Explain how deposit insurance contributed indirectly to the savings and loan crisis of the 1980s

Question

What will be an ideal response?

Answer 1

In the early 1970s, savings and loan institutions made mortgage loans to households at low interest rates. In the late 1970s nominal interest rates rose sharply as inflation increased. The savings and loans were in trouble; they had to pay high interest rates to attract depositors and were earning low interest rates on their past investments. Many S&Ls went bankrupt. The government tried to assist them by reducing the regulations that restricted the range of their investments and allowing them to make investments other than in housing in the hope that they would gain more profits. Depositors were not concerned about the investments being made because their savings were insured. Savings and loans became aggressive investors in speculative real estate and other risky projects, many of which ultimately collapsed forcing the government to provide funds to bail out the S&Ls. The implication is that had depositors not been insured they would have more carefully scrutinized the activities of the S&Ls where they had their deposits and that in turn might have limited the risky behavior of at least some of the institutions.