FSLIC. Raise your hand if you are old enough to recall what that stands for.
Briefly, FDIC : Bank :: FSLIC : Savings and Loan
You have to interpret the second “:” as “was to”, not “is to”. The Congress formally declared the Federal Savings and Loan Insurance Corporation (FSLIC) dead in 1989, after a decade-long illness. It was beyond bankrupt at the time. Its functions were subsumed into the Federal Deposit Insurance Corporation (FDIC).
I mention this bit of economic history because of the recent failure of the Silicon Valley Bank. That seems to have been driven by the same factor that drove the majority of S&Ls into bankruptcy in the 1980s.
Briefly, they borrowed short and lent long. Short, as in short-term. The money they took in — borrowed from their depositors — could be withdrawn at any time. Long, as in long-term. They apparently bought a lot of U.S. Treasury bonds. Which, although liquid enough at any given time, are still long-term loans to the U.S. Treasury. (And a fundamentally odd thing for a bank to invest in, when you get right down to it. It’s as if they couldn’t be bothered to find something with a better rate of return.)
In any case, as with any fixed-return asset, the price of those bonds drops as interest rates rise. Owning a lot of fixed-return long-term securities, in an era of rising rates, is a recipe for bank failure. (Or, as in the case of the 1980s, S&L failure.) As I shall explain below.
And, after more than a decade of more-or-less zero inflation and below-zero real interest rates, I have to wonder how many more banks are now lurking out there, in our current environment of rising interest rates, waiting to fail from that same root cause.
If you just want to see a professional write-up of the S&L crisis — minus the dirt — this piece by the Federal Reserve Bank of St. Louis is about as good as it gets.
Skipping the details, how does the FDIC operate?
U.S. banking regulation has a lot of generally-unrecognized quirks. Many of these derive from the fact that States were in the business of chartering banks long before the Federal government got in on that. States never relinquished that right. As a consequence, what appears to consumers today as a more-or-less monolithic industry is actually a mix of a institutions following different rules and regulations.
The practical consequence of this is that almost anything you say about bank regulation and deposit insurance will have some exception, somewhere. In Virginia, it appears that all state-chartered banks are in fact FDIC insured, meaning that they are subject to Federal regulation. But you can find states that allow some commercial banks to have no deposit insurance (e.g., CT), to (typically) states that operate bank insurance funds secondary to the FDIC, insuring deposit amounts in excess of the $250,000 FDIC limit (e.g, MA). You can also find entire categories of bank-like institutions that only exist under state charters (read the CT reference above to get the gist of that).
The FDIC insures most bank deposits in the U.S., so it’s worth a paragraph or two to explain the finances of that. (The FDIC reference page is here, the corresponding Credit Union reference page is here.).
The FDIC gives every bank a risk rating (termed CAMELS), based on factors such as capital adequacy and the riskiness of their underlying assets. This risk rating seems to be a pretty good predictor of which classes of banks are at higher risk of failure.
Source: Federal Deposit Insurance Corporation, Staff Studies. Report No. 2020-01. A History of Risk-Based Premiums at the FDIC, January 2020.
The FDIC charges banks a quarterly insurance premium based on the amount of insured deposits and the riskiness of the bank. As you can see, a large and risky bank might easily pay 10 times the insurance premium of a small bank with low apparent default risk.
Source: https://www.fdic.gov/deposit/insurance/assessments/proposed.html
In normal times, best I can tell, on average, covered institutions pay insurance premiums equal to about 0.12 cents per dollar of deposits. Effectively, that’s what you pay, in order to have your deposits insured. The bank just makes that transaction on your behalf. But the FDIC can add a temporary surcharge if the amount in the insurance fund gets too low.
The target value for the deposit insurance fund is 2% of the value of all of the covered assets (Source: FDIC). Which doesn’t sound like a lot, but the FDIC is a “full faith and credit” entity, meaning that the Federal government has to step in and make good on those insured deposits even if the insurance fund itself has been depleted.
(Oddly enough, while banks and S&Ls are insured by the FDIC, Federally-chartered credit unions are not. They are insured by a different “full faith and credit” entity, the National Credit Union Share Insurance Fund, and are supervised by the National Credit Union Administration.)
That “designated reserve ratio” was 1.25% of assets before the near-death of our banking system in 2008-2009. I went over this years ago, in Post #341. Since the demise of the FSLIC in the 1980s, we’ve only had one episode where, arguably, the FDIC’s Deposit Insurance Fund was subject to significant strain.
The graph below, courtesy of the Federal Deposit Insurance Corporation (FDIC), show the surge in bank failures that occurred in 2008 and 2009. In 2008, despite significant intervention by the Federal Reserve to try to stabilize the financial system, banks with assets amounting to more than a third of a trillion dollars failed.
