Resident Fellow Alex J. Pollock

Treasury Secretary Henry Paulson's proposal yesterday to overhaul the U.S. mortgage system, Sen. Chris Dodd's proposed HOPE for Homeowners Act and Rep. Barney Frank's mortgage bill are the latest suggestions for government intervention in the current financial crisis. Government responses during downturns may sensibly include temporary actions to avoid self-reinforcing downward spirals or debt deflation--in other words, to "bridge the bust" and then be withdrawn as private market functioning returns. The Home Owners' Loan Corporation (HOLC) was one such successful temporary intervention; its help in the 1930s mortgage crisis holds lessons that are still relevant.

Today's economic situation, while serious, is minor compared with the financial collapse of 1933. That year, about half of mortgage debt was in default. On Dec. 31, 2007, serious delinquencies in the United States were 3.62 percent of all mortgages. In 1933, the unemployment rate had reached about 25 percent (compared with 4.8 percent today). Thousands of banks and savings and loans had failed. The amount of annual mortgage lending had dropped about 80 percent, as had private residential construction. States were enacting moratoriums on foreclosures. The average borrower that the HOLC eventually refinanced was two years' delinquent on the original mortgage and about three years behind on property taxes.

The prelude to that national crisis was unfortunately familiar: a period of good times and confident lending and borrowing. The 1920s featured many interest-only loans, balloon payments, frequent second mortgages, the assumption of rising house prices and trust in the easy availability of the next refinancing. Then came the defaults, debt deflation and "frozen" markets.

The Home Owners' Loan Act of 1933 created the HOLC. The agency eventually grew to about 20,000 employees but was designed as a temporary program "to relieve the mortgage strain and then liquidate," as one early description put it.

The Treasury was authorized to invest $200 million in HOLC stock. In current terms, based on the consumer price index, that's about $3 billion, but if adjusted based on the change in gross domestic product per capita since 1933, it would be about $20 billion. The act initially authorized the HOLC to issue $2 billion in bonds, or 10 times its capital, which relative to GDP per capita would be about $200 billion today. The idea was that for three years the agency would acquire defaulted residential mortgages from lenders and investors, give its bonds in exchange, and then refinance the mortgages on more favorable and more sustainable terms. Lenders would have a marketable bond earning interest, although with a lower interest rate than the original mortgage, in place of a frozen, non-earning asset.

Lenders 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 loss of principal by the lender was an essential element of the reliquification program--just as it will be in today's mortgage bust.

The HOLC's investment in any mortgage was limited to 80 percent of the appraised value of the property, with a maximum of $14,000. That means the maximum house price to be refinanced was $17,500, equivalent to a $270,000 house today adjusting by the consumer price index but about $1 million based on the change in median house prices.

The act set a maximum interest rate of 5 percent on the mortgages the HOLC made to refinance the old ones it acquired. The spread between this mortgage yield and the cost of HOLC bonds was about 2.5 percent. With today's long-term Treasury rates around 3.5 percent, an equivalent spread would suggest a lending rate of 6 percent.

While it existed, the HOLC made more than 1 million loans to refinance troubled mortgages; that was about a fifth of all mortgage loans nationwide. By 1937, it owned almost 14 percent of the dollar value of outstanding mortgage loans. Today, a fifth of all mortgages would be about 10 million loans, and 14 percent of outstanding mortgage values is about $1.4 trillion--approximately the total of all subprime mortgage loans.

The HOLC tried to be as accommodating as possible with borrowers but did end up foreclosing on about 200,000, or one-fifth, of its own loans. Given that all of its loans started out in default and close to foreclosure, another perspective on the HOLC foreclosures is that the agency's loans had an 80 percent success rate.

A key provision of the Home Owners' Loan Act was 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.

Those considering government intervention today should keep the successful HOLC principles in mind.

Alex J. Pollock is a resident fellow at AEI.