Some of us remember the "the savings and loan crisis" of 1989 that swept across the country. Today we are experiencing a similar crisis, known as the "mortgage meltdown." How do these two events compare?
First, what caused the Savings and Loan crisis of 1989? This situation had its roots in the high interest rates of the early1980's. With rates up as high as 19%, the low interest loans held by S & L's plummeted in value. In addition, highly regulated S & L's were limited in the interest rates they could offer depositors. They could not compete with a recent financial innovation, the money market fund, which paid higher rates. People pulled their money out. Basically, many S & L's were close to insolvent.
Also, at this time (1981) the Tax Reform Act was passed, allowing individuals to deduct losses on rental property from their ordinary income. Every doctor, lawyer and dentist went out and bought rental property. Negative cash flow was not a problem. Depreciation and cash flow losses were deducted from their regular income, for a nice tax savings. This set the stage for a surge in demand for real estate. Strong demand always raises prices and inventory. New loan structures, such as adjustable rates, negative amortization, and buy-downs were popular. These loans were a response to the high interest rates of the time. They allowed more people to buy real estate. And, the thing was, a whole lot of people wanted to buy real estate.
In an attempt to restore S & L's to profitability, new laws were passed, softening their regualtion. S & L's could pay higher interest to their depositors. And, they could make development loans, with an equity stake in the project. Developers could get a loan and a business partner at the same time. Higher loan ratios, and loose accounting practices became the norm. As interest rates came down, some S & L's were marginally profitable again.
Then the federal government changed direction in two important ways. First, in 1985, the de-regulation of S & L's began to go the other way. Federal regulators required S & L's to have more net worth on their books, and curbed their involvement in development deals. And second, in 1986, the tax incentive to own rental property was phased out. Without this tax advantage, the value of real estate was significantly reduced. Properties began to flood the market. The already weak S & L's were forced to take back foreclosed property. About 1,000 savings & loans closed.
Of the 20 largest institutions that failed, 14 were in Texas. Looking back, we can see that S & L's, with government support, tried to regain profitability by riskier lending practices and by investing in the real estate boom of the time.
Today we are experiencing a "mortgage meltdown." This is a complex situation that has its roots in the financial innovations of the 2000's. Now we have "bundled debt obligations," structured by investment firms and sold to investors here and overseas. Mortgages are "sliced and diced" and repackaged. This process brings money in to the US to fund many things - the growth of our businesses, our real estate ownership, and our credit card consumption. The risk to investors is watered down, or hedged, because their investment is spread across many different debt obligations. The perception of low risk made it very easy to find investors around the world. Financial engineers found that if you build it, they will come.
This liquidity, combined with low interest rates, fueled the demand for real estate - long considered a stable, low risk investment. Lenders were able to be more liberal in their qualification of home buyers. If you were breathing, you could buy a house. People saw 10-30% appreciation in their neighborhoods, and could get a 6% loan with no money down. A mortgage loan is one of the best, lowest interest loans you can get. New homebuyers got into the market; homeowners sold and moved up; investors came out of the woodwork. And, lots of people borrowed against their homes, and used the cash for other things.
As in the mid 1980's, demand for real estate raised prices and inventories, as builders came into the market. For the past five years, the health of our whole economy was attributed in large part to the growth in equity that people had in real estate. The mortgage meltdown began when lots of people found that they could not sustain the payments on their loans. Foreclosures created a self perpetuating downward spiral in real estate prices. These "bundled debt obligations" turned out to be riskier than people thought.
Instead of S & L's, it is investment firms, such as Bear Stearns, who have lost the value of their assets. Bear Stearns was offered an emergency rescue by our government because of the interconnectedness between them and other banks and investment companies. Like foreclosed homes in a neighborhood, their fall could bring down other investment firms, and threaten the stability of our financial system.
Looking at both the S & L Crisis of 1989 and today's mortgage meltdown, we see that liberal lending practices plant the seeds of their own downfall. And, that strong demand for homes, with continued price escalation is not sustainable. In 1989, we waited for the foreclosures to stop before we began to see home prices stabilize. In some areas this has happened, and inventory is dropping. And, as we move forward, we could use a new financial innovation - one that limits borrowers to what they can truly afford.
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