Figure 234

Percentage Changes in Oil Prices: 1960-97

Source: Charles W. Smithson, Managing Financial Risk: A Guide to Derivative Products, Financial Engineering, and Value Maximization, 3rd ed. (New York: The McGraw-Hill Companies, 1998).

home mortgage loans. Before the increases in interest rate volatility came about, short-term interest rates were almost always lower than long-term rates, so the S&Ls simply profited from the spread.

When short-term interest rates became highly volatile, they exceeded long-term rates on various occasions, sometimes by substantial amounts. Suddenly, the S&L business got very complicated. Depositors removed their funds because higher rates were available elsewhere, but home owners held on to their low-interest-rate mortgages. S&Ls were forced into borrowing over the short term at very high rates. They began taking greater risks in lending in an attempt to earn higher returns, but this frequently resulted in much higher default rates, another problem with which the S&Ls were unfamiliar.

There were other economic and political factors that contributed to the astounding size of the S&L disaster, but the root cause was the increase in interest rate volatility. Today, financial institutions take specific steps to insulate themselves from interest rate volatility.

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