It took 40 years, but we finally got a new S&L crisis

The demise of Silicon Valley Bank (SVB) and the repercussions that have followed are eerily reminiscent of the collapse of savings and loan associations in the early 1980s. Like others, we wonder at the reasoning that allowed billions of uninsured deposits that could disappear at the first sign of trouble to be invested in long-term securities bearing interest rates at the lowest levels in the past 80 years.

In 1981, we became the regulators of a savings and loan industry that had been forced by federal law into a similar “borrow short and lend long” profile. With approximately $600 billion in assets, ironically about nine times the size of SVB on an adjusted basis, the industry was insolvent by about $150 billion on a fair market basis.

Why? Historically S&Ls were permitted to make fixed-rate mortgage loans of up to 30 years, funded by short-term deposits like modest passbook accounts representing the savings of middle-class Americans. It worked just fine when rates were stable and volatility was low.

Then Congress had a big idea in 1966 that turned out to be one of the most expensive policy mistakes in history. Regulation Q was applied to S&Ls to reduce their costs so they could offer lower interest rates on mortgage loans. It capped the rate of interest they could pay savers at 5.5 percent, while states had created usury laws limiting the interest rates chargeable by S&Ls on mortgage loans to between 6 and 8 percent.

This created an illusion of stability that hypnotized consumers, bankers and regulators into thinking it would always be that way. 

By the early 1980s, interest rates had reached all-time highs in part due to actions taken by Paul Volcker’s Federal Reserve Board to constrain runaway inflation. The prime lending rate at major banks reached 21 percent.

At the same moment, a more attractive substitute for savings deposits emerged for small and medium savers. Unregulated money market funds (like cryptocurrencies, the shiny new instruments of the 1980s) could offer market rates of return that were at the time more than twice those offered by S&Ls.

A wave of deposit withdrawals began to drain liquidity, forcing S&Ls to sell assets and, once Congress reversed field and repealed Regulation Q, pay higher rates for savings accounts. This left most institutions earning 7 percent on their long-term mortgage portfolios while being forced to pay deposit interest rates as high as 12 percent to remain liquid. Borrowing at almost twice the cost of what you are earning won’t keep you in business very long. 

This problem was dropped in our laps in 1981. At our disposal was a miniscule FSLIC – Federal Savings and Loan Insurance Corporation — with just $6 billion to cover a negative net worth of about $150 billion.

Working within this reality, it became clear that only the best managed institutions of the 4,500 S&Ls could survive, and then only if we acted creatively and quickly to alter rules and accounting conventions to buy them time. Institutions were temporarily allowed to sell their long-term fixed-rate assets at market value while writing the loss off over the expected remaining life of the original term.

It may have been financial alchemy, but it allowed the best institutions to generate operating cash balances to survive until interest rates decreased. When we met with Paul Volcker in 1981, we realized that he had to choose between raising interest rates to stifle double-digit inflation and annihilating the S&L and other industries. He chose to raise rates and stop inflation, and about 1,400 S&Ls failed over that decade. Does this sound familiar to the challenges we face today?

Current banking regulators have adopted similar stopgap approaches to curtail the liquidity crisis created by SVB’s failure. Allowing institutions to hold long-term securities and borrow from the Federal Reserve against their book value rather than marking them to market has the same result as some of our S&L fixes. But as we learned, marshalling the full financial resources of the federal government to backstop losses and allowing institutions to pledge assets at face rather than market value can obfuscate the losses that are embedded in portfolios. 

With three critical financial panics in just the last 15 years, Congress and the regulators have learned how to cap financial fires. But they haven’t learned how to prevent them or reverse the damage done to the economy in the process. Just the opposite — their policies often inadvertently create the tinder for the next financial fire. 

The story of SVP underscores that the effectiveness of a regulatory system developed in the 1930s has finally been superseded by fintech, crypto, social media, blockchain and decentralized finance. Financial risks are being greatly exacerbated by the explosive spread of both rumor and fact instantaneously, something that demonstrated in just a matter of days how the effectiveness of our most powerful stabilizer – deposit insurance – had been neutralized.

The history of financial services proves the adage that the failure to know history guarantees that it will repeat itself. How could banks like SVP have been permitted to create classic S&L balance sheets just waiting to explode under the watchful eye of hundreds of federal and state regulators? We will observe with interest the further unfolding of this rapidly moving financial tragedy and the solutions that are chosen.

We understand as well as anyone that when an economy has been abused by the government’s own financial decisions, the medicine may be worse than the cure, particularly when market discipline is replaced by an expectation that the government will always bail us out.

Richard T. Pratt is an emeritus professor of finance at the David Eccles School of Business at the University of Utah. He is a former chairman of the Federal Home Loan Bank Board and Merrill Lynch Mortgage Capital. Thomas P. Vartanian is a former general counsel of the Federal Home Loan Bank Board and the executive director of the Financial Technology & Cybersecurity Center. He is the author of “200 Years of American Financial Panics.” Together, they closed more than 400 institutions and merged another 1,000 distressed by the event of the 1980s.