So Long to the Savings and Loan Association

Well, the final nail is being hammered into the coffin. The Savings and Loan industry is going to be “legacy”…and, rightfully so.

The New York Times writes the obituary: “Financial Bill to Close Regulator of Fading Industry,” http://www.nytimes.com/2010/07/14/business/14thrift.html?_r=1&hp. “The most remarkable piece of the financial regulation bill that Democrats hope to send the president this week is the directive to dismember and close the Office of Thrift Supervision. The decision is all the more remarkable because it cuts against the grain of a bill devoted to expanding federal regulation, and because it has had virtually no opposition, save for the obligatory protests of the agency’s senior management.”

The original Savings and Loan Association was created to help Americans own their own homes. The S&Ls deposits were time and savings accounts, no transaction accounts, and the assets of an association were mortgages. An S&L could hold 80% of its assets of more in mortgages…not mortgage-backed securities or any other type of synthetic concoction of mortgage instruments or derivatives. These were the single family mortgages of individual families, most of them known personally by the people who ran the association.

Furthermore, these financial organizations were mutual institutions. That is, they were owned by their depositors. No stock holders, no maximizing shareholder value, no gimmicks, no nothing. By law they took time and savings deposits and, by law, they originated mortgages to hold on their balance sheets.

How did they make money? Well, for much of their history they paid 1 ½% to 2% interest on their deposits and collected 4% or so on their mortgages. Their expenses were extremely low. In a typical institution there were only one or possibly two managers (men) and a clerk and maybe two or three tellers or a receptionist (all women). They were mutual institutions so that they did not have to earn anything like 15% on paid-in equity. A 1% return on assets was really good and it just went into the surplus account anyway. Remember George Bailey (Jimmy Stewart), the Bailey Building and Loan Association and the movie “It’s A Wonderful Life.”

The demise of the industry is just another example of how much inflation can be the “stealth” destroyer of stability. The health of the industry was dependent upon the interest rate spread presented above. And, in non-inflationary times when interest rates remained relatively stable, the S&Ls could prosper because the interest rate spread they earned paid for expenses and added to the association’s surplus.

There were cyclical problems, but regulators, specifically using Regulation Q (Reg Q), put a lid on the rate that these institutions could pay depositors so that a positive interest rate spread could be maintained although this “lid” caused something called “dis-intermediation”, an outflow of deposits, that put pressure on the liquidity of associations. This disintermediation was just a time period these institutions had to go through until interest rates stabilized once again.

However, this disintermediation problem points up the underlying weakness of the Savings and Loan Industry. The industry was built on the foundation of interest rate risk: the assets of the typical Savings and Loan Association had an effective average maturity of twelve or thirteen years. The deposits had a maturity of…well, they were very short term deposits.

The periodic problem of disintermediation pointed up the underlying risk that existed within the industry. However, the inflation of the 1960s basically killed the industry. As inflation rose toward the end of the decade, interest rates rose as inflationary expectations got built into the term structure. That is, interest rates, both long-term and short-term, rose.

Well, the typical S&L saw the cost of deposits rise by a substantial amount almost across the board while the return they earned on their assets rose only modestly. All of a sudden, thrift institutions were faced with negative interest rates spreads and they could not exist in such an environment.

This is when deregulation started and accelerated dramatically through the 1970s. Basically, the idea of a thrift institution was dead by then. Not only did regulators allow balance sheets to become more like commercial banks, bank executives were drawn into the industry to run the thrifts. And, of course, thrift institutions were allowed to shed their “mutual” charter and become stock institutions. I took one thrift institution public in 1985 and ran another thrift that had just gone public in 1987.

I have spent a lot of time over the past two years writing about how inflation in the United States over the past 50 years or so basically undermined the financial system as it was known, created a tremendous environment for financial innovation, and helped to change the makeup of American society, where employment in financial services reached 40% or more of the workforce when, before 1980, employment in financial services had never exceeded 15% of the workforce.

The inflation created by the federal government since January 1961 forced the collapse of the post-World War II international financial system as the United States took itself off the gold standard on August 15, 1971 and floated the United States dollar. The inflation of the 1960s resulted in the rise in interest rates that destroyed the foundation of the thrift industry in the United States and created the conditions that led to the Savings and Loan crisis of the late 1980s and early 1990s. The continued inflation of the late 20th century led to the stock market bubble in the 1990s (the dot.com boom), the demise of the Glass-Steagall Act, and the asset bubble (both in the stock market and housing) of the 2000s.

