Conning the IADC newsletters.

AuthorMcDonald, John J., Jr.

International Association of Defense Counsel Committee members prepare newsletters on a monthly basis that contain a wide range of practical and helpful material. This section of the Defense Counsel Journal is dedicated to highlighting interesting topics covered in recent newsletters so that other readers can benefit from committee specific articles.

SIMILARITIES BETWEEN THE SAVINGS & LOAN CRISIS AND TODAY'S CURRENT FINANCIAL CRISIS: WHAT THE PAST CAN TELL US ABOUT THE FUTURE

This article originally appeared in the September 2009 Fidelity and Surety Committee Newsletter.

  1. Introduction

    It goes without saying that the financial industry, along with numerous other sectors of the United States and global economies, are currently in peril. According to statistics posted on the Federal Deposit Insurance Corporation's (FDIC's) website, in 2008, twenty-five financial institutions failed in the United States; and as of July 7, 2009, 52 financial institutions already have failed in 2009. (1) By comparison, in 2007, only three banks failed, and in 2005 and 2006, no banks failed. (2) Along with this significant increase in bank failures, it is no surprise that financial institutions have been the main focus of litigation by both private parties and the government.

    Despite what some could refer to as sensationalism in the media regarding the unprecedented nature of the current crisis, this country weathered a similar collapse of its financial sector during the Savings & Loan (S&L) crisis of the 1980s. From 1986 through 1995, 1,043 S&Ls, holding $519 billion in assets, were closed, and the number of federally-insured S&Ls decreased from 3,234 to 1,645. (3) As of December 31, 1999, losses from the S&L crisis totaled approximately $153 billion, costing U.S. taxpayers $124 billion and the S&L industry $29 billion. (4) Notwithstanding these staggering figures, there is very little debate that the current financial crisis is more widespread than the S&L crisis of the 1980s. In any event, the S&L crisis provides a roadmap for the types of claims and insurance disputes we can expect to see arising from today's bank failures and bailouts.

  2. The Savings & Loan Crisis

    From somewhat modest beginnings (historically, S&Ls or thrifts, were community-based institutions that provided two types of services to their customers: retail savings deposits and lending of those deposits for residential mortgages), S&Ls were allowed to grow and expand beyond their means and abilities. Through a combination of speculative lending, greed, lax oversight, and reactionary legislation, the bubble grew and burst, resulting in significant losses and litigation. Although the S&L crisis is, by and large, behind us, it offers many lessons as to the bases of today's crisis. The similarities as to the causes, responses, and fallout are striking. Even a broad examination of what gave rise to the S&L crisis and governmental and public response causes one to quickly realize that the litigation that follows today's crisis is, and will be, no different, nor will the similar targets of the litigation be a mere coincidence. Consequently, the S&L crisis provides a blueprint as to what we can expect to see, and are seeing, by way of litigation.

    1. Background

      Federally-chartered S&Ls were first created in the 1930s to promote home ownership after the Great Depression. During the Great Depression, thousands of commercial banks failed--with 4,000 banks failing in 1933 alone. (5) In response, Congress established: (1) the Federal Home Loan Bank Board (FHLBB), which regulated the S&L industry; (2) the Federal Savings and Loan Insurance Corporation (FSLIC), which insured deposits in S&Ls; and (3) the Federal Deposit Insurance Corporation (FDIC), which regulated federally-chartered commercial banks and provided a federal deposit insurance program. (6)

      In the late-1960s, inflation and interest rates increased sharply. Congress applied "Regulation Q" interest-rate caps, which previously applied only to commercial banks, to S&Ls. Regulation Q capped the interest rates that S&Ls could pay depositors and helped to control S&L's costs. (7) During the late-1970s and early-1980s, interest rates once again skyrocketed, and inflation increased as a result of government deregulation of interest rates. However, Regulation Q no longer provided a solution to S&Ls because money-market mutual funds emerged in 1972 as a safe and fairly liquid investment alternative to S&L deposits. Because money markets were not subject to Regulation Q, they could pay higher interest rates to investors, and depositors began to pull their deposits from S&Ls and invest in money markets, causing the S&L industry to suffer massive withdrawals and losses beginning in late-1979. (8)

