SAVINGS AND LOAN FAILURES

Since the early 1930s savings institutions had enjoyed more than 50 years of economic success. However, the end of the 1970s threatened industrial prosperity with unprecedented high inflation and interest rates. The financial structure of the typical thrift was at the core of the problem. Most institutions borrowed for short terms, in the form of depositors' savings accounts, but lent for long terms through fixed-rate home mortgages. While interest rates remained stable, thrifts could earn acceptable profits. When market forces caused rates to soar, the delicate balance was threatened, as payments to depositors' rose without a corresponding increase in receipts from mortgages. In 1978 regulators allowed thrifts to pay higher interest rates on certificates of deposit. This checked disintermediation (savers going to other institutions), but the cost of funds rose. Profits, therefore, shrank or turned into losses.

Thrift executives knew that erosion of net worth jeopardized the industry's health. They sought relief from long-term, fixed-rate loans that tied them to low returns. The U.S. Congress was not prepared to back an industry-wide bailout. As a compromise, it passed the Depository Institutions Deregulation and Monetary Control Act (DIDMCA) in 1980, granting additional lending powers to thrifts. Most promising was the ability to originate short-term consumer loans and high-yield commercial real estate loans. Despite DIDMCA, about 36 percent of all thrifts were losing money by the end of 1980. Even worse, in 1981 about 80 percent of the industry lost money. Congress reacted with additional deregulation in 1982. It passed the Garn-St. Germain Act, giving thrifts even broader investment powers.

The government also allowed thrifts favorable reporting treatment. Purchasers of failing institutions were given special accounting privileges. In addition, thrifts were authorized by the Federal Home Loan Bank Board (FHLBB) to utilize lenient Regulatory Accounting Principles (RAP). The FHLBB allowed thrifts to reduce their capital requirements from five percent to three percent between 1980 and 1982. This leniency was allowed to keep troubled thrifts from being taken over by regulators.

After deregulation, and with interest rates subsiding in 1983, the industry appeared to be heading toward prosperity. Thrifts attempted to grow out of their problems by generating more high-yield investments. The real estate market was booming, so thrift managers were tempted to invest in risky commercial ventures. They often disregarded such factors as lack of expertise, unfamiliar geographic territories, and questionable appraisals and underwriting. Loan brokers and junk bond brokers also found an eager market in the thrift industry.

Depositors continued to patronize savings institutions despite growing losses and failures. DIDMCA had increased deposit insurance coverage to $100,000. With this level of insurance, depositors had little fear of losing their savings at faltering institutions. Indeed, the failing institutions often offered the highest rates.

In 1986 the Tax Reform Act repealed liberal depreciation and personal deduction provisions. Many commercial real estate deals were structured around such tax shelters. Without them, the enormous market for real-estate syndicates dried up. At the same time worldwide oil prices dropped, which negatively affected the economic health of states that relied on the oil industry. The real estate market in the Southwest went sour almost overnight, affecting real estate values throughout the country. The booming real estate market of 1983–1986 was transformed into an overbuilt market by 1987.

In 1988 the FHLBB committed nearly $40 billion in 1988 to take over failing institutions, merge them into marketable packages, and sell them to investors. But the program almost bankrupted the Federal Savings and Loan Insurance Corporation (FSLIC). FHLBB Chairman Danny C. Wall either concealed the depths of the FSLIC insolvency or did not recognize the extent of the problem. Matters were made worse by errors in judgment on the part of thrift managers, by the greed of investors, by weak examination and supervision practices by regulators, and by numerous alleged cases of fraud and misconduct on the part of thrift insiders, regulators, investors, and members of Congress.

When President George Bush (1989–1993) took over the presidency in 1989, he was extremely concerned about the unstable condition of the FSLIC and the accumulated losses at hundreds of thrifts. With the assistance of Richard C. Breeden, executive director of the White House Regulatory Task Force, Robert R. Glauber, undersecretary in the Treasury Department, and L. William Seidman, chairman of the Federal Deposit Insurance Corporation (FDIC), Bush drafted the Financial Institutions Rescue, Recovery, and Enforcement Act (FIRREA). In August, 1989, the act was approved by Congress and President Bush signed FIRREA into law a few days later.

FIRREA had four explicit goals. The first was to improve the ability of regulators to supervise savings institutions by strengthening industry capital and accounting standards. The second was to return the federal deposit insurance fund to a sound financial base. The third was to provide funds to deal with the disposal of failed institutions. The fourth was to strengthen the enforcement ability of regulators through reconfigured powers and a new organizational structure. An unstated goal of FIRREA was to return the emphasis of the business to its roots of home mortgage lending.

FIRREA featured several key provisions. It dissolved both the FSLIC and the FHLBB. The responsibility of insuring the thrift industry's deposits reverted to the FDIC. The duty of supervising the Federal Home Loan Bank (FHLB) system and individual thrifts was passed to a new organization, the Office of Thrift Supervision (OTS). Two new additional organizations were created. The Resolution Trust Corporation (RTC) was formed to dispose of the assets of failed thrifts. The Resolution Funding Corporation (RFC) was created as the fund-raiser for the RTC. The RFC was initially authorized to borrow up to $50 billion, through bonds, to fund RTC activities.

