The text below is a transcript of audio from Episode 25 of Onward, "The Big Bang: The origin of modern real estate and banking."
Disclaimer: This transcript has been automatically generated and may not be 100% accurate. While we have worked to ensure the accuracy of the transcript, it is possible that errors or omissions may occur. This transcript is provided for informational purposes only and should not be relied upon as a substitute for the original audio content. Any discrepancies or errors in the transcript should be brought to our attention so that we can make corrections as necessary.
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Cardiff Garcia:
Hello and welcome to Onward, the Fundrise podcast, where you can find out more about what's happening at Fundrise and where you'll hear some in-depth conversations about the big trends affecting the U.S. and global economies. We are recording this on Thursday, August 10th, 2023. Before we start today's show, we'd like to ask that you please keep rating and reviewing the show in those podcast apps. We love hearing from our listeners and we have heard from so many listeners good feedback, occasionally some constructive criticism, and we love that too, and we want all of it. So keep rating and reviewing.
Also, evergreen reminder that this podcast is not investment advice. It's intended for informational and entertainment purposes only. With that, let's get on with the show. This is the don't look back in anger, look back in search of lessons episode. I'm Cardiff Garcia of Bazaar Audio, and I'm joined as always by CEO of Fundrise and resident financial historian, Ben Miller. Ben, how are you, man?
Ben Miller:
Cardiff, happy summer.
Cardiff Garcia:
Yeah, same to you. As we get on into the late summer, you've been doing a little bit of reflecting on the past and there's a topic that I believe you are obsessed with. Is that too strong to say?
Ben Miller:
Yeah. Obsessed with.
Cardiff Garcia:
That you want to talk about today on the show, what is it?
Ben Miller:
The S&L Crisis. So as I say many times, I'm obsessed with learning the lessons of history because if you understand why something is and where it came from, you're more likely to be able to have a good idea where it's going. The Savings and Loan Crisis is a period that most people don't know anything about. It receded into ancient history. It's funny because I'm obsessed with it for a bunch of reasons. Let me list them out for you because there are really three reasons why.
Cardiff Garcia:
Okay. Reasons for obsession with the Savings and Loan Crisis of roughly the late '70s through the early '90s. So people like you and I were kids, but a lot of people in finance now were too young to have some sense of why it mattered so much and the scale of the crisis. But yeah, tell us why are you so obsessed with it?
Ben Miller:
Okay. Because I think of it as there's three epics of finance in American history. There's really that pre-Depression, there's the Depression to the 1980s, and there's the 1980s to now, and the S&L Crisis is the turning point. It's the big bang of finance. It's the origin, and so it birthed modern real estate, which I want to talk about. I think it actually birth modern banking, which we can talk about. It was the first, in my opinion, first nationwide bailout of the banking industry. It set the template for how regulators think about banking crises.
It really does foretell the 2008 financial crisis uncannily so, and then there's all these parallels about patterns of human errors, patterns of human history, how did government behave on the way up and the way down, how did market participants behave, the history of it captures all of those things, which are basically almost everything that matters in finance. So that's why I'm both obsessed with it and think it's really important for people to know about.
Cardiff Garcia:
So I think listeners are sold. I'm sold. I think people are going to stick around for this one having established why this topic is so interesting and so important. So as a teaser, we are going to, first, you and I, Ben, go through some of the history of the savings and loans, and we're going to try to explain in depth, but with clarity, the S&L crisis itself, what actually happened, and then we're going to talk about the lessons of it, why it matters today, and what people should be thinking about depending on whether you are an investor, whether you're part of a financial institution, a regulator, and so forth. So let's do it.
How far back should we start do you think? Should we go all the way back to the 1830s, the founding of the savings and loans? The murky origins of the savings and loans is that these were just collectively gathered pools of money that people would then give to someone to finance a house, then the money would get paid back and it would be lent out to somebody else. But it was all very informal. So these existed that way for a while. But the important thing to note is that they were very simple. Okay, you put your money into this thing like a deposit. It was lent out to somebody to finance a home and then it would get paid back. But maybe we should start with the formal establishment of the S&L industry in the early 1930s. So why don't you take it from there?
Ben Miller:
Well, so much of what you learned history or things that you think of as normal didn't exist before certain dates. So you think of a home mortgage as a normal thing or being able to save your money somewhere as a normal thing. But if you think back, let's just pick the 1930s or some period around the Depression, this turning point in banking, if you lived in a small town in America, there was no place to save your money. It wasn't a thing. There was no place to get a home mortgage. The way mortgages used to work is you get them from insurance companies and they were structured very differently than people think of them now.
So they were all balloons, a very short loan that would then come due and you had to pay it all off, and they didn't amortize, interest only. So a lot of times what happened was people would get a mortgage, it would come due and they couldn't get another one and they'd get foreclosed on. So before the S&Ls, there was much more perpetual indebtedness and it was just a different dynamic. Most people didn't get to buy homes, they couldn't afford to buy homes. There weren't mortgages for it. If you did borrow, you're often getting in trouble.
So you have this totally different world where there was no financial industry as you think of it today. So the big idea was let's find a way people save money and borrow for creating their home ownership. That was a really big idea. I think everybody supported it. That basically was the impetus behind creating this new idea called a savings and loan Thrift.
Cardiff Garcia:
This happened in the early 1930s when there were a couple of laws passed establishing the industry. It did a couple of things. One is it formally established the concept of a Thrift, which is another word for a savings and loan or an S&L. So those terms you and I are going to be using interchangeably throughout the show. It established Thrifts and it also established a Federal Savings And Loan Insurance Corporation, which insured some of the deposits that people put into the Thrifts. So the way these things work is really simple. They would take deposits and they would use those deposits to then finance home mortgages. That's all they did.
