Similarities Between SL and the Housing Crisis

ONE WAY BANKS HAVE OF ATTRACTING MONEY is by offering above market rates on CDs and savings accounts. With six-month treasuries yielding 3.2%, guaranteed rates of 5.0% on CDs or savings accounts will attract capital.

Such rates should not be government guaranteed but they are. Money will always flock to the highest guaranteed returns.

Washington Mutual, Corus Bank, Bank United, Countrywide Financial and others are all attracting capital because of FDIC insurance. Can they make it up by lending it out higher? Perhaps, but only by taking on additional risk. Would those banks attract as much capital without FDIC insurance? Hardly.

It was excessive risk that got WaMu, Citigroup, Merrill Lynch, Bear Stearns, Countrywide and others into trouble in the first place.

If this financing scheme fails, the taxpayer will be left holding the bag. Does this ring a bell? It should because that is what happened in the S&L Crisis.

S&L Crisis Revisited

Wikipedia has this take on the Savings and Loan Crisis:

“The Savings and Loan crisis of the 1980/1990s was the failures of savings and loan association in the United States. Over 1,000 savings and loan institutions failed in ‘the largest and costliest venture in public misfeasance, malfeasance and larceny of all time.’ The ultimate cost of the crisis is estimated to have totaled around $160.1 billion, about $124.6 billion of which was directly paid for by the U.S. government.

“A taxpayer funded government bailout related to mortgages during the Savings and Loan crisis may have created a moral hazard and acted as encouragement to lenders to make similar higher risk loans during the 2007 subprime mortgage financial crisis.

“The background

“Savings and loan institutions (also known as S&Ls or thrifts) have existed since the 1800s. They originally served as community-based institutions for savings and mortgages. In the United States, S&Ls were tightly regulated until the late 1970s. For example, there was a ceiling on the interest rates they could offer to depositors.

“In the 1970s, many banks, but particularly S&Ls, were experiencing a significant outflow of low-rate deposits, as interest rates were driven up by the high inflation rate of the late 1970s and as depositors moved their money to the new high-interest money-market funds. At the same time, the institutions had much of their money tied up in long-term mortgage loans that were written at fixed interest rates, and with market rates rising, were worth far less than face value. That is, in order to sell a 5% mortgage to pay requests from depositors for their funds in a market asking 10%, a savings and loan would have to discount their asking price on the mortgage. This meant that the value of these loans, which were the institution’s assets, was less than the deposits used to make them and the savings and loan’s net worth was being eroded.

“Under financial institution regulation which had its roots in the Depression era, federally chartered S&Ls were only allowed to make a narrowly limited range of loan types. Late in the administration of President Jimmy Carter caps were lifted on rates and the amounts insured per account to $100,000. In addition to raising the amounts covered by insurance the amount of the accounts that would be repaid was increased from 70% to 100%. Increasing FSLIC coverage also permitted managers to take more risk to try to work their way out of insolvency so that the government would not have to take over an institution. When Jimmy Carter left office in January 1981, 3,300 out of 3,800 S&Ls lost money that year. In 1982 the combined tangible net capital of this industry was $4 billion. The chartering of federally-regulated S&Ls accelerated rapidly with the Garn-St Germain Depository Institutions Act of 1982, which was designed to make S&Ls more competitive and more solvent. S&Ls could now pay higher market rates for deposits, borrow money from the Federal Reserve, make commercial loans, and issue credit cards. They were also allowed to take an ownership position in the real estate and other projects to which they made loans and they began to rely on brokered funds to a considerable extent. This was a departure from their original mission of providing savings and mortgages.

“Imprudent real estate lending

“In an effort to take advantage of the real estate boom…many S&Ls lent far more money than was prudent, and to risky ventures which many S&Ls were not qualified to assess. L. William Seidman, former chairman of both the FDIC and the Resolution Trust Corporation, stated: ‘The banking problems of the 80s and 90s came primarily, but not exclusively, from unsound real estate lending.’

