate is fixed; it will never change. This seems reasonable, because interest rates have stayed at about this level for some time.

Good Times Savings and Loan pays about 4% on savings and time deposits to customers who keep their money there. This number is under the Regulation Q cap.

If we imagine that these are the only transactions Good Times engages in (to simplify things), Good Times Savings and Loan is indeed experiencing good times. It’s taking in 6% interest on the loan and paying out 4% interest on deposits. It operates at a tidy little 2% profit, assuming all else is held equal.

Now let’s fast forward to 1981. Regulation Q is gone (or at least starting to be phased out—it went away completely around 1986) and the market interest rate has shot up. Just about the only thing that’s the same is that the Smith family is still paying money on their mortgage. So here’s what we have:

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Mortgages are loans taken out to buy real estate (generally a residence). Mortgages tend to be long-term loans, often thirty years or more to maturity. Today, it’s common to have an ARM (Adjustable Rate Mortgage), where the interest

rate the consumer pays on the loan varies with the market interest rate.

The Smith family is still paying their mortgage from Good Times Savings and Loan, still with their fixed interest rate of 6%.

Regulation Q is gone, and market interest rates are up, so Good Times Savings and Loan has raised the interest rate it pays on deposits (it’s got to, to keep its customers). Let’s say now they’re paying 10% on deposits (an exaggeration, and totally hypothetical, but it makes the point more clear).

Good Times might want to consider changing its name, because times are no longer very good at all. It’s taking in 6% interest on the loan and paying out 10% interest on deposits. It’s making no profit at all—in fact, it is losing money (6% - 10% = negative 4%!).

We can see that S&Ls are facing a real dilemma.

Many Americans at the time had their money in savings and loans. If savings and loans all became insolvent and went out of business, these Americans would be quite unhappy. So you’d think that these customers would have a huge problem with the situation, right?

Actually, the public was largely indifferent to the problem for some time. Their money was at stake, but there was no public outcry for several years. Many reasons accounted for this, and some of the most important are listed below.

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If S&Ls drop the interest rate payable on deposits below what they’re taking in on these mortgages, they’ll lose customers and go out of business. But if they continue paying an interest rate higher than what they’re taking in on mortgages, they’ll go out of business too.

Reasons for Initial Public Indifference to the S&L Crisis

The public was lulled into a false sense of security because of deposit insurance . In class we’ve discussed FDIC insurance and how a potential problem with it is that if people feel their deposits are “too safe” they may not take the time to monitor their banks. During the S&L crisis, deposits in savings and loans were covered by FSLIC insurance, and the same problem existed. Bottom line: people have lots of things on their minds, and when they assume their deposits are protected anyway, they don’t take the time to worry about problems with their financial institution.

Accounting methods obscured the problem . Many of these savings and loans used a type of accounting called historical cost accounting. In a nutshell, historical cost accounting means that losses are not recorded until they’re actually taken. To understand this better, imagine someone who invested in Beanie Babies when they were a big craze. If this person paid $10,000 for a huge collection of Beanie Babies, there may have been a time when that collection could be resold for $50,000, but that time is over. That same collection sold today may only bring in $50. Under historical cost accounting methods, however, the Beanie Babies would be recorded as an asset at the price they were bought for, right up until they’re actually sold—even if the owner knows he’ll take a loss eventually. So with this method even those customers who kept an eye on the books didn’t see the whole picture.

Many insolvent S&Ls didn’t go out of business immediately . Just because a business is insolvent on the books doesn’t mean it goes out of business that day. Some savings and loans operated under a policy of forbearance—the idea that it might be worse on customers for a S&L to go out of business (possibly causing a public scare) than for it to keep trying to operate and maybe get things back on track.

So it’s the 1980s, and we have insolvent S&Ls, unclear accounting methods, uninformed consumers, and a whole host of other problems. Let’s go back to the political front, where S&L managers lobbied for the removal of requirements for them to invest in those troublesome long-term fixed rate mortgages.

Their reasoning was simple: They said that if they could diversify their uses of funds, investing in different loans with higher yields, they could pull themselves out of insolvency and maybe stay in business. And though it took a little bit of time, they were successful. In 1982 the Garn-St. Germain Depository Institutions Act was passed, allowing S&Ls to invest in more diverse uses of funds.

Problem solved? The answer’s still no.

