Trying to Help S&Ls: How Organizations with Good Intentions Jointly Enacted Disaster


William H. Starbuck, New York University


P. Narayan Pant, National University of Singapore

Published in Z. Shapira (ed.), Organizational Decision Making, Cambridge University Press, 1996, pages 35-60.

Failures of U.S. savings and loan institutions (S&Ls) in the 1980s added up to one of the largest financial disasters ever to hit the nation. The costs fell on everyone because the Federal Savings and Loan Insurance Corporation (FSLIC) insured the deposits. In 1990, the General Accounting Office estimated that the insurance losses would ultimately exceed $325 billion -- over $1,000 for each resident of the USA (Barth, 1991).

Since many books and articles have appeared about this disaster, a reader might wonder what else there is to say. Improbably, this chapter argues that several explanations do not work and that analysts have slighted some important factors. Analysts have ignored or deemphasized the effects of decision processes and nearsighted analyses. Most analysts have also focused on events during the 1980s and understated the importance of long-term trends and abrupt policy changes.

The decision processes involved many organizations. Most of these were loosely coupled in that their actions only sporadically affected others, and they often acted without considering the likely impacts on others. Many organizations were also tightly coupled in that broad agreement and shared perceptions shaped most actions, and one organization's acts could sometimes profoundly affect another's future.

Because the disaster had many possible causes and involved many actors, understanding it requires a grasp of numerous details. The first section of this chapter recounts the history of the S&L industry, setting a context for events in the 1980s. The second section then assesses nine theories about what went wrong. The third section describes the disjoint interactions in decision processes. The fourth section emphasizes how long-term trends made a disaster of some size inevitable.


The government confers favored status

American S&Ls originated to support home building (Strunk & Case, 1988). People wanting to build homes made deposits in S&Ls that lent funds contributed by many, and depositors could withdraw deposits only at substantial cost. Nearly all S&Ls were mutual associations owned by depositors. As White (1991: 61) explained, "The attitude that many thrift executives had about their business could almost be described as a 'calling': After all, they were actively involved in promoting home ownership and encouraging thrift. It was no accident that Jimmy Stewart's George Bailey ran a small savings and loan association in Frank Capra's 1946 film It's a Wonderful Life."

S&Ls originally faced little competition. Commercial banks and mutual savings banks raised funds mainly by issuing notes payable on demand. They then made short-term loans, usually commercial ones. S&Ls made no commercial loans.

Many S&Ls failed in the 1930s. Since depositors could not withdraw funds on demand, S&Ls experienced no runs, but many depositors did make withdrawals (Barth, 1991). Also, S&Ls had few or no retained earnings to cover losses. States often did not require S&Ls to maintain minimum reserves of capital, and some states forced S&Ls to distribute all earnings.

Prompted by S&L failures, Congress created 12 regional Federal Home Loan Banks (FHLBs) in 1932. These were corporations owned by the S&Ls in their districts. FHLBs were supposed to keep S&Ls liquid by judiciously advancing funds. The new Federal Home Loan Bank Board (FHLBB) would supervise both FHLBs and S&Ls.

Two years later, the government created FSLIC to insure S&Ls' deposits. Congress wanted to give depositors confidence but feared that deposit insurance might enable S&Ls to compete with commercial banks. So, Congress forbade S&Ls to accept demand deposits and restricted their assets to fixed-rate mortgages on homes. These restrictions basically continued until 1980, although Congress did authorize loans for education and housing fixtures in the 1960s and added some depository options in the 1970s.

Until 1932, all S&Ls held state charters. However, Congress authorized federal charters when it set up FHLBs. By 1993, two-thirds of all S&Ls had federal charters, and these controlled 85% of all assets. Thus, federal regulators gradually became much more relevant than state regulators.

FHLBB required S&Ls to have only small amounts of equity capital. In 1934, FHLBB set the requirement at 5% of insured deposits, about 4.6% of assets, which was far below the requirement for commercial banks. In 1980, Congress opined that 5% seemed too high, so FHLBB lowered the requirement to 4% and later to 3%. The solid line in Figure 1 shows that S&Ls' equity declined from 8.5% in the early 1940s to a reported low of 2.1% in 1989.

S&Ls' true net worths were even below those shown in Figure 1 after 1981. Instead of widely accepted accounting practices, FHLBB told S&Ls to use Regulatory Accounting Practices (RAPs) that FHLBB defined. One RAP let S&Ls with deficient equity capital report capital-to-assets ratios that averaged data from more than one year -- the current year plus 1 to 4 preceding years. This was an old RAP that suddenly began causing trouble in the 1980s. Another troublesome RAP, created in 1981, allowed S&Ls to classify losses on bad mortgage loans as "goodwill" that they could amortize over 40 years. As a result, when S&Ls sold bad mortgages their profit statements could ignore nearly all losses, and most of the losses appeared as equity capital on their balance sheets. Barth (1991: 50) reported that by late 1983, this "goodwill" constituted over 90% of S&Ls' reported equity capital. Also in 1981, FHLBB authorized S&Ls in financial trouble to issue Income Capital Certificates that FSLIC purchased. Although these were loans from FSLIC, a RAP said that they should appear as equity capital on S&Ls' balance sheets. By this means, FSLIC could make insolvent S&Ls appear solvent by loaning them equity capital. A former FHLBB staff member explained that "there really was no capital-to-asset requirement" in the 1980s. This was literally true for new S&Ls, which could take 20 years to satisfy FHLBB's equity capital requirement.

Favoritism extended to income taxes. Until 1951, S&Ls paid no federal taxes. When they became subject to federal taxes in 1951, they could avoid paying them by deducting from income any funds reserved for bad debts. Many S&Ls did begin paying taxes in 1962, when Congress limited this deduction to 60% of reserves for bad debts. The deduction was cut to 40% in 1979, 34% in 1982, 32% in 1984, and 8% in 1987.

In 1966, rising interest rates led Congress to put ceilings on the rates S&Ls could pay depositors. Industry representatives protested that these ceilings suppressed deposit growth. But as Figure 2 shows, deposit growth began declining in 1964, 2 years before the ceilings; and by 1971, deposit growth resembled that during1945-1963.

