Friday, February 13, 2009

The Savings & Loan Crisis vs Today

In short, the Savings & Loan Crisis occurred because Congress took the worst possible path when deciding how to "help" the S&L industry. In fact, the nature of the S&L mistake was remarkably similar to the mistake made by Congress that led us to our current crisis.

The S&L Crisis was set off by the repeal of Regulation Q. Quick history. S&Ls were created during the Depression to assist homeowners. They were given a legal advantage over commercial banks in the area of mortgage origination. However, as a trade-off for the advantage in mortgage origination, the S&Ls were not allowed to offer commercial loans. Okay. That worked. The concept was good for a few decades.

However, in the 1970s the securities markets changed and the government took a place in the mortgage business -- Fannie and Freddie. The era of Securitization began in 1977. Wall Street was able to package Ginnie Mae mortgages and sell GNMA securities tied to those pools. Thus, the operating environment for S&Ls changed. The secondary market for mortgage loans was created. Thus, the bank or S&L that originated a mortgage was able to sell the loan to another party. Meanwhile, interest rates were rising and the S&Ls began losing money. The S&L industry was in tough shape.

The leaders of the S&L industry went to Congress for relief. They got it. In fact, they got what they wished for. During Jimmy Carter's administration, Congress repealed Regulation Q, which was the law that defined the differences between S&Ls and commercial banks. Suddenly S&Ls could offer the same loans as banks.

However, one barrier remained. It was not possible for banks to buy S&Ls. Big mistake. Suddenly S&Ls were in the commercial loan business competing with banks. At the same time, builders realized it was easy to gain control of an S&L and then get loans for any project imaginable.

Oil prices were rising and fueling a huge building boom in the oil states. Both residential and commercial properties were under construction. The S&Ls were lending to the oil drillers and the home-buyers. When oil prices cracked in 1983, the S&L real estate bubble popped. Things went downhill from there.

However, Congress could have handled things in a different way. It could have removed the obstacles that stopped banks from acquiring S&Ls. If banks had been able to buy them, the economy would have escaped most of the damage.

By the way, another key change that magnified problems was the increase in coverage offered by deposit insurance. Carter raised the coverage offered by the FDIC and the FSLIC to $100,000, up from $40,000. Unscrupulous S&L managements realized the amount of assets available to them for speculative lending activities was multiplied two and one-half times. They had won the S&L lottery.

In the current crisis similar mistakes were made. The worst mistake was opening the door to underwriting loans that were extended to people with lousy credit scores, no downpayment money and poor job prospects. Who opened the door? Congress. The first step was the 1977 Community Reinvestment Act, another time-bomb from the Carter presidency.

If anyone chooses to review that process that got us where we are, the reviewer will see that all laws were met. The documents describing the various troubled securitizations were complete and drawn up as required by the SEC. Moody's, Fitch and Standard & Poors rated the securities, which were then sold to institutional investors. But it seems nobody read the prospectuses and other documents. It seems that everyone put their faith in the ratings from the Rating Agencies. Bad move.

Meanwhile, no one from the Fed, the Treasury or the SEC took a close look at these securities or the markets to which they were tied. Why? Probably because billions of dollars of tax revenue was flowing into Washington as a result, and, at the same time, home-ownership was soaring. Who would tamper with that?

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