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S&Ls, Ten Years Later

September 20, 1999

[from the Financial
Post
, Monday, September 20, 1999]

This year marks the 10th anniversary of the Financial Institutions Reform, Recovery and
Enforcement Act (FIRREA), Washington's answer to the great financial disaster known as the
savings and loan crisis. At the time, Congress blamed lax regulation. We now know the blame lies
with over-regulation.

Originally, the S&L crisis was seen as a uniquely American mishap. In fact, it was but one of a
slew of banking crises around the globe. Since 1980 when the crisis began, fully two-thirds of the
182 nations that belong to the International Monetary Fund have suffered similar problems.

In August of 1989, after 10 years of crisis, Congress belatedly authorized outlays of more than
$150-billion (all figures in U.S. dollars) to close failed S&Ls that should have been liquidated
years earlier. Rather than admit to its own mismanagement, Congress used FIRREA to deflect
blame to directors, officers, lawyers, accountants and others who had been caught at the tiller
when the system sank into insolvency.

Subsequent research reveals why this kind of scapegoating was silly. Fraud, which some have
mistakenly identified as the major factor in the S&L crisis, accounted for less than 10% of the
clean-up costs. The more important factor was an ill-advised government rule: Since the 1930s,
S&Ls had been required by law to make long-term, fixed-rate home mortgages funded by short-
term deposits. In the early 1980s, short-term interest rates rose above long-term interest rates. By
1981, almost all S&Ls were reporting losses, and their liabilities exceeded the value of their assets
-- largely home mortgages.

Congress played legislative catch-up for the rest of the decade. In 1980 and 1982, S&Ls were set
free to become more like commercial banks, which had remained largely immune to risks inherent
in borrowing at short-term interest rates while lending at long-term rates. The S&Ls mostly
rushed into commercial real estate. Congress also bought time by lowering the capital
requirements for S&Ls, encouraging yet greater leverage in real estate investments.

The commercial real estate market stumbled badly in the mid-1980s with the precipitous decline
of energy prices and federal tax reform. The former produced a regional recession in the
Southwest, while the latter drove down commercial real estate prices by eliminating some juicy
tax breaks.

Then things got ugly. In 1989, Congress shuffled regulatory bureaucracies, raised capital
requirements and, ironically, required S&Ls to retreat to home lending, where they had first
gotten into trouble. Compounding the damage, they forced institutions into a fire sale of their
relatively modest portfolios of high-yield bonds, which had performed well throughout the
decade. Last, but hardly least, Congress eliminated "goodwill" as an asset in S&L portfolios,
pulling the rug out from under many institutions and adding a potential $50-billion of taxpayer
liability, when the Supreme Court agreed that the government could be sued for reneging on what
amounted to contracts.

To dispose of nearly $1-trillion worth of assets seized from failed S&Ls, Congress established the
Resolution Trust Corp. FIRREA was part of a broader wave of financial re-regulation that
hamstrung the government in recovering the full value of assets in liquidations. These regulatory
shifts helped precipitate the 1990 recession, during which banks and S&Ls reduced loans by about
eight times the amount of their decline in capital.

Since small-business borrowers have fewer substitute sources of credit available to them than
large ones, the decline in bank lending disproportionately affected their ability to spur innovation
and long-term economic growth. The outcome was thus the worst of all possible worlds: a
national recession triggered by an excess supply of real estate, the needless destruction of asset
values and greater liabilities for taxpayers.
The S&L crisis has echoes in the recent East Asian crisis and other banking crises around the
world. Excessive government intervention has limited allowable activities, hobbling financial
institutions' attempts to reinvent themselves by diversifying both their assets and liabilities.

The
absence of efficient capital markets, and dependence on ossified banking systems, has left these
countries with daunting resolution costs. It will cost Mexico about 19% of its annual GDP,
compared with just 2% to 3% of America's GDP in the S&L crisis.

In addition, following in the footsteps of the U.S., Japan is proving that excessive forbearance--not resolving insolvent banks in a timely fashion--is excessively costly. Though gambling on a
favourable turn in interest rates or a sharp rise in asset prices may sometimes work out, generally
it creates the costly debacles that the U.S. and many countries elsewhere have failed to dodge.

We live in a time of extremely successful government spin. As in the case of the S&L crisis,
Congress has fingered lax regulation as a major culprit in the East Asian and other international
banking crises.

But the far bigger problem lies with the destabilization by-product of regulation--government
determining who lends how much to whom for what. That role should be left to individuals with
capital at risk.

---------------

JAMES R. BARTH, a senior fellow at the Milken Institute, served as chief economist at the Federal
Home Loan Bank Board and its successor, the Office of Thrift Supervision, from 1987 to 1989.
He delivered a version of this paper Friday in Toronto at the Ludwig von Mises Institute's
conference on Austrian Economics and the Financial Markets. c) copyright The National Post, 1999


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