The financial industry encompassing banking, financial services and insurance companies play a very important role in the economy of any nation, and are therefore important in ensuring liquidity in the economy. They are strategically positioned to accept savings from customers, and provide loans to consumers and businesses for a reasonable profit. Their importance therefore lies in their ability to ensure consumers get value for money whenever they resort to save funds, and that businesses and consumers who need loans either for business operations, mortgage financing and/or personal activities can get adequate levels of financing, thereby ensuring continued economic growth.
However, history tells us that these financial institutions have always been known to digress from this traditional business model of ensuring economic growth and liquidity, into riskier profit making activities that could endanger the whole economy in the wake of an economy crisis, such as in the great depression of 1920s, savings and loan crisis of the 1980s, dotcom bubble burst in the early 2000s, and most recently the subprime mortgage crisis starting 2007. Therefore according to Hopkins and Hopkins (1984), the activities of these institutions must be properly regulated and monitored against risky, unscrupulous and economically dangerous activities. These activities may be poised to increase the value of the firm in the short term, and increase benefits attributable to core stakeholders, but may result in tragic occurrences such as the insolvency of a large number of organisations, which is what happened in the great depression, during the S&L crisis and also most recently in the subprime mortgage crisis.
A core example of these occurrences would be in the activities of savings and loan organizations in the United States from 1970 – 1990. Financial regulation, or more precisely – financial deregulation, has been acclaimed as one of the major causes of the scandal that forced about 50% of the S&L businesses in the US into insolvency (Mishkin, 1998; Curry and Shibut, 2000). A critical analysis of the causes, effects of financial deregulation, occurrences, and effects on financial regulation would be analysed in following chapters, in a bid to determine the extent to which regulation could have been employed in averting, or more importantly managing the crisis in a much more appropriate manner.
2.BACKGROUND – SAVINGS AND LOAN INDUSTRY
The savings and loan industry had been operating in the US since the 19th century, and was established under the premise of collecting savings from customers at market interest rates, then providing mortgage and personal loans to other consumers for a higher interest rate (Cebula and Hung, 1992). The businesses were owned by a number of shareholders, usually in a community, thereby limiting the extent to which one person or a group of people could have an influence on the activities of the organisation.
The industry experienced rapid growth during the post world war II era, when millions of service men returned after the war to set up their lives and build families (Mishkin, 1998). The baby boom era that erupted increased the need for real estate, which subsequently increased the number of houses built, and the number of mortgage loans provided for these houses. The period of rapid growth was closely followed by an increasing need for these institutions to attract deposits from customers, in order to fuel further mortgage loans, thereby increasing competition between retail banks and S&L organizations for better access to bank’s deposits (Kester and McGoun, 1989).
Regulation Q was therefore imposed as an interest rate cap that limited the rate that each industry (retail banking and S&L businesses) could give for customer deposit (FDIC, 2002). Thereby limiting competitive pressures within the market. However, this interest rate cap made it impossible for these organizations to compete effectively in times of high interest rates, as customers usually withdrew their deposits in order to earn more interest in money market instruments (Shoven et al, 1991). A series of regulatory changes were therefore proposed and implemented in the between 1980 – 1982, which affected the businesses that S&L businesses could lend to, and also impacted on their financial accounting and risk practices.
3.ECONOMIC AND FINANCIAL REGULATORY ISSUES
As proposed by Konoe (2009), economic and macro economic crisis that result in the fall of a huge number of businesses are not necessarily as a result of one factor, but of a combination of several factors that may have metamorphosed over a period of time. The issues that led to the huge fall of a number of S&L businesses could therefore be explained in terms of the current economy of the US at that period in time, the financial situations facing the industry, and regulatory frameworks in place to ensure ethical business practices across the industry.
a. Economic Issues
High Interest Rate volatility in the 1970s and early 1980s exposed S&L organizations to interest rate risks. These coupled with double digit inflation figures frequently resulted in asset/liability mismatch, in which the organizations were paying more interests for deposits, than were being obtained through fixed rate long term mortgage rates (Shoven et al, 1991).
