It should be a deeply sobering thought for Americans that the U.S. housing finance sector has collapsed twice in the last three decades. Of course, we know that there was the painful shriveling of the huge U.S. housing and mortgage bubble of the 2000s, but only twenty years before there was the mass failure of the savings and loan (thrift) industry, up to then the dominant mortgage lenders, first from interest rate risk and then from bad loans. That resulted in the failure of the government’s savings and loan deposit insurance fund, which required a $150 billion taxpayer bailout. The bonds sold in 1990 to finance that bailout run to 2030, so the taxpayers will be paying for the 1980s bailout for 15 more years from now! Does the U.S. as a nation have a natural ineptitude for housing finance? Moreover, the savings and loan crisis was mixed together with a severe commercial banking crisis.
Here’s a financial history quiz: How many U.S. thrift institutions and commercial banks do you think failed or had to get government assistance in the 1980s crisis? Before you read the answer, what’s your number?
The correct answer is that all told, 1,332 U.S. thrift institutions failed between 1982 and 1992. In the same period, 1,476 U.S. commercial banks failed. That is a total of 2,808 financial institution failures, or an average of 255 failures per year over those eleven years. That is on average five failures a week over a decade. Pretty tough times in the financial system!
But how well is that 1980s financial collapse remembered? How much do you remember about it, dear Reader? That probably depends on your age. Consider, for example, a fellow who is today a responsible bank senior vice president or regulator or central banker and 50 years old. In 1982, he was 17 and doubtless thinking much more about girls and football than about the crisis in housing finance, so he can remember little if anything about it. Conversely, the 50 year old senior vice president or regulator or central banker of 1982, who had to deal with the crisis, is now 83 and probably long retired, if alive. For today’s 29-year old bond trader, the 1980s are ancient and irrelevant history and even the panic of 2007-2009 is pretty long ago.
The natural process of aging, mortality and new generations cuts heavily against the effective retention of the lessons of financial history. Financial history could be taught in universities or on the job, but mostly is not. This helps the cycles of boom and bust continue.
How serious was the 1980s crisis? Well, in that decade the then-Chairman of the Federal Reserve made a Friday night phone call to the Governor of the Bank of Japan. His reported first words were: “The American banking system might not last until Monday”!
Here’s another quiz: Which year was that? What was the immediate crisis which gave rise to the call? Who was the Federal Reserve Chairman who made such an extreme statement?
The right answers are: 1982. The global sovereign debt crisis. Yes, there have also been two sovereign debt crises in the last three decades; the second one still in process with the threatened post-bailout default on Greek government debt. The 1980s sovereign debt crisis was then known as the “LDC (less-developed country) debt crisis.” The Federal Reserve Chairman was Paul Volcker.
At the same time as the savings and loans (as directed by their regulator) were making soon-to-be disastrous long-term, fixed rate loans funded with short-term deposits, hundreds of American banks, including all the big ones (along with banks in Europe, Japan and Canada) had been on a lending spree to the governments of the less-developed, or as we would now say, emerging countries. This disastrous lending spree had been widely praised by official and private cheerleaders as “recycling petro-dollars” in the jargon of the time– displaying everyone’s typical inability to foresee the coming crisis. By the spring of 1982, the Federal Reserve was making special loans to the Bank of Mexico to make the latter’s financial statements look better. In August, 1982, Mexico defaulted on its debt and it belatedly became obvious to everybody that the heavily indebted LDC governments could not pay what they owed.
As economist Richard Koo, at that time the head of the International Financial Markets Section of the New York Federal Reserve Bank, recalls, therefore the “big U.S. banks were all virtually bankrupt.” At the same time, it was realized that the thrift industry was in the aggregate bankrupt. What a combination!
But that was not all. At the same time, two other bubbles were deflating: an oil bubble (sound familiar?) and a farmland bubble. So not only was the thrift industry on the way to a huge taxpayer bailout, but nine out of the biggest nine banks in oil-centric Texas failed, along with many others, and the Farm Credit System, a government-backed lender, failed, too, and had its own government bailout. No wonder Volcker was phoning up his central banking brethren!
Here is your last quiz: What did Chairman Volcker do to confront the massive losses on the loans the banks had made to the governments of the LDCs? Face the facts and take the write-downs? Mark the loans to market? Try to reduce the credit exposure to these insolvent borrowers? Have a stress test?
Which alternative did he choose?
The correct answer is: None of the above. Instead, Volcker ordered the bank regulators not to classify these loans as non-performing, in spite of the fact that they were bad loans—in other words, to cook the books– and ordered the banks to keep the game going with new loans to the insolvent borrowers, pushing off recognition of billions in losses for years.
Thus the forceful Chairman Volcker “steamrollered though,” as Koo says, with a bold strategy and a very high-stakes gamble, which he got away with. At the same time, the regulator of the savings and loans, the hapless Federal Home Loan Bank Board, was likewise postponing loss recognition, cooking the books, and making big gambles, which it however lost.
The Federal Home Loan Bank Board was abolished by Congress in 1989 and replaced by the Office of Thrift Supervision. The Office of Thrift Supervision was in turn abolished by Congress in 2010.
Sic transit gloria in American housing finance. In the meantime, the Federal Reserve, which created the 1970s runaway inflation and its interest rate aftermath which broke the thrifts, has advanced to ever greater power and prestige. With striking irony, the Federal Reserve in the aftermath of the 2000s bubble has become the biggest investor in long-term, fixed rate mortgages there is—in effect, the biggest savings and loan in the world.
Alex J. Pollock is a resident fellow at the American Enterprise Institute in Washington, DC. He was President and CEO of the Federal Home Loan Bank of Chicago 1991-2004.