Self-Justification Is Usually a Mistaken Excuse Not to Address Powerful Trends

Adverse new circumstances are almost universally viewed as being very temporary by those with the authority and opportunity to do something about adapting to the irresistible forces involved. A revealing example of this psychology at work occurred in the U.S. savings and loan industry during the 1980s.

At that time, the country was wracked by a very high rate of inflation and a desire on the part of Presidents Carter and Reagan and the Federal Reserve to bring that inflation quickly under control. Interest rates soared to very high levels and stayed high as a result.

For savings and loan institutions (S&Ls), this occurrence was a disaster. These S&Ls had almost all of their depositors' assets tied up in long-term home mortgages at interest rates well below the then-prevailing rates paid to depositors. To keep the depositors' money, the S&Ls had to continue to offer interest rates well above what they could earn with the money. Shareholders' capital rapidly evaporated amid the mounting losses.

Such circumstances had occasionally occurred in the past, and the U.S. government had always stepped in to save the savings institutions. That experience lulled the S&L executives into a fatal lassitude about their circumstances during the Reagan years.

At a time when they could have raised more equity capital, sold the mortgages for a loss, and closed down unprofitable operations, the executives procrastinated hoping for better times.

Finally, these executives began to realize that no government bailout was on the horizon. Unwilling to face the music for their procrastination, they began to look desperately for new places to put depositors' funds that offered enormously high rates of returns.

Some began investing alongside borrowers in new commercial ventures, such as residential shopping centers, and resort developments. Others bought barrels full of high-yield bonds (later dubbed "junk" bonds). Still others began to speculate by buying second mortgages that had poor collateral. The problem with all of these investments was that they, too, would fail if interest rates stayed high (or went higher), because the high interest rates would harm the underlying activities being financed.

This problem was compounded later by the Federal Government stepping in and requiring that all of these assets be liquidated at "fire-sale" prices whenever an S&L got too near to running out of equity capital. Although many of these bets would have paid off handsomely if held over a decade or more to a time when interest rates were much lower, the government liquidations tended to cause still greater losses in the short term.

Each liquidation then made the holdings of the remaining solvent institutions less valuable, threatening them with liquidation, as well.

This circumstance put the S&L executives in a situation like the gambler who puts all of her money on one hand of poker only holding a pair of eights. Unless she wins in the short-run, she is out of business. And many of these institutions did just that went out of business.

Many of these executives considered themselves to be pillars of the community and felt that they were doing the right thing at every step of the way. Visions of the movie, It's A Wonderful Life, may even have been on their minds.

As you might imagine, some executives were less than candid with their boards and regulators about what they were doing. Their desperate actions (in making very risky loans and investments) in the end caused the losses to multiply enormously, and taxpayers were forced to make good on their deposit guarantees for these institutions to the tune of many tens of billions of dollars.