The oil prices also doubled in 1979, owing to events in oil producing OPEC countries. These deterred real estate investments and subsequently crippled the value of residential and commercial properties in oil producing states. However the Tax Reform Act enacted in 1981 subdued this effect, and enabled homeowners to claim tax back on loss generated by properties they own (FDIC, 2002). This fuelled an increased activity in the real estate market, as a consortium of individuals and businesses came together to invest in the real estate market, in order to limit the level of tax they paid out on other corporate and individual profits (Kester and McGoun, 1989). However, five years later the Tax Reform Act of 1986 revoked those benefits attributable to loss bearing properties, thereby leading to a rapid fall in real estate prices, as they were no longer of appeal to corporate and individual investors seeking tax breaks. The fall in real estate prices as a result of tax break, and also the rise in oil prices, led to a situation whereby real estate was of a hugely reduced value in oil producing states, and also reduced in several other states likewise (Steward, 1991).
b. Financial Regulation
The interest rate ceilings that were imposed in the 1960s to limit competitive activities in the S&L industry were revoked in 1980, thereby allowing S&L businesses to compete against banks and other money market institutions in attracting customer deposits (FDIC, 2002). This enabled them to offer higher interest rates in order to attract deposits, often higher than the going market rate. These unrealistic interest rates led to scenarios whereby S&L businesses were paying higher rates for savings, much higher that rates obtained on their long term fixed rate mortgages. They therefore needed to engage in projects that earned higher loan rates, thereby subsequently increasing the risk profile of their loan portfolio (AP, 1991).
A series of regulatory reforms also ensued during that period, liberalized S&L powers thereby increasing the portion of their loan portfolio that could be lent for commercial purposes. The Financial Institutions Regulatory and Interest Rate Control Act of 1978 enabled savings and loan organizations to loan capital to construction and development companies up to 5% of their capital. Further statutory and regulatory changes that ensued also enabled these businesses to invest capital in other market categories apart from real estate (FDIC, 2002).
Other legislations put into place in 1980 also reduced the net worth requirements that S&Ls had to have in order to remain solvent and continue business as usual from 5% – 3% from 1980 – 1982. The Federal Home Loan Bank Board (Bank Board) also allowed S&L businesses to appear solvent by issuing income capital certificates. The Bank Board also removed limitations on the number of people that could own an S&L business from 400 stockholders, to just one. State governments such as California, Texas and Florida also followed the Federal Government’s regulation, enabling state savings and loan companies to invest 100% of customer deposits in any kind of venture they felt was appropriate (Cebula and Hung, 1992).
The Insurance board in charge of S&L deposits (Federal Savings and Loan Insurance Corporation – FSLIC), also increased the insurance on savings deposits from $40,000 – $100,000. Thereby increasing the amount of deposits in the S&L industry, as deposits were assured that the government would reimburse them for any deposit they made up to that amount in any insolvent S&L business (Calavita et al, 1999). The increase in deposit insurance also prompted the rise of brokered deposits, in which a broker would collate a large amount of deposit from investors, and invest them in the S&L offering the highest interest rates (Lannon, 1991). These according to Salinger (2005), facilitated dubious practices from these brokers, and risky practices from S&Ls who had to provide the highest interest rates in order to attract deposits, just so they could provide risky loans to businesses at even higher interests for them to break even. Mason (2004) asserts that this cycle is a major reason behind the dubious practices that accounted for over 15% of total insolvencies.
4.CRITICAL ANALYSIS OF THE EVENTS
According to the accounts of Mason (2004), the S&L businesses were already witnessing a downturn prior to the deregulation of the sector. They had increasing competition from money market instruments, which led to disintermediation in which customers opted to invest directly in the money markets that provided higher interest rates. They were unable to compete effectively due to interest rate volatilities and the caps already fixed by the government, which limited the rates they could offer. This economic situation therefore seems like some sort of two way situation in which S&Ls were stable but declining businesses during the initial regulatory period, and became more unstable, experienced sudden jerk in growth, an a subsequent decline in total value as a result of risky activities that ensued after deregulation. Hopkins and Hopkins (1984) asserts that if the industry was never deregulated in the first instance, it may have led to an era of consolidation in which businesses bought themselves out in a bid to establish larger S&L businesses that had more economic leverage and scale. However Kester and McGoun (1989) dictate in contrast to Hopkins and Hopkins, that certain aspect of the deregulation were actually needed, such as the removal of the interest rate ceilings, and the ability to loan to other businesses. These were needed because of the current state of the economy in which real estate prices were falling rapidly and interest rates were volatile. However they concludes that these should have been done with the same prejudice and oversight given to the banks that already enjoyed these benefits, and if those were enacted, the crisis that resulted in that economic situation could have been minimized or largely avoided.