Next, S&Ls faced competition from money market mutual funds that offered higher interest rates, and deposit growth dipped again in 1973-1974. In response, Congress let S&Ls offer depository options closely tied to short-term interest rates. These included interest-bearing checking accounts, short-term money market certificates, and small savers' accounts. However, these options did not keep pace with interest rates available elsewhere, and deposit growth sagged again in 1978-1981.

FHLBs' stabilizers become a steady source of funds

FHLBs were to ensure the availability of enough funds for home mortgages by making "advances" whenever S&Ls faced temporary shortages (White, 1986). These advances had two important properties: First, because advances came from money borrowed by the U.S. government, the advances let S&Ls borrow as if they were only as risky as the government. Second, because the S&Ls owned the FHLBs, S&Ls could strongly influence the amounts advanced.

Figure 2 states FHLB advances outstanding at year end as percentages of S&Ls' total deposits, and compares advances to changes in deposits. Advances did sometimes compensate for fluctuations in deposits -- especially in 1966-1983 when changes in advances correlated -0.53 with changes in deposits. But over the period 1940-1993, changes in advances correlated slightly positively (0.14) with changes in deposits.

Figure 3 shows that advances became an ever larger fraction of S&Ls' funds. A former FHLBB staff member portrayed this expansion as a policy shift, "Then when their deposits went to hell, they began to try to use advances to keep the S&Ls going." Yet, the data show no sudden changes from a policy shift. From 1947 to 1987, outstanding advances grew at a rather steady rate that exceeded the growth rate for S&Ls' assets. (Growth at a constant percentage rate generates a straight line on a logarithmic scale.)

Figure 4 compares new advances with new mortgage loans by S&Ls. Until 1980, advances underwrote less than a quarter of S&Ls' new mortgage loans; after 1980, they underwrote over half.

Thus, FHLBs played an amazing role in S&Ls' evolution. Although Congress set up FHLBs to provide short-term liquidity for home mortgages, FHLBs gradually became long-term sources of funds that were going into commercial mortgages, mortgage-backed securities, and nonmortgage investments. By 1993, FHLBs' new advances were more than twice S&Ls' new loans for home mortgages.

The Federal Reserve Board (FRB) shifts interest rate policies

Since the 1930s, the U.S. government has used interest rates to influence macroeconomic variables such as investment, employment, and inflation. FRB's federal funds rate influences the rates at which commercial banks lend to commerce and industry, and hence affects investment and employment.

For many years, FRB had kept the federal funds rate low and changing slowly. Then, on October 6, 1979, FRB announced policies "that should assure better control over the expansion of money and bank credit, help curb excesses in financial, foreign exchange and commodity markets and thereby serve to dampen inflationary forces." These policies included "less emphasis on confining short-term fluctuations in the federal funds rate" (Document S241-6.1 of the Congressional Information Service, 1980: 44).

Uncontrolled, interest rates rose rapidly. Figure 5 shows rates for new conventional mortgages; other rates behaved similarly. The dashed line graphs S&Ls' average rates on all outstanding mortgages, which, of course, lagged the current rates.

As interest rates shot up, protests arose over FRB's policy. In mid-1982, FRB again began trying to control interest rates and dropped the federal funds rate substantially. Interest rates started to subside.

When in 1979 FRB announced its intention to let interest rates rise, it had not said that it was doing so because it was expecting a recession. It had explained that it needed to reduce inflation and that controlling the money supply was more important for that purpose than controlling interest rates. Yet, in March 1983, FRB's chairman blamed the high interest rates during 1980-1982 on the recession of 1980-1981 (Committee on the Budget, 1983). The chairman also stated firmly in 1983 that interest rates would have to remain high as long as the federal deficit remained large. During 1982-1986, interest rates dropped 33% while the federal deficit rose 73%.

When we asked former FHLBB staff members if they had forecast the interest rate rise, they said they had not seen interest rates as something to forecast. "Short rates are cyclical; they go up and down. Who would have forecast that the Fed [FRB] would do what they did?" Furthermore, they said, they no one would have believed such a forecast, let alone have acted on it. "Everybody knows that forecasts have a risk about them, and every organization has an institutional bias."

Congress grants freedoms in 1980 and 1982

The Depository Institutions Deregulation and Monetary Control Act of 1980 (DIDMCA) phased out ceilings on the interest rates S&Ls could pay depositors (Brewer et al., 1980; Garcia et al., 1983). It raised the maximum deposits that FSLIC insured from $40,000 to $100,000 and let S&Ls offer Negotiated Order of Withdrawal (NOW) accounts to individuals and not-for-profit organizations. In addition, S&Ls could issue mutual capital certificates that counted toward equity capital. S&Ls could now make credit card loans, lend for personal and commercial purposes, and lend for acquisition and development of real estate. Congress told FHLBB to set S&Ls' equity capital requirement between 3% and 6%, implying that it should be lower than 5%.

In 1982, the Garn-St. Germain Act let federally chartered S&Ls offer deposit accounts that would compete with money market mutual funds. It also said S&Ls could accept demand deposits if these facilitated business relations. S&Ls gained added flexibility for commercial mortgages and consumer loans.

Even the extensive freedoms granted in 1980 and 1982 had short-term effects on S&Ls' assets and deposits. Deposit growth fluctuated but remained positive until 1989. As Figure 6 shows, total assets and assets per S&L rose steadily for at least fifty years until 1989, when assets turned down.

Assets per S&L increased more rapidly than total assets because the number of S&Ls kept declining. Figure 6 shows how the number of S&Ls declined after the early 1960s.

S&Ls back away from home mortgages

Total mortgages, the solid line in Figure 7, developed less linearly than assets and deposits, and they departed markedly from linearity after 1980. Lending for traditional home mortgages flattened in the early 1980s and then declined even though home ownership was booming. In 1977, S&Ls held 47.5% of all home mortgages; by 1993, they held only about 4%.

One factor in this change was mortgage securitization. Instead of holding mortgages, originators of mortgages sold them to investors as securities. In 1980, 17% of the new mortgages were going into securities; by 1986, this percentage had shot up to 58% (Brumbaugh, 1988). S&Ls both sold mortgages and bought mortgage-backed securities. In many instances, an S&L sold mortgages at a discount and then bought them back as mortgage-backed securities that paid higher interest rates (Lewis, 1989).

The upper portion of Figure 8 shows increasing commercial mortgages and mortgages on multifamily buildings, and the lower portion shows increasing nonmortgage investments. In 1975-1979, nonmortgage assets comprised 17% of the total; from 1990 to 1993 they comprised 40%.

