Sunday, January 18, 2009

Saving And Loans Crisis

---Deregulation of thrifts enabled them to take out long term loans, fueling the real estate bubble ---High inflation lead to the high cost of funding, futher fueling the risk taking of thrifts. ---Tax Reform Act of 1986 made real estate invesment unattractive, triggering the criris Causes of S&L Crisis in 1980s and early 1990s Previously, banks had done only short-term lending on commercial real estate construction. For example, by law, they could lend on a new office building solely for the construction period and were required to have a follow-on .take out. by a long-term lender, primarily insurance companies, as a part of the required package. When this requirement was repealed, many banks, large and small, began to make loans without .take outs. and real estate lending became the fastest-growing area in the banking business. The change was sudden and dramatic. Prior to the 80s, U.S. banks. real estate loans were less than 10 percent of the portfolio. By the mid-80s, some banks had 50 to 60 percent of their loans in real estate. Inflation in the 70s had made real estate a very attractive option as it enhanced nominal value. The generous bank lending and inflationary pricing set off the real estate construction mania. Tax Reform Act of 1986 Until the Reneue Act of 1951, savins and loans were exempt from federal income taxes. Although this act terminated their tax-exempt status, savings and loans could nonetheless avoid paying taxes because up t 100% of their taxable income was deductible through the establishment of a bad debt reserve. By enacting 26 U.S.C. § 469 (relating to limitations on deductions for passive activity losses and limitations on passive activity credits) to remove many tax shelters, especially for real estate investments, the Tax Reform Act of 1986 significantly decreased the value of many such investments which had been held more for their tax-advantaged status than for their inherent profitability (to only 8%). This contributed to the end of the real estate boom of the early to mid '80s and facilitated the Savings and Loan crisis. Prior to 1986, much real estate investment was done by passive investors. It was common for syndicates of investors to pool their resources in order to invest in property, commercial or residential. They would then hire management companies to run the operation. TRA 86 reduced the value of these investments by limiting the extent to which losses associated with them could be deducted from the investor's gross income. This, in turn, encouraged the holders of loss-generating properties to try and unload them, which contributed further to the problem of sinking real estate values. This turmoil and repositioning in real estate markets was caused not by changes in market conditions.[citations needed] Deregulation The deregulation of S&Ls (aka thrifts) gave them many of the capabilities of banks, it did not bring them under the same regulations as banks. Savings and loan associations could choose to be under either a state or a federal charter. Immediately after deregulation of the federally chartered thrifts, the state-chartered thrifts rushed to become federally chartered, because of the advantages associated with a federal charter. In response, states (notably, California and Texas) changed their regulations so they would be similar to the federal regulations. States changed their regulations because state regulators were paid by the thrifts they regulated, and they didn't want to lose that money.[citation needed] Imprudent real estate lending In an effort to take advantage of the real estate boom (outstanding US mortgage loans: 1976 $700 billion; 1980 $1.5 trillion)[citation needed] and high interest rates of the late 1970s and early 1980s, many S&Ls lent far more money than was prudent, and to risky ventures which many S&Ls were not qualified to assess. L. William Seidman, former chairman of both the Federal Deposit Insurance Corporation (FDIC) and the Resolution Trust Corporation, stated, "The banking problems of the '80s and '90s came primarily, but not exclusively, from unsound real estate lending."[3] Brokered deposits One of the most important contributors to the problem was deposit brokerage.[citation needed] Deposit brokers, somewhat like stockbrokers, are paid a commission by the customer to find the best certificate of deposit (CD) rates and place their customers' money in those CDs. These CDs, however, are usually short-term $100,000 CDs.[citation needed] Previously, banks and thrifts could only have five percent of their deposits be brokered deposits; the race to the bottom caused this limit to be lifted. A small one-branch thrift could then attract a large number of deposits simply by offering the highest rate. To make money off this expensive money, it had to lend at even higher rates, meaning that it had to make more, riskier investments. This system was made even more damaging when certain deposit brokers instituted a scam known as "linked financing." In "linked financing", a deposit broker would approach a thrift and say he would steer a large amount of deposits to that thrift if the thrift would lend certain people money (the people, however, were paid a fee to apply for the loans and told to give the loan proceeds to the deposit broker). This caused the thrifts to be tricked into taking on bad loans.[neutrality disputed] Michael Milken of Drexel, Burnham and Lambert packaged brokered funds for several S&Ls on the condition that the institutions would invest in the junk bonds of his clients. End of inflation Another factor was the efforts of the federal reserve to wring inflation out of the economy, marked by Paul Volcker's speech of October 6, 1979, with a series of rises in short-term interest rates. This led to increases in the short-term cost of funding to be higher than the return on portfolios of mortgage loans, a large proportion of which may have been fixed rate mortgages (a problem that is known as an asset-liability mismatch). This effort failed and interest rates continued to skyrocket, placing even more pressure on S&Ls as the 1980s dawned and led to increased focus on high interest-rate transactions. Zvi Bodie, professor of finance and economics at Boston University School of Management, writing in the St. Louis Federal Reserve Review wrote, "asset-liability mismatch was a principal cause of the Savings and Loan Crisis".[1]

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