Sunday, March 8, 2009

Other People’s Money, Part I

For some of us here in Texas, the current economic problems look like a repeat of something that happened here twenty-five years ago, except on a bigger scale. Back then I was still practicing law, and I spent most of a decade working to recover money lost by the government in the savings and loan scandal.

For those of you that don’t remember (or haven’t watched It’s a Wonderful Life for a few years—and it you haven’t, then it’s time again given the current economy), savings and loans used to be a sort of quaint, old fashioned financial institution. To begin with, all they did was offer savings accounts and make home mortgages. Savings and loans were small, local institutions often organized by community leaders in small towns so that people could get mortgages to buy or build homes in the town. They were somewhat sleepy organizations that often operated by the 3-6-3 rule: Pay 3% interest on deposits; loan money at 6% for home mortgages; and be on the golf course by 3:00 p.m. in the afternoon.

Nobody made a lot of money (in fact savings and loans were often mutual organizations, owned by their depositors, much the same way as credit unions are now organized). But a few people had steady jobs and every person in the community had a place to save money and knew where to go to get mortgages.

This all changed in the 1980s. A new federal law allowed savings and loans to accept deposits from anywhere in the country, and if a savings and loan raised the interest rates on savings high enough, then it could attract hundreds of millions of dollars in deposits in $100,000 chunks (the maximum deposit the government insured at that time) from people with no connection to the community where the savings and loan was located.

A group of unprincipled investors saw an opportunity. It was easy and cheap to buy a savings and loan from its small town owners. The owners had never got much return and many of them were tired of the effort put into the organization—it was community service rather than a real money maker. Once you owned a savings and loan, then you could raise interest rates until you attracted as much money in deposits as you wanted—a hundred million, several hundred million, a billion or several billions.

But you had to pay the interest on those deposits, and that meant making high risk, high reward investments. I’ll write more about this in the coming days, but most you will already guess the ending: Risk means losses. Not wanting admit you are insolvent means covering up your original losses until there is no legal way to stay afloat, and, in the end, no illegal way to stay afloat either.

The reason people would take those risks is the same reason we ended up in the current mess. They were playing with Other People’s Money. Understanding OPM was the key to understanding the mess we got into in the 1980s, and I think it’s the key to understanding the mess we are in today.

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