Government Policies and S&Ls

In 1980, the Carter Administration implemented the Depository Institutions Deregulation and Monetary Control Act, allowing thrifts to diversify their asset portfolios and eliminating Regulation Q’s cap on deposit interest rates. However, the government increased the Federal Deposit Insurance Corporation subsidy for banks from $40,000 to $100,000 at the same time. This along with the Garn-St. Germain Depository Institutions Act of 1982, which gave thrift banks greater latitude to invest in real estate loans induced unrestrained real estate lending, resulted in the government creation of one of the greatest catastrophes in U.S. banking history. 

The National Review describes how both the American Bankers Association and Franklin Roosevelt opposed deposit insurance for three reasons: “First, it means there is no incentive for depositors to monitor the solvency of the banks and S&Ls in which their funds are deposited. Second, the flat-rate premiums provide no incentive to the owners to maintain solvency; in effect, these premiums represent a subsidy from solvent institutions to weak ones. Most important, deposit insurance creates a moral hazard for the owners of weak or insolvent banks and S&Ls, in effect setting up a one-sided bet. If they make unusually risky loans that do not later default, all the returns accrue to the owners; if these loans fail, the losses are borne by the insurance fund and, ultimately, the taxpayers. Heads I win, tails you lose. One should be surprised only that the insured depositories did not attract more crooks and frauds.” Thrifts were virtually given unlimited access to capital by the government, as they could promise to pay high interest rates on deposits to depositors who didn’t care about the thrift’s huge gambles (motivated by GSGDIA) due to the FDIC insurance increase. 

 Edward Kane expands on this by describing "although the Savings and Loan (S&L) debacle is extremely complex… simple-minded cartoons and horror movies can illustrate how the S&L insurance fund turned into such a mess. ...In movies such as George Romero's Night of the Living Dead and Dawn of the Dead, corpses climb out of their graves and walk around hunting for food. They are hungry for only one thing—human flesh. As soon as these living-dead "zombies" feed on another human, the human quickly dies and becomes a zombie too. Many S&Ls have, for some time, been zombie institutions. These institutions were insolvent in the sense that their assets had fallen below the level at which they could cover their deposit debt. These zombie S&Ls were able to survive only because they could feed off taxpayers through the device of government-guaranteed federal deposit insurance." This disastrous reregulation compounded with Depression era policies that had essentially divided the financial industry into strictly organized and vulnerable silos, resulted in 1,043 thrifts failing between 1986 and 1995 according to FDIC data.