Term Paper on "Savings and Loan Crisis"

Term Paper 6 pages (1942 words) Sources: 5 Style: APA

[EXCERPT] . . . .

S&L

The discussion explored the causes of the crisis and explains the potential solutions. Inflation, deregulation and financial mismanagement are the major causes for the current Savings and Loan crisis. Inflation is defined as "An increase in the amount of currency in circulation, resulting in a relatively sharp and sudden fall in its value and rise in prices ("What is the real definition of inflation?")." Inflation affects the Savings and Loans industry because it influences investment decisions and in some cases increases the need for people to borrow. Deregulation allowed lenders to circumvent scrutiny and approve very sketchy mortgages and engage in questionable lending practices. In other words, deregulation allowed lenders to operate without supervision. Financial mismanagement occurs at both the institutional and consumer level and such mismanagement can have terrible consequences. There are several different remedies that have been proposed. These remedies include everything from a moratorium on foreclosures to the freezing of interest rates.

Introduction

At the current time there is a great deal of economic turmoil in the United States of America. Although the president has been hesitant to state that the economy is in recession, most Americans know that the economy is in bad condition. A major aspect of the current economic condition in the country has to do with the savings and loans crisis. The discussion will explore the causes of the crisis and explain the potential solutions. Inflation, deregulation and financial mismanagement are the major causes for the current

Savings and Loan crisis, but the government has proposed potential solutions.

Causes of the Crisis

Inflation

Inflation is a major concern as it pertains to the current state of the economy. There are several definitions of inflation, for the purposes of this discussion we will rely on the following definition "An increase in the amount of currency in circulation, resulting in a relatively sharp and sudden fall in its value and rise in prices ("What is the real definition of inflation?")." The value of the dollar decreased dramatically over the past year when compared with other currencies such as the Euro. In addition to the increase or abundance of American currency in circulation, the demand for oil all over the worlds has contributed greatly to the increased price of fuel. The substantial increase in the price of fuel combined with the quest for alternative fuels has led to an increase in the cost of transporting food and a decrease in the amount of food available. This has resulted in dramatic increases in the cost of food throughout the world.

Inflation affects the Savings and Loans industry because it influences investment decisions and in some cases increases the need for people to borrow. This increased need to borrow may come in the form of increased credit card use, the taking out of loans including home equity loans and lines of credit.

Inflation is a particular problem in the current economic environment because not only are wages not keeping up with the costs of basic goods and necessities but many are loosing their jobs altogether. This means that people are defaulting on payments to creditors.

Deregulation

As with previous savings and loans crises that have taken place in America, deregulation has played a substantial role in creating economic instability. Most economists agree that deregulation in various aspects of financial deregulation have contributed greatly to the past and current crises involving the Savings and Loans industry. According to an article entitled "The Bubble Economy: The Financial Meltdown Is the Logical Consequence of Deregulation" the current crisis has been caused by Sub-Prime Mortgage lending and practices.

The author points out that deregulation allowed lenders to circumvent scrutiny and approve very sketchy mortgages and engage in questionable lending practices. In other words, deregulation allowed lenders to operate without supervision. The author explains that following the Savings and Loans Crisis of the 1920's certain regulations were put in place. Under the Glass-Steagall regulation financial institutions were policed carefully and FDI insurance was made available to prevent a run on the banks. There were also several regulations put into place as it pertained to prevent conflicts of interests and protect people from foreclosure through longer term mortgages.

Over time these regulation were repealed and in the 1980's regulator started to make exceptions for the Glass-Steagall regulations and in 1999 Congress abandoned the regulations altogether. This deregulation allowed "financial supermarkets like Citigroup to operate any kind of financial business they desired, and profit from multiple conflicts of interest (Kuttner, 2007-page 20)." Many of the scandals of the 1990s involving internet companies and the problems with Enron and other large corporations occurred because the SEC and Bank regulator were no longer policing these organizations as it pertained to conflicts of interest.

Financial Mismanagement

There are several forms of financial mismanagement that affect savings and loans institutions. These forms include such problems as the Enron debacle, impractical hedge fund risks and sub-prime mortgages. One of the primary causes of the current crisis has been the sub-prime mortgage lending practices of several financial institutions. The United States Department of Housing and Urban Development (HUD) explains that subprime mortgages "are for persons with blemished or limited credit histories. The loans carry a higher rate of interest than prime loans to compensate for increased credit risk ("Subprime Lending")."

Sub-Prime Mortgages, Hybrid mortgages and other types of interest only mortgages are problematic because of their very nature and the shear number of people who took out these types of loans over a ten-year period. For instance

The number of sub-prime mortgages soared from about $35 billion in 1994 to about $530 billion in 2004 -- more than 20% of all new mortgages last year. That growth helped propel the homeownership rate to a record 69% in 2004. But foreclosures are a potential problem. Although the foreclosure rate on sub-prime mortgages was a modest 3.5% in the first quarter of 2005, it was nine times the foreclosure rate for prime borrowers (Peterson, 2005, pg 30)."

Since 2005 there has been a steady and substantial growth in the number of foreclosures that have occurred as it pertains to sub-prime mortgages and other types of nontraditional mortgages. The inability of buyers to pay the higher monthly payments has led to an unprecedented increase in the number of foreclosures and thus the number of bank owned properties has increased dramatically.

Foreclosures -- when they are minimal-- do not make or break most financial institutions because the institution can usually absorb the lost or recoup some of the money by selling the property. In other words, financial institutions know that some borrowers will default on their loans and have mechanisms in place that allow the institution to handle such defaults. However, the current situation is much different because there are so many foreclosures that the market is flooded with homes and thus the price for which homes can be sold has decreased dramatically. As such financial institutions cannot unload these properties so that they can recoup the losses caused when people defaulted on their loans. This impedes greatly upon the ability of financial institutions to offer new loans, which only adds to the problem of the increase of properties on the market.

In addition to the foreclosure issue, many home owners now owe more on their homes than what their homes are worth. This means that they can no longer apply for equity loans. In addition, many homeowners who already have home equity lines of credit can no longer access these lines of credit to pay bills, make home improvements, or pay tuition for their children.

Overall sub-prime and nontraditional mortgages have been viewed by many as a form of financial mismanagement and some institutions have been accused of predatory lending.

Many, if not all of these financial institutions that offered these types of loans to buyers knew that the buyers were not in a position to pay the mortgages, particularly when interest rates changed or when the interest only period ended. In fact some of the financial institutions inflated the incomes of potential buyers so that they could qualify for home mortgages.

In other cases, the credit of the buyer was not questioned or checked by the lender.

It is also evident that many consumers are guilty of financial mismanagement. Many homebuyers were completely aware that they would not be able to pay their mortgages after the interest only period was over. In many cases people were impatient and wanted to purchase homes while the real estate market was hot.

In addition, some people took a substantial risk and purchased homes believing that they would be able to sell their homes prior to the end of the interest only period.

Financial mismanagement at the consumer level can also be seen as it pertains to credit card use and the lack of saving. Many Americans have a significant amount of credit card debt, as a result of purchasing nonessential items. With this being understood, financial mismanagement occurs at both the institutional and consumer level… READ MORE

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