Numerous thrift powers were restructured. FIRREA banned investment in junk bonds, limited investment in nonresidential loans, set loan-to-one-borrower limits to national bank levels, and placed strict limitations on loans to affiliated parties. Most important, it mandated that thrifts hold at least 70 percent of their assets in mortgage-related investments. Penalties for failure to comply were tough at both the corporate and the individual level.

FIRREA directed the OTS to set capital requirements for thrifts at levels no less stringent than those of national banks. Core capital requirements were set at three percent of total assets, and tangible capital was set at 1.5 percent of total assets. Thus, the definition of capital itself was altered. The previous reliance on RAP standards of accounting was abolished.

President Bush's stated intention was to fix the thrift industry permanently by closing down or selling hundreds of thrifts. His method of ensuring that old problems would not resurface was to subject surviving thrifts to the capital and accounting rules applied to national banks.

FIRREA was a sharp response to the thrift crisis. Considerable controversy arose in the business community, especially among the thrifts that were directly affected. Some analysts believed that the capital requirements would bankrupt more institutions than necessary. There was a large group of thrifts working slowly to recover from their problems. They were not grossly insolvent but they would not be able to meet new capital requirements for years. Continued weaknesses within the real estate markets did not help. Imposing stringent standards on a weakened industry pushed hundreds of these thrifts over the brink. This presented the RTC with a larger, more expensive task than the government had expected.

The short-run impact of FIRREA on the business community extended further than the thrift industry. FIRREA caused all lending institutions to tighten credit practices, so businesses had to postpone or cancel worthy projects. Tight credit contributed to a declining economic climate. Banking regulators tightened oversight and enforcement in their industry. Although inflation and interest rates were in check, banking became more conservative. Many banks were satisfied to watch profit margins improve through lower costs of funds. The resulting "credit crunch" contributed to job losses throughout the economy. Closings and mergers within the thrift industry meant an additional dramatic drop in jobs.

By the end of September, 1991, the OTS estimated that 464 thrifts (21 percent of the industry) were on the brink of takeover. These institutions had not been seized because there was no money available to do so. The OTS intended to take over all failing institutions and have the RTC either sell them intact or liquidate them piecemeal. To dispose of a thrift intact, the RTC had to make up any negative net worth. The goal was to entice investors, especially commercial banks, to purchase failing thrifts through the financial backing of bonds issued by the RTC/RFC. Unfortunately, FIRREA stripped thrifts of many powers that had made them attractive investments. Unless a thrift could open new depository markets for a bank, it did not offer much advantage to the prospective purchaser.

FIRREA's objective of making depository insurance financially sound also failed to be met. FIRREA did not correct the problems that existed in the FSLIC; it merely pushed the problems onto the FDIC, jeopardizing its solvency. Because the $100,000 insurance coverage was not changed, depositors and institutions remained susceptible to risk-taking. Since fixed insurance premiums were not changed, risky institutions were afforded the same degree of protection at the same cost as safe institutions.

Resolving the thrift crisis involved huge federal payments to honor commitments made by the FSLIC and new ones resulting from FIRREA. A substantial amount of the borrowing was to be repaid from the sale of assets of failed thrifts. Unfortunately, asset sales could not cover the large borrowings. This shortfall became the responsibility of taxpayers. Like the national debt, the FIRREA debt will likely fall on future generations of taxpayers.

Several lessons emerged from FIRREA and the events that led to its passage. First, deregulation in the early 1980s seemed to hamper thrift industry efforts to reverse losses. More lenient rules and broadened powers were not accompanied by stricter supervision. Second, the deposit insurance system encouraged carelessness on the part of depositors and depository institutions. Fixed-price premiums ignored risk and transgressed the cardinal rules of insurance. Third, FIRREA may have been based on sound intentions, but the effect was similar to that of overmedication of a sickly patient. Good principles applied abruptly may have led the industry toward extinction. Fourth, an improperly funded program cannot expect success. FIRREA was more ambitious than its budget would allow. The final costs may not be known for generations.

FURTHER READING

Bush, Vanessa, and Katherine Morrall. "The Business Reviews a New Script." Savings Institutions, October 1989.

Lowy, Martin E. High Rollers: Inside the Savings and Loan Debacle. New York: Praeger, 1991.

Mayer, Martin. The Greatest-Ever Bank Robbery: The Collapse of the Savings and Loan Industry. New York: Charles Scribner's Sons, 1990.

Pilzer, Paul Z., and Robert Deitz. Other People's Money: The Inside Story of the S and L Mess. New York: Simon and Schuster, 1989.

United States Congressional Budget Office. The Economic Effects of the Savings and Loan Crisis. Washington, DC: United States Congressional Budget Office, 1992.

Community Reinvestment Act (1977)

Fred Galves

Congress adopted the Community Reinvestment Act (CRA) (P.L. 95-128, 91 Stat. 1147) in 1977 to combat "redlining," the "systematic denial of credit to persons living within a certain area." CRA prohibited redlining by requiring regulated financial institutions to show that their depository facilities met the "convenience and needs of the communities in which they are chartered to do business."