It's crucial for the subsequent history of savings and loans to understand that that's all they were. This is the original 3-6-3. You put in your money as a deposit, you get paid 3% on the deposit, you lend it out if you're a Thrift at 6% and by 3:00 PM you're on the golf course. Thrifts for many, many decades were just that simple. That's all they were designed to do.
Ben Miller:
Now let me add, probably the most famous Thrift in American history is in the movie It's a Wonderful Life.
Cardiff Garcia:
That's right, Jimmy Stewart, absolutely.
Ben Miller:
That's a Thrift. So what's different about a Thrift than the way people think about banking today is that they were not banks. They only really did one thing and there was no shareholders. It was a mutual. It was owned by the depositors, like the way Vanguard's owned by the investors. So there wasn't this idea of a bank executive that was getting rich owning the bank. It was owned by the depositors. So it made the bank very conservative, has simple mission and it was about serving local customers. So local savers and local homeowners. I just want to emphasize this again, because it's so hard for people to imagine. I wouldn't say this happened in our lifetime because I remember before 1990s, everything was regional. Banks were regional, radio, TV. TV, literally you had an antenna and you only could watch local TV. Retail wasn't a national phenomenon. This idea of local companies serving local consumers.
Cardiff Garcia:
With personal relationships, by the way. You knew your banker well.
Ben Miller:
There's a concept they called "neighbors helping neighbors". That was why It's a Wonderful Life struck home for so many people.
Cardiff Garcia:
There's a couple of things that are crucial to know from what you just said, crucial to emphasize. One is that Thrifts did not lend outside of a certain radius. They were serving people who wanted mortgages in their geographic area. The second is that it really was just for mortgages. Thrifts were not making commercial loans, they weren't making credit card loans, consumer loans and things like that. They had that one specific purpose, okay? They were there to take deposits and lend them out for people who wanted to finance a home, to buy a home. It was a mortgage focused product. That's what they did for many, many decades. We should maybe fast forward a few decades into the post-war era to 1966 when something called Regulation Q was passed. This is going to play a big role in what happens later. Do you want to talk about that and why it matters?
Ben Miller:
I'll say this, you can add to it, basically the idea of home ownership was such a powerful idea. Everyone in Congress really wanted to support home ownership. One of the things I want to touch on as I talk about this in one of the big lessons is how much these economic narratives drive everything underneath of it. So you can get technical, you can talk about what's happening in markets, but actually these big ideas drive so many of the assumptions of what is a good policy or what's a good investment or a good loan. So back then, encouraging home ownership was extremely politically popular. That's the epic I'm talking about, from the end of the Depression, so 1932 is when this Federal Home Loan Bank Act is passed, all the way to 1980. So that's a long time, 50 years.
In the middle of that 1966, they passed this Regulation Q, basically it's meant to protect the savings and loans because everybody loves them. It basically caps the amount depositors can get paid for saving, and it gives them a higher interest rate. They can basically give depositors 50 BPS higher savings rate than banks can. So essentially you're going to put your money with the S&Ls because you're going to get paid more to do that.
Cardiff Garcia:
But that amount is capped. In other words, if an S&L is now lending money at a certain interest rate and then it's paying its depositors a lower interest rate, it's going to be able to make money. What Regulation Q did was it capped the amount that S&Ls could pay to its depositors. That is going to play an important role later. So we have to know that that has been established. Some other things were happening in the 1960s and 1970s that are really important to understand. You had very high inflation and you had subsequently very high interest rates later on during the era of Paul Volcker. So that is something that's going to set up the origins of the crisis.
There's one other thing that happens, which is that mutual funds are introduced into the financial landscape, and those end up becoming competitors to the S&Ls in a very important way. So that's the '60s and '70s. But let me kick it back to you, Ben. Anything else going on in that era that you think listeners should know about?
Ben Miller:
I think you nailed it, basically. We're not going to talk about essentially what caused all the inflation, but the short of it is that we end up with a lot of inflation in the 1970s and the interest rates go higher and then they go much higher. But you're talking about even in the 1970s interest rates go into the 7, 8, 9% and then at the end of the '70s going into the '80s, they go to almost 20%.
Cardiff Garcia:
It's such a radical change from the environment that existed before. What do you think about the introduction or the popularization of securitization during this time and the government-sponsored entities? How big of a role did things like Fannie Mae and Freddie Mac play, do you think?
Ben Miller:
So I separate the problems into three groups, so assets, deposits and then profitability. Let me just take each in part and we can talk about-
Cardiff Garcia:
For the Thrifts, you mean?
Ben Miller:
For the Thrifts, yeah. So basically talking about what is the primary way people save and home mortgages, what people think of as banking now. They had approximately a trillion dollars in assets back then, and they had made millions and millions of home mortgage loans. So the home mortgage loans, they went out were typically around prime. So those loans would be a 5% or 6% loan with a 30 year fixed rate interest and they were amortized. The big idea is that basically if you stayed in your home for 30 years, you'd have no home mortgage at the end, your interest rate would be fixed, and the depositor was also a fixed saver. So on both sides it was a fixed rate and they made a spread and that was their business pretty simple.
But if you have a trillion dollars of mortgages at a fixed rate of 5% let's say for 30 years, and interest rates go from 5% to 20%, your assets are now, at least on a market basis, worth much less. So that's super similar to what's happened in the last 24 months. That's one clear parallel. So I'll just give you some math because I think the math of it is shocking. So okay, if you have a 30 year mortgage at a 5% interest rate and interest rates go to 20%, what's that mortgage worth according to markets?
Cardiff Garcia:
Very, very little. Why would you buy something that's paying you 5% if now suddenly you can get something that pays you 20%?
