Best Practices For BIS II Implementation
A savings and loan association (S&L) is comparable with a bank, but with a limited portfolio of products. They offer savings accounts for people who want to store their money at an interest and they offer mortgages for people who want to buy a house. These institutions were not considered banks in the US and fell under separate regulations. The problem with these banks occurred in the late seventies when the interest rates started to increase. As the interest rates increased people shifted their money from the deposits (which had a relatively low interest rate), directly to the money market. This meant that the banks were either losing their funding, or the costs of funding were dramatically increased. This caused problems for banks because the mortgages which they had sold were often long term fixed interest loans. This means that the interest paid to depositors became more than the interest received from the mortgages.
As a result to this predicament several laws were changed. The S&L's were allowed to offer higher rates on their deposits (to compete with the money market rates). The S&L's were allowed to invest directly in real estate. The government credit insurance was expanded. And finally the S&L's were allowed to increase their funding from brokered deposits. A deposit broker invested money from consumers in certificates of deposit (a short term loan to a bank or large corporate), at a fee.
These changes together had a negative effect on the business. The increased government insurance and decreasing margins (increasing costs) stimulated the S&L's to take more risks. The increased freedom allowed them to do so. Mortgages were sold to bad creditors at high interest rates, to cover the increasing costs of funding. The increased use of deposit brokers led to fraudulent behaviour among those brokers. They forced S&L's to invest the funding provided by the broker, into junk bonds. For which the broker then received additional fees from the junk bond issuer.
Because of these developments, during the eighties several S&L's went broke. The government was forced to cover the losses and compensate the deposit holders. This became an enormous drain on the budget. The production of houses dramatically dropped as a result. In 1989 the regulation on S&L's was dramatically changed to combat these problems.