Accordingly, the balance in the FDIC’s Deposit Insurance Fund ran negative during that wave of bank failures. Near as I can recall, this got absolutely no press coverage at the time. Plausibly, the FDIC kept fairly quiet about it, and at the same time the FDIC avoided a cash-flow issue by requiring banks to make their next three years insurance premium payments, up front, to keep the money flowing. (That, from detailed reporting in the Journal of Accountancy.)
Source: FDIC
Unsurprisingly, after that, they upped the target from 1.25% to 2% of covered assets.
In short, the FDIC’s Deposit Insurance Fund was stress-tested in that episode, came up a bit short, and, accordingly, has been required to run a bit more conservatively ever since. Acknowledging that if things really go south, the full faith and credit of the U.S. government stands behind them.
Unlike the S&Ls, discussed below, the proximate cause for those bank failures was the collapse of the sub-prime mortgage bubble, leading to a sharp downward adjustment in US housing prices, of a sort that had not been seen in the US for generations. The blue line below (from the Saint Louis Federal Reserve) shows an index of U.S. housing prices. The hump, peaking around 2006, is “the housing bubble”. The red line, for reference, is the US Consumer Price Index. The graph runs from 1975 at the left, the 2019 at the right. The gray bars are recessions.
Basically, a lot of banks made what in retrospect were a lot of really bad loans, based on ludicrously inflated real estate prices. Based, in turn, on what in hindsight was clearly a speculative bubble in real estate, driven by exceptionally easy credit, even for high-risk properties.
Finally, the billion-dollar question: How much does the FDIC lose when it shuts down a bank? Obviously, that varies, but after staring at a few tables in various sources, a good guess is about 8% of the assets of the bank. So if the Silicon Valley Bank is typical, and has $200B – $250B in assets, the Deposit Insurance Fund can expect to take a hit of about $20B. Far below the current balance of around $120B in that fund.
The 1980s S&L crisis and the death of the FSLIC.
Source: An Examination of the Banking Crises of the 1980s and Early 1990s,
The first thing to grasp is that S&Ls are not the same as banks. Back in the day, they were a distinct class of depository institutions with their own separate regulators and insurance fund. For purposes of this discussion, these were institutions that, by law, offered savings accounts to small depositors and used that money primarily to fund home mortgages. In their heyday, half the home mortgages in the U.S. were funded by S&Ls.
Note that I said “savings accounts” above. Not checking accounts. The radical notion of allowing S&Ls to offer checking accounts (NOW accounts) did not occur until 1980, with the Congress’s first attempt to quash the S&L crisis.
The interesting historical difference between a savings account and a checking account is that you couldn’t demand to withdraw your money held in a savings account. These days, all vestiges of restrictions in withdrawal from savings accounts have disappeared (reference). But there was a time when S&Ls could say, sure, you can have your money — sometime.
In fact, I have both a checking and a savings account at my local credit union. If you bother to read the fine print in the account agreement, I find the following disclosure:
" The Credit Union reserves the right to delay the availability of funds deposited to accounts that are not transaction accounts for periods longer than those disclosed in this policy."
Translation: If they are having a problem, they have the right to prevent me from withdrawing money from my savings account. Even now. Even in 2023. These days, with both savings and checking paying close to zero interest, this hardly matters. I might as well keep the entire balance in checking. But this is a holdover from the days of bank runs and interest-bearing savings accounts. You got paid interest for your deposit, but the quid pro quo is that in the event of a bank run, you were stuck. For other specialized types of saving accounts — Holiday Club, Christmas Club — the restrictions are more explicit, and typically involve penalties for excessive or early withdrawals.
And that’s by design. With clauses such as that, the bank needs to keep fewer “reserves”, that is, less cash-on-hand and other liquid assets, to satisfy regulatory requirements. This lets it put a higher fraction of deposits to work earning interest, and so (in theory) should lead to better economic performance.
In short, prior to 1970, say, S&Ls were a backwater of American banking. They could only offer savings-type accounts, and they were highly restricted in the types of assets they could invest in. The maximum interest they could pay on deposits was set by law. By and large, they were community lending institutions that issued mortgages, and little else.
Then along came the economic turmoil of the 1970s and 1980s. Let me summarize the situation — borrowed short and lent long — in one graph.
The key to understanding why the S&Ls were trapped by rising interest rates is to understand that as interest rates go up, the value of fixed-income securities goes down. Among which are fixed-rate mortgages. When the prime rate is 4%, a mortgage paying 6% is an attractive investment. When the prime rate hits 21.5%, not so much. If you want to sell a 6% mortgage in that environment, you’re going to have to sell it at a deep, deep discount.