Ben Miller:
It's worth 25% of what it used to be worth. So 75% loss just on the interest rate from 5% to 20%. So home's still going to pay back, there's no question about that. But think about a 75% loss across the entire mortgage business. The savings and loans effectively were going insolvent just because the interest rate difference had marked their assets essentially to a loss. That's not a problem, we have just recently seen, as long as you have no forced selling of those mortgages. If you can hold those mortgages 30 years, then it's fine. You can hold to maturity as they say. But if you're forced to sell them at market rates and take that loss, then you're insolvent.
Cardiff Garcia:
The other problem, by the way, for the S&Ls was that suddenly with interest rates so high, depositors weren't as willing to give their money to the S&Ls because the S&Ls were capped on the interest rate that they could pay depositors. So on the one hand, their assets, which are these mortgage loans that they're giving to borrowers are losing value because of higher interest rates. But higher interest rates are also making it so that depositors don't want to stay with the S&Ls, and their deposits are crucial for financing those very mortgage loans. But instead, depositors are fleeing to get higher deposit rates with money market funds because the S&Ls are capped by regulations from paying a higher amount on those deposits.
Ben Miller:
What's happening today, today's a smaller scale, but basically you have higher interest rates than before. It went from zero to five, back then it went from five to 20. So there's a difference there. But essentially today's mortgage, I'll just do the math for today, if you had a 30 year mortgage at a 3% interest rate, which a lot of people have 3% interest rate in their mortgage for 30 years, and interest rates went to 6%, which actually probably interest rates today are closer to seven, but just at 6%, that mortgage today is worth 40% less. So probably 7%, 50% less. So there's a 40 to 50% loss on today's 3% mortgages now is 5 or 7%. So it's very similar.
If you're a depositor, you moved your money out of your checking account that was getting almost zero and you moved it to money market fund that's probably getting 5%, or maybe you took it to markets and getting almost 5%. So you're basically moving your money out of the bank's deposits so that you could get basically with market rate. So that was happening to every S&L in the country, and that was causing them basically to go insolvent. Then the last point, which you started to bring up, is that your home mortgage you could now go get from the markets. You didn't have to get it from a bank, you could get it from a broker.
Cardiff Garcia:
This takes us into the late 1970s, early 1980s. So these economic pressures are really squeezing the Thrifts from both sides. Now at this point, the regulators and the government have an interesting choice. One is do what they can to try to keep the S&Ls going and hope that over time they are restored to health, or they could have taken some steps to resolve the problem very early on. For example, they could have paid back the depositors of the Thrifts, but otherwise shuttered the operations of all of these insolvent S&Ls and tried to resolve the problem early. They didn't do that. They passed a series of laws in the early 1980s that did the opposite, that tried to keep the S&Ls going through a variety of means. So what should we know about what happened in roughly the 1980 to 1982 period?
Ben Miller:
So we're transitioning from the background to how do the government respond. It's called the makings of the crisis. There's so many errors in this, it's hard to enumerate them. But let me just say a few things because I really feel like, again, in the 1980s there was a big idea. Reagan gets elected on this idea of basically big government needs to go away, we need to deregulate. So underneath I think of the decision to ignore the problem and kick the can and hope the S&Ls would grow their way out, I think were two main things, or really three. One was this big idea called deregulation, two is S&Ls were loved, and I think they didn't want to just shut the industry down, and three, it was going to cost a lot of money. It was going to cause a government bailout. Nobody wanted a government bailout. That was unattractive politically. So there was a lot of reasons for the politicians to want to sweep it under the rug and hope it goes away naturally.
Cardiff Garcia:
Even more specifically, the regulators and the government did a few things. They allowed the S&Ls to have looser capital standards, which essentially bought them a little bit of time. They didn't enforce capital standards very much, and they deliberately chose not to enforce the capital standards that they already had on the books, even the relaxed ones. They also started allowing S&Ls to make investments other than just in home mortgages. So S&Ls were freed after the early 1980s to invest in other kinds of financial products.
They were free to invest in commercial real estate. They were free to invest in junk bonds, which junk bonds were becoming very, very popular in the 1980s, most famously because of Michael Milken and Drexel. So S&Ls suddenly had the ability to take on way more risks than they had in the past, and they were given a little bit of leniency, a lot of leniency actually by the government to basically stay alive for a little bit longer in the hopes that by doing business a different way that they would be restored to health.
Ben Miller:
Let me just double down on that because in retrospect, it looks so negligent to be almost criminal. But at the time, the big idea was free markets. So what happens is the S&Ls features are freed them up. They could basically innovate and grow and grow their way out of the hole, and interest rates were falling and they say, "Okay, well, this will work itself out because the markets will do their magic." The part that seems borderline criminal is just the way that the Congress and regulators ignored the problems that were happening. They changed the accounting rules. These S&Ls didn't have to follow GAP. They got rid of lending limits. There's no LTV. They could invest basically in anything.
There was a ton of lobbying. I think that everybody knows that industry lobbies affect government, but you could see how the S&L lobby really affected the regulator and Congress. So you have an S&L, savings and loan that is wiped out, has no equity. Let's say you're the CEO of this savings and loan, and you have no equity in it, and you're like, "Okay, well, the only way to save it is basically to grow our way. We have to make more profitable loans with fatter interest rates and bigger fees. We got to drive income to basically get out of this hole." So it's natural for you to take on more risk. That I think is a really important part of the human behavior here is when you have nothing left to lose, you're going to gamble. You're going to risk it.
Cardiff Garcia:
So the incentives here were all aligned towards the S&Ls, which again, most of which were insolvent by this time in the mid-1980s or early 1980s, to take these enormous risks, including as you noted, by investing in a lot of products that they didn't understand and were absolutely not specialists in. You know who was a specialist in all these products? The people selling them.
