Here is a good video from Bill Black on the origins of the Savings & Loan crisis in the U.S. The roots of the crisis go back to the stagflation of the 1970s when interest rates spiked under Paul Volcker. As S&L’s borrowed short and lent long, it meant a mismatch between their long-lived and low-yielding S&L assets and the shorter high-interest S&L demand deposits and liabilities. Many savings and loans became deeply insolvent.
The right thing to do would have been to address the problem straight away and have the regulator seize insolvent institutions, likely resulting in hundreds of billions of losses for taxpayers. Instead, a legislative ‘fix’ was found which allowed the S&L’s to masquerade as solvent institutions, which incented many S&L executives to load up on risk as a ‘fix’ for their insolvency. A lack of regulatory oversight then created a Gresham’s law of bad behaviour driving out good. In describing this phenomenon in this last financial crisis in the UK, I wrote:
The Bradford and Bingleys of the world used lower interest rates to justify jacking [the maximum mortgage debt to income limit] constraints up to 3.5 times or four times income. Eventually these constraints hit six times in the UK.
How do you compete against that as a bank? All of the business is going to Bradford and Bingley and you are getting stuffed. I guarantee you shareholders won’t like that. As an executive, you better find the holy grail of prudent but profitable lending or follow Bradford and Bingley on the road to easy money. Otherwise, you will be out of a job.
Eventually, even the prudent relax their standards too – that’s how risky behaviour drives out good when risk is rewarded. See my comments in “James Galbraith: How financial stability creates instability.”
In the S&L days, the result was a criminogenic environment ripe for fraudsters to enter the marketplace. Rates came down, but the competitive landscape had changed. Therefore, many S&L’s loaded up on high risk assets like junk bonds – and not just the insolvent ones. Looting was also commonplace. When the economy turned down, loans went bad in spades and bond defaults skyrocketed. The result was a wave of insolvencies, bank runs and crisis as well as over 1,000 felony convictions of financial executives.
Black explains this in greater detail below (with a fairly good but not unbiased overview of the politics of the affair).
The FDIC has a good S&L chronology I highly recommend. In reviewing this episode in 2008 after the Lehman affair, I wrote:
The S&L crisis bears keeping in mind as many comparisons to that period regarding deregulation, risk, and bailouts are now being made. One note about the S&L crisis that I should make is that relaxing accounting rules caused the crisis to mushroom in size. And this bears noting as the onerous FAS 157 is creating quite a stir right now. Basically, the accounting rule mandates marking-to-market of various securities.
I am sympathetic to calls to relax the rule as it is pro-cyclical, meaning it naturally swings along with the business cycle. Marking to market causes balance sheets to be inflated during booms like the one we just had and it may cause them to be artificially deflated during busts like the present one.
However, experiences like the Savings and Loan crisis show that relaxing accounting rules in order to bail out financial institutions is probably a bad idea and leads to much greater losses. It is better to take the losses in the first place and move on.