Falling interest rates are giving the nation's savings and loan associations their first relief from a five-year landslide of losses that has forced 850 S&Ls to go out of business since 1980.

With interest rates down to the lowest level since the late 1970s, the savings and loan industry this year could finally begin to make enough money to rebuild the damage done by deregulation and the highest interest rates in modern history.

"It appears we will have a very strong earnings year -- our best ever -- in 1985," William B. O'Connell, president of the U.S. League of Savings Institutions predicted Friday. The best year for the S&Ls was 1978 when the industry earned a record $3.9 billion.

Federal Home Loan Bank Board Chairman Edwin J. Gray said the 3,150 federally insured associations that he regulates could make more money in 1985 than they made in the last four years -- $4 billion, $5 billion, maybe more if interest rates stay down.

Gray said a year of record earnings could buy time to rebuild and restructure the battered industry and replenish the shrinking reserves of the Federal Savings and Loan Insurance Corp.

Because of widespread S&L failures, the FSLIC fund has shrunk from 1.04 percent of insured assets in 1980 to 0.76 percent at the end of 1984. FSLIC now has only $5.9 billion to insure almost $1 trillion worth of deposits. FSLIC insures individual deposits up to $100,000.

"Our mandate is to protect the safety and soundness of the fund," Gray said in an interview Friday in which he called for federal legislation to restrict many of the risky savings and loan practices that have produced growing losses for FSLIC.

"It is necessary for Congress to deal with that issue now so we can halt the unnecessary losses to the fund," said Gray, who complained that under cover of deregulation some savings and loans have invested in "fast-food restaurants, wind farms and race horses" with federally insured deposits.

A year of low interest rates and high profits would also allow S&Ls to make further progress on the massive restructuring that began in 1979 and 1980 when the Federal Reserve Board allowed interest rates to soar while it struggled to control the growth of the nation's money supply and Congress began to lift limits on interest rates paid by financial institutions, he noted.

In that period of the late 1970s, the nation began to see a homogenization of its major financial institutions, and the savings and loan industry was suddenly thrust into direct competition with major Wall Street brokerages, large commercial banks and giant retailers such as Sears Roebuck and Co. for customer funds.

The kind of a breather offered by low interest rates, Gray added, would also permit thrifts to sell off more of the old low-interest loans that caused previous losses and to get rid of some of the unprofitable investments that are now the industry's most serious problem.

But for many savings and loans the anticipated relief will be too late.

"Many more institutions are likely to fail in the near future," a team of Home Loan Bank Board economists predicted earlier this month in an academic paper that was formally disavowed by the agency.

Most savings and loans that fail are merged into other financial institutions with aid from FSLIC. Gray himself predicts at least 500 more S&L's will be merged out of existence in the next five years as the industry gradually adjusts to changes in its marketplace.

Other students of the thrift industry are not so optimistic about how smoothly that period of adjustment will go. "I'm not entirely confident," said Andrew Carron, a former Brookings Institution researcher now with Shearson Lehman Bros. in New York.

"My reaction is that the transition will be a little bit rockier," he added. "We need a plan to deal with the problem, a five-year plan. There is no clear mandate from the President, the Treasury Secretary or the chairman of the Federal Reserve."

Citing the weakened condition of large numbers of savings associations, Carron said, "Someone is going to have to pay the bill for all these institutions that are in trouble."

More than 400 federally-insured savings and loans would have a negative net worth if they kept their books by generally accepted accounting principles, the economists noted. Savings and loans use unique "regulatory accounting" that allows them to show greater assets than would otherwise be possible.

Even by this more generous accounting method, 71 federally insured savings and loans reported they had no net worth as of Dec. 31. Net worth is the cushion that a business has left after it subtracts everything it owes -- its liabilities -- from what it owns -- its assets.

Another 806 associations do not meet the 3 percent minimum net worth required by federal regulations, Bank Board figures show.

Low net worth is the single most important factor in predicting whether a savings and loan is likely to be in trouble, but does not necessarily mean an institution will fail, concluded the authors of the Bank Board study, headed by James Barth, a George Washington University economist and visiting scholar at the Home Loan Bank Board.

Federal regulators allow many S&Ls with inadequate net worth to keep operating because they can't afford to do anything about them "given available financial and human resources" noted Barth and three other agency economists who worked on the study.

"Yet not closing these institutions most likely increases the eventual cost to the FSLIC as the institutions try to overcome their problems through riskier activities," the economists concluded after reviewing hundreds of failed associations. "Delay is therefore costly."

Barth and his three collegues carefully noted that their predictions "do not necessarily reflect the views of the Federal Home Loan Bank Board." After that disclaimer, they went on to offer the most ominous public predictions made so far by anyone inside the savings and loan regulatory agency:

"Although there has recently been an unprecedented number of thrift institution failures, the even larger number of institutions with negative and extremely low positive levels of net worth indicates that the number of future failures is likely to be large.

"The Federal Savings and Loan Insurance Corporation's reserves, however, are at an extremely low level, so that even a relatively small increase in the number of failures could swamp the fund."

While the FSLIC insurance fund had only $5.9 billion in cash as of Dec. 31, the 71 savings and loans in the most critical condition had assets of more than $11 billion at the end of last year, the economists pointed out. The additional 800 endangered institutions had assets totaling $300 billion.

Questions about the adequacy of deposit insurance funds began to surface when the private Ohio insurance plan was wiped out by the failure of a single savings association in March. New doubts were raised two weeks ago after the state of Maryland was forced to take over the private Maryland Savings-Share Insurance Corp. because of runs on two troubled Baltimore savings and loans.

Both the Ohio fund and MSSIC had relatively larger reserves than FSLIC but Gray insisted there is no comparison.