Ben Miller:
So one of the things that was really exciting to real estate people back then in the '80s was that you could go buy a building with a 100% loan. So if you're going to buy a building for $10 million, they would loan you $11 million. So the real estate people who I know were like, "It was great time because we could really get great loans, we could do all these deals." What the Thrift got was big fees. So an $11 million loan on a property, maybe the Thrift would get $500,000 fee. $500,000 fee is terrific because it helps get you out of the hole of losses that the Thrifts can solvent so they have to dig their way out by making extra profits, and then everybody working there starts getting paid. So now you're getting big salaries, big parties. So taking risk looks really attractive in the beginning and they did.
Cardiff Garcia:
Yeah, they took enormous risks. By the way, the point about regulatory capture that you noted is really important. This was the era of a lot of financial scandals related to the Thrifts. The most famous one, of course, is from Lincoln Savings and Loan, which was run by a guy named Charles Keating, who was later, by the way, convicted on all kinds of charges for all kinds of crimes. But what he did was he essentially paid massive campaign contributions to the famous Keating five senators hoping to get lenient regulations. What we also know is that back then, one of the private advisors to Lincoln, to Charles Keating, who was writing letters on his behalf to the regulators, was a little guy named Alan Greenspan, who later became the chair of the Fed.
So this was a dirty time in finance, and a lot of that dirtiness also applied to the S&Ls, but that's not all that was going on. There were economic things happening at the time as well. So for example, in the mid-1980s, there was a big commercial real estate bubble that was driven partly by higher oil prices, which drove up the cost of real estate in Texas, which produces a lot of oil. So the Thrifts were essentially lending into a bubble. That bubble was partially also fueled by regulations passed in the 1980s, or deregulations I should say, that were later reversed. So regulations drove up the bubble and then contributing to the bubble bursting.
When the bubble did burst around 1986, the Thrifts lost so much money because they had lent right into the bubble because they had been allowed to lend into the commercial real estate sector, which was something they'd never been able to do before. So after this period of illusory growth for the S&Ls in the mid-1980s, because they were taking all these risks and things were good for a time, then when the real estate bubble collapsed, oil prices collapsed, all kinds of other things started happening, the true insolvency of the Thrifts wasn't just revealed. It had gotten so much worse than it had been earlier in the decade when the regulators and the government failed to resolve the crisis.
Ben Miller:
Let me add to that because we're getting to the crescendo here, and it's really interesting. So the regulators probably could have resolved the S&L crisis for about $25 billion in the early '80s, approximately. How much it actually costs, there's so many different numbers here. I think it costs at least 250 billion. We can talk about that later. But they magnified the problem by 10x and 250 billion in 1980 something used to be a lot of money. I want to just point out the biggest mistake the regulators and Congress made around deregulation is they deregulated the asset side of the business, but the bank still had government insured or implicitly government insured deposits.
Cardiff Garcia:
The Thrift did, you mean?
Ben Miller:
The Thrifts. Sorry, the Thrifts did. Yeah. So here you are, a Thrift, essentially, effectively can borrow infinite amount from people backed by the government and then turn around and lent anything you want. So you deregulated only half the business. You'd gotten rid of deposit insurance, full deregulation, free markets probably would've done their magic, but here you only deregulated half of it and left the deposit insurance, and that was the big mistake. But the deeper insight I want to point out here is the '80s were a go-go period, totally go-go. I think one of the things economists really miss, classical economists, they believe in this idea of supply and demand, that's what sets prices.
I think what you see over and over again is supply of money determines the supply of products much more than I think the classical economics say about the supply and demand set by demand for the product and supply of producers. So there was too much real estate built, housing and office buildings and hotels, because there was so much supply of money. If somebody gave you billions to build, people would do it. We saw the same thing happen I think recently, for example, with the tech bubble. There was so much supply of money because of quantitative easing. There was just a bubble and a lot of things because there was oversupply of money, nothing to do with demand from customers. So that's what caused this real estate and Wall Street boom through the '80s.
Cardiff Garcia:
It's worth pausing also to understand where this focus of danger was here. So the depositors, as you noted, are insured. The federal government had a regulator that was supposed to manage a fund that would pay back depositors when S&Ls would fail. But that fund consistently was way underfunded. It didn't have nearly enough money in it to pay back depositors for all of the massive losses that the S&Ls were suffering, right? So that may have been part of the impetus for just kicking the can down the road in the early 1980s. But the problem was that by allowing the S&Ls to take these bigger risks, its bad assets ended up becoming way bigger too.
So that by the mid to late 1980s, it wasn't just that its mortgage loans had gone bad, all of these other super risky financial products that they had bought had also gone bad. Now you have all of these depositors, most of whom, by the way, are like mom and pop types. These weren't sophisticated financial institutions themselves. The depositors and Thrifts were like normal folks. The government didn't have nearly enough money in its deposit insurance fund to essentially pay them back if it had allowed the S&Ls to go under sooner.
So what happens in 1987 is that the Government Accountability Office does a study essentially saying, "Sorry, but most savings and loans are in fact insolvent, but that the insurance fund by a massive amount doesn't have nearly enough money to potentially compensate the insured depositors." So what does Congress do? It again kicks the can down the road for another couple of years, topping up the insurance fund, but not by nearly enough the magnitude of the shortfall. It's almost impossible to think about it.
Ben Miller:
I can put numbers to it. I have the numbers for you.
Cardiff Garcia:
Yes, please do. Because it splits my head open.
Ben Miller:
It costs at least $150 billion. That's a minimum. I think there's a lot of off balance sheet financing. That's why it's much bigger, in my opinion. The insurance fund had 6 billion. So Congress, clearly what happened in 1986, '87 seven when they kicked the can is basically it's too close to the election, and actually, I have a quote from the guy who ends up taking over.
Cardiff Garcia:
Oh, please, I love me a good quote from the '80s.