“Keeping insolvent S&Ls open

“Whereas insolvent banks in the United States were typically detected and shut down quickly by bank regulators, Congress sought to change regulatory rules so S&Ls would not have some acknowledge insolvency and the FHLBB would not have to close them down.”

Public Policy Causes of the S&L Crisis

While Wikipedia has many of the facts correct, pointing the blame at deregulation is missing the boat. In the Concise Encyclopedia of Economics, Bert Ely gets it right. Ely lists in his article 15 reasons but the first one really says it all:

“Federal deposit insurance, which was extended to S&Ls in 1934, was the root cause of the S&L crisis because deposit insurance was actuarially unsound from its inception. That is, deposit insurance provided by the federal government tolerated the unsound financial structure of S&Ls for years. No sound insurance program would have done that. Federal deposit insurance is unsound primarily because it charges every S&L the same flat-rate premium for every dollar of deposits, thus ignoring the riskiness of individual S&Ls. In effect, the drunk drivers of the S&L world pay no more for their deposit insurance than do their sober siblings.

“Borrowing short to lend long was the financial structure that federal policy effectively forced S&Ls to follow after the Great Depression. S&Ls used short-term passbook savings to fund long-term, fixed-rate home mortgages. Although the long-term, fixed-rate mortgage may have been an admirable public policy objective, the federal government picked the wrong horse, the S&L industry, to do this type of lending since S&Ls always have funded themselves primarily with short-term deposits. The dangers inherent in this ‘maturity mismatching’ became evident every time short-term interest rates rose.”

History Rhymes

This time it was banks taking riskier and riskier lending positions. The underlying belief was that property values always go up so there was no risk. That belief was blown out of the water.

WaMu is heavily into Pay Option ARMs. An accounting absurdity let WaMu (and others) record negative amortization from those ARMs as earnings. The investment community cheered what should have been an enormous red flag. The Pay Option ARM problem went ignored for months as the following chart shows:

The chart shows that Pay Option ARM problems finally caught up with Washington Mutual in July 2007. In spectacular fashion, there was an asymmetrical unwind of the credit bubble at WaMu and many other financial companies.

Now Washington Mutual is attempting to sure up its balance sheet by attracting capital at above market rates.

Watch Corus Bankshares

Corus Bank is another one to watch. According to its business model, as posted on Yahoo! Finance:

“Corus Bankshares, Inc. operates as the holding company for Corus Bank, N.A. that offers consumer and corporate banking products and services. The bank’s deposit products include checking, savings, money market, and time deposit accounts. Its loan portfolio primarily comprises commercial real estate loans, including condominium construction and condominium conversion loans; commercial loans; and residential real estate loans.

“The bank focuses its lending activities in various metropolitan areas in Florida and California, as well as in Las Vegas, New York City, and the Washington, D.C. Corus Bank focuses it lending in many of the major collapsing real estate bubbles in the country. Were it not for FDIC insurance would anyone want to take a risk on Corus Bank’s CDs?”

Woes at Bank United

BankUnited is another bank in trouble over Pay Option ARMs. According to Yahoo

“BankUnited, whose $15 billion in assets makes it the largest bank based in Florida, reported large increases in provisions for possible loan losses on its monthly option adjustable-rate mortgages in 2007. The bank’s non-current ratio has been rising for those loans, which permit borrowers to defer some monthly interest payments and thus increase their loan balances.”

If you would like to see the complete list of companies with problems, take a look at High Yield CD Rates. They all will mention FDIC insurance. Without it, who would invest with these companies?

FDIC is a moral hazard that caused the S&L crisis. Perhaps we are in for a repeat performance.

Regards,
Mike Shedlock
January 9, 2008

P.S.: The economic landscape of 2007 was marked by the burst of the housing bubble. A New Year brings new possibilities, but that is not necessarily good news when it comes to our housing markets. We’ve seen and heard the bubble burst; now is when we could actually be seeing the worst.