      As a result, S&Ls began to lobby Congress for deregulation of the industry, and Congress responded. In 1980, and again in 1982, Congress reduced the net-worth requirements for federally-chartered S&Ls, and S&Ls were allowed to meet this requirement by using more liberal regulatory accounting principles instead of generally accepted accounting principles. (9) In 1982, restrictions on the requirements regarding the minimum number of stockholders in S&Ls were eliminated, and individuals and small groups of investors, who often were not qualified, began to own and manage S&Ls. (10) During the federal deregulation of the 1980s, S&Ls also were allowed to offer adjustable-rate mortgages; take risks by extending their lending activities into other areas like commercial real estate loans, construction loans, etc.; offer loans not backed by collateral; and take direct ownership positions in a limited number of enterprises. Regulation Q interest-rate caps also were lifted, and the amount of federal insurance on an individual S&L deposit was increased from $40,000 to $100,000. (12)

      State deregulation followed suit with states relaxing lending rules to keep their state-chartered S&Ls competitive. This deregulation, coupled with a peak in oil prices and a booming real estate market in the Southeast and Texas, caused the S&L industry to grow exponentially. Between 1982 and 1986, S&L industry assets increased 56%. (13) Most S&Ls in Texas and California grew by more than 100% each year. (14)

      Much of the legislation and deregulation passed in the early-1980s essentially was reactionary. It was not designed to address the ever-increasingly apparent problems with the S&L model, but merely to mask those inherent weaknesses with the hope that ultimately the S&Ls would recover through the market. However, sweeping the problems under the rug did not solve the problems, and by the mid-1980s, the S&L crisis began to emerge as a significant number of S&Ls were crippled when the Texas oil and real estate markets entered into a deep recession, which caused increasing rates of default and decreased the value of collateral-backed loans provided by S&Ls. (15)

      The FHLBB also began to tighten regulations for S&Ls by increasing net-worth requirements, improving accounting standards, limiting direct investments, and doubling the number of examiners on its staff. But, the changes could not remedy the damage that had been done. The tightened regulations exposed bad investments, and S&Ls begin to fail; In 1986, 54 thrifts were rendered insolvent, and the FSLIC insurance fund became insolvent. (16) From 1986 to 1988, the FHLBB disposed of more than 300 insolvent S&Ls by liquidating them or finding acquirers. (17) By 1988, the FSLIC had a negative net worth of $50 billion. (18)

    2. Causes of the S&L Crisis

      Various factors contributed to the S&L crisis, including the government's failure to seize control of insolvent S&Ls earlier. By the early-1980s, hundreds of S&Ls were insolvent. However, instead of closing the banks, Congress began to deregulate S&Ls in order to encourage competition with commercial banks and money markets. For example, the increase in the federal deposit insurance for an individual S&L deposit allowed S&Ls to take greater risks with deposits as investors were less concerned with losing their savings if the S&L failed. (19) The increased insurance, combined with the elimination of interest-rate caps, also made it easier for S&Ls to attract depositors, including brokered deposits. In 1980, and again in 1982, the FHLBB lowered the net-worth requirements for S&Ls, which kept S&Ls that were on the verge of insolvency in business, and S&Ls were allowed to extend their lending activities into more risky areas--with minimal oversight, as the FHLBB lacked capacity to identify insolvent institutions because the number of field examiners at the agency was reduced significantly between 1981 and 1984 due to budgetary cuts and deregulation. (20) This left S&Ls to rely upon internal-risk management practices, which often were insufficient and led to underestimated and unrecorded economic risk. Moreover, the FHLBB revised accounting standards, which allowed S&Ls to create false assets or "supervisory goodwill" to increase their net worth. (21)

      Volatile interest rates and the faulty...

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