Ben Miller:
So the guy who ends up taking over all this stuff, his name's William Seidman, he ends up running the Resolution Trust Corporation, and he says, "Without a question, President Reagan dumped it on President Bush. I've learned agencies don't want problems on their watch. They'll do anything to defer problems to the next fellow's regime." Another really good one, if you want to get salacious here, I have two good vignettes or stories. One is that one of the worst offenders was a company called Silverado. So Silverado was an S&L. It goes belly up. They go and tell regulators that they're going belly up in August of 1988.
A month before that, their board member Neil Bush, George H.W. Bush's son and George W. Bush's brother, resigns from the board. He's basically on his watch, super complicit in a lot of really, really dirty stuff with Silverado. So they go to the regulators, they were insolvent. It's August, 1988, and the regulator says, "We'll give you till November, 1988 to work this out. We'll give you till a day after the election before we're going to declare you insolvent because we don't want George Bush's son being caught up in this really nasty savings and loan debacle."
Cardiff Garcia:
What was the second vignette?
Ben Miller:
Well, the second one, there's another company called Vernon S&L that blew up. It closed in March, 1987. I thought it was interesting to give you some stats here. So $1.4 billion in assets, 96% of its loans were in default.
Cardiff Garcia:
Oh my gosh, it's astonishing.
Ben Miller:
It cost taxpayers 1.3 billion. That's how nasty. You're talking about huge losses.
Cardiff Garcia:
I think the bailout portion for Lincoln Financial, which was the biggest of all of them, the one that was being run by Charles Keating was something like $3 billion. At one point they had two-thirds of their assets in junk bonds. It's a Thrift. This is not what these places are supposed to be doing. So this is all amazing. The end result was that finally, once George Herbert Walker Bush was in office, everybody got their act together, realized that this had to end. They essentially abolished both the regulator and the insurance fund and put up tens of billions of dollars, I can't remember what the final amount was, to essentially pay off the depositors.
They put a lot of the bad loans of the Thrifts into the RTC, the Resolution Trust Corporation, to be sold off to private industry through the years. That took another, I think, five or six years after it was established. That was the beginning of the end of the S&L crisis.
Ben Miller:
Some lessons here, not to get to the full lesson learned, but one of the things that happens to this, but there's a boom and the boom is self perpetuating. It starts to feed on itself and prices go higher and the loans look good. So there's this period basically where the losses get bigger because the booms just has a head of steam. The same thing happens with a bust. When things go bad, it starts to feed on itself. There's this systemic compounding nature of downturns just like upswings. So what happens basically in addition to that is also coincidences. So what happens coincidentally is oil prices fall 50%, and that makes the bust worse. There's all this overbuilding in real estate. Legislation, basically, you mentioned it, but there's really important legislative changes that make the real estate industry basically go bankrupt.
This is the worst real estate crisis in American history. It's worse than in 2008. It might be up there with the Depression. It's a tough call. But the thing that I think was wild is basically before the Tax Reform Act in 1986, real estate developers would do a deal and have these passive losses, which is basically in real estate, you can depreciate your assets, you can have interest rate deductions, and you could take those "paper losses" and sell them. So everybody in real estate in the '80s, not only were they getting a 100% loans, but people were buying into real estate through something called real estate syndication. Investors were buying into it and buying these losses to cover their taxes.
Cardiff Garcia:
To be clear, if you owed tax liabilities and you then also had these passive tax losses that you could buy from other places or these passive losses that would offset your tax liability in the current moment, even if in economic terms it wasn't quite right that something should depreciate that quickly.
Ben Miller:
Yeah, think about it right now, if you had $50,000 in taxes you owed, you would turn around and buy from a real estate person $50,000 in losses, maybe you could pay $35,000 for it, and now you have no taxes owed. The real estate developer just got $35,000 for selling a paper loss. He got a 100% loan on the property, so basically they get rid of that. Then the Financial Institutions Reform, Recovery, and Enforcement Act, which is the big, the government finally under, you said George H.W. Bush crushes the S&L industry because they're pissed, because basically Congress egged on their face for believing the S&Ls, that they were honest, and basically they got lobbied to not regulate them and then it turned out to be a big mistake. So they called it FIRREA.
What it did is it made the S&Ls have to dump a lot of assets, made them forced sellers, and that forced selling caused the market to collapse. A really good vignette of that is the junk bond market. Actually, I went out as part of my obsession with the S&L crisis, I've talked to people, a lot of people from that era, and one of my favorite people I talked to, I got to this person who was the private market broker in charge of selling most of the assets when basically government took them over. The Resolution Trust Corporation, the RTC, ended up taking all the assets, current terms they call it a bad bank. Form a bad bank, take all the bad assets, put it in there. It's about half a trillion dollars of assets back then, and then they had to sell them.
He basically was the main seller, main broker. I went and talked to him. He used to work at Drexel Burnham. His narrative of what went wrong, because what happened is basically when the government passed FIRREA, all the S&Ls had to stump their junk bonds, and that caused the junk bond market to collapse and then eventually put Drexel Burnham into bankruptcy, and then Michael Milken goes to jail. So his version of the story, I don't think he's read enough about the history of this, he just lived it, was that the banks were behind that. He felt like the banks hated Drexel Burnham, and they stuck that into the legislation so that it would force Drexel Burnham out of business. I don't know if that's true, because Drexel was eating the bank's lunch at the time.
Cardiff Garcia:
Ben, I think that's a good place to now start talking about the lessons of the S&L crisis for what's happening now. Why don't we start with governments and policy makers and regulators? What do you think are the main lessons that we should take from the crisis?
Ben Miller:
Yeah, because one of the reasons why it's so important is that 2008 financial crisis, the policy makers who made all the big decisions that you can think of during that period lived through the S&L crisis and they saw firsthand what worked and what didn't work. I think one of the reasons why, at least the regulatory response on 2008 financial crisis, actually it was good in comparison, just to put some numbers to it. the S&L crisis had about 3,000 S&Ls and banks go out of business at the end of all of this mess by 1995. In the 2008 financial crisis, it was about 500 banks. Obviously, some of them were quite big. I think the main lesson they learned was that the RTC, there was this idea of take all the bad assets and put them into this giant bad bank called the Resolution Trust Corporation, the RTC.
