[The following article, published by the Washington Post and also carried in the Sarasota Herald Tribune on November 29, 2019 is reprinted with permission from its author, Daniel Burge. The article responds to recent calls for the Federal Reserve to lower already historically low interest rates. Burgee provides a succinct and accurate description of efforts during the 1980s by both Congress and the Reagan Administration to pressure the former Federal Home Loan Bank Board and the former FSLIC to prop up badly insolvent S&Ls rather than providing meaningful financial assistance to merge them into stronger banks and thrifts as the FDIC did with the FDIC-insured mutual savings banks. Burge observes that the FDIC spent $7 billion from its own funds (maintained by bank assessments) to resolve the savings bank issues, while the much-delayed failure resolution costs for the S&L industry ultimately rendered the FSLIC insolvent and cost taxpayers over $125 billion.]
President Donald Trump has called Federal Reserve officials “boneheads,” and even speculated whether Fed Chair Jerome H. Powell was a “bigger enemy” than China’s Xi Jinping. Most recently, Trump claimed that the experts at the Fed “are their own worst enemies, they don’t have a clue.” “People,” the president later added, “are VERY disappointed. …”
The president’s mistrust of technocrats taps into a more widely shared sentiment. In the view of many Americans with populist impulses, both left and right, appointed technocrats or experts wield too much power. Regular voters have no direct way of holding these officials accountable when they make serious mistakes.
These concerns are understandable. But the savings and loan crisis of the 1980s — at the time, the worst rash of banking failures since the Great Depression — demonstrates that populist-oriented prescriptions might be worse and more dangerous. Sometimes effective regulatory decisions are politically unpopular. They can only be enacted by technocrats insulated from pressure by elected officials who are focused on short-term political objectives.
The S&L debacle had its roots in the rising inflation of the late 1960s and 1970s. In October 1979, with inflation around 11 percent, Federal Reserve Chairman Paul Volcker tightened the money supply, and allowed short-term interest rates to reach double digits in an effort to stop the inflationary spiral. As a result, savings and loans and mutual savings banks — which were community-oriented local banks — confronted disaster.
Before the high inflation of the late 1970s, these institutions had concentrated on making home loans. According to the standard joke, during the mid-20th century, bankers from these local institutions paid 3% interest on deposits, charged 6% on home loans, and headed to the golf course at 3 p.m.
But Volker’s disinflation turned this model into a disaster. On the one hand, S&Ls and MSBs had to pay higher interest rates to satisfy their customers. On the other hand, S&Ls and MSBs still had fixed-rate home mortgages that they had extended in years when interest rates were lower on the books. These older loans earned less than the new going rate for deposits. That meant that local banks paid more interest to their depositors than they made on their loans.
As a result, S&Ls and MSBs lost money. Lots of money. Savings and loans struggled to stay afloat in a pool of red ink deeper than $100 billion. Meanwhile, $3.3 billion of losses over three years threatened to debilitate MSBs. Both sets of institutions tottered on the brink.
The two crises unfolded in dramatically different ways. The MSB troubles cost the Federal Deposit Insurance Corporation (FDIC), which insured their deposits, roughly $7 billion. By contrast, the S&L problems ultimately cost American taxpayers $123.8 billion.
According to economists Paul M. Romer and George A. Akerlof, if the management program for mutual savings banks had been applied to S&Ls, the cost of the savings and loan crisis would have been substantially reduced.
Different regulatory agencies oversaw the two sets of local institutions. The FDIC insured the deposits of mutual savings banks. A separate entity with a different structure, the Federal Savings and Loan Insurance Corporation (FSLIC, pronounced “fizz-lick,”) backed the funds of S&L customers. Importantly, technocrats with financial and political independence managed the FDIC, while the Federal Home Loan Bank Board oversaw the FSLIC’s operations. The FSLIC remained vulnerable to political considerations because Congress controlled its purse strings through the appropriations process.
With such a financial structure, officials at the Bank Board could not easily ignore political pressure. The Reagan administration demanded that its appointed technocrats be faithful to its political agenda.
L. William Seidman, who served as FDIC chairman between 1985 and 1991, later recalled that “anyone calling for more banking supervision was branded a ‘re-regulator’ and by extension a disloyal Reaganite, the worst condemnation possible inside the Reagan administration.”
In January 1982, Bank Board Chairman Richard Pratt took actions that comported with the Reagan administration’s approach. He permitted S&Ls to make loans with even less of their own funds at stake. This action contributed to a deeply perverse incentive structure: S&Ls could grow and profit from high-risk, high-reward loans, without worrying about losses, which would first accrue to the FSLIC, and then to American taxpayers.
Later in 1982, Congress — cheered on by Pratt and the Reagan administration — made things worse by opening up previously closed off risky lending areas for S&Ls, including that of commercial real estate. Soon thereafter, the insolvent S&Ls that were still operating began making reckless, “Hail-Mary” loans with government-insured deposits. Other bankrupt S&Ls engaged in outright criminal activity, such as looting. Over time, losses piled up, bankrupted the FLSIC and left American taxpayers with a mess.
In contrast, the FDIC averted disaster by pursuing more measured policies than the FSLIC. In 1982, chairman William M. Isaac explained that “the FDIC … does not intend to litter the financial landscape for decades to come with crippled banks.”
Rather than allowing its banks to “gamble for resurrection” as Pratt permitted some S&Ls to do, Isaac pursued policies that bought time until the high interest rates declined. With many favoring the FSLIC’s approach, the FDIC received its fair share of criticism. But given that the FDIC’s funding was not subject to lawmakers’ political considerations, Isaac and his colleagues successfully resisted politically motivated but misguided fixes.
The case of the S&L crisis reveals that while technocrats may appear aloof and unaccountable, their insulation from politics is important for sound crisis management. Banking troubles tend to present policymakers with difficult choices that require careful analysis. Sometimes, the right responses to a crisis are politically unattractive to the administration in power and Congress.
For this reason, today’s lawmakers would be well-advised to protect the relative independence of appointed technocrats.
Daniel Burge is an associate lecturer in American Studies at the University of Massachusetts, Boston.