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The Dilemma for S&L Managers after Garn-St. Germain

S&L managers always had mortgages as their use of funds, and that’s what they’re familiar with. Now a whole new world of different uses of funds has opened up—a world they have no experience in and not all that much knowledge of. Predictably, trouble ensues.

They’re desperate . These savings and loans are in serious financial trouble, and the managers know it. This is a last-ditch effort to try and salvage the industry’s financial health. Who do you think makes crazier bets in Las Vegas—the person there to have a little fun and casually gamble $50 she found in her pocket, or the person who’s been playing all day, has already lost it all, and is desperate to get his life back? Desperation can make people—or companies—or financial institutions—take inadvisable risks.

They’ve got to make a lot of money fast, and that means risk . In other words, these S&Ls had to find investments that would give a high return, and we’ve discussed that those investments that offer a high yield tend to be those with a high level of risk.

So these S&L managers go out into markets they know nothing about, feeling desperate and knowing they’re starting from a bad position, and they take on lots of risk in the hopes of pulling in some high yields.

You think they succeeded? Of course not. We don’t call it the “savings and loan crisis” for nothing.

Bottom line: S&Ls as an institution had a crash from which they never fully recovered, the government had to pay a lot of money, and financial institutions in general never really got back those big savers who decided they liked the money market better than working with them. Listing just a few of the major results from the S&L crisis should give you an idea of the magnitude of its effects.

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Results of the S&L Crisis

S&Ls never recovered . Although S&Ls are still around today, they lost almost one-fourth of their numbers to the crisis, and many economists predict that they are likely to die out as a separate depository institution at some point.

The crisis was costly . The bailout of the S&L industry cost the nation somewhere between $100 and $150 billion dollars, some of which came from taxpayers and some of which contributed to huge federal budget deficits of the period.

We got rid of FSLIC insurance . This didn’t happen right away, and it’s not a bad thing, but the S&L crisis caused a lot of people to come to a couple of different conclusions. The first was that the FSLIC dropped the ball during this crisis and probably made things worse. The second was that it probably wasn’t the best idea to treat banks and savings and loans differently. They seemed very similar to consumers, so why shouldn’t they seem the same to DI regulators? And why shouldn’t they be covered under the same insurance organization, if they were so similar? So FSLIC went away, and all depository institutions are covered under FDIC insurance today.

MMMFs got huge . As DI customers disintemediated and went into the money market, many through buying MMMFs, MMMFs became a major part of the financial landscape. Also, the sort of securities that tend to be included in an MMMF—for example, commercial paper (debt from companies with the very best credit)—became important economically as well.

So there you have it. Public scandal, poor money management, laws that were too rigid to keep up with economic circumstances, and revisions that came too late—not to mention corporate bungling, political tensions, and a heavy taxpayer payout—describe the savings and loan crisis in brief.

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Questions to Test Your Understanding

1) What was Regulation Q? How did it contribute to the savings and loan crisis?

2) Did getting rid of Regulation Q solve the problems from the savings and loan crisis? Why or why not?

3) Why wasn’t Regulation Q initially a problem? What changed in the mid-1960s to cause difficulties? (Use a graph in your answer).

4) Why were S&Ls hit harder than other depository institutions during the S&L crisis?

5) What factors explain the initial lack of public response to the S&L crisis?

6) What effects from the S&L crisis last until today?

Extension Questions

1) In retrospect, if you had been a politician or economist at the time, what changes would you have suggested to avoid or reduce the negative effects from the S&L crisis?

2) Do you think the S&L crisis would never have happened if Regulation Q hadn’t existed? Why or why not?

3) We said in class that insurance like that from the FDIC or FSLIC is intended to make DIs more safe. Use the S&L crisis as evidence that sometimes they can make DIs less safe. How would you suggest DIs handle this problem?

References and Sources for Further Reading

Gilbert, R. Alton. “Requiem for Regulation Q: What It Did and Why It Passed Away.” The Federal Bank of St. Louis Review. February 1986. <http://research.stlouisfed.org/publications/review/86/02/Requiem_Feb1986.pdf> (June 25 2006).

Ritter, Lawrence S., William L. Silber, and Gregory F. Udell. Principles of Money, Banking, and Financial Markets. Addison Wesley, 2003.

Thomas, Lloyd B. Money, Banking, and Financial Markets. Thomson South-Western, 2006.

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