What Really Happened to the USA Savings and Loan Industry

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What Really Happened to the USA Savings and Loan Industry

By Jonathan Larson

The death of the Savings and Loan industry caused the typical assortment of finger-pointing, official hearings, investigations, and other irrelevant motion usually seen in Washington whenever genuine political anger is felt from beyond the beltway.

In Houston, an investigative journalist thought he found a Mafia or C.I.A. connection to the S & L crises.

But searching for 'the bad guys' is not going to shed much light on the problem nor return but a tiny fraction of the money involved. In fact, looking for a few 'criminals' may be leading us away from the real problems.

The 'bailout' of the S & L is still estimated at $500 billion. It defies belief that the C.I.A., the organization that brought us the Bay of Pigs invasion, could organize such a grand theft. The Mafia could never have infiltrated that many organizations. In spite of the stories of the private jets and artwork associated with some of the more notorious S & L failures, bizjets and artwork are not expensive enough to bring down that many institutions nor cost more than the Vietnam war.

And no matter how much fun it was to watch Neil Bush squirm, the S & L tragedy is certainly beyond the scope of the totality of 80's pinhead yuppies.

Above the clamor for blood there is the occasional voice heard that the directors of the failed S & L's may not only be innocent, but in fact victims. If they are, all evidence seems to indicate that they are yet another of the victims of the high interest rates associated with the war on inflation. For only long-term public policy could cause such a mess.

Inflation is most commonly defined as too much money chasing too few goods. This problem can occur irrespective money's form. When Spain was flooded with silver and gold from the Americas in the 16th century, they had inflation. People sometimes believe that now that money is information in a core memory unit of a computer or encoded on the back of a piece of plastic, inflation has become a more persistant problem. They are probably correct even though there is little casual relationship.

In fact, inflation exists largely because there are several types and causes. Because of this, adjustments in monetary policy and high interest rates, the only methods of flighting inflation in the 1980's, are something like wide-spectrum pesticides that do not kill all the pests and wind up killing songbirds and other things we want to save. A look at the main inflation types will reveal why this is so.

#1) Inflation in the price of real property. Nothing acts more like the standard economic model of money chasing goods than land. Except for some heroic but otherwise insignificant efforts by the Dutch, the amount of land on the planet has remained constant for a very long time. Increase the supply of money and the price of real estate will rise. Decrease the supply and the price will fall.

But even this most simple form of inflation has complications. Not all land is equally attractive and most of the really interesting land has buildings on it. Pure farmland responded to the 1979 monetary cure for inflation almost immediately. By 1982, speculation in farmland had ended and the price of land had returned to something resembling the value of the crops that could be produced thereon. But land with buildings, or even land that could be built on, was subjected to the more sophisticated inflations.

#2) Commodity inflation (with a bow to Barry Commoner) is a more complex form that showed itself in the 70's. The law of non-renewable resources states that every barrel of oil (scoop of ore, etc.) extracted from the earth make the next barrel more expensive to find and extract. The easy to find oil was found first. The first oil well was less than 200 feet deep and was found in Pennsylvania on dry land. Now oil is extracted from extremely inhospitable places like the North Sea with wells thousands of feet deep.

Although commodity inflation applies to any natural material desired by the industrial state, oil was special for two main reasons; a) oil is burned and so is destroyed in any meaningful sense, and b) oil is virtually irreplaceable. Almost all American cities were designed around the automobile. To do without oil is unthinkable.

With people willing to pay any price for oil because their survival was at stake, higher oil prices of the 70's drove all other forms of inflation as people strove to keep up with the price rise of this basic necessity to their lives.

Commodity inflation was so persistant that none of the milder attempts to combat this form of inflation in the 70's was even partially successful. The stringent monetary policy of Volker only worked against oil prices over a much longer period of time. Mexico, then Venezuala, Nigeria and so on began to produce more oil as their economies sank deeper into interest-driven debt. Iran got into a war with Iraq which meant they had to cheat on their production quotas. By 1983, the power of OPEC to raise oil prices at will had been broken.

Some ground was also gained on the demand side of the equation. While Americans still needed their daily fix of petroleum supplies in order to live, technological changes such as more fuel-efficient cars allowed them to live on somewhat less. Disorganization in OPEC combined with a reduced demand kept oil prices essentially steady throughout the 80's. However, because of its special nature, commodity inflation as it applies to oil will certainly return with a vengence.

But inflation can still persist because of the most complex form:

#3) Market or producer inflation (with a bow to John Kenneth Galbraith.) Land nor commodities are very interesting except what people do with them. What humans do to natural resources gives them their value. The silicon in sand has far less value than the silicon in a computer chip. The whole goal of industrial enterprise is to add highly specialized value to natural resources. Those that are successful form industrial monopolies based on expertise, tooling, and other capital. Industrial monopolies are not the absolute monopolies referred to in economics textbooks or cursed by the 'Trustbusters.'

Industrial monoplies are similar to the output of a great chef. Many can prepare food, some can do it so well, they can command a premium price. Most of the very profitable products of the 20th century are based on secret, patented, forms of expertise using very expensive 'untinsels.' Mercedes Benz, for example, has a highly successful industrial recipe. Mercedes-Benz does not have a monopoly on the construction of transportation devices nor even of automobiles and trucks but if a person wants a Mercedes, he or she has to buy from Mercedes.

