What was the savings and credit crisis? How has this affected investors?
What was the savings and credit crisis?
In the 1980s, there was a financial crisis in the United States which stemmed from soaring inflation as well as the rise of high yield debt securities, called junk bonds, which resulted in the bankruptcy of more than half of the country’s savings and credit institutions. (S&L).
A savings and loan institution, also called savings, is a community bank. It provides current and savings accounts as well as consumer loans and mortgages.
The concept of the S&L began in the 1800s. They were formed with a mission to help the working class with low cost mortgages so they could afford homes. The most famous example of a savings appeared in the movie It’s a wonderful life. There were over 3,200 S&Ls in the United States in the 1980s; fewer than 700 remain today and the S&L crisis is estimated to have cost taxpayers up to $160 billion.
What caused the savings and loans crisis?
The savings and loan crisis stemmed from a variety of factors, but none contributed more to it than inflation. The early 1980s were a difficult time for the United States, as consumers faced rising prices, high unemployment and the effects of a supply shock – an oil embargo – which caused skyrocketing energy prices. The result was stagflation, a toxic environment of rising prices and slowing growth, pushing the economy into recession.
In order to fight inflation, the Federal Reserve had to take aggressive measures, and so it raised the Fed Funds rate sharply. This had a knock-on effect on all other short and long-term interest rates – they peaked at 16.63% in 1981 – and made the “American Dream” of home ownership nearly impossible. .
That is, until a “revolution” in real estate financing was introduced: mortgage instruments that reflected changes in interest rates, called rolling or variable rate mortgages. These would make the owner liable to bear some of the risk in the event that interest rates rise sharply again – and come back to haunt global markets during the 2007-2008 financial crisis.
How were S&Ls affected by inflation in the 1980s?
Inflation didn’t just hit homebuyers in the 1980s. Bonds had long been a way for companies to raise cash, but during the recession many companies that had previously issued investment grade bonds received credit downgrades, which reduced their obligations to a more risky, speculative or junk status, which meant their likelihood as default had increased. This did not, however, stop Big Business in the 1980s. Corporations simply began to finance their activities, such as mergers or leveraged buyouts, through junk bonds, as did thrift institutions. and credit.
The savings and credit crisis explained
The problem for the S&Ls was that many of the loans they made were long term and fixed rate. So when the Fed raised interest rates sharply, S&Ls were unable to generate enough capital from existing depositors to offset their debts. In addition, restrictions imposed by laws such as the Federal Home Loan Bank Act of 1932 placed limits on the amount of interest a bank could charge its account holders, which tied their hands. S&Ls earned less interest on their loans than they paid on their deposits. The phrase “borrow short to lend long” was coined.
New consumer account holders were attracted to other banks offering vehicles like money market accounts, which had better higher savings rates; as a result, many S&Ls became insolvent.
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The federal government, which itself dealt with the adverse effects of the recession, such as a hiring freeze in 1981, lacked the manpower to oversee the S&L industry as it became more combustible. Instead, officials made the shocking decision to deregulate industry in the hope that it would self-regulate. But less oversight has caused even more egregious things.
How were S&Ls connected to junk bonds?
Deregulation allowed S&Ls to invest in even riskier instruments that would offer the high returns they needed: junk bonds became the speculative vehicle of choice for financiers behind S&Ls hoping to offset the damage caused by fixed rate mortgages. Surprisingly, the government did not charge the S&Ls that made these investments premiums on their deposit insurance; in fact, all S&Ls paid the same premium.
S&Ls also took advantage of other regulatory loopholes, which served to delay their insolvency, adding years and billions more to the burden on taxpayers. For example, they invested heavily in speculative commercial real estate, especially in Texas. They also made “deposits through a broker,” which split client funds into $100,000 increments, which could then be deposited into different S&Ls in search of the highest interest rates. , leaving a written record. S&L’s financiers also flagrantly violated generally accepted accounting principles, accounting for losses on their balance sheet as “goodwill.”
One example involved investor Charles Keating, who bought up to $51 million in junk bonds for his S&L, Lincoln Savings & Loan, even though he technically suffered a net loss of $100 million. These junk bonds came from Michael Milken’s company, Drexel Burnham; both men were convicted of securities fraud and racketeering and sentenced to prison.
But Keating’s actions didn’t stop there. Even more incredible, Keating was also responsible for sending $1.5 million in campaign contributions to five US senators. The incident became a political scandal known as the Keating Five and involved Senators John Glenn (D-Ohio), Alan Cranston (D-California), John McCain (R-Arizona), Dennis DeConcini (D-Arizona), and Donald Riegle (D-Michigan).
Keating’s bribes were an attempt to pressure the Federal Home Banking Board to investigate his S&L, but in 1991 the Senate Ethics Committee determined that Cranston, DeConcini and Riegle all had improperly interfered with the Lincoln Savings investigation, while Glenn and McCain were cleared. All five were allowed to complete their terms in the Senate, but only Glenn and McCain won re-election.
What are the consequences of the savings and credit crisis?
In 1989, President George H. W. Bush introduced the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA), which reformed the S&L industry by providing $50 billion to shut down or “bail out” failing S&Ls and stem new losses, as an additional 747 S&Ls declared bankruptcy between 1989 and 1995.
In addition, FIRREA required all S&Ls to sell their junk bond investments and establish stricter capital maintenance requirements. It also created new penalties for fraud at federally insured banks. A new government agency, the Resolution Trust Corporation, was created to resolve the remaining S&Ls. It operated under the Federal Deposit Insurance Corporation (FDIC) until its final dissolution in 2011.
The S&L crisis is one of the causes of the American recession of 1990, which lasted 8 months. During this period, home buying fell to its lowest level since World War II.
Do S&Ls still exist?
Yes, but today’s S&Ls have merged or been taken over by bank holding companies. They are run with much stricter regulations, requiring 60% of their assets to be invested in residential mortgages and other consumer products, for example.
Is saving safe in a recession?
While a recession can be a natural part of the business cycle, Roger Wohlner of TheStreet.com thinks several categories of bonds and bond funds can help your portfolio stay more stable.