The difficulties we have been experiencing in the last few years can also be traced back to the inflation of the past fifty years. Yet, inflation is sneaky and people tend to forget it in pointing their fingers at the “bastards” that “caused” the financial collapse.

The economist Irving Fisher captured this situation in his book titled “Inflation”: “If it is inflation and the one who profits is the business man, the workman calls the profiter a ‘profiteer.’ The underdog reasons as follows: ‘How did I get poor while you got rich? You did it, you dirty thief. I don’t know just how you did it; your ways are too subtle, sinister, dark and underground for simple me; but you did it all the same’

But, none of us—neither the farmer, nor the workman, nor the bondholder, nor the stockholder—thinks of blaming the dollar. So the real culprit stands on the curbstone watching us poor mortals as we beat out each other’s brains, and has the last laugh.” (This was written in 1933.)

So, good-bye to the Savings and Loan Industry. You did America well. But, your time is past. Rest In Peace (RIP).

The Problems of the Savings Industry

In an earlier post I reported that the weakness being experienced in the year-over-year rate of growth of the M2 measure of the money stock could be attributed to shifts in deposits from thrift institutions into commercial banks. (September 25: http://seekingalpha.com/article/163456-thrift-struggles-dragging-down-m2-growth.)

On Tuesday, September 29, I wrote about commercial banks and how bank holding companies had raised a substantial amount of funds in the capital markets from the second quarter of 2008 to the second quarter of 2009 but most of the funds raised by these institutions went into non-bank subsidiaries. Chartered U. S. banks saw some increase in assets over this time period but these funds went into cash assets, government or agency securities, and mortgages, mostly of the commercial type.

We also have data from the flow-of-funds accounts that give us some insight into what is happening at savings institutions and credit unions. The real success story seems to be that connected with credit unions. The credit union industry ended the second quarter of 2008 with almost $900 billion in financial assets. All other savings institutions had assets of about $1,400 billion and the Office of Thrift Supervision (OTS) reported that thrift institutions had assets that amounted to only $1,100 at the end of the second quarter.

Who would have ever thought that the credit union industry would ever be about the same size as the thrift industry?

Credit Unions grew by $73 billion, year-over-year, and the credit that they extended seemed to expand during this time period at a fairly steady pace.

The bad news: savings institutions, which include savings and loan associations, mutual savings banks, and federal savings banks, performed abysmally. For one, industry assets, according to the OTS fell by 27% over the last year, reflecting the failure and sale (to commercial banks) of several large thrift institutions. Total loans at these institutions fell by 35%.

The total decline in financial assets for the industry was $420 billion: the mortgage portfolio of the industry declined by almost a third or $360 billion. Consumer credit also declined by about $14 billion.

According to the OTS, the industry as a whole earned a profit of $4 million—yes, that’s million—in the second quarter. This is the first quarterly profit since the third quarter of 2007.

The industry added almost $5.0 billion—yes, that’s billion—to loan loss provisions in the second quarter. This loan loss provision was exceeded in history by only five other quarters. However, these five other quarters were the five quarters just preceding the second quarter of 2009.

The OTS reports, however, that “96.2% of all thrifts exceed ‘well-capitalized’ regulatory standards.” These institutions, we are told comprise 95.9% of industry assets but most of them are relatively small. So, institutions with approximately $45 billion in assets are in not “well-capitalized” thrifts, by industry standards. The number of problem thrifts reached 40 at the end of the second quarter.

Yet the industry has about $40 in what are called troubled assets, about 3.5% of Total Assets. Troubled assets are noncurrent loans and reposed assets.

It seems as if the thrift industry is dying and needs to be consolidated and merged into the commercial banking industry. (And this from a person, myself, who successfully turned around two thrift institutions.) I don’t believe that there should be a merger of thrift institutions with the credit union segment of the industry. Credit unions seem to be doing something right. (I have worked, in recent years, with groups to form three credit unions and I believe that credit unions can fill a very important gap in consumer finance, credit and banking services.)

The thrift industry played a very important role in the history of the United States (and elsewhere in the world). In the current era of securitization and financial innovation, I believe that savings institutions have exceeded their useful lifetime. The savings and loan crisis saw the collapse of the industry and the 2000s just verified that the industry really needs to continue to shrink and become incorporated into other segments of the market.