However the Fed took the different approach and opted to deregulate the entire market, as this was seen as a method of stabilising growth in the market, ensuring profitability and liberalising the methods in which these thrift organisations lent money (Mason, 2004). The ability to lend to other parties apart from personal loans and homebuyers, and also collect deposits from brokers, were seen as a method of ensuring profitability and growth in the market (Curry and Shibut, 2000). Lannon (1991) states that these actions may have made sense as a true capitalist and free market approach, as these businesses could have been able to set their prices and compete effectively against each other and other organisations in the money market such as banks and financial institutions. These actions according to Barth et al (2004) would have ensured better survival for these businesses, as long as their activities were overseen, but it was not.
b. One man ownership
The risky activities of these organizations were escalated when the government enabled only one person to own an S&L business, as opposed to previous practices (Salinger, 2005). The major point raised in relation to this proposition, was why the government would allow banks’ competitors to be owned by one individual when the banks themselves were not allowed to be owned by one individualGuidelines on ownership were not imposed, and there were no set rules on the level of management competency that the companies needed to have in order to be run by one individual (Cebula and Hung, 1992).
According to Barth et al (2004), it was these deregulatory measures that actually prompted dubious accounting practices different from that of banks, which S&Ls were competing with, it also resulted in the introduction of higher than manageable interest rates and brokers who collated deposits from a number of parties and invested them into the best interest payer. If the market was never deregulated, then the interest rate ceiling would have always been enacted, and though that could have limited the competitive capacity of S&Ls, it would have also ensured that they adhered to their predominant practices, and never resorted to paying higher than manageable interest rates, or attracting brokered deposits in a bid to shore up their capital base (Mishkin, 1998). According to Shoven et al (1991), if the banks instead were limited in their ability to compete with S&Ls in specific regions or states, then it would have ensured that these companies could compete effectively in those given markets. Mason (2004) also states that enabling thrifts to act like bank without imposing the same regulatory oversight and accounting principles practices by banks was always headed for disaster.
c. Real Estate Tax Reform
One of the other major causes was the Tax Reform Act that was established and abolished in 1981 and 1986 respectively (Hermalin and Wallace, 1994). Investors were initially allowed to deduct loss-bearing assets from their tax payables, which prompted a series of passive investments in property, so investors could take up loss bearing assets that could be deducted from their annual earnings. These activities drove up the market value of real estate, and also the number of mortgages granted to these passive homebuyers. When this tax advantage was abolished in 1986, passive investors who had bought real estate as a method of claiming tax benefits began to offload as their properties had become financially useless. These drove down the prices of real estate as a huge number of investors were trying to offload their real estate properties (White, 1991). A fall in real estate value would result in losses for the homebuilders – which S&Ls were now allowed to lend to; and loss to homebuyers – whose home value may now be much less than the mortgage owed on it. Due to regulatory lax on accounting standards, most of these thrifts had equity values that were less than 2% of their total asset base, and still allowed to stay solvent (FDIC, 2002).
d. Depository Insurance
Finally, the depository insurance that was increased from $40,000 – $100,000 acted more like a moral hazard, since most depositors who were already aware of the risky business practices of these S&L businesses, did not have to care much about the solvency risk of the business where their deposits were held, since the government had already opted to secure deposits (Brewer and Mondschean, 1994). The question now was not on which businesses were safer to invest in, it was in which businesses had the higher deposit rate (Haveman, 1993). The S&L businesses therefore realised that in order to continue to attract deposits they needed to offer higher – sometimes unrealistic – interest rates (as fixed long term mortgages usually had lower rates), and in order for the company to breakeven on these interest rates, they needed to offer the loans at higher prices (Shoven et al, 1991). The only projects or businesses that would be willing to pay higher interest rates for their loans would be those that are unable to obtain prime loans – often handed out to organizations with good credit rating and business reputation.
Therefore based on these analyses, it could be deduced that a coherent analysis of the structure of the crisis would be:
Interest rate volatility and inability to compete with money markets
Removal of interest rate ceilings
Ability of S&L businesses to lend to organizations, as opposed to just mortgage lenders
Real Estate Tax reform act 1981 enabling investors to buy property for the sake of reducing tax payable
Deposit insurance increase from $40,000 – $100,000
Rise of brokered deposits
Real Estate Tax Reform Act 1986 removing tax benefits associated with loss bearing properties.
Flex of accounting rules, thereby allowing GAAP insolvent businesses to run under the RAP framework.
Hopkins and Hopkins (1984) further asserts that it was these risky lending, high interest rates and long term fixed mortgages that led to the widely acclaimed asset/liability mismatch occurring in the industry. The asset/liability mismatch in conjunction with the drastic fall in real estate crisis that ensued after the tax reform act of 1986, helped to catapult the crisis deeper.
