The long unwinding road

01.25.2012 - Money Matters

It has often been said that history repeats itself.  Indeed it does.  Most people have forgotten about the Savings and Loan crisis of the late 1980′s.  Although it pales in comparison in many ways it was a precursor to the 2008 financial crisis.

In 1980, the S&L industry was deregulated which then allowed them to make a wide range of consumer loans as well as commercial real estate loans similar to commercial banks.  S&L’s, which for the most part had been state chartered, could now obtain a federal charter accompanied by less stringent regulations.  Thrifts raced to become federally chartered and obtain the advantages including deposit insurance through the Federal Savings and Loan Insurance Corporation (FSLIC).

With regulations loosened, the S&L’s soon began to engage in increasingly risky activities.  Many S&Ls lent far more money than was prudent to ventures they were not qualified to assess, especially commercial real estate according to William Seidman, former chairman of the Federal Deposit Insurance Corporation (FDIC) and later the Resolution Trust Corporation (RTC).

Risky lending practices along with widespread corruption ultimately led to the insolvency of the FSLIC.  From 1986 through 1995, the number S&Ls declined by almost 50% from 3,234 to 1,645 including 747 insolvent S&Ls liquidated by the Resolution Trust Corporation.

The Glass–Steagall Act of 1933 instituted banking reforms that were designed to control speculation.  It was a reaction to the collapse of a large portion of the commercial banking system in 1933 and separated risky investment banking activities from traditional commercial banking activities.

At the height of the S&L crisis only the US economy was in a recession as opposed to the global recession precipitated by the 2008 financial crisis.  The total loss from the S&L crisis to the FSLIC and RTC was estimated to be about $152.9 billion according to an FDIC report.  Losses from the 2008 financial crisis have been estimated to be around $3.5 trillion spread across the globe over 20 times as great.

Many believe the 1999 repeal of the Glass–Steagall Act’s provisions helped precipitate the 2008 financial crisis.  Commercial banks could now acquire investment banks giving the latter access to former’s deposits.  Consumers, corporations and governments were able to leverage up their assets even more.  What flavor CDO, CLO, CMO do you want today?  It fostered a debt super-cycle that created a mountain of debt.  When the housing market collapsed it burst the credit bubble and exaggerated the severity of the financial crisis.

It is no wonder then that two of the most prominent investment management firms, Bridgewater Associates* and Pimco**, have such a gloomy outlook for the domestic economy as well as much of the global economy.  Their assessment is that it will take some 10 to 20 years to work through the mountain of debt that has been accumulated globally.

Until the debt burden has been worked down to a manageable level economic growth will continue to be anemic.  Clearly, the Federal Reserve Board’s view is that the economic recovery remains extremely fragile and will remain so for an extended period.  This afternoon it announced that it was unlikely to raise interest rates before the end of 2014.  Previously, its position had been that it was unlikely to raise interest rates until mid-2013.

That said, all bets are off if a solution is not quickly found to resolve Europe’s sovereign debt crisis.  A default by one or more of the Eurozone’s members or other untoward action would quite likely precipitate a global recession.

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 * – Bridgewater Associates is the world’s largest hedge fund manager with $120 billion of assets under management.  It was ranked as the best performing hedge fund manager in the world in 2010 and 2011.

** – Pacific Investment Management Company, or Pimco as it is more commonly known, is one of the largest investment management firms in the US with over $1.35 trillion of assets under management.