The Federal Response to Home Mortgage Distress: Lessons from the Great Depression

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The full paper, published by the St. Louis Fed, is here - http://research.stlouisfed.org/publication...05/Wheelock.pdf

I've pasted the Conclusion section (only) below:

CONCLUSION

The recent distress in the U.S. home mortgage market has parallels in the experience of the Great Depression. Like the recent episode, the increase in mortgage defaults during the Depression coincided with a sharp decline in house prices after a period of rapid gains. Also like the recent experience, mortgage defaults during the Depression were more prevalent on mortgages with unconventional terms, such as short-term, non-amortizing loans. Furthermore, mortgage underwriting standards appear to have deteriorated before the downturn of the 1930s, as they did toward the end of the recent housing boom. However, unlike the recent experience, the main cause of mortgage

loan distress during the 1930s was the sharply contracting economy and falling price level. One estimate is that, on January 1, 1934, about half of all mortgages on urban, owner-occupied houses were delinquent. Not surprisingly, this level of distress prompted numerous local, state, and federal actions to relieve and reform mortgage markets.

The federal government responded to the distress in mortgage markets first by creating a new federal agency, the Federal Home Loan Bank System, to provide a source of loans for mortgage lenders. The federal government then tackled the problem of delinquent loans directly by creating the Home Owners’ Loan Corporation, which purchased delinquent loans from their originators. The HOLC purchased some one million loans, which it refinanced as long-term, fixed-rate, amortizing loans payable in monthly installments. Arguably, the HOLC was highly successful. Despite acquiring only delinquent loans, the HOLC ended up foreclosing on fewer than 20 percent of the loans it refinanced. Furthermore, the HOLC operated without a direct taxpayer subsidy (other than its initial $200 million capitalization, which it eventually repaid). The HOLC did, however, refuse many loans on the grounds that the borrower lacked the income to make loan payments. The HOLC also loaned no more than 80 percent of the appraised value of the underlying property, though its appraisals were often higher than the current depressed market values. The HOLC also benefited financially from an expanding economy, rising house prices, and falling interest rates, which lowered its funding costs, especially during World War II.

The sharp increase in mortgage delinquencies and foreclosures during 2007 prompted numerous calls for government intervention in housing and mortgage markets, including the creation of an HOLC-like agency to purchase delinquent mortgages. The right of lenders to foreclose on collateral is the main reason why the interest rates on secured loans, such as home mortgages, are typically much lower than those on unsecured loans, such as credit card debt. Ordinarily, mortgage foreclosures receive little notice from the public because they have little impact on parties other than the delinquent borrower. However, when the number of foreclosures is high or concentrated geographically, they can lower property values, destabilize neighborhoods, and impose other social costs. Such “externalities” can justify government intervention to reduce the number of foreclosures.

Any government response to mortgage distress would entail some cost. For example, a government purchase of delinquent mortgages, or expanded federal mortgage guarantees or insurance, could impose a substantial monetary cost on taxpayers. Some policies, including a government bailout of delinquent loans or expanded loan guarantees, could also encourage increased financial risk-taking and thereby lead to further instability in the future. Other actions, such as a government-imposed moratorium on loan foreclosures, could simply delay inevitable adjustments that are necessary to restore the functioning of mortgage and housing markets. Such direct government intervention could also increase the cost of loans for future borrowers by encouraging lenders to add a premium to loan interest rates to compensate for the risk that government officials might re-write the terms of loan contracts.

A full assessment of the benefits and costs of government programs to alleviate mortgage distress during the Depression requires further research. There is scant evidence that the acquisition of delinquent mortgages by the HOLC during the 1930s encouraged risky lending. However, the Great Depression experience may not be especially relevant for addressing how a taxpayer bailout of delinquent borrowers and their lenders would affect behavior today because of differences in the underlying causes of mortgage distress during the two periods. Conceivably, a bailout would more likely encourage risky behavior in the present situation (in which lax underwriting was an important cause of the increase in defaults) than during the Depression (when a sharp decline in economic activity was themain cause of defaults). Thus, while the federal response to mortgage distress during the Great Depression provides insights about how the government might respond to the current wave of defaults, the very different conditions underlying mortgage distress during the two periods warns against drawing strong conclusions from the historical experience for the current episode.