These investment changes likely reflect S&Ls' ownership. By 1993 only 28% of S&Ls were mutual associations; 72% were stock companies.

New tax laws take effect in 1981 and 1986

Confronting recession, the Reagan administration tried to stimulate the economy. Two tax changes in 1981 created investment opportunities for S&Ls: The investment credit went up and the allowable depreciation on real estate doubled. These changes made real estate partnerships more profitable, and investors created many new partnerships -- which sought mortgages or other loans from S&Ls.

The new real estate partnerships were willing to pay high interest rates, and they made speculative investments. Entrepreneurs created partnerships in which investors would incur operating losses throughout the period of ownership but would receive capital gains (gains over what properties originally cost) when partnerships liquidated. Since investors could deduct the operating losses against ordinary income, the government was sharing the losses. Indeed, for most investors, the U.S. government was paying about half of the losses. Because the U.S. government taxed capital gains at only 40% of the rate on ordinary income, moderate capital gains could more than offset accumulated losses. At least, this was the plan. Most partnerships never produced gains.

These partnerships disappeared rapidly after Congress enacted tax changes in 1986 that made real estate partnerships less desirable: Capital gains lost their favored status. Maximum tax rates dropped. Depreciation periods for real estate rose again. Losses on passive activities -- those in which a taxpayer plays no administrative role -- could no longer offset highly taxed ordinary income. Nearly all investors in real estate partnerships had passive roles. Partnerships that might once have made after-tax profits over the long run suddenly turned into heavy financial drains with no prospect of profit. Investors lost interest in real estate partnerships, so new ventures could not attract funds and existing ventures could not find buyers for their properties. Finding themselves with unsaleable properties and the prospect of continuing annual losses, many existing partnerships declared bankruptcy. S&Ls that had lent to partnerships found themselves holding land or buildings that were very difficult to sell.

The solid line in Figure 9 shows the percentage of loans outstanding that S&Ls foreclosed. In the late 1970s, this rate was at or below 1%. After 1986, it exceeded 2%.

Disaster strikes!

The number of S&Ls had declined for many years, and it was not unusual for 2% or even 3% to close in a year. But 6% closed in 1980 and 11% in 1981. S&Ls had regularly earned 10% to 15% on equity capital, and in 1978-1979 their profits soared to 20-24%. Then their earnings dropped to only 4% in 1980, and they lost 22-23% in 1981 and 1982. Figure 10 graphs these shifts.

Some 1980-1982 closures were due to insolvency. The insolvency rate, which had traditionally stayed below 0.1%, rose to 0.8% in 1980, 1.9% in 1981, and 6.6% in 1982. For public consumption, RAPs made it appear that insolvencies declined in 1983-1987. Yet, the real situation was very different. The solid line in Figure 11 shows what insolvency rates would have been if S&Ls had counted only tangible assets.

Figure 11 also shows the public data about unprofitable S&Ls over the period 1978-1989. These data show that earlier losses spread broadly: 91% of S&Ls shared losses in 1981-1982 that equaled 43% of the equity capital of all S&Ls. Later losses were more concentrated: 40% of S&Ls shared losses in 1987-1989 that equaled 75% of the equity capital of all S&Ls. However, after 1981, the public data understate S&Ls' losses because RAPs let S&Ls amortize losses on bad mortgage loans over many years.

In May 1987, Congress's investigative unit, the General Accounting Office (GAO) (1987: 6-7), declared that FSLIC had misrepresented its earnings. FSLIC had reported breaking even in 1985 and losing $3.6 billion in 1986; but GAO estimated that FSLIC had lost $1.1 billion in 1985, had lost $10.9 billion in 1986, and was $6.3 billion in debt.

Also in 1987, FSLIC estimated that "the cost of providing assistance to about 280 currently insolvent institutions may range up to $21 billion. Assistance to another 100 institutions that currently appear to have little chance of recovery could add $4 billion to [FSLIC's] losses" (GAO, 1987: 6). Actual events made these estimates wildly optimistic.

Congress creates new regulators and imposes new requirements

Doing something about the S&Ls was a priority of the Bush administration when it took office; and in August 1989, Congress set aside more funds for resolving insolvencies and changed the regulatory structure. It created an agency to deal with insolvent S&Ls and replaced FHLBB with two new agencies, one to regulate S&Ls and another to supervise FHLBs. Congress abolished the bankrupt FSLIC and placed S&L deposits under the agency that insures deposits in commercial banks. Congress also raised insurance premiums, set more stringent standards for equity capital, and authorized more penalties for mismanagement or criminal acts. In 1991, Congress (1) required annual examinations by federal examiners, (2) placed limits on deposits made through deposit brokers, and (3) said S&Ls with state charters must observe most limitations placed on S&Ls with federal charters.

These changes evidently affected many trends. The percentage of equity capital shot up (Figure 1). Deposit growth turned negative for the first time (Figure 2). Assets and deposits turned down, and assets per S&L flattened (Figure 6). S&Ls' investments in mortgages, especially home mortgages, turned down (Figure 7). Nonmortgage investments stopped increasing, and investments in commercial mortgages increased even more (Figure 8).


The S&L industry followed several long-term trends. Assets and deposits grew steadily until 1989, when they turned down. The number of S&Ls declined regularly, a trend that accelerated slightly after 1980, so the average size of an S&L increased until 1989. Other trends were less stable but persistent. Equity capital shrank as a fraction of S&Ls' assets until 1990. FHLB advances were a growing source of long-term funds until 1988. S&Ls invested increasing amounts in mortgages until 1989; and until 1981, they invested increasing amounts in home mortgages.

The industry also faced challenges in the 1980s. FRB let interest rates rise in 1980-1982, then lowered them again. Congress let S&Ls engage in new activities, and they responded by investing in commercial mortgages and especially nonmortgage investments. New tax policies in 1981 and 1986 first encouraged and then discouraged risky real estate partnerships.

However, these short-term changes all occurred before 1989. According to the public data, long-term trends did not change much until 1989. That year, Congress passed legislation that was supposed to end the S&L disaster.


Analysts have advanced at least nine theories about this disaster, all of which blame actions by the U.S. government partly or wholly. However, some theories contradict the existing evidence, and others explain only small fractions of the losses. Each theory focuses on a few phenomena while ignoring others.

