🚦 The US savings and loan crisis (1980s)
The cost of deregulation and rising interest rates
💡 New on Macro Mornings? Start here
🚦 This is part of a 52-week series on Macro Mistakes - Designed for those who want to learn from history.
I share lessons from the biggest macroeconomic mistakes made by investors, companies, and countries, helping you avoid similar pitfalls and capitalize on future opportunities. Feel free to catch up on previous emails here if you'd like to start from the beginning!
Dear all,
In today’s edition of "Macro Mistakes," we focus on the U.S. Savings and Loan Crisis of the 1980s, a period in which hundreds of financial institutions collapsed due to poor regulation, excessive risk-taking, and the unintended consequences of rapidly rising interest rates.
This crisis serves as a stark reminder of the importance of regulatory oversight and monetary policy in maintaining financial stability.
✍ The Story
Savings and Loan Associations (S&Ls), also known as thrifts, were specialized financial institutions that primarily focused on accepting savings deposits and making long-term fixed-rate mortgage loans.
For decades, these institutions played a vital role in helping Americans buy homes. However, by the 1980s, S&Ls were facing serious challenges.
In the late 1970s, inflation in the United States was soaring, largely driven by the oil crises of 1973 and 1979.
In response, the Federal Reserve, under Paul Volcker, implemented aggressive interest rate hikes to curb inflation, pushing the federal funds rate to a peak of 20% in 1981.
While this policy successfully brought inflation under control, it had a devastating effect on the S&Ls, which were locked into long-term, low-interest mortgages.
At the same time, deregulation measures in the early 1980s allowed S&Ls to engage in more risky activities, including commercial real estate lending and speculative investments.
Many S&Ls, eager to boost profits, took on excessive risk, investing in high-yield, high-risk ventures. When these investments soured, the losses piled up, leading to widespread insolvency.
❌🚫 The Macro Mistake
What went wrong, and how could it have been avoided?
The U.S. Savings and Loan Crisis was caused by a combination of factors, but at its core, it was a failure of macroeconomic policy and regulatory oversight.
Interest rate risk: S&Ls were highly vulnerable to interest rate fluctuations because they were holding long-term, low-interest mortgage loans, while the cost of their short-term liabilities (deposits) was rising due to the Federal Reserve’s rate hikes.
This mismatch in duration led to significant losses when interest rates spiked.
Deregulation without adequate safeguards: The Garn-St. Germain Depository Institutions Act of 1982 allowed S&Ls to engage in riskier activities, but without the proper regulatory framework to manage those risks.
As a result, many S&Ls invested in speculative projects that ultimately failed.
Moral hazard: The Federal Savings and Loan Insurance Corporation (FSLIC), which insured deposits at S&Ls, created a moral hazard problem.
Knowing that deposits were insured, S&Ls had an incentive to take on greater risk, as they didn’t bear the full consequences of potential losses.
👨🎓 The Macro Lesson
The U.S. Savings and Loan Crisis offers several important macroeconomic lessons:
1. Interest rate sensitivity matters: Financial institutions that hold long-term, low-interest assets are particularly vulnerable to rising interest rates.
Understanding the duration risk and how interest rate fluctuations can impact different sectors is critical for macro investors.
2. Regulation must keep pace with innovation: While deregulation can spur growth, it also introduces new risks.
When financial institutions are allowed to engage in riskier activities, strong regulatory frameworks must be in place to monitor and manage those risks.
3. Avoid moral hazard: Government guarantees, such as deposit insurance, can create a situation where financial institutions feel emboldened to take excessive risks, knowing that they won’t bear the full consequences.
Policymakers must design safeguards to mitigate this moral hazard.
The U.S. Savings and Loan Crisis ultimately led to the collapse of more than 1,000 S&Ls, with the FSLIC facing insolvency.
The U.S. government was forced to step in, creating the Resolution Trust Corporation (RTC) to manage the liquidation of failed S&Ls.
The total cost of the bailout was estimated at $160 billion, with taxpayers shouldering about $125 billion of that burden.
In response to the crisis, Congress passed the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) of 1989, which restructured the regulation of S&Ls, increased oversight, and imposed stricter standards on the industry.
🔒 Macro Bonus
Investors who understood the interest rate risk facing the S&Ls and the broader financial system could have avoided significant losses during this period.
Furthermore, those who recognized the overleveraging and speculative risk-taking by financial institutions could have positioned themselves to profit from the eventual collapse by shorting bank stocks or investing in safer assets, such as Treasuries.
How does this apply today? Interest rate sensitivity remains a critical issue for financial institutions, especially in times of rising rates.
The U.S. Savings and Loan Crisis serves as a cautionary tale about the dangers of poor regulation, interest rate risk, and moral hazard.
As macro investors, we must keep a close eye on the regulatory environment and the potential risks that arise when financial institutions are allowed to take excessive risks without adequate oversight.
Next time, we’ll explore another macro mistake: The Collapse of Bear Stearns (2008) and how the subprime mortgage market brought down a major investment bank.
Alessandro
Founder of Macro Mornings
🙏 YOUR VOICE MATTERS - Help me
📝 TrustPilot - Leave a review and share your experience - I’d be truly grateful!
📣 Feedback Form - Help me improve Macro Mornings by sharing suggestions!
🏆 PRO MEMBERSHIP
📚 The Art of Financial Freedom 👉 51 Macro Lessons to Success Your Future
🔑 Get your Mentorship PRO here