Insight Line—March 26, 2007

Over the course of the past few months, investors have tried in vain to conceptualize, categorize and analyze the potential implications of distressed or defaulted subprime mortgage loans on the nation’s financial system.

To be sure, the research and analysis is impressive. And investors arguably are now more versed on the inner workings of the subprime mortgage market. However, as impressive as all this information flow might be, I suggest that at best it is nothing more than a guesstimate. The complete story may not be known for months or years. And even then it may not be completely clear because, you see, at the risk of invoking a much overused cliché, I believe this time it is different. Let me explain.

I suggest that much of the current level of investor angst owes its origins to those remembering, or Googling, the savings and loan insolvency crisis of the late 1980s. Arguably, the comparisons are compelling. Then as now, well meaning intentions ultimately produced unintended consequences.

Seeking to mitigate the massive disintermediation of funds from the nation’s deposit-taking institutions, industry lobbyists, with the full support of federal and state regulators, persuaded Congress to enact the Depositary Institutions Deregulation and Monetary Control Act of 1980. The key feature of the bill raised the federal deposit insurance on bank and savings and loan deposits to $100,000.

It wasn’t long before federally insured deposits at banks and savings and loans found other “opportunities” beyond the traditional real estate, commercial and industrial loans. As history attests, untold billions of dollars poured into numerous well documented high-risk ventures—with devastating results. From 1982 through 1991 more than 1400 FDIC-insured banks failed. In Texas alone, more than 500 insured banks failed. Total insured losses exceeded $1 billion in each of these 10 years, topping $6 billion in 1988, 1989 and 1991. By the end of 1991, the balance in the Bank Insurance fund was a negative $7 billion.¹

The final cost, though still debated, has some estimates suggesting the tab to the federal government, banks and savings and loans reached well into the hundreds of billions of dollars.

All of which, in broad generalities, seemingly justifies investors’ heightened concerns over why the current distress in the subprime mortgage market may evolve into another devastating financial contagion. After all, in a sense, if it happened once can’t it happen again?

Perhaps, but critical to the answer is whether the facts today are the same as they were then. As I see it, such is not the case.

Granted, there are elements within the current financial concerns that bear a strong resemblance to events of the past. Lax lending standards and overextended lenders are part and parcel of the comparison. On the other hand, what is not evident is, I believe, why this time history may not be the best guide.

As I see it, the critical difference between then and now is back then the ultimate responsibility for a vast amount of the defaulted loans rested exclusively with the federal government because of the previously mentioned enhancement to federal deposit insurance. Simply put, irrespective of the losses, if the funds came from insured deposits, federal rules guaranteed full restitution (within the limits)—irrespective of underlying rationale for the loss of funds.

Thirty years later, owing to numerous regulatory changes to the deposit taking and credit lending functions of financial intermediaries, insolvency and/or default risk no longer rests disproportionately on the coffers of the federal government. Instead, it is spread amongst willing investors. Furthermore, the financial system today is multiples of that available to absorb losses in the late 1980s. All of which gives me cause to suggest that while a cursory reading of today’s headlines suggests history is repeating itself, I suggest this time it is different.

¹ ““A Brief History of Deposit Insurance the United States,” prepared for the International Conference on Deposit Insurance, Washington D.C., September 1998, p. 54.

This material has been prepared using sources of information generally believed to be reliable. No representation can be made as to its accuracy. The forecasts and opinions in this piece are not necessarily those of Van Kampen, and may not actually come to pass. Information in this report does not pertain to any Van Kampen product and is not a solicitation for any product.