The lack of adequate lending, coupled with the depletion of available government funds, had caused economic decay in poor neighborhoods and left the urban areas crime ridden and economically devastated. Congress hoped by codifying an affirmative obligation to meet the needs of local communities that financial lending mandated by CRA would foster neighborhood stability and revitalization.

Originally, Congress intended CRA to respond to problems associated with depository institutions transferring funds they received as savings deposits from local residents to borrowers outside the communities regardless of whether the communities were rural, urban, or suburban. Thus, at its inception, Congress's intent was to improve the banking services in poorer communities, although Congress knew the likely beneficiaries would be racial minorities. However, regulators soon discovered that CRA had little real power, and that the law was difficult to enforce because of its vague language. In its first twelve years (between 1977 to 1989), the CRA merely required banks to show a good faith effort in becoming more aware of the needs of the communities they served.

SUBSEQUENT LEGISLATION

This situation changed in 1989 when Congress amended the CRA as a part of the Financial Institutions Reform, Recovery Enforcement Act (FIRREA). FIRREA amended the CRA by mandating public disclosure of all CRA reviews. This was a substantial change because it allowed the American public to have access to a banking industry "report card."

FIRREA established the four-tiered grading system that is still in effect today to evaluate a bank's CRA performance. The rating system is: (1) "outstanding," (2) "satisfactory," (3) "needs to improve," or (4) "substantial noncompliance." After Congress adopted FIRREA the regulatory agencies issued a joint statement that outlined a set of twelve new assessment factors that would be used to examine the banks for CRA compliance.

Congress implemented another change to the CRA as a part of the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA). FDICIA required public discussion regarding the regulator's assessment of an institution's CRA performance in the public portion of the CRA evaluation. Under FDICIA, regulators must consider this record when the agency is examining an application for a deposit facility by the financial institution. The institution's performance may be a basis for denying or conditioning that application on further activities.

In response to a growing number of bank complaints regarding the intensive documentation required under CRA, President Clinton proposed changes that made the CRA less burdensome to the banking industry, while still preserving its intended purpose. The new regulations replaced the twelve assessment factors with a more quantitative system based on actual performance as measured by various tests. These new regulations emphasize performance, not process. Many experts argue that the new, revised approach to the CRA enables banks to focus more on the lending, and less on the paperwork.

CRA IMPACT ON AVAILABILITY OF LOANS

Public and administrative efforts have succeeded in getting money to individuals in poor neighborhoods. By 1993, 14 percent of the 152 banks examined in their first six months of 1993 did an "outstanding" job under the CRA. That was up from only 8 percent of those banks examined between July 1990 and December 1992, prior to the implementation of the new regulations. Moreover, the CRA has decreased the racial disparities in lending practices. Between 1991 and 1995, while conventional home-purchased loans to whites increased by two-thirds, loans to blacks tripled (from 45,000 to 138,000 a year) and loans to Hispanics more than doubled. During the same period, loans in predominantly minority neighborhoods rose by 137 percent—while loans in areas where population was almost all white grew by just 37 percent.

LITIGATION AND CONTROVERSY

The Justice Department has sought to enforce the fair lending laws, and this may also have had a positive impact on banks' willingness to invest in minority neighborhoods. The utility and fairness of the CRA, however, continues to generate substantial debate in congress and among advocacy groups. Former Senator Phil Gramm, Republican of Texas, for example, stated that "I want to get back to lending and end these kickbacks whereby you give the protesting organization money, but you don't make loans in the community." Senator Gramm was claiming the community groups were using the CRA rating as a way of unfairly taking money from banks.

However, John Taylor, president of the National Community Reinvestment Coalition questioned this criticism. In testimony to the House Committee on Banking and Financial Services, he admitted there might have been a few instances of "greenmail." However, his organization and its membership renounce this practice as counterproductive, since it creates adversity and may not produce long lasting collaborations among banks and community groups. He states that because these partnerships involve a high degree of cooperation and trust, extortion is simply not a part of the partnership.

The Community Reinvestment Act is good legislation for all involved. The banks make profits from loans they probably would not have made unless the government assisted the credit transfers. Consumers win because they have the much-needed resources to keep their communities economically viable. This leaves our country in a more democratic and economically fair place for all.

See also: Community Development and Banking Financial Institutions Act of 1994; Fair Housing Act of 1968.

BIBLIOGRAPHY

Baldinucci, E.L. "The Community Reinvestment Act: New Standards Provide New Hope." Fordham Urban Law Journal 23 (Spring 1996): 831, 846–856.

Canner, Glenn B., and Wayne Passmore. "Home Purchasing Lending in Low-Income Neighborhoods and to Low-Income Borrowers." Federal Reserve Bulletin 81 (February 1995): 71–103.

Garwood, M., et al. "The Community Reinvestment Act: Evolution and Current Issues." Federal Reserve Bulletin (1993): 251–267.

Johnson, Marcia, et al. "The Community Reinvestment Act: Expanding Access." Kansas Journal of Law & Public Policy 12 (2002): 89–123.