Theory 1. Government regulations forced S&Ls to make long-term loans from short-term funds, thus making them vulnerable to rising interest rates. Until 1980, regulators barred S&Ls from borrowing long-term funds or making short-term loans. S&Ls offered chiefly long-term home mortgages at fixed rates of interest, whereas their depositors could withdraw on short notice. Friend (1969) pointed out that this made S&Ls vulnerable to losing money. When interest rates go up, S&Ls might have to pay more for deposits than they would receive from mortgage loans issued earlier.

Such a rate change did occur in the early 1980s (Figure 5), but this interest-fluctuation theory cannot explain all the losses by S&Ls in the 1980s. Figure 12 graphs two key interest rates: The interest rates that S&Ls received on mortgages stayed above those S&Ls paid for borrowed funds in every year except 1981.

The rates in Figure 12 may explain S&Ls' losses in 1981 and 1982, but even this is questionable because the recession in 1980-1982 caused bad loans that lowered S&Ls' profits (Kane, 1985). After 1983, S&Ls' differential between interest revenue and interest cost attained new highs. Figure 13 shows this differential and the industry's before-tax profit. S&Ls were suffering their largest losses in 1988-1989, when the interest rate differential was setting all-time highs.

Theory 2. FRB caused S&Ls' losses by abandoning a long-standing interest rate policy that was a key basis for S&Ls' practices. The abrupt rise in interest rates in 1979-1982 is the basis for a theory voiced by former officials at FHLBB. When FRB allowed interest rates to rise freely in late 1979, S&Ls were caught holding long-term fixed-rate mortgages, while depositors discovered opportunities to invest elsewhere at higher rates.

Nevertheless, S&Ls' industrywide profit turned negative for only 1 year, and then by only a small amount. When S&Ls issued new mortgages, they did so at higher and variable rates. At most, the interest rate differential may explain S&Ls' losses in 1981-1982, which totaled $12 billion before taxes. Although these losses affected almost all S&Ls and consumed almost half of S&Ls' equity capital, they came to less than 4% of the insurance loss paid by American taxpayers.

Theory 3. FRB's allowing interest rates to rise led S&Ls to take extreme risks. S&Ls with negative implicit equity capital supposedly take extreme risks because they have nothing to lose. Friend (1969) pointed out that rising interest rates would reduce implicit market values of S&Ls' mortgage loans and thus their implicit equity capital. For example, if an S&L has loaned $100 million at an average interest rate of 6%, its interest income is $6 million. If the current interest rate is 8%, the S&L's existing loans are worth only $75 million because $75 million in new loans would yield $6 million of income. If this hypothetical transaction did occur, the S&L's equity capital would drop by $25 million.

In 1978, the equity capital of federally insured S&Ls averaged only 5.6% of assets, so the average S&L would have been implicitly bankrupt if the interest rate rose to 106% of the rate at which it had issued loans. However, this did not happen. In the worst year, 1981, S&Ls' current interest rate for new funds rose to only 103% of the rate at which they had issued loans.

Moreover, principles of accounting bar S&Ls from recognizing loans' market values unless they liquidate. Thus, this theory may help to explain the large insurance losses after S&Ls became insolvent, but it does not explain why S&Ls became insolvent.

Theory 4. Because the federal and state governments gave S&Ls more freedom, S&Ls pursued risky policies that caused large losses. White (1991) compared the 1985 assets of S&Ls that survived and failed in 1986-1990. On average, soon-to-fail S&Ls had more nontraditional assets and less equity capital, more were stock companies rather than mutual associations, and more held state charters rather than federal ones. White also said that rapidly growing S&Ls were more likely to hold nontraditional assets and more likely to receive funds from nontraditional sources such as large certificates of deposit.

However, White did not make multivariate analyses or control for the states in which S&Ls operated. Failure rates differed greatly among states, with Texas, California, Louisiana, Florida, and Ohio accounting for about 40% of the failures. Californians are among the heaviest users of S&Ls, but Louisianans are among the lightest. Thus, both failure rates and nontraditional investments might have reflected regional economic conditions or states' regulatory practices. White's argument about rapid growth focused on 1980-1986; he said that growth had been much higher in 1983-1984 than before or after. Although 1983-1984 had a high growth rate, similarly high rates had occurred several times before, whereas unusually slow growth distinguished 1979-1982 and 1985-1988 (Figure 2).

From January 1985 through September 1986, 284 S&Ls failed. GAO (1989) "judgmentally" selected 26 of these S&Ls that had caused 57% of the insurance losses and compared them with a matched sample of 26 solvent S&Ls. All the failed S&Ls had made nontraditional investments, and most had taken nontraditional deposits. Compared to 12 solvent S&Ls, 19 failed S&Ls had made loans to developers for land and construction. Compared to 5 solvent S&Ls, 21 failed S&Ls had issued "jumbo" certificates of deposit for the insurance maximum of $100,000. The jumbo deposits had often come through deposit brokers who place clients' funds at high interest rates. GAO stressed the volatility of such deposits. However, GAO merely looked at raw frequencies without weighing alternative factors. For instance, of the 19 failed S&Ls that loaned money to developers for land and construction, 11 were in the Dallas (Texas) FHLB district, and others had made such loans in Texas.

Benston and Pant did make multivariate analyses. Focusing on 1981-1985, Benston (1985) found that failing S&Ls had the same percentages of nontraditional investments and nontraditional deposits as did sound ones, and that S&Ls with state charters had lower failure rates than ones with federal charters. Pant (1991) estimated that S&Ls' aggressiveness and product diversity had little impact on financial performance. Indeed, more aggressive S&Ls may have failed less often. S&Ls with more diversified strategies after deregulation tended to be those with more diversified strategies before deregulation, and S&Ls that solicited deposits aggressively after deregulation tended to be those that had solicited deposits aggressively before deregulation.

The dubious evidence that failing S&Ls pursued riskier strategies also casts doubt on two theories that blame the S&L disaster on deposit insurance.

Theory 5. Deposit insurance keeps depositors from watching how S&L managers invest. This theory says that deposit insurance leads depositors to pay less attention to the actions of S&L managers (Barth, 1991; Eichler, 1989; White, 1991). Thus, deposit insurance might make failures more likely when S&Ls' equity capital nears zero, for managers might take high risks then. The theory conjectures that managers would take less risk if depositors have more to lose.

