The Savings and Loan Crisis, The RTC, and the Paulson Plan

(There has been a recent discussion regarding the Paulson Plan with a great number of individuals comparing it to the Resolution Trust Corporation (RTC) that was created after the savings and loan crisis. The purpose of this post is to explain the S&L crisis and then (very) briefly contrast the RTC with the Paulson Plan. The information on the S&L crisis comes from my lecture notes for Money and Banking. The main resource used in putting together these notes is Frederic Mishkin’s Economics of Money, Banking, and Financial Markets. Any errors are my own.)

Before the 1980s, federal deposit insurance seemed to work exceedingly well. Bank failures between the creation of the FDIC and 1980 were very rare. This changed greatly after 1981.

Early Stages

Financial innovations, as we have previously discussed, severely cut into the bottom line of the traditional banking business. Commercial banks were losing money to instruments like money market mutual funds.

As profitability fell, banks were forced to undertake new activities. These activities tended to be very risky, including the failure to diversify loans and purchase of financial futures and junk bonds. Further, the fact that the government stood to provide insurance in the wake of a failure provided little incentives for banks or their customers to fully take account of the risk involved in these new activities.

The following set the stage for the problem:

• Deregulation gave more power to S&Ls beyond home mortgages.

• This deregulation was coupled with an increase in the mandated amount of deposit insurance (from $40,000 to $100,000).

• Deregulation also phased out Regulation Q, which had placed ceilings on interest rates.

• S&Ls began engaging in new activities in which many managers were not qualified.

• There was rapid growth in new lending, especially in real estate.

• The quest for profitability began to cause banks to ”specialize” in loans to certain industries.

The consequences:

• Increases in inflation and contractionary monetary policy put upward pressure on interest rates leading to rising costs that were not matched by higher earnings because most mortgages were issued at lower, fixed rates.

• A recession in 1981-1982 caused a collapse in the prices of energy and farm products which led to significant defaults on loans among S&Ls.

• HUGE collapse of S&L industry with more than have with negative net worth (insolvency) by the end of 1982. Losses were estimated at about $10 billion.

Later Stages

Exacerbating the problem:

• Regulatory agencies lacked the funds to close the S&Ls and pay their depositors.

• Regulators used regulatory forbearance. In other words, they failed to exercise their regulatory powers.

• Savings and Loans began to take a great deal of risk to grow out of insolvency.

• The results were disastrous. Insolvent institutions were unknown to the general public and the insolvent firms were competing alongside the solvent. This forced solvent firms to pay higher rates of interest in trying to compete with the insolvent firms who were desperate for funds to make risky bets. This squeezed the lifeblood from the solvent banks and even dragged some of them into insolvency.

Competitive Equality in Banking Act of 1987

The CEBA gave financing to the regulatory agency of the S&Ls, but the funding was not sufficient and was even below the requested amount by President Reagan (which was also probably a low balled number to begin with – $15 billion). Further, regulatory forbearance continued at the behest of Congress. The losses continued throughout the 1980s.

Savings and Loan Bailout: The Financial Institutions Reform, Recovery and Enforcement Act of 1989

Upon taking office in 1989, President George H.W. Bush proposed new legislation to provide the adequate funding to close the insolvent S&Ls. The FIRREA did the following:

• Eliminated the former regulatory structure that was in place and gave this power to the Office of Thrift Supervision.

• Further, the S&L insurance system was eliminated and the FDIC overtook these powers.

• Finally, the Resolution Trust Corporation (RTC) was created to sell off the real estate assets of the insolvent thrift firms. The RTC was able to sell 95% of the assets of the insolvent firms, with a recovery rate exceeding 85%. Afterwards, the RTC went out of business in 1995.

• The bailout cost $150 billion.

Federal Deposit Insurance Corporation Improvement Act of1991

The FDICIA followed from the FIRREA and was passed for two reasons:

• To recapitalize the FDIC’s Bank Insurance Fund.

• Reform deposit insurance and regulatory system to minimize taxpayer losses in the future. To minimize moral hazard, the FDIC must now close failed banks using the least costly method. This creates the likelihood that uninsured depositor losses will occur. A provision exists, however, in that if two-thirds of the Governors of the Federal Reserve and the directors of the FDIC deem an institution ”too big to fail” and is approved by the Treasury Secretary, all depositors will be protected. This should only be done when the failure to do so would result in significant economic losses.

In addition, the FDICIA created a ranking of banks by the level of capitalization. Banks in the lowest group are prevented from paying above average interest rates on deposits and can even be closed by the FDIC if the amount of equity capital falls below a certain percentage of assets (2%).

The Paulson Plan Versus the RTC

The preceding analysis hopefully provides enough background to discuss the Paulson Plan in contrast to the RTC. Under the Paulson Plan, the government would be purchasing assets with uncertain value from currently operating institutions. This is a direct contrast to the RTC in which the government was selling the assets of failed institutions. The Paulson Plan raises many important questions. Uncertainty is the primary reason that firms cannot estimate the value of their assets. Given this uncertainty, counter-parties are unwilling to purchase such assets because of the fear that they might overpay. How precisely will the government entity created under the Paulson Plan value these assets when those in the industry do not? Further, what incentive does the entity have to ensure that they are purchasing the assets at a favorable price?

The lack of oversight and incentives suggests that the Paulson Plan is one that is likely to overpay for assets that few, if any, are able to accurately price under current conditions. This represents a significant bailout for Wall Street at the expense of taxpayers, which is neither warranted nor acceptable. Whether or not any such bailout would put an end to the crisis is debatable. However, what is not debatable is the dangerous precedent that such action would set. I urge my fellow economists, and fellow taxpayers, to reject such a plan.