And so, as rates rose, two things happened. The value of S&L’s existing mortgage fell, so that if they had to sell them, they’d take a loss. And, separately, they began to lose deposits, and (once rates were deregulated) then had to pay higher interest to keep those deposits. Higher than what they were earning on their portfolios of mortgages.
They were trapped. If they liquidated their mortgages to pay off depositors, they took a loss. If they raised interest rates enough to keep their depositors, they took a loss. There was no way out.
Congress then spent the better part of a decade trying to do anything other than liquidate the bankrupt S&Ls. They loosened restrictions on S&Ls. They loosened them some more. They basically urged S&LS to take ever-more-risky bets in the hope that they would somehow earn themselves out of the hole they were in.
In short, the Congress turned what had been a backwater of American banking was turned into America’s biggest casino. All in the hopes that the S&Ls could earn enough to make up from the losses incurred by borrowing short and lending long in an era of rising interest rates.
From the original chart, it looks like a lot of S&Ls lasted until the end of the 1980s, but that’s an illusion. Regulators turned a blind eye to the fact that many of those S&Ls were technical bankrupt, because they didn’t have enough money in the FSLIC to liquidate them. At the time, the term was “zombie” S&Ls. Technically, dead, yet still functioning. Meanwhile, the industry kept falling deeper and deeper into the hole.
After a few well-publicized scandals, the Congress finally threw in the towel circa 1989. About a third of S&Ls were declared insolvent and were liquidated. The FSLIC was bailed out by abolishing it and transferring the liabilities to the FDIC. I assume the taxpayers in general made up for those cumulative losses, but I haven’t bothered to look up the details of that final FSLIC transaction.
I’m sure there was plenty of malfeasance along the way. And some pre-existing regulations got in the way. But the basic story — the reason a third of the industry went bankrupt — is far more mundane. A combination of
- Lending long (e.g., 30-year fixed mortgages).
- Borrowing short (e.g., checking deposits, savings deposits, CDs).
- Rising interest rates.
That’s just bad news, no matter who the actors are. Maybe they have adequate capital and current earnings to keep going. Maybe not.
And now? Of toilet paper and bank runs, or bank runs were the original flash mobs.
Much like the 1970s/1980s, we’re now in an era of rising interest rates, following a prolonged period of low interest rates and low inflation.
Public information about of the failure of the Silicon Valley Bank sounded like the S&L crisis all over again. Sure, if you look hard enough, you can find some combination of malfeasance and incompetence. But from what I’ve read, the main problem is that they tied up much of their capital in long-term Treasuries. Borrowed short, lent long. Which, in the era of stable and low interest rates that existed from 2008 to circa 2022, was just fine. But in an era of rising rates, was a form of economic suicide.
As long as their depositor base remained stable, that wasn’t necessarily a problem. As long as they could earn enough to stay in business, they didn’t have to realize the losses on those long-term bonds.
But as soon as somebody suggested that withdrawing your money might be prudent, it was game over. That rapid withdrawal of funds forces them to sell off assets to pay back their depositors. And if the bulk of your assets are now far under water — well, you’re bankrupt in short order.
Are there more of these in the pipeline? Now way for the public to know. But I wouldn’t be surprised. And, I wouldn’t be worried either. If you look at the numbers, banks fail all the time.
The problem here isn’t with the regulators. Having learned some hard lessons from the foot-dragging of the S&L crisis, our regulatory authorities don’t screw around when a bank is in deep trouble. They come down like a ton of bricks. That’s not because they’ll somehow salvage more value out of the bank if they do that.
The problem is that — let’s face it — people are idiots. Bank regulators act decisively to quash any general run on the banks. The same mentality that gave us months of toilet paper shortages during the pandemic will give us bank runs.
Now, deposit insurance should have put an end to that. But in the era of constant internet disinformation, you know there’s somebody out there, right now, trying to start a bank run just to see if they can do it. Maybe a foreign government. Maybe just a home-grown jerk. It doesn’t really matter. Not to mention that you don’t even have to get up out of your chair to move your money out of a bank.
My take on it is that for the Feds to come out and say, hey, you’re covered, no matter what the size of the deposit? I don’t necessarily think that was good policy. I don’t think it was bad policy. I think it was probably the only policy that would work, in this circumstance.
Because now deposit insurance isn’t just facing traditional human stupidity. It’s facing stupidity, as amplified by social media and the internet. Bank runs were the flash mobs of their day. My guess is that bank regulators have to work faster and harder now, to stop those, than they have for the past half-century. So far, they seem up to the task. Let’s hope it stays that way.