Theory 6. Deposit insurance leads S&L managers to take risks because insurance premiums do not reflect risk taking (Kormendi, Bernard, Pirrong, & Snyder, 1989). S&Ls' premiums did not vary with the riskiness of managerial practices, FSLIC did not require strict monitoring of managerial behavior, and FSLIC coverage had no practical limits. Thus, S&Ls incurred no added costs, says this theory, if they took more risks.

Theory 7. Incompetent managers squandered money and crooks stole it. In a 1988 report to Congress, FHLBB called fraud and insider abuse the most "pernicious" causes of failures. GAO (1989) also emphasized "unsafe practices" and "alleged criminal activity," although it noted that failed S&Ls had made nontraditional investments and accepted nontraditional deposits. Table 1 lists several differences between failed and solvent S&Ls.

Table 1. Practices at 26 Failed S&Ls versus 26 Solvent Ones




Cited by examiners for recordkeeping and control deficiencies



Unsafe practices in nonlending activities, such as acquiring a subsidiary without first obtaining an appraisal



Cited by examiners for improperly analyzing borrowers' abilities to repay



Violated the regulation limiting the amount loaned to a single borrower



Violated the regulation against dealing with other firms controlled by the same officers and directors



Violated the regulation against conflicts of interest



Passive boards of directors



Insiders charged with crimes



Cited by examiners for excessive compensation of officers



Change in control



GAO sharply criticized supervision by FHLBB and FSLIC. Of the studied S&Ls, examiners had described all 26 failed ones as requiring "urgent and decisive corrective measures." However, in 20 of these S&Ls, examiners let over a year elapse between examinations, and 5 of the S&Ls had no examinations for over 2 years. Twenty-two of the failed S&Ls had agreed to correct problems, but 11 of these had violated the agreements and FHLBB had taken actions against only 4 violators. GAO remarked "that violations and unsafe or unsound practices at these failed thrifts had often persisted for years." Reinforcing GAO's observations, Wang, Sauerhaft, and Edwards (1987) found hundreds of S&Ls that had had no examinations between January 1984 and July 1986 (see also Kane, 1989).

This theory has stronger evidential support than others. Still, GAO merely looked at raw frequencies without weighing possible causes, and GAO selected failed S&Ls with especially large insurance losses. Because GAO paired S&Ls of similar size in the same geographic areas, the comparisons suppressed effects of firm size, local regulatory practices, and local economic conditions. Pant (1991) found more evidence of criminality in larger S&Ls and in those in smaller metropolitan areas having more volatile economic conditions.

Theory 8. The government discounted problems and postponed action, thus making losses much worse. Brumbaugh (1988) asserted that FHLBB and Congress were postponing action, which was increasing costs and shifting costs from S&Ls to commercial banks and taxpayers. Barth (1991) argued that it was this delaying behavior that converted bad business judgment into insurance losses. He noted that most insolvent S&Ls had reported insolvency many months -- indeed, years -- before regulators intervened. Meanwhile, the insolvent S&Ls continued to lose money. Kane (1989: 66) argued, "FSLIC officials (acting under constraints imposed by the politicians to whom they report) adopted a strategy of denying the problem, suppressing critical information, granting regulatory forebearances, and extending expanded powers to troubled clients. They gambled on the possibility that time alone would cure the problem."

While agreeing with Barth and Brumbaugh, White (1991: 112) said, "the true debacle occurred largely between 1983 and 1985; but the wave of losses, insolvencies, and closures began only in 1986." According to White, FHLBB began raising regulatory requirements and FSLIC's insurance premiums in 1984 and began backing away from RAPs in 1987, but very gradually.

Some evidence supports White's interpretation. In 1986, FHLBB announced a higher equity capital requirement that symbolized its intentions even though few S&Ls could meet the requirement (Figure 1). S&Ls cut back on nonmortgage loans after 1987 (Figure 8), and they stopped growing after 1988 (Figure 6). FHLB advances leveled after 1988 (Figure 3). On the other hand, S&Ls foreclosed fewer mortgages after 1987 (Figure 9).

Theory 9. The tax laws changed. An S&L trade association, the Savings & Community Bankers of America (1994: 2), explained, "Changes in real estate tax laws in 1986 led to a rapid and unanticipated fall in real estate values in many over-built markets, causing many borrowers to default on loans. Increasing competition from banks, nonbank financial institutions, and government-sponsored housing finance agencies decreased the profitability of residential mortgage lending and worsened the growing thrift crisis. This confluence of events led to the failure of a large number of savings institutions, eventually bankrupting the federal Savings and Loan Insurance Corporation, at a huge cost to the taxpayer."

The dashed line in Figure 9 compares S&Ls' mortgage foreclosures to those by all lenders. Until 1983, S&Ls' foreclosure rate was the same as or less than that of other lenders. After 1986, S&Ls foreclosed at more than twice the rate of other lenders, whereas other lenders' post-1986 foreclosure rates were similar to their pre-1986 rates.

The 1986 tax changes may not have caused the higher foreclosure rates in the late 1980s. First, S&Ls' foreclosure rates started to move up in 1981, right after speculative real estate partnerships became more profitable and 5 years before passage of the 1986 tax law. Second, S&Ls held less than 10% of the commercial mortgages. Mortgages on apartments and commercial buildings were held mainly by commercial banks and life insurance companies, so these lenders should have had larger losses from the tax changes than S&Ls. They did not. However, the tax changes probably hit S&Ls' investments more heavily. S&Ls had less experience with commercial mortgages than commercial banks and insurance companies, so they invested less wisely. Some S&Ls followed poor practices (Table 1), and some were pawns of real estate opportunists. S&Ls had little equity capital (Figure 1), so small losses could make them insolvent.

An Appraisal

The disaster likely had several causes that differed over time. Figure 10 and Figure 11 suggest that it included at least three periods: 1980-1982, 1983-1986, and 1987-1991. A fourth period may have started in 1992, as White (1991) predicted that the 1989 legislation would cause more insolvency.

Low equity capital caused trouble through all three periods (Barth, 1991). After 1979, S&Ls' economic environments became much less stable, and S&Ls made much riskier investments. Congress or FHLBB should have required much more equity capital, since companies in construction and real estate, the domains where S&Ls were investing, had equity capital that averaged 26-28% of assets. Instead, Congress urged FHLBB to lower the capital requirement, and it did so.

