Savings and Loan Associations (S&L)

Savings and Loan Associations (S&Ls), also known as 'thrifts', are financial institutions that were once the bedrock of the American dream. Their original, noble mission was beautifully simple: to accept savings deposits from local community members and use that pool of capital primarily to issue residential mortgage loans. Think of them as the original community banks, created with the specific social purpose of promoting homeownership. For decades, they operated on a straightforward and stable business model, taking in short-term deposits and making long-term loans for houses. This structure made them a cornerstone of local economies across the United States, providing a safe place for families to save and a reliable source of funding to buy a home. However, their story takes a dramatic turn, offering one of the most powerful case studies in financial history on the dangers of mismatched assets and liabilities, perverse incentives, and what happens when risk is misunderstood.

For much of the 20th century, running an S&L was considered one of the most stable, if unexciting, jobs in finance. The business model was famously summarized by the “3-6-3 rule”:

• Pay depositors 3% interest on their savings.
• Lend that money out as mortgages at 6% interest.
• Be on the golf course by 3 PM.

This simple model worked because the environment was stable. A key piece of federal legislation, Regulation Q, placed a cap on the interest rates that banks and S&Ls could pay on deposit accounts. This kept their cost of funds predictable and low. As long as they could lend out money for mortgages at a higher rate, they could reliably earn a profit, known as the net interest margin. They were specialized, community-focused institutions that stuck to what they knew best: residential lending. For the average person, they were a trusted pillar of the financial system.

The sleepy world of S&Ls was shattered in the late 1970s and early 1980s by a combination of economic turmoil and ill-conceived regulatory changes.

The primary villain in this story was runaway inflation. To combat soaring prices, the Federal Reserve, under Chairman Paul Volcker, dramatically increased interest rates. This created a catastrophic asset-liability mismatch for the S&Ls. Their assets were long-term, fixed-rate mortgages made years ago at low rates (e.g., 6%). But their liabilities—the deposits they needed to fund those loans—were short-term. Suddenly, savers could earn double-digit returns in new, innovative products like money market funds, which were not subject to Regulation Q. A massive wave of disintermediation occurred as depositors pulled their money out of low-yielding S&L accounts to chase higher returns elsewhere. To survive, S&Ls had to offer higher rates to attract and retain deposits, but they were still stuck with portfolios of old, low-yielding loans. Their profits evaporated, and massive losses mounted. They were legally bankrupt, paying more for their money than they were earning on it.

Washington’s response was, unfortunately, a cure that proved worse than the disease. The Depository Institutions Deregulation and Monetary Control Act of 1980 and the Garn-St. Germain Depository Institutions Act of 1982 were passed to “help” the S&Ls. These acts phased out Regulation Q and, crucially, allowed S&Ls to diversify away from mortgages and into much riskier ventures like commercial real estate development, corporate loans, and even junk bonds. This deregulation was combined with a fatal flaw: the government increased federal deposit insurance to $100,000 per account. This created a textbook case of moral hazard. Depositors had no reason to worry about how risky their S&L had become; their money was guaranteed by the U.S. taxpayer. This gave S&L operators a dangerous incentive: they could make wild, speculative bets with depositors' money. If the bets paid off, the owners got rich. If they failed, the government would cover the losses. As the great investor Charlie Munger often says, “Show me the incentive and I will show you the outcome.” The outcome was a speculative frenzy that led to catastrophic failure.

By the late 1980s, the S&L industry had collapsed, resulting in one of the largest financial debacles in U.S. history. The federal government had to step in with a massive taxpayer-funded bailout, creating the Resolution Trust Corporation (RTC) to manage and sell off the assets of hundreds of failed thrifts, often at fire-sale prices. The S&L crisis serves as a goldmine of wisdom for any value investor.

• Understand the Business Model: The S&L story is a masterclass in the importance of understanding a company's vulnerabilities. Their simple business model was completely exposed to interest rate risk. Before investing, you must ask: what external factors (interest rates, commodity prices, regulations) could cripple this business?
• Incentives Drive Everything: The combination of government guarantees and deregulation created an environment where reckless behavior was rewarded. Always analyze the incentives of management. Are they aligned with long-term shareholder value, or are they encouraged to take foolish risks?
• Stay Within Your Circle of Competence: S&L managers who were experts in simple home loans were suddenly playing in the high-risk worlds of commercial real estate and junk bonds. They strayed far outside their circle of competence, with disastrous results. This is a crucial lesson for companies and individual investors alike.
• Crisis Creates Opportunity: While the crisis was a national disaster, it created immense opportunities for disciplined investors who had cash on hand. The RTC's sale of distressed assets allowed shrewd buyers to acquire property, loans, and other securities for pennies on the dollar, leading to immense fortunes for those who were prepared.