The Savings and Loan Crisis of the 1980s

In essence, a savings and loan (S&L) is a firm whose projects are long-term mortgages, whose customers are homeowners that mortgage their homes, and whose debtholders are depositors. In a typical project, an S&L will invest in a 30-year mortgage, where the cash flows from the project are mortgage payments.

In the 1970s, market traditions and pressures led S&Ls to finance their projects by relying heavily on short-term debt, borrowing from depositors. Nominal capital requirements were that an S&L’s equity be no less than 6 percent of its liabilities, leading S&Ls to have debt-to-capital ratios of approximately 95 percent. Not surprisingly, the S&L industry was among the most highly leveraged in the United States.

S&Ls borrow short-term, but invest long-term. Notably, the prices of long-term bonds are more sensitive to interest rate changes than are short-term bonds. Therefore the assets of S&Ls are riskier than their liabilities.

When the interest rate is i, the present value of a one-year zero-coupon bond that pays $1 is 1/(1 + i). In contrast, the present value of a consol bond that pays $1 every year into perpetuity is 1/i. By comparing the two present-value formulas, it is easy to see that when the interest rate rises, the percentage decline in price is greater for the long-term bond than for the short-term bond.

In the 1970s, S&Ls with short-term liabilities and long-term assets exposed themselves to risks associated with increases in interest rates. The gap between long-term mortgage rates and short-term CD rates declined precipitously. As the difference between mortgage rates and short-term rates closed in the mid-to-late 1970s, the market value of S&L liabilities grew relative to the market value of S&L assets, to the point where the industry became insolvent. However, accounting rules did not require the recognition of market value losses in mortgages caused by interest rate increases.

S&Ls could have ended their (losing) bets on interest rate risk by selling their mortgages and reinvesting in short-term assets or by hedging. However, either action would have required S&Ls to recognize, for accounting purposes, that they were insolvent. Instead, they gambled by continuing their overall exposure to interest rate risk and by investing in assets that featured high credit risk.

Interest rates dropped sharply after 1982. The high-risk gamble did pay off for many S&Ls. Yet in 1983, thirty-five percent of institutions still sustained losses. By generally accepted accounting principles (GAAP) 9 percent of all S&Ls (representing 10 percent of industry assets) remained insolvent, meaning that the market value of their liabilities exceeded the market value of their assets.

In most corporations, it is debt holders who confer a put option on equity holders. However, in the case of S&Ls, the debt holders are ordinary depositors. S&L debt comprises the deposits of ordinary people. If an S&L were an ordinary corporation, then bankruptcy would mean that some depositors lost some or all of their savings. In order to prevent such a situation from coming about, S&L deposits were government insured, up to $100,000, with the Federal Savings and Loan Insurance Corporation (FSLIC). In essence the FSLIC, rather than depositors and debt holders, conferred a put option on the equity holders of S&Ls.

In mid-1982, virtually every S&L was insolvent, except for those that had just received charters. The industry, with roughly $750 billion in liabilities was insolvent: The market value of its liabilities exceeded the market value of its assets by roughly $150 billion. Moreover, the FSLIC that insured deposits had only $6 billion in assets.

Clearly, the insurance guarantee represented an enormous contingent liability that was off the books of the U.S. Treasury. Therefore the $144 billion (= $150 - 6) was not reflected in the federal budget deficit. Having conferred a put option on the equity holders of S&Ls, the U.S. government was in the same position as a debt holder in the theoretical framework described in the chapter.

Managers representing the interests of equity holders have an incentive to maximize the value of the put option, thereby transferring wealth to equity holders. Managers can increase the value of the put option by adopting risky projects. S&Ls make loans for acquisition, development, and construction (ADC). Many insolvent S&Ls did indeed make ADC loans to high-risk developers with poor reputations. That is, the S&Ls behaved as if they were averse to asure loss and “gambled for resurrection.” On average, such gambles failed. Ultimately, many of these investments did indeed fail, giving rise to a major financial crisis that in 1989 required government intervention.

Interestingly, during the S&L crisis of the 1980s, the majority of insolvent S&Ls actually appear to have refrained from maximizing the value of the implicit put option and did not choose to invest in extremely risky projects. Fewer than 100 (of roughly 4000) CEOs of S&Ls engaged in seriously abusive behavior in response to unfavorable business conditions and the potential for moral hazard.

Case Analysis Question

1. Discuss any psychological phenomena that you perceive to have been at work in the S&L crisis, emphasizing the implicit option features described in the case. Relate these phenomena to the issues described in the chapter text.