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Nov 19, 2008

We Can Learn From The Savings And Loan Crisis

An economic recovery is based on confidence, which follows from profits earned from a new analysis. The Savings and Loan bank crisis in the 1980's is an instructive example.

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"Savings and Loans" were specialized banks that were allowed to invest only in local home mortgages. They had the guarantee of the federal government to pay back their depositors. These banks lobbied for more freedom to make riskier and more lucrative loans. They attracted a huge amount of money under the government guarantee, attracting depositors into high interest certificates of deposit. When the economy had a downturn, almost all of these banks failed.

In this S&L crisis, the government made good on the guarantee to pay back the depositors, and it took ownership of the buildings and assets backing up the failed loans. This is similar to our current financial situation, both in cause and effect, but now bigger and through the mechanism of making failed housing loans.

Amy Alkon at AdviceGoddess quotes Nicole Gelinas at City Journal about how the Saving and Loan crisis in the 1980's was resolved.

[edited] Consider what got us out of the savings and loan crisis of the late eighties and early nineties. William Seidman was head of the FDIC in the eighties and of the federal Resolution Trust Corporation, which handled the S&L aftermath. The U.S. government closed down failed S&L institutions and had to sell off their holdings.

These holdings consisted of $600 billion in diverse assets, including office buildings, hotels, golf courses, and apartment complexes. Seidman said “There was no real market for such assets. We decided we had to create a market. We said, we’re going to start selling these properties at whatever price we could get.”

Private owners of similar assets howled "You’re driving the market down". Congress was critical. "Congress asked us to keep the assets for five years to get prices up. I said if I’m sitting here just waiting to sell my assets, the price isn’t going to go up." Selling initially at distressed prices was “the only way we could get it done. We began to sell.”

Investors who bought assets at rock-bottom prices found that there was real value there, which encouraged investors to purchase more of the assets, increasing demand and raising the prices at future sales. Within a year, many formerly distressed properties approached 70 percent of their original values.

Investors, including large institutions, have a pragmatic and fearful follow-the-leader mentality. Many institutions in the current crisis failed to do their homework, to individually value the Mortgage Backed Securities (MBS) and the more synthetic and dangerous Collateralized Debt Obligations (CDO) which they bought. They accepted the market price and the opinions of rating services (Standard & Poor's, Fitch) who themselves did little investigation before assigning AAA (very safe) ratings. The government was buying these or similar bonds, so this and the AAA rating was good enough for investing institutions.

Today, all of the housing assets are questioned, and the MBS and CDO bonds based on them. They don't have a value because they are painted by the same brush. It doesn't matter that analysis shows some are good and some are bad. Trusted institutions already did a worthless "analysis", so how can one trust an analysis now? The same investors that happily bought MBS bonds when everyone bought them, now won't buy them at any price because no one else is buying them. This is follow-the-leader.

The only way out is for the owners of these questioned bonds to do a careful analysis and sell some of those bonds for any price available. After some time, when those buyers have profits on the purchase, others will believe the analysis and will be willing to pay more. Analysis and profits go together, and only new profits from those bonds will encourage a higher price and reasonable valuations.

This sets the timescale for a recovery. It won't happen faster, and further government mistakes will make it slower.

See We Guarantee It to read how government guarantees and a huge off-budget loan operation called Fannie Mae and Freddie Mac lost $650 - $1000 billion and produced our current recession and bank failures. It is a long post, but only a few words per billion dollars lost. We learn again, that if you want a huge crisis, you need the wisdom and power of government.

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