The RTC ended up with, as I said, about half a trillion dollars of real estate assets at that time, which is 2 trillion today or something. It was 120,000 properties and there were 4,000 people working at the RTC to sell all these loans, sell all these assets. So it's just a massive policy approach. You saw nothing like that in 2008. There was no let's take all the bad assets and sell them off through the government. I think they really did a opposite approach, which became famous as extend and pretend. Extend and pretend, kick the can, and that I think was a really important lesson from 1992 to 2008 and some of the lessons not learned.
Cardiff Garcia:
I'd love to say one of the lessons to learn is don't be captured by the industry, but that's probably always going to be a risk. That danger is never going to go away of people in an industry lobbying with huge amounts of money to get regulations twisted in their direction. Sometimes maybe those regulations might even make sense, but very often it's just being made in order to help industry players make more money. That certainly was the case back then.
Ben Miller:
Again in 2008, if I were to split, I would say the regulators did a pretty good job and have done a pretty good job since then. They did a terrible job in the '80s, absolutely failure F, and since then I think the regulators just are much more sophisticated, better resourced. Reagan cut, the member examiners cut the budget of the regulator of these savings and loans during this period. So I think the regulators get much, much higher marks now and that the politicians get as bad, if not worse marks, because you think about leading up to 2008 financial crisis, same thing happens. The same combination of Bush and Clinton deregulated, Congress encourages home ownership. That's basically Fannie and Freddie blow up and then all this financial innovation and you end up with the same problem as the S&L crisis, just instead of 500 billion, it's 5 trillion or something, much, much bigger potential downside from the banking crisis of '08.
Cardiff Garcia:
Plus, you had the introduction of Dodd-Frank, you have much more careful scrutiny of capital standards at the banks, certainly at the big banks, and now a lot of the midsize and regional banks.
Ben Miller:
So you're talking about '09, '10, only after the crisis?
Cardiff Garcia:
Yeah, yeah. I'm talking about in the time since the great financial crisis, just a lot more scrutiny, perhaps more dangerous is what's happening now in the non-bank lending sector. But at least in terms of the biggest banks you do have regulators still paying a lot of attention to them. You still have stress tests. You still have just an environment where there's still frankly a lot of skepticism towards "big finance". That has not gone away, even though the 2008, 2009 crisis was now 14 years into the past. So I think you're right about regulators generally doing a better job now than they were in the 1980s certainly, which was just famously one long rodeo.
Ben Miller:
Two quick things on this. The place where we're seeing the recent blowup in banking sector, which is banks bigger than 50 billion and smaller than 250 billion was deregulated by Trump. So in 2018, he deregulated that slice of the banking sector, and that's where Silicon Valley Bank and Signature and First Republic, that's really where we've seen the problems. So one of the lessons should be learned, and we will never learn, is that you really can't deregulate banking if you're going to give them deposit insurance. The other smaller point, just the difference between then and recent crises, '08, or even recent, is in the S&L crisis, the government put 3,600 executives in prison. They really went after the executives that time. We did not see that after '08.
Cardiff Garcia:
Correct. Yep. Okay. So those are a couple of good lessons. So about regulation and about the government. What else? What's the next bucket that you would put the lessons of the S&L?
Ben Miller:
Well, let me go to my two favorites, which is the big bang of real estate and banking. So let me do banking first more briefly, but just realize that before this, modern banking didn't exist. So banking before this was fragmented by state, by asset class, by business and by corporate structure. Previously, banks weren't allowed to do interstate banking before early '80s basically. As part of this deregulation, they allowed the banks become national banks like Citigroup and Banks of America bought up a lot of players and became national banks as we know them today. Before that, they didn't exist. Everything was regional.
S&Ls did home mortgages and banks did corporate lending to big companies. That's the way the world existed back then. Then now, banks lend to home mortgages and commercial real estate and corporate lending and consumer lending. But before, the different structures only lent to their category. There wasn't this idea of a supernational bank doing all lending to all assets. Then the idea of commerce, you have credit cards, checking account as a form of running your business. That was separated. S&Ls weren't allowed to do that. So commerce, banking and security business, which was basically what investment banks do versus what banks used to do, and that got eliminated finally end of the period. So you end up with all banks doing all kinds of businesses.
The corporate structure, way back in the day, 80% of the S&Ls were mutuals. They weren't joint stock companies. Most banks and investment banks especially were partnerships. When they went public, there's basically been this normalization to public joint stock corporations. That's where all banks are today. So all of these things were not the case before the 1980s. This is why I say it's the birth of the modern banking sector that comes at this change in epics.
Cardiff Garcia:
What is the takeaway from that evolution for now, given that, as you said, the banking system, the modern financial landscape is so different now than it was back then? Are there any lessons that we should be careful not to learn just because the environment is so different?
Ben Miller:
People's memories are short. So the mistakes we made in the '80s will be ancient history, maybe they almost already are. So we're surely make that mistake again. People who remember '08 or 2020 won't remember them in 2030. So I think that there's sad human behavior of repetition that is definitely, definitely a takeaway from all of this history.
Cardiff Garcia:
Ben, right now we're in an environment where the Fed is raising rates. We already saw earlier this year that some mid-sized banks were squeezed in a similar way as the S&Ls were squeezed in the late '70s and early '80s in that interest rates are rising, their loan portfolios were losing value and they were losing depositors to money market mutual funds, just like back then. There was some stress there, but the government did backstop a lot of what was happening, which was helpful to stop any contagion at the time. But we're still in that environment right now. Interest rates are high, possibly still rising. So at least that has been one place that's been a source of stress, mid-sized banks. But I'm wondering what else we should be paying attention to given the lessons of the S&L crisis.
