Understanding The S&L Mess

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For the first time nearly all commercial banks in the country were being held to uniform rules—those of the FDIC. But the FDIC was a third layer in the federal regulatory framework, added to the comptroller of the currency and the Federal Reserve. Worse, S&Ls could now get federal charters as well as state ones, and those that did came under the regulation of both the FSLIC and the Federal Home Loan Bank Board (FHLBB). In addition, the Federal Housing Authority began to issue mortgage insurance and, of course, detailed regulations. It was a regulatory tangle only a bureaucrat—or someone bent on manipulating the system--could love.

The S&L industry would never have survived the upheavals of the 1930s and 1940s but for the cartel the government fostered to protect it.

The final reform of the 1930s was to establish, in effect, a government-sponsored banking cartel. Commercial banks, savings banks, and savings and loan banks carved up the banking business among themselves. Commercial banks became full-service banks, offering both checking and savings accounts and consumer loans to individuals while continuing their business banking. Mutual savings banks and S&Ls offered savings accounts and made local real estate mortgages. The former specialized in commercial real estate, the S&Ls almost exclusively in single-family houses.

The number of new charters was closely regulated to prevent “excess competition.” For instance, while the assets of S&Ls grew in the twenty years from 1945 to 1965 from $8.7 billion to $110.4 billion, the number of S&Ls remained steady at the slightly more than six thousand that had survived the debacle of the early 1930s.

With the Second World War, prosperity returned both to the country and to the banking system. The Federal Reserve was able to keep interest rates remarkably steady for a quarter of a century, and this allowed the interest rates paid on individual accounts to be steady. When an uptick in inflation in the early 1960s threatened to raise the interest paid by banks to their depositors, Congress quickly fixed maximum interest rates. Lacking the allure of checking accounts, savings banks and S&Ls were allowed to pay one-quarter percent more than full-service banks on savings.

Had the banks arranged such a thing among themselves, it would have been called price-fixing and a combination in restraint of trade. Because it was done by Congress, it was perfectly legal. But the effect, of course, was to insulate the banks from the signals of the marketplace, and American banks began to lag noticeably behind banks in Europe and Japan in technical innovation.

It was a very cozy arrangement for everyone in the banking business, however. Big-city commercial banking was, as it always had been, where the action was. Country and savings banking was low-key, low-stress banking. One wit called it 3-6-3 banking because the bankers paid 3 percent on deposits, charged 6 percent on loans, and hit the golf course by 3:00 P.M.

Then Lyndon Johnson tried to fund a war and a massive social program at the same time, and inflation grew. Richard Nixon severed the close connection between gold and the dollar, and inflation took off. Unregulated interest rates rose sharply, while the legal interest rates that could be paid by banks to depositors remained unchanged.

Had that been all, then average citizens would have had no choice but to keep their money in banks and suffer accordingly from the price-fixing, anticompetitive banking system crafted in the 1930s. But that was not all. Wall Street brokerage houses and mutual funds began moving aggressively to acquire the little guy’s capital with something called the money market fund. The interest paid by money market funds was not regulated and thus was far higher than could be offered by banks. People thronged to the new funds, withdrawing their savings from banks in ever-greater amounts.

This deposit flow from low-paying savings accounts to high-paying money market accounts was given the wonderfully sonorous technical name of disintermediation. Sonorous or not, it was a mortal threat to savings banks and S&Ls. Commercial banks could cope with disintermediation. Demand deposits carried no interest anyway, and savings deposits were an important but not vital part of their deposit base. Much of their loan portfolios were short-term. But the savings bankers, faced with a rapid decline in deposits while holding long-term loans at low, fixed interest rates, went to the federal government for help.

Politicians fairly rushed to their aid. It is not hard to see why. As Sen. David H. Pryor of Arkansas explained, “You got to remember that each community has a savings and loan; some have two; some have four, and each of them has seven or eight board members. They own the Chevy dealership and the shoe store. And when we saw these people, we said, gosh, these are the people who are building the homes for people, these are the people who represent a dream that has worked in this country.” These were also, of course, the very sort of people that politicians most want the support of.