What it means
Savings and loan associations were built to do one simple thing: take in savings deposits and lend them out as long-term, fixed-rate home loans. That worked while interest rates were low and stable, because the interest earned on old mortgages comfortably exceeded the interest paid to depositors.
The model had a hidden weakness, since deposits could reprice in months while mortgages locked in a rate for decades. When interest rates rose sharply in the late 1970s and early 1980s, thrifts had to pay far more for deposits than their old mortgages were earning.
Many were losing money on every dollar they held, and a large number were insolvent in all but name. Regulators faced a choice between closing them, which the insurance fund could not afford, and letting them carry on.
Policymakers chose to loosen the rules to give the thrifts a chance to recover. Restrictions on the types of loans were relaxed, accounting standards were softened and the limit on insured deposits was raised.
Owners of weak thrifts, who had little left to lose, were then tempted to gamble on risky property developments and commercial loans, because the government insurance protected depositors whatever happened. When the bets failed, losses overwhelmed the federal insurer for thrifts.
Congress passed the Financial Institutions Reform, Recovery and Enforcement Act in 1989, which abolished the old insurer and regulator, created new ones and set up the Resolution Trust Corporation to close failed institutions and sell their assets. Total costs ran well over $100 billion, most of it borne by taxpayers.
For business people the episode is a standing lesson in several ideas. Borrowing short and lending long creates interest rate risk, insurance can encourage risk taking when it is not priced to risk (economists call this moral hazard), and regulatory forbearance can turn a manageable problem into a far larger one.
In practice
Real-world examples.
Example
A regional thrift has $200,000,000 of old fixed-rate mortgages and sees its funding costs jump above the rate on its loans. Management responds by chasing higher yields in speculative office developments, a decision that ends badly when local property prices fall.
Example
A bank treasurer today reads about the crisis when designing a rate risk policy. She sets limits on the gap between asset and liability repricing so that a rate rise of two percentage points cannot erase more than a set share of the bank's capital.
Example
A policy analyst at a think tank uses the episode to argue that deposit insurance premiums should reflect the risk each institution takes. She points out that when every depositor is protected at the same price, owners have an incentive to gamble.
Formula
Calculation
Net interest spread = Yield on assets - Cost of funds.
Imagine a thrift holding $100,000,000 of 30-year mortgages that pay a fixed 6% a year, so interest income is $100,000,000 x 0.06 = $6,000,000. When market rates jump, the cost of its deposits rises to 10%, so it pays $100,000,000 x 0.10 = $10,000,000 in interest. The spread is 6% - 10% = -4%, and the thrift loses $6,000,000 - $10,000,000 = -$4,000,000 a year before any other costs.Case study
Seen in the real world.
Prairie Ridge Savings is an entirely fictional thrift with $400,000,000 in assets, almost all of them 30-year fixed-rate mortgages written when rates were low. In this illustrative story, a sharp rise in market interest rates pushes its cost of deposits above the yield on its loan book, and its capital begins to disappear.
The owners, who are personally exposed, respond by moving into land development loans that pay much higher interest. For a while the strategy seems to work, and the thrift reports healthy income, but the new loans are poorly underwritten and depend on rising property prices.
When local prices fall, the loans default and the thrift is closed by regulators. The illustrative lesson is that the original problem was a mismatch between short-term funding and long-term assets, and that the attempt to gamble out of it made the loss far larger. The board of a fictional neighbouring lender, having watched the failure, cut its rate gap and raised more capital, which meant it survived the same rate rise.
Watch out
Common mistakes.
- Blaming the crisis only on fraud, when interest rate risk and weak regulation were the main drivers.
- Assuming it was a banking crisis in general, when it centred on thrifts that specialised in home mortgages.
- Believing deposit insurance protects against bad behaviour, when it can encourage risk taking if premiums do not reflect risk.
Questions
People also ask.
What is a savings and loan association?
It is a financial institution that takes savings deposits and mainly makes home mortgage loans, and it is sometimes called a thrift.
What was the Resolution Trust Corporation?
It was the government body set up in 1989 to take over failed thrifts and sell their assets.
Why does the crisis still matter?
It shows the danger of borrowing short and lending long, and it shaped later rules on capital, supervision and deposit insurance.
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