Ben Miller:
The source of the problems in S&Ls, interest rate risk, interest rates changed and they took huge losses. That's happened again. The scale is smaller because it went from zero to 5% as opposed to five to 20. But the amount of financial instruments in the country or the world much bigger because not just in the United States, the same thing happened in Europe where we had negative rates in Europe. So there's an embedded amount of losses in the world's financial system that are not marked to market just like before in the trillions, maybe even more than in the trillions. It's hard to say. One of the interesting things you take away from looking back at it is that happens in the early '80s. By 1982 or '83, it was clear that they were insolvent, S&Ls were insolvent, and it doesn't blow up until seven or eight years later.
So it takes a long time because everybody's basically trying to kick the can, provide some coverage, hope it works itself out. That's exactly what's happening now. A very similar program is the bank term funding program. So basically that's a program that fed created when Silicon Valley Bank failed. Basically says, "Oh, you have these mortgages that are underwater because of interest rates." The Fed will lend you 100% and give you liquidity. So that's maybe a good program, maybe not, but it's a similar idea. The sentiment is, okay, there's these embedded losses because of the change in interest rates, we need to figure out ways to kick this can so that hopefully it works itself out. What happened last time was that it got a lot worse as a result, not a lot better.
Cardiff Garcia:
That makes sense. One big difference, at least it seems to me, is that back then the regulators essentially made it possible for the S&Ls to take these new and much bigger risks that they didn't understand. That actually does not seem to be happening in this case. There is some kick the can stuff going on, but they're not saying that suddenly small and mid-sized regional banks can take on huge risks that they didn't understand before. If anything, I think the regulators are clamping down a little more, insisting on very stringent enforcement of strong capital standards and so forth. Earlier this year, one of the banks at least was sold, the one that wasn't working out. Signature Bank was bought by New York Community Board. So some of this is a little bit different. The scale of the problem is certainly different. So it does seem like some of the lessons have been learned. What do you think about that?
Ben Miller:
Yeah, I think it's way better way, way, way better than before. We didn't put numbers to this, but going into the early '80s, the S&Ls started with only maybe three or 4% equity to debt. So they were, whatever that is, 30 times levered. So that's how much equity, because typically we're mutually owned. Where would the equity come from? There was no source of equity because it was a mutual bank. This time coming off of oh eight, we really went into a pro-regulatory environment. In the 2010s, banks got heavily regulated and I think that's what protected us. They have much more equity, they're much more conservative. So we're going into a similar interest rate change, but with a much better footing.
Cardiff Garcia:
Finally, Ben, we always want to tie what we're saying into what you're doing at Fundrise. What do you think are the big lessons for investors of the S&L crisis and its parallels to what's happening right now?
Ben Miller:
Finally got back to my true obsession, which is how did the S&L crisis rebirth the real estate industry. The real estate industry is totally unrecognizable from where it was before this. So what happened is that the real estate industry essentially got burnt down. By the end of the S&L crisis, there's no money in the sector. Basically everybody's foreclosed on. The RTC ends of owning most real estate assets in America. It's a little bit of exaggeration. Out of this period is a rebirth, this phoenix, and everything we take for granted is normal in real estate. This is how normal, this is how people do real estate, didn't exist and we're birthed in this period. So real estate private equity, which is now a trillion dollar space, didn't exist really before this.
CMBS, which we had Sheki on here, that's a trillion dollar industry that was birthed out of this. Public REITs, which really didn't exist before this got birthed out of this. So let me just give you a little bit more about this rebirth because it's fascinating, because I think that's what likely to happen again in some form or fashion. So let's talk about real estate private equity. So why does it get birthed out of this period? Well, if the RTC is going to sell 120,000 properties, they don't sell them one by one. They sell them in pools, a pool of a thousand loans or a thousand properties. So who can buy a thousand properties? Only another pool, only a pooled vehicle of investors, private equity funds.
So basically, Wall Street shows up and says, "Okay, we'll create these private equity vehicles." Basically the first portfolio that's sold by the RTC is sold to a partnership, 50-50, between Blackstone and Goldman and this guy, Joe Robert, who used to work at RTC and then ended up running this first private equity transaction. So all the big names you would know of in real estate got their start in this period, everybody, Starwood, Apollo, Cerberus, Canyon, Barry Stern, like Leon Black, every real estate mogul was either created or wiped out, all the guys I've had on my podcast, they were wiped out in this period. They didn't talk about it. Then they rebuild their wealth.
Even the idea of a private equity fund, that's actually used to be called an opportunity fund. It was invented by Sam Zell and Richard Saltzman in 1987. They invented this idea of a pooled vehicle. They go around to 48 pension funds. They convince him to do this. Zell ends up buying everything. He gets this nickname the Grave Dancer. He's going to be on my show actually in Maine, and I know Richard Saltzman. He ends up buying tons of office buildings. He takes it public, becomes equity office, which he sells to Blackstone for $39 billion. He also created equity residential, Kimco. All the public REITs basically have to go public. The only source of liquidity is the public markets. So you're talking about this massive birth, and I have two quotes here, but I'll give you one from the Washington Post, 1995, they called it "The Greatest Transfer of Wealth outside of armed rebellion in the history of this country."
Cardiff Garcia:
Extraordinary. I'm wondering, Ben, if there is something of that story in the latest rise of private credit funds, which are often investing in the kinds of credit that the mid-size banks are pulling back from right now, partly because of the economic environment and the stresses that those mid-sized banks experienced earlier this year.