But everyone who makes things struggles to have a unique and equally successful recipe. The reasons are simple. 1) If a person or company has an industrial monopoly, they can raise prices in spite of efforts to hold down price increases. 2) Manufactured goods have minimum prices. Many costs of manufacture are built into the basic ability to make things. These fixed, enabling, capital costs mean that even if a manufacturer would want to lower prices, he or she cannot. Instead, the only alternative in many cases to raising or stable prices is to cease production.

Ironically, the enforcement element of monetarism, high interest rates, raises the fixed costs of production and means that anyone who can raise prices, will do so because the alternative of bankruptcy is so grim.

Even by 1990 when the fight against inflation had been waged for 11 years and had been highly successful against higher land and commodity prices, medicine costs continued to escalate because both doctors and medical equipment manufacturers seem to be uncovering new and unique products and processes that can be defined as industrial monopolies.

Given the varied forms of inflation, the nature of S & L's, and the weapon of high interst rates used to fight inflation, the S & L tragedy was almost inevitable.

S & L's had a wonderful mission--to provide low cost mortgages for home ownership. This they did very well. Low-cost home ownership in the 50's and 60's created and defined the enlarging American middle class. Because of the S & L mission, capital reserve requirements and supervision was minimal. The last thing on which a member of the American middle class was going to default was his or her home. These were the safest investments imaginable.

But the basic S & L flaw was that while the investments were in long-term mortgages, the deposits were in short-term instruments. This was never much of a problem until interest rates went from 8% in 1978 to 20+% in 1980 and no one with an 8% (or 7.5% or 5%) rushed out to have his mortgage raised to 20%.

The S & L's screamed for help. Congress threw them the 'lifeline' of deregulation. The S & L's were forced by economic circumstance from their safe cozy world of financing the nests of America's middle-class into the high-risk world of high-interest lending.

And what a crazy world it turned out to be. There are precious few legitimate investments that return 20+% or even the 10-12% that S & L's sought as the decade of the 80's continued. Their traditional line of business--homes--had never been an investment but rather a consumer product. This continued to be true even though raising prices for housing due to the heavy influx of the 'baby boom' into market caused many to treat housing as an investment. Related fields such as real estate development and energy exploration were coming under the control of monetary policy and were losing their ability to return at high rates.

This did not leave the loan officers at the S & L's with much to choose from. Real industrial monopolies such as new and patented medicines were beyond their reach and attempts at such monopolies in the real estate world such as high-priced vacation condos and downtown office space proved futile as everyone in the business chose to finance the same sort of development.

Even in the realm of traditional lending by S & L's--building--the concept of the industrial monopoly was essentially beyond the average expertise of the typical loan committee. Homes, while harder to produce than a hamburger, are still fairly simple products. Homes are assembled from prefabricated components such as windows, plywood, nails, carpet, doors, etc. using tools that are mass-produced, cheap, and available anywhere.

Anyone with money, reasonable care, and the ability to organize strenuous physical work can build homes. Many people build their own quite successfully. The difference between the builder of a few homes a year out of the back of his truck and one who builds hundreds is mostly determined by an access to capital.

Even skyscrapers are assembled from prefabricated parts and while much more difficult to build than a house, are well within the reach of many builders.

Imagine the scene of the typical S & L in 1983. They have been told that their investment must return a higher rate. They already know that unimproved land is no longer appreciating in value but is actually falling. Middle-class homebuilding has all but collapsed in the recession of 81-82.

The search begins for projects which have a higher value built into the structure. The notion of the industrial recipe applies in some degree to homebuilding. Higher priced housing is more profitable because it contains unique features that are the product of specialized skills. Only upper-priced housing sold during the recession of 81-82 because only the rich who were essentially unaffected by the recession were able or fearless enough to buy.

Suddenly, in every loan committee, a similar kind of decision was reached. High-priced housing with plenty of features became the appropriate form of housing to fund. Within months, there was a glut of expensive housing.

The principle was also applied to expensive vacation destinations and commercial real estate. Charles Keating of Lincoln Federal Savings and Loan is an example of a builder who actually took over an S & L for the purposes of funded his own pet projects. He built a hotel in Arizona with the most specialized skills employed. There are probably more guilded ceilings in Keating's hotel than in the Palace of Versailles. And while Keating employed an army of craftsmen, his hotel would have to charge $300/night and would have to be 90% occupied to pay the bills.

Therin lies a supreme irony. Those areas of the country which were considered properous were those same areas of the 'go-go' S & L's. Obviously, free lending policies are good for the economy. But the distortions imposed by high-interest rates caused the kind of building guarenteed to fail if enough people did it at the same time. The rich are rich by definition because there are few of them. Selling to them returns high profits only if done by an exclusive few producers.

The death of the S & L industry was only one of the serious problems associated with the crazy rates of interest that have troubled the world's economies since 1979. It may not even be the most serious. But $500 billion is still a lot of money for which most Americans could have thought of better uses.