5.RESULTANT EFFECT OF THE SCANDAL
a. Total Cost
The total cost of the crisis as at 31 December 1999 was $153 billion, which was bore by the US government ($124 billion), and the sales of failed thrift assets (29 billion) – Curry and Shibut (2000)
The cost that the US government bore was much higher than the intended target, when President Bush announced the bailout in 1989, and resulted in a huge national deficit within that period (Kester and McGoun, 1989).
b. Reduction in number of S&L businesses
The total number of S&L businesses had fallen from 3,234 in 1986 to 1,645 in 1995, while 1,043 thrift organizations with assets of over $500 billion failed (Curry and Shibut, 2000). This was due to aggressive closures by the regulatory authorities that had been slow to react initially. Assets of insolvent banks were seized, shareholders were wiped out, and troubled loans and deposits were sold to other thrifts and banks, while the residual assets were sold at the highest possible price (White, 1991). The main aim of the regulatory authorities was to return customer deposits and increase net present value of losses (Curry and Shibut, 2000).
Outstanding mortgages in the insolvent businesses were securitized in what is now called mortgage backed securities, and saved the regulatory authorities about $60 billion. The total market share of thrift organizations in terms of customer residential mortgages fell from 53% in 1975 to 30% in 1990 (Lannon, 1991)
6.REGULATORY REFORMS THAT ENSUED
Following President Bush’s speech in 1989 regarding the scale of the S&L crisis and the role the taxpayer had to play, it was clear that the current measures being put in place to tackle this crisis were not adequate enough to avoid an industry shutdown (Konoe, 2009). The Financial Institutions Reform, Recovery and Enforcement Act was therefore enacted in 1989, and passed by congress, and the main aim of this act was the restructure the US financial regulation, especially those supervising the thrift industry (FDIC, 2002).
The major aim of the regulation was the dissolve the incumbent FHLBB (Supervisory bank board) and FSLIC (Deposit Insurance for thrifts), and establish the Office of Thrift Supervision, which would now be in charge of regulating and supervising activities in the thrift industry, and the Resolutions Trust Corporation, responsible for taking over and liquidating assets of incumbent organisations (Calavita et al, 1999).
The FDIC, which was already responsible for deposit insurance for US banks were now given extended responsibility in insuring thrift organizations, therefore extending the same accounting, regulatory and risk standards expected of banks (FDIC, 2002).
According to Salinger (2005), these actions came late in time, as if they were enacted early in 1986, the number of losses witnessed by the industry could have been greatly reduced and some of the liquidity could have been averted. However a number of lessons have been learnt based on these occurrences, and some of these lessons would subsequently be used in managing the subprime crisis.
The main lessons learnt from crisis that erupted within this period, was reflected in the method of supervision imposed on the thrift industry, and several other banks not necessarily operating in that capacity (Konoe, 2009). The Resolution Trust Corporation was entrusted to liquidate any thrift or bank that did not necessarily meet capital requirements, and fell short of regulatory standards in terms of risk profile and business activities. Apart from the 50% of thrifts liquidated, an extra 1,600 banks were also affected indirectly (Barth et al, 2004). Several operational guidelines were also imposed on the activities of thrift organizations; whilst the customers they could funds to were again restricted (Stewart, 1991).
The steps taken by the regulatory authorities within that period for the thrift companies are very much different from that taken recently during the subprime crisis, when the US government decided to bailout failed banks, financial and insurance companies with funds totally $700 billion. For instance, instead of pumping money in order to shore up the capital of these organizations, the authorities then seized their assets, wiped out shareholders, and sold these assets. These ensured that failed organizations with bad management were not allowed to continue business services, and resulted in a fewer number of thrift organizations that were able to conduct business effectively (Meier, 2008).
However, some of these strategies were adopted on a small scale for the failed Wachovia Bank, and several other state owned banks. The FDIC took over the assets of the company, and divided them based on their risk profile, then sold off these assets to other strong banks, whilst insuring them against future losses (Meier, 2008). This is very identical to the steps it took during the S&L crisis, and illustrates that the regulatory authorities have learnt their lessons with regards to managing and liquidating the assets of insolvent organizations.
The illusion that these organizations had learnt a lesson on a broad scale however, seems to have been lost when the same risky business practices and mortgage lending led to the failure of organizations during the subprime crisis (Konoe, 2009). It is even debated by Meier (2008), that it was the assurance of a bailout as witnessed during the S&L crisis, that warranted those practices, citing that the US government would bear the cost if the subprime mess ever went under – which it did.
Financial regulation is a two edged sword. Too much of it may lead to lack of competitive advantage and overregulation, while too little of it may lead endanger the whole financial economy, and whatever it stands for. Business practices that are solely based on profit maximization without consideration of the key stakeholders – which are the customers and tax payers that may eventually bear the brunt – would engage in activities that aim to increase their present net worth, with no consideration of future implications.
Therefore financial regulation of these activities should be carried out in such a way that it ensures that these practices run profitably, whilst still considering its benefits the whole economy.
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