Now, let's say a few words about the S&L crisis of the 80s that served as a trigger to the introduction of a comprehensive system of bank regulation in the United States and simultaneously around the globe. First of all, the S & L Crisis has been widely studied, and I have to mention here that the subtitle to our course, Other People's Money is taken from the title of a well-known book written about that by Paul Zane Pilzer. That is just entitled Other People's Money. And the story here goes like this. That, and S&L is the following institution. So this is a bank-like institution. That here is some equity as we see, hopefully. Then the main liability is the time deposit. So, people made deposits for some more or less long period of time, maybe a year, maybe a couple of years but really in units of years. And its main assets, residential mortgages. So basically, the idea, this is an S&L, savings and loans association. The idea is that these people, they finance the homes of these people. And often times, because they were raised on the regional principle, those were basically the same people. So let's say the dwellers of this region county, some of them who, at the same time, do not need to buy a new house, they could put some money on their savings account with this S&L and effectively, they would fiance these mortgages. Now, these are insured, and they're insured by Federal Savings and Loans Insurance Corporation. So basically, we can see whenever there is the deposit insurance, then there is a potential threat of moral hazard. And we will see what special kind of a problem with two here. Now, the setup for this in the 1970s and 80s was such that that was the time of risk taking, And deregulation. Well, that does not mean that before, people were just risk averse and really conservative and they were highly regulated. But indeed, there was some regulation in many areas of the US economy, in airlines, in insurance, and some other areas, in banking. But, it was not the kind of regulation that would prevent problems that we are talking about right now. And then also, this whole time was the, sort of, jump start or jump restart of the US economy and people started to take more risks. This entrepreneurial spirit was really core at this time. That also coincided in time with the jump in the interest rates. And that was the key trigger of the S&L crisis to occur. In order to talk about that, I will just flip over the chart and we'll reproduce that once again and we'll see what happens. Now, again, this is equity at an S&L, this is the S&L simplified balance sheet. These are time deposits and these are residential mortgages. What if interest rates, Go up significantly, like this. Then we see because the maturity and duration of residential mortgages is quite high. The maturity is 30 years and that can be shown that duration is sort of kind of long. Then, the market value drops sharply as interest rates go up. So we can put it like this. It's a little bit exaggerated. But the key story is that you can see that the market value of these residential mortgages now, is less than the market value of the liabilities. Because the market value of time deposits does not change that much. So, that was the case that a lot of these S&Ls became sort of, as it was called, zombie organizations. So their equity was negative. Now, you can see that this pushes the management of this S&L to engage in very risky projects. Because if I arrive at the high state, then I might be back in the black, if I arrive at the low state, I was insolvent and I am insolvent. Who cares? So it's important to notice that this setup resulted in massive abuses based on this moral hazard situation. And the question is, how come that an institution that is actually insolvent can keep on going? And here we come to the point of how regulation of these S&Ls was arranged before. The key story was the so called book value reporting. That means that, Even when that was already a zombie. In reports, the management could show the book value of these mortgages, this whole amount and on paper, it will still solvent. Well, clearly, if you disclose that you're all ready insolvent, then you will be obviously set up to bankruptcy and disappear. You'll lose your job and then your shareholders will lose money. So, people had incentives to postpone this in the hope of seeing, let’s say, maybe, interest rates will go down and then this will be better for me and some other miracles if you will. And the result is that these problems have accumulated for a while. And as oftentimes happens, it was not exactly a bubble, it was just the set of postponed serious problems. It burst and the overall check for finally the tax payers, because deposits were insured, added up to $550 billion. Well, that all set up, let's say, laid ground for comprehensive bank regulation that we'll discuss in the episodes to come. But for now I will stop here by adding just one more thing. It was how many? It's about 20, 25 years have passed since. And in 2007, 2008, we saw another huge crisis that was global crisis dealing with a lot of powerful financial institutions. The main idea in which was still the same moral hazard and inadequate regulation. So we can see that although regulators, they have really repaired a lot in the system, but they ever since have been lagging behind. But before, it's always easy to blame someone. Before we did so, we have to proceed from here and see what these people, the regulators around the globe have done, and ensure that massive problems like this will be much less likely to happen. In the next episode, we we'll discuss bank regulation in much greater detail.
