If you’ve seen It’s a Wonderful Life, you know about “building and loans,” the precursors to savings and loans, or what are also called “thrifts.” In order to help the thrifts out with a liquidity crisis, not unlike what is happening now, President Hoover established the Federal Home Loan Bank Board (FHLBB) in 1932 for the purpose of lending money to thrifts so that they could lend money to people like you and I.

Savings and loans did a fairly respectable business and saw their assets rise from $10bn in 1945 to $600bn in 1979. According to Paul Clikeman in Called to Account – Fourteen Financial Frauds that Shaped the American Accounting Profession (which is the source of information for this blog), “…savings and loan executives thrived by following the simple ‘3/6/3 rule’ – take in deposits at 3 percent interest, make loans at 6 percent interest, and be on the golf course by 3:00 every afternoon.” The loans were secured by real estate and borrowers needed a reasonable down payment or a federally insured loan. Not much in the way of risk.

Although, those in the business of making loans can be exposed to something known as “interest rate risk.” You probably know that if you put $10,000 in a bank, the money doesn’t actually sit in the vault night and day humming a Cole Porter tune and waiting for you to visit. The bank lends most of it to others at a higher interest rate than it pays you, pocketing the difference. This is fine so long as what the bank pays you is less than what it can get on its loans. Someone in the government apparently figured that bankers couldn’t follow the basic math and passed the Interest Rate Control Act in 1966 which limited the rates that banks and thrifts could pay depositors.

I mentioned above that there wasn’t much in the way of risk connected with savings and loans. But what happens when the markets start paying depositors 10%? If, as a banker, I don’t come close to the prevailing rate, people will take their money elsewhere to get a better return. And here’s where it starts to get difficult. All my loans are for 30 years fixed at 6%, but I now have to pay 10% to the people whose money I’ve lent. It sounds like I’m going to come up 4% short on my green fees. This is “interest rate risk.” It is compounded (pardon the pun) by the fact that I have “borrowed short and invested long.” That is, I’ve borrowed from my depositors for perhaps one or two years (in a certificate of deposit) and lent it out for 30 years.

You’re probably thinking Rick’s been reading too much of the tax code lately – banks don’t pay 10% on savings accounts! Well, they couldn’t because of the Interest Rate Control Act. But in 1980, treasury bills were paying 15.6%, and people could invest in treasuries through something called a money market fund. So, when their certificates of deposit termed out, vast amounts were pulled out of S&Ls by depositors and moved into money markets (never mind that money market accounts were never really insured until recently when a new phrase enter the vernacular – “break the buck”).

Regulatory Cascade

In 1980, President Carter signed the Depository Institutions Deregulation and Monetary Control Act which allowed S&Ls to increase the rates paid on depository accounts. So far so good. At least S&Ls could stem the tide of cash flowing into money markets. But what about that “borrowing short and investing long” problem? The solution was found in something called the adjustable rate mortgage (ARM). In 1982, President Reagan cut the shackles on the S&L industry in the form of the Depository Institutions Act and allowed S&Ls to issue ARMs which alleviated interest rate risk. But like all good legislation, more is better. S&Ls could now issue unsecured loans and invest in something called “junk bonds” (think Michael Milken).

Interest rates were rising in the late 1970s, and it would be some time before accounting standards moved away from the historical cost principle and adopted “Mark-to-Market.” Remember all those loans made at 6% under the “3/6/3” rule mentioned above? Well, if I can now get 12% on a loan, my 6% loan isn’t worth as much any more. It has decreased in value. Thanks to the historical cost principle, however, S&Ls were not required to report losses on these loans – causing the value of the assets on their balance sheets to be overstated.

Compounding matters yet again, in 1982, the FHLBB allowed S&Ls to use what are called Regulatory Accounting Principles (RAP) rather than Generally Accepted Accounting Principles (GAAP). According to Clikeman, “RAP inflated savings and loans’ assets and hid the severity of the industry’s problems…Using RAP, only 73 savings and loans were insolvent in 1984.” Using GAAP, however, 449 S&Ls were insolvent.

The worry among economists in the current crisis is that by not allowing large banks to fail and instead tinkering with regulatory and reporting requirements, the U.S. will duplicate the mistakes made by Japan with its banks in the 1990s which resulted in a decade of no growth. Rather than studying the Great Depression, the government should probably be studying the S&L crisis instead.

Remember the saying – a rising tide floats all boats. It’s only when the tide goes out that you see who’s been swimming naked.