This is the 2nd post of my grand financial/online poker opus. I used the Stock Market crash of 1929 as a bit of a prelude to the modern lead up to the 2008 Financial Crisis, which in the opinion of many renowned economists and journalists, started in 1979. Thanks for reading.
With the passing of the Glass-Steagall Act in 1932/33, banks were separated into 2 areas, commercial and investment. Not only did this cut down the size of the banks in the late 1920's, but the potential economic damage that could be caused by a widespread contagion. Banks no longer were able to use customer deposits in the same way as before, which was viewed as reckless gambling. The separation also helped to cut back on the conflicts of interest by banks that profited by customer loss. The act also created the Federal deposit insurance corporation, otherwise known as the FDIC. It insured customer deposits in Federally approved banks up to a specific amount, which could potentially assuage fears in times of financial crisis, as in the late 20's and early 30's. Another important provision in the Glass-Steagall Act was Regulation Q, which stopped the practice of interest bearing checking accounts on customer deposits which supported aggressive competition amongst banks to attract more capital during the 1920s, termed "the race to the bottom". Regulation Q also limited the amount of risk that a bank could put it self in and encouraged investment in substitute areas like money market accounts and other banking alternatives which supported competition. At the end of the day, the Glass-Steagall act was put into place in order to stop systematic risk while protecting consumers. Another important event was the construction of the Federal Savings and Loan insurance corporation which was created as a part of the National Housing Act of 1934. It's intention was the same as the FDIC with respect to insuring deposits in Savings & Loans companies as well as stopping the failures of financial institutions across the country.
This brings us to the mid 1970's when the Savings and Loan industry was facing the first of 2 major challenges. The S&L industry was having a difficult time competing for capital in a slow growth economy facing high inflation. Depositors were taking their money out of Savings and Loan companies and putting them into market accounts which earned more in times of high interest rates. The second hurdle the lack of customers given the fact potential home owners had a harder time qualifying for a mortgage which meant less customers for the S&Ls. In 1979, the Federal Reserve raised interest rates again as a tool to curb inflation which put S&Ls at a breaking point.
In 1980, congress passed the first of 2 major acts of deregulation in order to help financial institutions especially the hurting Savings and Loan industry. The Depository Institutions Deregulation and Monetary Control Act removed the power of setting interest rates by the Federal Reserve and allowed financial institutions the ability to charge any interest rate they chose. It also gave banks the ability to merge and S&Ls could offer checkable deposits. The Savings & Loan industry was now able to compete on what at first appeared to be a more even basis for customer deposits than before and with the additional deregulation the S&Ls could use that capital from mortgages sold in to the secondary market to reinvest in order to seek better returns. The S&Ls commonly sold those mortgages to larger Wall Street banks that not only paid lower than face value for them, but re bundled the mortgages into a pool and resold them to the S&L industry as government backed bonds charging high fees. Another way the larger banks were ahead of the curve in light of the deregulation of 1980 was the fact that they had the liquidity to offer higher interest rates to their customers which in turn attracted investors to their stock.
According to a study published in the "Journal of Finance", entitled, An examination of the impact of Garn-St. Germain Depository institutions Act of 1982 on Commerical banks and Savings and loans, "...present evidence that the Depository Institutions Deregulation and Monetary Control Act of 1980 provided a wealth transfer from non-Federal Reserve System member banks and Savings and Loans (S&Ls) to Federal Reserve Member Banks. Furthermore, Cornett and Tehranian (1989) find that the banking deregulation passed in 1980 benefited stockholders of large banks and savings and loans but produced negative abnormal stock returns for small banks and savings and loans."
S&Ls were forced to compete by offering higher than normal interest rates compared to the assets in their portfolios which caused them to be insolvent. By 1980 many of the already distressed institutions were failing. This raised strong concerns in Congress that if S&Ls were facing these desperate conditions, then the entire financial system could be at risk if a large percentage of Savings and Loan industry went under.
"The changes in the economic and financial conditions resulted in a demand for further reform of the financial system, and eventually, the passage of the Garn-St. Germain Depository Institutions Act of 1982." (pg.3)
The Garn-St. Germain Depository Institutions Act was intended to give further support to the housing industries on both the lender's side and borrower's side. According to William K. Black, the Act was based on legislation first put forth in Texas, which at the time was one of the most profitable states with respect to their Savings and Loan industry. It deregulated many areas of Commercial loans by expanding the areas of lending and home loans by financial institutions. They could now offer a wider array of mortgages with less restrictions on who they could sell them to. S&Ls could now lend at a higher ratio compared to the capital they had. The Act also allowed more lenient accounting rules with which they would report their financial stability which made them appear to be more profitable. They were allowed to increase the percentage of commercial and consumer loans within their portfolios led to an unbalanced business acumen that would later prove costly. They were also allowed to invest, for the first time, in state and local government revenue bonds.
These areas of deregulation were meant to make the market more fair and balance, especially for the smaller financial institutions like small S&Ls the ability to compete with larger banks as well as non-regulated entities, like money market funds and brokerage houses, but in reality, it gave the large banks pathways to capital that regulation hadn't allowed before. This perpetuated the inequality in competition which put pressure on the S&L industry to take on more risky investments and "sell short" in a long term market. This act, in effect, created a "race to the bottom" with respect to deregulation by the Federal government and the State governments in order to compete for S&L charters. It was easy for financial institutions to switch between being a Federal Charter or a State Charter while being backed by the FDIC. The attraction was what the institutions would be allowed to invest in under a given charter. The S&Ls naturally went where there was the least amount of regulation and oversight. As a result, the S&Ls grew at an enormous rate and were able to leverage their risk more so than ever before without having to back up their loans with capital.
The icing on the cake was that there was little to no oversight, especially in States like California and Texas where the loan default rates were higher than average. The Savings and Loan industry was experiencing a housing boom in the mid 80's in the light of deregulation. Smaller S&Ls that were once insolvent were now climbing their way out of failure and looking forward to successful endeavors, until 1986. The Reagan administration continued its policy of tax cuts with the passing of the Tax Reform Act of 1986 which may have been the final straw in breaking the back of the Savings and loan industry as well as popping the housing boom of the mid 1980's. One of the provisions in the Tax Reform Act was to remove tax shelters in the area of passive real estate investment, both in housing as well as commercial investments. This helped to cause a decline in housing prices which forced investors to sell which then compounded the problem by lowering prices even more. As prices fell, investors defaulted, and the institutions holding the mortgages in portfolio, especially small S&Ls, were forced to sell those mortgages which caused housing prices to fall even more.
As the dominoes fell in one institution, so did others on down the line, much like 1929. Home owners defaulted at a high rate, smaller financial groups like S&Ls quickly became insolvent, and bond holders who were not insured lost their savings. By the late 1980's the Federal Savings and Loan Insurance Corporation itself was insolvent due to the number of S&L bankruptcies which numbered in the thousands. Tax payers, many of whom had never used a Savings and Loan were paying the cost of this debacle which was estimated at $160.1 billion. That amount was not including Federally insured S&L losses before 1986 or after 1996. As it was in the financial crashes of 1893, 1907, and 1929, capital had to be injected in order to stop a systematic crash that could have very well shut down the entire U.S. economy which in turn could cause a world wide contagion.
In hindsight, the Savings and Loan crisis of the mid to late 80's appears to be one that was manufactured out of ignorance, ego, and recklessness. Government on both sides of the aisle believed that the Financial sector would act in the best interests of home owners, investors, and their own institutions by being responsible and regulating themselves. They were wrong.
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