FRB's abrupt shift in interest rate policy made low levels of equity capital visibly problematic in 1980-1982 because S&Ls lost money for 2 years. A more gradual policy change would have let S&Ls adapt to higher interest rates without incurring losses.

By 1983, S&Ls had raised interest rates, but then they ran into trouble of their own making. They had begun making more loans for apartment buildings and commercial buildings in the 1960s and stepped up this practice after 1980. They also made many more nonmortgage investments after 1980. Meanwhile, they were converting from mutual associations to stock companies. These changes not only made their investments riskier, they erased S&Ls' support from depositor-owners and their privileged status as the government-supported lender for home mortgages. That is, S&Ls voluntarily abandoned their distinctive competence and their grass-roots political support.

Not only did S&Ls lack experience in appraising nonmortgage loans, their regulators assumed that S&Ls took little risk and had little criminality or corruption. Federal S&L examiners overlooked problems, and FHLBB corrected problems apathetically. Thus, self-interested opportunists came as borrowers and owners.

A combination of less competence, more risk taking, more criminality, more self-interest by S&Ls' managers, and impotent regulators invited trouble. However, the effects of these factors should have built up gradually, so they do not explain why the disaster accelerated suddenly in 1987-1991. Similarly, delayed recognition of problems -- due to either bureaucratic oversight or deceptive accounting standards -- should have occurred gradually. The new regulatory structure authorized in 1989 probably had no effects until after the massive losses had abated.

Thus, the sudden, massive losses in 1987-1991 probably had two main causes. First, stricter regulatory standards after 1986-1987 may have forced S&Ls to acknowledge more bad debts and helped FHLBB to see the disaster's size. Second, tax changes in 1986-1990 transformed many investments into bad loans that no longer had as much concealment from RAPs.

Government agencies caused trouble both by ignoring problems or reacting too slowly and especially by overreacting or acting too quickly. The disaster might have been much smaller if FHLBB or the Reagan administration had acted more swiftly or more forcefully. FHLBB could have raised the equity capital requirement gradually as S&Ls made riskier investments. FRB could have changed its interest rate policy in stages, allowing S&Ls to adapt incrementally. Congress tended both to overreact and to take misguided actions.


The story of this disaster resembles a play in which some actors form groups that move together but most actors seem to ignore each other. Ropes link certain actors, and every so often, an actor who feels constrained jerks a rope and unwittingly upends another. Some actors interject fragments from other plays, and some rewrite the script. Different people play each role in each scene, bringing sundry abilities and changing emphases.

Sitting in the middle of the stage is a draped object that grows more and more immense. But not only do the actors not peek under the drapery, they ignore this object entirely. One actor constantly dances around this object without acknowledging its presence, except when he tosses more drapery over it. Mainly, this actor seems to be echoing the motions and statements of others.

Despite distractions and diversions, the motions have an overall consistency, as if specific actors and specific actions and statements do not matter all that much. Everyone gradually drifts closer and closer to the large object, until finally several bump against it and dislodge its drapery. Then all the actors assail the one who has been dancing around the object, killing him as well as a few of themselves. The survivors celebrate their triumph.

The S&L industry attracted different managers at various times. Long ago, managers were proponents of home building who saw themselves as serving their communities as well as their firms' depositor-owners. As mutual associations gave way to stock companies, some owners became managers serving their own interests. By the 1960s, managers were showing less interest in home building as such and more interest in profit making. After 1982, the industry drew many opportunists from construction and real estate development, who used S&Ls to abet sales at inflated prices.

In Washington, the S&L industry supported two trade associations that did not always agree. One represented mainly large S&Ls, and in the 1980s it tended to argue that each FHLB district presented distinct issues that called for different treatment. The other, which represented diverse S&Ls, tended to argue that all S&Ls deserved similar treatment. A Washington insider told us that both trade associations exerted strong influence on Congress in the 1980s, and Congress's behavior is consistent with such influence until 1989.

Specific S&Ls also exerted strong influence. Brumbaugh (1988: 174) remarked:

Throughout the 1980s, for example, the industry demanded and received regulatory forbearance, primarily in the form of lower net-worth requirements, accounting forgiveness, and forestalled closure of insolvent thrifts. Each of these acts provided short-run subsidies to thrifts -- insolvent and solvent. A microcosm of this behavior exists today in Texas, one of the states hardest hit by thrift insolvencies -- over 40 percent of income losses for the third quarter of 1987 were in thirty-nine Texas thrifts. Powerful thrift interests successfully lobbied Congress, particularly the Texas congressman who is Speaker of the House, to make regulatory forbearance part of the scaled back FSLIC recapitalization plan [passed in 1987]. The result of the early 1980s forbearance, however, was an unintended exacerbation of thrift problems, as insolvent thrifts gambled for resurrection, fraud grew, and deflation further ravaged thrifts' portfolios.

Not only did S&Ls strongly influence Congress, they also influenced FHLBB. Presidents of the S&L-owned FHLBs met frequently with FHLBB, and FHLBB staff members told us that these presidents strongly influenced policy decisions. In an internal memorandum, a senior official in the executive branch reported in 1985, "They [the senior officials in FHLBB] clearly feel impotent to close down insolvent thrifts as rapidly as they would like. They feel tightly bound by lack of FSLIC funding and also by opposition of the insolvent thrifts themselves, who are perceived to dominate the trade groups and to have much clout on Capitol Hill."

Influence flowed the other direction only rarely. FHLBB occasionally toughened its rules, although FHLBB probably never took actions that most S&Ls opposed and it seldom punished rule violations. In 1989, Congress imposed heavy costs on S&Ls.

That 1989 legislation, passed shortly after a change of administration, shows how personnel changes altered policies. The Reagan administration had taken little action because of internal debate about the disaster's size and the need to close insolvent banks promptly. One side questioned FHLBB's efficacy and advocated swifter, stronger action; the dominant side insisted that the federal budget not include larger sums for this purpose. An internal memorandum stated, "Because of deposit insurance, failure in the thrift industry is a bureaucratic decision as much as an economic fact." Thus, stronger action did not occur until the Bush administration took office.

