When I was growing up in Tennessee, someone forced to choose between two unpalatable alternatives was said to face a choice between the devil and the deep blue sea. We now face such a dilemma.
The Federal Savings & Loan Insurance Corporation (FSLIC) is effectively bankrupt, as are hundreds of the S&Ls whose deposits it is supposed to insure. In 1987, the $13.4 billion in losses suffered by the thrift industry's troubled institutions swamped the $6.6 billion in profits reported by the healthy ones. Just to handle the current situation, the FSLIC will need an infusion of at least $50 billion over and above what S&Ls pay for their insurance, estimates consultant Bert Ely, who has followed the growing thrift crisis closely.
Soon Congress will be forced either to renege on promises to depositors or to close hundreds of insolvent thrifts and use taxpayer money to pay federally insured depositors. It's not hard to guess which way Congress will go.
How did the thrift industry find itself in such a mess? First, federal regulators historically required S&Ls to invest in long term, locally generated home mortgages, which were funded by short-term savings deposits. When interest rates began to rise rapidly in the late 1970s, thrift managers found themselves paying more to hold on to deposits than they were earning on their long-term loans. Caught in this squeeze, many S&Ls depleted their equity capital and became insolvent.
Federal regulators did not, however, quickly shut down the growing number of insolvent S&Ls. Instead, they hid the problem by changing the rules and letting thrifts get by with less capital. Managers of insolvent S&Ls soon realized they had little to lose by accepting greater risk in hopes of earning greater profit. After all, federal deposit insurance—for which teetering S&Ls paid no more than did more solid competitors—would reassure depositors and protect insolvent thrifts from runs.
A shaky S&L could therefore offer above market rates on deposits while making riskier and riskier loans. Success would mean a recapitalized institution; failure would be taken care of by the FSLIC.
To make matters worse, Congress granted thrifts new freedoms in 1980 and 1982—without dealing with the many inadequately capitalized institutions. Managers of sick S&Ls now had an even wider range of ways to assume above-normal risks in their search for above-normal returns.
Given this history, it isn't surprising that the thrift industry is in its current dismal state—with resources clearly inadequate to heal itself. Since Congress will not renege on promises to depositors, a taxpayer bailout now appears inevitable. But taxpayers ought to at least get value for their money—substantive reform as a condition for the bailout:
1. Apply a strict closure policy to all federally insured institutions. Rapidly ridding the system of zombie S&Ls is the primary justification for giving the FSLIC access to federal coffers. Insolvent institutions should be closed as quickly as possible—no mergers, no more forebearance—and insured depositors paid. Henceforward, the shakiest federally insured depository institutions, those with capital measured at 3 percent of assets or less, should be given 30 days to raise new equity capital or be placed in the hands of federal liquidators.
2. Enforce, roll back, and eventually eliminate federal deposit insurance. Only depositors—not institutions—should receive federal protection and then only up to the promised $100,000 per account. Ultimately, federal deposit guarantees should be reduced and eventually eliminated. Thrift managers must once again assume responsibility for maintaining depositor confidence. And until depositors again have reason to prefer better-managed thrifts to riskier ones, thrift managers will not fully focus on running stable institutions.
3. Deregulate the thrift industry. Anyone should be allowed to buy one or more S&Ls as long as all are properly capitalized. And once the industry is freed from the stranglehold of its walking dead, thrift managers should be allowed to pursue any line of business they choose. The government need not continue to protect a specialized mortgage industry. Money will be available to qualified home buyers, and institutions that choose to specialize would remain free to do so.
As difficult as it is to stomach, a taxpayer bailout of the FSLIC is all but inevitable. To resolve the worsening situation in a timely manner, it may even be desirable. We must ensure, however, that Congress and federal regulators draw the right lessons from this fiasco and declare the 54-year experiment with federal deposit insurance a failure. For coming to the rescue, taxpayers must exact substantive reform that will prevent a future disaster of similar proportions.
Catherine England is director of regulatory studies at the Washington-based Cato Institute