What lessons did we learn from the Savings and Loan crisis that came to a head during the 1980s? Please bear in mind that this whole fiasco directly cost us taxpayers about $125 billion. Other indirect costs, including funding of the resulting federal deficits of the 1990s pin the total cost at a much higher figure. But did we learn anything from it?
I hope the S&L crisis hasn’t dimmed or become fuzzy in the minds of Americans, because one of the lessons we should have learned is that government intervention to rescue lenders from poor business practices causes far more problems that it solves. The S&L crisis was made worse by several orders of magnitude by government meddling that prevented the market from appropriately responding. But it seems that today we are on the threshold of wanting to repeat some of the same mistakes that significantly contributed to the S&L crisis.
S&Ls had a long history of performing well in the mortgage industry for a century. During the 1960s more Americans bought homes than ever before, financing them at rates of 5% and less. Life was good. And then we experienced rampant inflation and skyrocketing interest rates in the 1970s. To be competitive with other investment instruments, S&Ls had to offer higher rates to their investors than they were receiving from their debtors.
It was obvious that in the long haul this business model was completely unsustainable. How did S&Ls end up in this situation? After WWII, the government implemented regulations intended to increase home ownership. While this produced many salutary effects, it also led to S&Ls being too deep in fixed low-rate assets, and therefore, insufficiently flexible to deal with market changes. In effect, S&Ls were encouraged to act as if the economic conditions of the late 50s and early 60s would go on unchanged forever. S&Ls ignored common business sense by accepting this wonderland scenario.
When interest rates went up in the 1970s, S&Ls started writing mortgage loans at the higher rate, but the bulk of their assets were locked up in 30-year mortgages written at much lower rates. Investors naturally expected to earn interest at the new market rates immediately. S&Ls could either figure out ways to keep investors on board or risk losing enough investors that they would go out of business. Either way, insolvency was going to be the end result. It was only a question of how much time would transpire before that happened.
Seeing the looming problem, politicians came to the rescue in an attempt to save the floundering S&Ls. Over the next few years, laws and regulations were passed that artificially kept failing S&Ls in business. Had the market been allowed to deal with the crisis early on, there would have been pain, but ultimately the market would have corrected itself. Politicians put off the pain — and made the crisis many times worse — by intervening and shielding S&Ls from natural market pressures.
But all the king’s horses and all the king’s men couldn’t stop the S&L Humpty-Dumpty from falling, nor could they put him back together again. By the time the S&L collapse could no longer be stopped by politicians, Humpty-Dumpty was much larger and sat much higher, so his fall was much greater. Once again, Congress rushed in to pick up the pieces and save the market from dealing with the natural consequences of bad business decisions, resulting in the taxpayers forking out many billions of Dollars. Players learned that if business mistakes are big enough, they will ultimately not have to bear the full cost. Thus, Congress ended up encouraging riskier business behavior.
Fast forward to 2007. In recent years, mortgage lenders have climbed over each other in an effort to attract increasing numbers of Americans to their loan products. Home builders have been in on the take as well, working hard to attract buyers that have marginal repayment capacity. This has led to a significant increase in sub-prime lending. But common business sense dictates that making high risk loans will inevitably lead to a high default rate. This all hit the fan recently, when there was a sharp rise in the number of foreclosures in the sub-prime mortgage market between 2006 and 2007, resulting in what is being called the 2007 sub-prime mortgage crisis.
Politicians, ever eager for votes and ever eager to expand power, are licking their chops and planning increased regulation that would have the effect of overreacting, punishing some, and shielding the market from the natural consequences of shoddy lending practices. As Jerry Bowyer reports in this NRO article, mortgage lenders are not lending at the moment because they fear the congressional backlash that is about to be unleashed, even as the market is effectively responding to correct the excesses that led to the “crisis.”
The ironic thing is that, as Bowyer notes here, this whole issue is really just a tempest in a teapot. He cites the fact that “only about 0.6 percent of U.S. mortgages are currently in foreclosure. That’s up a hair from roughly 0.5 percent last year.” But since these additional 35,000 foreclosures are ostensibly for lower cost homes, “the recent increase in sub-prime foreclosures amounts to 0.01 percent of net U.S. household wealth.”
In other words, the sub-prime “crisis” has been blown way out of proportion, making headlines in a slow news cycle. The market is already correcting the problem. But none of this will stop politicians from grandstanding on and trying to make political hay with this issue. And just about anything they are assaying to do will only make matters worse. Here’s hoping that Congress will take its most usual course of action and end up blathering a lot while doing nothing. Sometimes it’s good when politicians can’t accomplish anything.