The Reagan administration also did not act more forcefully because formal reports said S&Ls were doing rather well. Internal memoranda observed that "In 1984, FSLIC insured thrifts ended in the black" and "1985 may be one of the most prosperous years for thrifts." Of course, those ideas arose from RAP profits, which understated losses from bad loans. Only later did the administration discover that they had relied on deceptive reports.

Others were also misled by RAP reports, including FHLBB, FSLIC, and the S&Ls' trade associations. Given its optimistic appraisal of the industry's condition, the Reagan administration wanted S&Ls themselves to pay for cleaning up their industry, and the trade associations endorsed this view. Because the trade associations doubted the competence of FHLBB and FSLIC, they proposed new organizations to resolve bad loans, and the Office of Management and the Budget (OMB) refused to give FHLBB more staff to dispose of insolvent S&Ls. Within OMB, a staff member reported:

Chairman Gray [of FHLBB] stressed the point that the industry feels that FSLIC staff are incapable of solving the current problem. This has been the main reason why the industry is unwilling to capitalize the FSLIC fund.

We have talked with thrift industry trade groups and disagree with Chairman Gray. First, we believe that the distrust is not confined to FSLIC staff, but that the industry also distrusts Bank Board staff and the Board. However, we believe there is support for raising the funds needed to shore up the FSLIC fund. The industry is clearly divided on this issue. While a majority of the members favor solving the industry's problems in-house, there are a few large powerful thrifts which do not want to bear the additional costs (they would rather see the federal government pay for it).

Chairman Gray thanked OMB for having authorized FSLIC an additional 40 [employees], but mentioned that this was not enough to solve the problem. He contends that FSLIC needed flexibility from federal civil service rules to hire and retain qualified personnel. Chairman Gray indicated that the FDIC [which insures commercial banks] has 2,500 employees involved in liquidations, compared to FSLIC's professional staff of only 81. He pointed out that the average salary of a FSLIC professional was $35,800, while people on Wall Street doing equivalent work earned over $100,000. Chairman Gray believes that the only people who would work for FSLIC were the ones that could not get a job on Wall Street.

The 1986 tax changes show actors' ignoring their effects on others. According to a person who helped to design these tax changes, no one thought about their possible effects on S&Ls' solvency.

FRB's policy shifts in 1979 and 1982 also show actors ignoring their effects on others and show roles changing when new actors step in. The 1979 policy shift followed appointment of a new chairman. The 1982 policy shift, backing away from high interest rates, occurred even as Congress was passing the Garn-St. Germain Act to help S&Ls deal with high interest rates. If one takes FRB's public statements at face value, neither policy shift took account of potential effects on institutions for lending money, such as the regulatory structure for S&Ls. However, some of FRB's public statements lack credibility. It explained its 1979 shift differently at times; and although FRB did not say so publicly, its 1982 shift was likely intended to quiet complaints about high interest rates.

Apparently, key actors did not see connections between FRB's control of interest rates and FHLBB's equity capital requirement. FHLBB could get by with a low equity capital requirement as long as (1) S&Ls made low-risk investments, (2) S&Ls' economic environment was stable, and (3) S&Ls remained profitable. FRB's policies strongly influenced S&Ls' profits and their environment's stability. When FRB shifted policies, FHLBB needed to require more equity capital.

FHLBB was, of course, the actor who danced around the disaster while ignoring it, and in 1989 FHLBB became the scapegoat everyone assailed. But it is hard for someone sitting in the audience to see FHLBB as the villain, or to interpret FHLBB's slaying as a triumph. Congress designed FHLBB to reflect influence from S&Ls themselves; and when FHLBB attempted to restrain S&Ls, Congress intervened on the side of S&Ls. The executive branch gave FHLBB far too few resources for it to act effectively. With the executive branch, Congress, and the trade associations all doubting FHLBB's competence and effectiveness, it certainly could not exercise moral leadership.

On occasion, FHLBB tried to use symbolism to show mastery of its environment. For example, amid the turmoil of 1980, Richard Marcis and Dale Riordan (1980) of FHLBB's Office of Policy and Economic Research made elaborate forecasts of the industry's balance sheets and income-and-expense statements for 8 years. One scenario assumed that interest rates would decline from their highs reached in early 1980; a second scenario envisaged interest rates remaining steady through 1988; and a third scenario postulated interest rates increasing from current levels.

Marcis and Riordan made predictions without explaining them. They did not specify why they expected interest rates to have predicted effects. They (1980: 5) asserted that the newly passed DIDMCA would "significantly impact S&Ls" and that S&Ls' new abilities would be "of great significance" on both the asset and liability sides of balance sheets, but they did not describe the nature of this significance.

Yet, Marcis and Riordan described S&Ls' future in minute detail. For each scenario, they specified percentages of assets in various classes to three decimal places. They detailed assets, liabilities, income items, and expenditure items painstakingly for 9 years. It seems that they intended this detail to demonstrate their understanding of the industry's condition and developmental possibilities and to legitimize their conclusion -- that S&Ls would be far down the path to total recovery by 1988.

Regulatory agencies and bank examiners in 50 states and federal examiners in 12 FHLB districts played ostensibly minor roles. But some explanations of the disaster have said that these bit players were among the true villains (Kane, 1989).

With all these changing actors and changing actions, it is amazing that long-run trends persisted. Yet, the disaster seems to have sprung from interactions between consistent long-run trends and erratic policy shifts. The actual character of these policy shifts appears secondary. Long-run trends were constructing an increasingly unstable situation in which a large perturbation would someday trigger disaster.


Four long-run trends framed the disaster: (1) high and increasing favoritism by Congress, (2) escalating support from and trust by regulatory agencies, (3) low and declining equity capital requirements, and (4) declining holdings of home mortgages and declining ownership by depositors. Ironically, three of these trends arose from others' efforts to help S&Ls, and S&Ls themselves helped to shape all four trends.

First, Congress showed favoritism toward S&Ls. Congress set up FHLBs in a way that let S&Ls borrow via the U.S. government, and it insisted that S&Ls should pay artificially low premiums for deposit insurance. Kane (1985) argued that the low premiums gave S&Ls an incentive to minimize equity capital.

One reason for Congress's attitude may have been S&Ls' standing as symbols of home ownership -- almost as central to the American dream as motherhood and apple pie. Another reason may have been that S&Ls' depositors and borrowers were voters. S&Ls represented respected political constituents.

