The Rise of S&Ls

The origins of the savings and loan industry can be traced back to the 1830s, when community-based institutions began pooling deposits and issuing mortgages to local homebuyers. This grassroots lending model, combined with the establishment of federal oversight like the Federal Home Loan Bank System in 1932, allowed S&Ls to thrive through much of the 20th century.

By facilitating homeownership and providing a stable source of mortgage financing, S&Ls played an instrumental role in the post-World War II housing boom and suburbanization of America. Their narrow focus on long-term, fixed-rate residential mortgages served as a cornerstone of the U.S. housing finance system for decades.

However, as the 1970s progressed, a new economic reality began to emerge that would shake the very foundations of the S&L business model. Runaway inflation and spiking interest rates exposed the vulnerability of holding billions in older mortgages with rates as low as 6% on their books. This asset-liability mismatch crushed profitability and led to the first rumblings of distress.

In an effort to “revitalize” the struggling industry, policymakers embarked on an aggressive deregulation wave in the early 1980s. This set the stage for S&Ls to rapidly expand their activities far beyond the traditional residential lending realm into riskier asset classes like commercial real estate and corporate debt.

By 1980, there were over 4,800 S&Ls holding nearly $600 billion in assets and commanding a 53% share of the residential mortgage lending market. However, this once-stalwart industry would soon find itself at the epicenter of one of the most devastating financial crises in American history.

Factors Driving the Meltdown

Deregulation

A major catalyst that enabled the S&L crisis to unfold was the deregulation movement of the early 1980s, spearheaded by the Garn-St. Germain Depository Institutions Act of 1982. This sweeping legislation removed long-standing restrictions on the activities S&Ls could engage in, allowing them to venture into areas like commercial real estate lending, construction financing, and corporate debt investments like junk bonds.

While the intent was to provide S&Ls greater flexibility to generate higher returns, this expansion of permissible activities was not accompanied by modernized capital requirements or enhanced regulatory oversight from entities like the Federal Home Loan Bank Board (FHLBB). In essence, S&Ls were granted new powers without sufficient safeguards to ensure those powers could be managed prudently.

Emboldened by deregulation, S&Ls rapidly plowed money into speculative commercial real estate projects and aggressive acquisitions of office towers, shopping malls, hotels, and other income properties. However, they often lacked the institutional expertise and robust risk management controls to properly underwrite and monitor these more complex asset classes.

Excessive leverage, poor underwriting standards, and a herd mentality toward chasing higher yields in new lending areas became commonplace. Many S&Ls found themselves dangerously overexposed to volatile real estate markets without sufficient capital buffers to withstand a downturn.

Interest Rate Volatility

Compounding the S&L industry’s woes was the unprecedented interest rate volatility that characterized much of the 1970s and early 1980s. As the Federal Reserve aggressively raised rates to combat runaway inflation, with the prime rate peaking over 20% in 1981, S&Ls found themselves in a severe profitability crunch.

With billions in older fixed-rate mortgages on their books carrying rates as low as 6%, the spread between their asset yields and cost of funds turned increasingly negative. Depositors also began pulling funds in search of higher returns elsewhere, forcing S&Ls to pay up or risk crippling capital outflows.

In a desperate bid to offset these pressures, many S&Ls reached for higher yields by doubling down on riskier lending activities like commercial real estate development and speculative construction projects. A vicious cycle took hold – higher interest rates eroded profitability, driving a pursuit of riskier investments that ultimately magnified losses.

Regulatory Failures

At the core of the S&L crisis were profound lapses in regulatory oversight that enabled excessive risk-taking to spiral out of control. Agencies like the FHLBB lacked the resources, expertise, and political insulation to properly monitor and rein in the industry’s overexpansion into new asset classes.

Delays in identifying and resolving insolvent S&Ls became commonplace, as regulators often turned a blind eye or lacked the fortitude to intervene. This “forbearance” approach allowed undercapitalized institutions to continue operating and digging an even deeper hole.

Moreover, the Reagan administration’s deregulatory zeal and hands-off approach to the financial sector fostered an environment of regulatory capture, where S&L executives wielded undue influence over policymakers. High-profile scandals like the Keating Five affair exemplified these governance shortcomings.

Fraud and Criminal Activity 

As the S&L industry’s financial condition deteriorated through the 1980s, outright fraud and criminal misconduct became increasingly prevalent. Cases like Lincoln Savings & Loan and its proprietor Charles Keating, who was later convicted of fraud and racketeering, made national headlines.

At Lincoln and other failed S&Ls, executives engaged in egregious lending practices, funneled funds to personal business ventures, and grossly inflated asset valuations to mask insolvency. Lax internal controls, poor auditing standards, and the erosion of ethical norms enabled these activities to fester.

The Real Estate Fallout

Given the centrality of real estate lending to the S&L business model, it was inevitable that the industry’s collapse would have severe impacts across property markets. And those impacts were indeed staggering. 

By 1989, over 1,000 S&Ls holding an estimated $519 billion in assets had failed, leaving the federal deposit insurance fund insolvent. This represented a massive contraction in available credit for real estate development and mortgage lending at a time of already-deteriorating economic conditions.

The consequences reverberated across the real estate landscape. Foreclosures and delinquencies on commercial properties like office buildings, shopping centers, apartments, and hotels surged as overleveraged S&Ls began calling loans. According to data from the Federal Deposit Insurance Corporation (FDIC), by 1991 over 13% of commercial mortgages held by S&Ls were non-performing.

This tidal wave of distressed assets severely impacted property valuations and pricing across asset classes. Deal activity ground to a halt as lenders hoarded capital to cover losses. Local markets like Texas, Arizona, and California that had seen rampant overbuilding during the S&L boom years were hit particularly hard.

The liquidity crunch also spilled over into the residential housing market, as S&Ls that had traditionally provided the majority of mortgage financing pulled back lending activities. This exacerbated the economic downturn of the early 1990s, creating a self-reinforcing cycle of job losses, declining housing demand, and further real estate distress.

While the real estate impacts were national in scope, certain regional markets were exposed to an outsized degree of fallout from the S&L crisis due to their concentration of lending activities. The state of Texas, with its heavy economic reliance on oil & gas and its large number of S&L institutions, was arguably ground zero.

By the late 1980s, over half of the deposits in Texas S&Ls were tied to commercial real estate loans. When the overheated markets in cities like Dallas, Houston, and San Antonio began to unravel, it triggered a cascade of failures. Nine of the ten largest bank/S&L insolvencies resolved by the FDIC between 1986-1992 were Texas-based institutions.

The economic toll was immense, with Texas losing over 400,000 jobs during the crisis years. Scores of vacant office towers and half-built residential developments littered major metro areas. By 1990, over 25% of commercial properties in Dallas were in delinquency or foreclosure proceedings.