Ben Miller:
It's just generally the rise of private markets, essentially, that instead of getting credit from banks, whatever credit it is, you can get it from the private markets that are now 25 trillion. They're now bigger than the banking industry. I used to be a skeptic of it, and it gets a lot of negative ink in press. Journalists always talk about shadow banking. The regulators talk about it. But it's actually exactly what we were saying earlier. Nobody in the private market is government guaranteed. They're taking risks on their investment. So I think it just makes sense it would be the future, and over time we find that government guarantees of deposits and the way banking intermediates finance starts to really look like an anachronistic idea, something from the past.
Cardiff Garcia:
Interesting. Although I will say that in the time before government insured deposits, there were many more bank runs, there were many more financial crises. It was more common and they were enormous. A lot of economists credit the introduction of insurance, both with fewer financial crises overall, but also with fueling bigger crises when they do happen because all of this money ends up chasing higher returns in the unregulated parts of the financial sector.
Ben Miller:
But that was before money market funds. You can imagine a world where you save in a fund that doesn't lend, those money markets or a bank that just owns treasuries, and you don't have this idea where you save and then the bank turns around and lends it out. That's just a different way to intermediate finance and one that doesn't need the government. So it's the government backstop that's the problem, and that 10 years from now when people forget about how bank deregulation is a problem and we have another blowup, which has pretty much always happened in history of finance, and you might see that technology has made intermediation of finance basically better than using an old fashioned bank.
Cardiff Garcia:
If you think about it, in some sense, if you end up having these private credit funds, these vehicles, and if those vehicles themselves don't take on too much leverage because, by the way, some of them do, but if they don't take on too much leverage, then it's equity financing of credit, which is if you think about it, very safe because all of the losses are absorbed by the equity investors. I think you still are going to have to have a government backstop part of the financial markets because individual investors, small investors, retail types, normal folks like me, they don't want to be doing a ton of research about the bank that they're putting their money in. They just want to put their small amount of money into a bank, know they can use it for basic services like checking accounts and that it's safe. So I think you're still going to have to have that part of the financial landscape be government backstop, which means you're still going to need regulators, but it could make sense for the landscape to be more varied. What do you think about all that?
Ben Miller:
Well, I'm going further and saying that you don't save in banks in the future. You save into money market funds or other kinds of new instruments, and that the government backstop of banks and general way we treat debt has been to subsidize it. If we had debt priced like equity, borrowing become more expensive, which isn't necessarily bad, and individuals wouldn't be taking credit risk, which is not how the system would work. We're a long way from that, but AI and things like that could potentially be a disruptive way system. Think of intermediation. Mediation is what technology is best at, arguably better than banks. So we're in speculation here. So we're still at least a decade from probably we need one more blow up before people finally abandoned this way we did banking for the last couple hundred years.
Cardiff Garcia:
I love it, man. AI and financial intermediation, that's a future onward episode if I've ever heard it because you're talking my talk now. Ben, any final thoughts on the lessons of the S&L crisis before we wrap up?
Ben Miller:
It's wonderful to see the big picture in retrospect. The last interesting thing I summarize is that these big ideas are what really animate a decade. So you had deregulation in the '80s. You had a tech bubble in the '90s. You had housing bubble in the 2000s. You had QE and ZERP in 2010s, and now you have AI. There's a saying, where wise men start, fools follow. That's I think the lesson is that something that looks good in the beginning, will get overextended and no longer makes sense and the pendulum will swing too far. I almost feel that way today about the way that everybody thinks it won't be a recession because the pendulum is today sitting exactly perfectly. Inflation's well tamed, unemployment's low and the pendulum is exactly at midnight, but the momentum of that pendulum is taking us towards more monetary tightening, and we haven't seen the full impact. So that's what I mean about history and the cycles and the patterns and why I love them so much.
Cardiff Garcia:
All right. That's a great place to start wrapping up. I want to end Ben with something a little different. You and I did some deep dives. We did a lot of reading in preparation for this episode. I just wanted to recommend to our listeners some of the stuff that we read in case they want to pursue this themselves a little further. You read a book by Martin Lowy called High Rollers: Inside the Savings and Loan Debacle. Recommended, yay or nay?
Ben Miller:
Oh yeah. I reached out to the author Martin Lowy to see if I could talk to him because it was the best. For somebody who's obsessed with this, it was the best book I've read on it ever.
Cardiff Garcia:
Yeah. That book goes really deep on all these themes, but it also gives a nice summary, a nice, clear analysis of what happened. So that's what you read. I read individual chapters of a few other books to round out our source material here, and I can highly recommend a few of these. One is there's a forthcoming book by economist Linda Yueh called The Great Crashes that has a chapter on the S&Ls. There's an essay, a really short essay by Michael Lewis in a little known book of his called The Money Culture from 1991 that talks about the role of Salomon Brothers and Wall Street and how they made a ton of money off of this crisis during the 1980s. I recommend it partly because it's just funny because it's Michael Lewis. It's very amusing. It's very humorous.
Finally, there's a book by Sebastian Malibby, a really great financial journalist about the life and times of Alan Greenspan called The Man Who Knew too Much and that's a strong recommendation. You can just look up S&Ls in the index and go straight to those chapters. So really great. Yeah, awesome. Look at us. If not resident financial historians, students of financial history, is it accurate to call ourselves that?
Ben Miller:
Hopefully. Always a student.
Cardiff Garcia:
Always a student. Excellent. All right, so let's close out the show. Thanks to everybody for listening. You've been listening to Onward, the Fundrise podcast featuring Ben Miller, CEO of Fundrise. My name is Cardiff Garcia of Bazaar Audio. We invite you again to please send your comments and questions to onward@fundrise.com. If you like what you heard, rate and review us on Apple Podcasts and be sure to follow us wherever you listen to podcasts. Finally, for more information on Fundrise sponsored investment products, including relevant legal disclaimers, please check out our show notes. This podcast was produced by The Podcast Consultant. Thanks so much again for listening, and we'll see you next episode.