S&Ls grew more influential in Congress over time. They created active trade associations and hired effective lobbyists. The U.S. League of Savings Associations made large political contributions, along with the National Association of Realtors and the National Association of Home Builders. S&Ls focused contributions on members of the House and Senate banking committees (Kane, 1989: 52-53), and they expressed strong opinions about relevant legislation.

Second, the S&Ls had ongoing aid from regulatory agencies. FHLB advances gradually became a significant source of funds for the industry, and indirectly for home ownership and home construction. Advances outstanding were 13.3% of S&Ls' assets by the end of 1993, and FHLBs treated advances as support for the S&L industry rather than as funds owed to the American public. Even after the industry's deplorable condition became obvious, FHLBs did not reduce their advances.

In the early 1980s, FHLBB permitted S&Ls to portray losses on bad mortgage loans as assets and allowed S&Ls in trouble to issue Income Capital Certificates for purchase by FSLIC. Thus, insolvent S&Ls could describe themselves as solvent and continue in business with FSLIC as a silent partner.

FSLIC made perfunctory examinations of S&Ls. Rarely did an S&L have reason to fear examiners' arrival. Examiners came infrequently; they lacked competence; and when they found deficiencies, FHLBB, FSLIC, and the S&Ls ignored their complaints. S&Ls had great discretion.

Third, S&Ls had to meet no effective capital requirements. FHLBB and Congress set very low equity capital requirements, which they relaxed when S&Ls could not meet them.

Although S&Ls did not have to lower equity capital to the minima set by FHLBB, S&L managers may have assumed that FHLBB knew how much equity capital was essential. That is, some S&L managers may have thought they were behaving prudently as long as they exceeded FHLBB's requirements.

Favoritism, advances, RAPs, Income Capital Certificates, perfunctory examinations, and low equity requirements proved harmful in the long run. Low equity capital made S&Ls vulnerable to environmental changes. Escalating FHLB advances made S&Ls less dependent on and presumably less concerned about depositors. RAPs and Income Capital Certificates encouraged insolvent S&Ls to speculate recklessly and thus to multiply losses. Perfunctory examinations and nonenforcement of rules kept S&Ls from having to show competence. Congress did not question S&Ls' ability to use freedoms intelligently and prudently.

Fourth, S&Ls evolved from mutual associations that invested in home mortgages to stock companies that invested in commercial mortgages, mortgage-backed securities, and nonmortgage investments.

Not even FHLBB challenged the wisdom of S&Ls' strategic change. Through political influence and participation in governmental decision making, S&Ls made their existence an autonomous goal. FHLBB, Congress, and the executive branch all accepted the premise that S&Ls ought to exist even if they no longer promoted home ownership. So they agreed to S&Ls' proposals for change.

But this change meant that S&Ls were politically vulnerable when the Bush administration and Congress acted in 1989. S&Ls no longer symbolized home ownership and thrift, and they no longer had widespread political support. They had become merely another financial retailer, competing with commercial banks, insurance companies, and loan companies.

Large perturbations of the 1980s caused steplike departures from long-term trends. Institutional practices had adapted to long-standing policies. Then policy shifts upset the institutional practices.

Three types of perturbations seem to have been especially important. First, many years of slowly changing interest rates shaped expectations and institutional practices. Then FRB let interest rates rise rapidly for 2 years. Second, for many years, S&Ls had faced tight restrictions on deposits, investments, and interest rates. Then Congress gave S&Ls much freedom. Third, tax policies toward real estate had been stable during the 1960s and 1970s. Then the government made changes that encouraged speculative partnerships. Five years later, it not only repealed the earlier changes but eliminated policies that had been in effect for a quarter of a century.

Decisions shared by many loosely coupled organizations

Collisions between long-run trends and short-run perturbations probably typify decision processes involving many loosely coupled organizations. Because loose coupling makes communication difficult, organizations coordinate on the basis of expectations. Nearly all organizations adhere to traditions and avoid abrupt innovations, and trends tend to persist. Even nuclei of tightly coupled organizations, such as the networks of FHLBB and FHLBs, avoid abrupt innovations because they are unsure about the limits of their discretion.

But sometimes organizations do make abrupt innovations that perturb the overall system to significant degrees. The S&L disaster suggests that these perturbations have two properties: They involve unusually large actions, and the actors fail to anticipate secondary effects of their actions. FRB's 1979 policy shift stood out because FRB departed radically from recent tradition. The tax and S&L legislation called for sudden, significant changes rather than small, incremental ones. FRB forecast effects of its 1979 policy shift on inflation and employment but did not forecast the effects on S&Ls' profits. The Reagan administration forecast effects of the 1986 tax changes on taxes paid by partners but not on S&Ls' outstanding loans.

Both abrupt actions and blindness to secondary effects are prevalent in decision processes involving many loosely coupled organizations. Involvement of many participants who hold divergent views creates a need to motivate actions. Participants must achieve agreement that there is need for action and then agree on specific actions, so they are prone to define chosen actions as final solutions rather than experimental trials. Participants with divergent views need to focus on specific symptoms that are motivating them to act, so they tend to forecast only first-order results of their actions. Indeed, such decision processes often have an emotional air -- as in "the first 100 days."

Thus, there is hope for democracy. Citizens worry about cozy relations between Congress and lobbyists, about regulatory agencies being captured by the industries they supposedly regulate, and about government support flowing to special interests. These worries would be well founded if lobbyists, special interests, and industry representatives actually knew where their long-run interests lay. But the S&L disaster suggests that they lack such foresight. Indeed, this disaster suggests that strong influence may lead special interests and industry representatives to misjudge their abilities, to give away their assets, and to make more erroneous forecasts.

Washington's political climate leads participants to lie about current goals, to reconstruct past goals, to conceal actions, to generate deceptive information, and to disclose others' secrets. Since no one dares to trust those with whom they form coalitions, cooperation becomes unreliable. Since no one can depend on public reports about what is happening, actions have unstable bases. Since dependable facts do not exist, people act on the basis of theories that contradict available facts. The powerful cannot exploit power consistently. They cannot be sure who their friends really are. When they try to help friends, they often harm them inadvertently.


This manuscript benefits from the insights of Joan Dunbar, Roger L. M. Dunbar, Marshall Kaplan, Richard T. Pratt, Joseph Rebovich, Harry S. Schwartz, David Seiders, and especially Kathryn Eickhoff and Lawrence J. White.


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