"Its a different situation when it is the federal eagle that stands behind the deposits," he said. "It is the full faith and credit of the United States of America that stands behind their deposits. That's what makes the difference in terms of confidence."

Gray conceded that the full backing of FSLIC by the federal govenment is more by implication than legal authority. The "full faith and credit" of the nation was pledged in a Joint Concurrent Resolution in March of 1982 but that is a non-binding declaration that expresses only the "sense" of Congress.

Gray said he disagrees with the out-going Chairman of the Federal Deposit Insurance Corp. William Isaac, who has suggested merging FSLIC with the FDIC, the government agency that insures bank deposits. While the FSLIC fund has been shrinking, FDIC reserves have grown in the last five years from $11 billion to $18 billion.

Bankers generally are skeptical of tossing the troubled thrifts into their reservoir of deposit insurance, but some banking industry leaders say they will have to help their faltering fellow financial institutions.

Willard C. Butcher, chairman of Chase Manhattan Bank, warned members of the Business Council, composed of executives of large U.S. companies, recently that the savings and loans are going to need help.

"We've got billions of dollars of assets in the thrift industry with inadequate capital under it and my guess is that the banking industry will be called on," to help avert a crisis, Butcher said.

Chase is one of several large out-of-state banks that have expressed interest in buying some of Maryland's troubled thrift institutions. The Maryland General Assembly has not yet taken up legislation which would allow out-of-state banks to move into the state by taking over an ailing S&L. Lawmakers said last week they want to see how serious the S&L problem is and how serious out-of-state institutions are about helping before they pass any legislation.

Other Maryland lawmakers agree with Gray and key Congressional banking leaders that interstate banking is an important carrot that can be used to attract new financing for insolvent thrift institutions.

The potential profits to be made in an affluent state like Maryland are great enough that a big bank like Chase could afford to bail out a savings and loan in return for the right to do business in a new territory.

Regulators say they expect banks will be more willing to buy failing S&Ls as a result of a federal appeals court decision last week that seemed to close the "nonbank bank" loophole in the laws restricting interstate banking. It was cheaper to jump across state lines by opening a limited-service "nonbank" than by buying a troubled S&L. If that option is closed, acquisition of S&Ls may prove to be the only alternative.

A conspicuous advocate of new government controls in a Reagan administration dominated by deregulation, Gray recently gave Congress a series of proposed new regulations. He suggested limiting FSLIC insurance to associations that make substantial investments in housing, restricting risky direct investments, and making S&Ls that invest in risky ventures pay higher FSLIC insurance premiums.

Gray's proposals were immediately attacked as "re-regulation" by the U.S. League of Savings Associations and the National Council of Savings Institutions, the two industry organizations. The National Council last week hired former California congressman John Rousellot, long an opponent of regulation, as its chief Washington representative.

O'Connell, head of the rival trade group, insists the problems revealed by the recent S&L crises in Maryland and Ohio "should not be interpreted to apply generally to the business."

There is widespread support in Congress for many of the proposals endorsed by Gray, but they are certain to reopen the debate over whether regulation is the curse or the cure for savings and loans.

It was bungling by regulators that got the industry into trouble contends Jonathan Gray, a thrift industry specialist with the New York City securities firm Sanford C. Bernstein & Co.

"If they set out to destroy the industry, they could not have done so with more exqusitite finesse," Gray said. For years regulators demanded that savings and loans make only long-term, fixed-rate mortgages and limited thrifts to paying a quarter point more interest than banks on savings accounts.

Then abruptly the limits on interest rates were taken off, just as other factors were causing interest rates to rise. Thrifts suddenly found themselves paying more interest on deposits than they were collecting on loans. In 1981 and 1982 virtually every savings and loan lost money because of that mismatch in rates. The situation began to improve in 1983, but last year about one savings and loan in four was still losing money.

The industry attacked the problem by selling off the old low-interest mortgages -- often taking huge write-offs -- and replacing them with adjustable rate loans that protected the lenders against swings in interest rates.

About one-third of all mortgages outstanding now carry rates that rise and fall periodically with other interest rates, the U.S. League of Savings Associations reports. In January of this year, two-thirds of the new home loans were adjustable rate mortgages, though that percentage is now declining as interest rates fall.

Pleading that if interest rates were deregulated, investments should be too, the thrift industry over the last few years has persuaded Congress and state legislators to let S&Ls depart from their traditional mortgage lending activities.

That diversification sowed the seeds for what Gray and other regulators say is the industry's most serious problem -- bad investments, or in industry jargon, "asset problems." Many thrifts have not only made loans that cannot be collected or are not earning interest, they have invested directly in real estate projects that are losing money.

Most thrift failures this year will be caused by "asset problems," bank board officials say. Gray told a congressional committee recently that it costs three to five times as much to bailout a thrift that gets in trouble due to bad investments as to rescue one damaged by interest rate problems.

Direct investments in real estate and other ventures are not necessarily related to failure, the FHLBB study of failed thrifts found. But when an S&L with large non-housing investments goes under, the cost to the government soars.

Federally chartered-savings and loans are permitted by the Bank Board to put only 3 percent of their assets into direct investments, but those limits do not apply to many state-chartered S&Ls that are insured by FSLIC. California and Texas permit their state associations to put 100 percent of their assets in direct investments, Arizona lets the share goes as high as 36 percent and Florida to 30 percent.

Bank board officials say shaky savings and loans in those Sunbelt states are the most serious threat faced by FSLIC. Both Gray and House Banking Committee Chairman Fernand St Germain (D-R.I.) have suggested making state-chartered, federally-insured associations live by the same rules as federally chartered ones.

St Germain has said he "questions the wisdom of public policy which allows these operations to continue if the federal government has to come in and clean up the mess."