The FDIC, and How Soon We Forget

"Chairman Henry Gonzalez (D-Texas) and his committee are taking us back to 1980, when former Chairman Fernand St. Germain boosted deposit insurance to $100,000 an account (from $40,000) in the dead of night. To prevent another S&L disaster, we need to limit the deposit-insurance subsidy. A banking 'reform' without such limits is just another Nightmare on Pennsylvania Avenue."

The above passage comes from a Wall Street Journal editorial dated June 7, 1991. Amid an S&L meltdown that some deemed “the worst public scandal in American history”, the Journal’s editorial page was properly relentless in its pursuit of the main causes of the S&L crisis that like banking problems today, would fall at the feet of the American taxpayer.

Fast forward seventeen years, change the words a bit to the “worst banking crisis since the Great Depression”, and you have more problems in the banking sector tailor-made for a Washington class political eager as always to be seen “doing something”. Make no mistake that today’s “solutions”, including an increase in federal deposit insurance from $100,000 per account to $250,000 will sadly set the stage for further banking crises in the future.

So while politicians perhaps possess a congenital inability to factor past legislative mistakes into any of their actions, for those of us not politicians, it’s certainly worthwhile to recap what happened the last time Congress tried to save a portion of the banking system. Indeed, the historical parallels are hard to ignore.

Nearly 30 years ago, the savings and loan (S&L) industry was on life support. Amid skyrocketing interest rates between 1979 and 1982, S&Ls lost $4.6 billion in 1980, and $4.1 billion in 1981. By 1982, S&Ls had a negative net worth of $100 billion. Rather than allow the industry to die a slow death, much as we’re witnessing at present, Congress stepped in to save the day.

The slow death of the S&Ls began in the 1970s when interested rates skyrocketed in response to the weak dollar. In previous decades, the S&L sector was a prosaic one where its assets were long-term mortgages paying higher rates, while its liabilities consisted of short-term, lower-rate deposits. This worked well until short-term rates rose sharply. Unable due to regulations to pay depositors more than 5-1/2 percent, S&Ls gradually lost deposits to money-market funds paying well in excess of 51/2 percent, while the falling dollar eroded the value of their fixed-rate mortgages.

Regulations and poor dollar policy surely hindered the S&L industry back then, while the explosion of the mortgage-backed securities market and worldwide banking competition rendered S&Ls obsolete.

But like most long-established industries in the U.S., the S&Ls had powerful political benefactors interested in keeping them alive. Congress passed the Depository Institutions Deregulation and Monetary Control Act of 1980, and the Garn-St. Germain Depository Institutions Act of 1982 to keep them afloat. Both acts served to privatize any deregulation successes, while socializing the inevitable failures.

Whereas S&Ls were previously limited in terms of the interest rates they could offer depositors, the aforementioned legislation removed all caps on rates they could post to attract deposits. Capital requirements were reduced from 5 percent to 3 percent, plus S&L loans were no longer limited to home mortgages. To pay the high rates offered on deposits, S&Ls had the incentive to make higher-risk loans and equity investments in areas beyond traditional home mortgages, including commercial and construction loans. If the S&Ls had been left to fend for themselves in this newly deregulated world, the new legislation would have been fine.

The problem, as previously mentioned, was that Congress also chose to socialize any failures. The Garn-St. Germain bill raised the level of federal deposit insurance from $40,000 to $100,000. This created enormous moral hazard in that depositors could place their funds at high rates of interest with the S&Ls worry-free. And just the same, S&L executives could be lax in their lending and investment standards with full knowledge that U.S. taxpayers were on the hook if their investments soured.

Importantly, the weakest S&Ls had the greatest incentive to swing for the fences in making loans, and this made it even more difficult for the healthy S&Ls to compete. The rest, as they say, is history. More than 1,000 S&Ls failed in the 1980s. The bloodbath continued into the 1990s; much of it on the dime of U.S. taxpayers.

Looked at from the perspective of today, history is once again repeating itself. Rather than allow the economically cleansing process whereby failed banks and toxic assets experience a change of ownership at distressed prices, our federal minders have passed a $700B bill meant to keep banks afloat, and which will supposedly put a floor under the value of unwanted securities.

What’s ironic here is that for politicians so intent on freeing up markets that are allegedly frozen, the insertion of capital taken from the private sector (the very capital that deemed these assets unworthy) will only distort the market for these assets even more, thus creating a false marketplace that will make it even more difficult for illiquid markets to become liquid. For that reason alone, the bailout won’t work.

Even more ironic is that alongside these efforts to delay reality, Washington has increased the very deposit insurance that made past banking crises more problematic. It’s surely unfortunate how soon legislators forget past mistakes, though voters should rest assured that the legislation passed last week will not just fail to revitalize markets or the economy; additionally the legislative mistakes made last week merely lay the groundwork for future banking scandals. History has warned us.