Resident Fellow Alex J. Pollock

The housing and mortgage bust which inevitably followed the housing and mortgage bubble continues its downward course in 2008. American public discussion is now full of proposals for government interventions in the mortgage market.

This is a recurring phase of housing finance busts. There is a political imperative to Do Something. In a financial panic, everybody wants to get a government guarantee, and "Emergency Housing Acts" are common, historically speaking. History is clear that government actions are always taken. It is only a question of which ones. Government responses may sensibly include temporary actions to avoid a self-reinforcing downward spiral or debt deflation, to "bridge the bust" and then be withdrawn as normal private market functioning returns, as described in my talk, "The Cincinnatian Doctrine," at the 2006 World Congress. Temporary programs should inhibit as little as possible personal choice and the long run innovation and efficiency of the market, and they should not bail out careless lenders and investors or speculative borrowers.

The current U.S. housing bust has been described as the worst since the Great Depression. But while our current situation is serious, it is minor compared to what was happening in 1933, a financial and economic collapse virtually impossible for people today to even imagine.

In 1933, about half of mortgage debt was in default. (On September 30, 2007, serious delinquencies in the U.S. were 2.95% of total mortgages.) In 1933, unemployment had reached about 25%. Thousands of banks and savings and loans had failed. The amount of annual mortgage lending had dropped by about 80%, as had private residential construction. States were passing moratoria on foreclosures. The average borrower that the Home Owners' Loan Corporation (HOLC) eventually refinanced was two years delinquent on the original mortgage and about three years behind on property taxes.

The prelude to this vast crisis was, as always, a period of good times and confident lending and borrowing: the 1920s featured interest-only loans, balloon payments, the assumption of rising house prices, and firm belief in the easy availability of the next "refi," all familiar in our most recent bubble. Then came the defaults, the debt deflation, and "frozen" markets.

The Home Owners' Loan Act of 1933 directed the creation of HOLC in its Section 4, which took only three and a half pages of text. The subsequent history is well worth studying. HOLC grew to have about 20,000 employees, but was from the beginning designed as a temporary program, as described in 1935, "to relieve the mortgage strain and then liquidate."

The Treasury was authorized to invest $200 million in HOLC stock. How much was $200 million in 1933? If simply adjusted to the current dollars by the Consumer Price Index, it would be the equivalent of about $3 billion today. If adjusted by the change in GDP per capita since 1933, it would be about $20 billion. As a proportion of GDP, it would be over $46 billion.

The act originally authorized HOLC to issue $2 billion in bonds, or ten times its capital. Using the same three adjustment factors, this would be the equivalent of about $30 billion, $200 billion, or $468 billion today.

The fundamental idea was that for three years HOLC was to acquire defaulted residential mortgages from lenders and investors, giving its bonds in exchange, and then refinance the mortgages on more favorable and more sustainable terms. The lender would thus have an earning marketable bond, although with a lower interest rate than the original mortgage, in place of a frozen, non-earning asset.

The lender would often take a loss on the principal of the original mortgage, receiving less than the mortgage's par value in bonds. This realization of the loss of principal by the lender was an essential element of the reliquification program--just as it will be in our current mortgage bust.

HOLC's investment in any mortgage was limited to 80% of the appraised value of the property, with a maximum of $14,000. With an 80% new mortgage, therefore, the maximum house price to be refinanced would be $17,500 in 1933 dollars. Adjusting this by the Consumer Price Index would result in a current house price of about $270,000. Using the Census Bureau's change in median house prices since 1940 would suggest a current equivalent of approximately $1 million--so HOLC could be imagined to be able to operate today even with California house prices. The act set interest on the new mortgages to be made by HOLC to refinance the old ones it acquired at not more than 5%. The spread between this mortgage yield and the cost of HOLC bonds generated an average spread of about 2.5%. With long term Treasury rates of about 4% today, an equivalent spread would give a lending rate of 6.5%.

During its life, HOLC made more than one million loans to refinance troubled mortgages, which was about 20% of all the mortgage loans in the country. By 1937, it owned almost 14% of the dollar value of mortgage loans outstanding. This was a remarkable scale of operations. Today, 20% of all mortgages would be about 10 million loans, and 14% of outstanding mortgages would be about $1.4 trillion--approximately the total of all subprime mortgage loans.

HOLC tried to be as accommodating as possible with its borrowers, but being an at-risk lender, it did end up itself foreclosing on about 200,000, or 20%, of its loans. Since all these loans had started out in default and close to foreclosure, this seems to me a quite respectable performance.

The Home Owners' Loan Act provided that the directors "shall proceed to liquidate the Corporation when its purposes have been accomplished, and shall pay any surplus or accumulated funds into the Treasury."

In 1951, they did, returning to the Treasury an accumulated surplus of $14 million.

Alex J. Pollock is a resident fellow at AEI.