Land, Debt, and Crises

One hundred years of mortgage difficulties

The United States has yet to arrive at an approach to home ownership that meets with general approval. This essay will describe how mortgage policy evolved over the last hundred years or so.

The desire to own land shaped American culture and institutions. It caused conflicts between frontier settlers and Indian tribes. Government became involved in the 18th century with land offices, in the 19th century with the Homestead Act, and in many ways since.

One hundred years ago, the typical landowner was a farmer. Many farmers borrowed against their land, using mortgages. The typical mortgage required no repayment of principal for the first five years, when the entire balance became due. These were known as balloon mortgages. In the 1920s, farm prices fell. The decline in farm income meant that when the balloon mortgages became due, farmers did not have the money to repay the loans. This was compounded in the 1930s by lack of availability of credit due to bank failures in the Great Depression.

Roosevelt-era policy makers sought to correct these problems. With agencies like FHA and FNMA (Fannie Mae), they instituted 30-year mortgages that amortized. That is, principal was paid off gradually each year. There was never a balloon payment due. After 30 years, the mortgage was fully repaid.

To ensure that mortgage credit would always be available, policy makers fostered the Savings and Loan industry. By the 1960s, these institutions were responsible for making home ownership available. Their deposits were Federally insured. They paid a slightly higher interest rate than bank savings deposits (interest rates on consumer savings were regulated, with ceilings set by the Federal Reserve under so-called Regulation Q). The S&Ls were not allowed to make commercial loans, so that they were limited to mortgage lending.

Banks and S&Ls were not allowed to operate across state lines. Within each state, they typically were limited in terms of branching. They were much smaller than the largest banks today.

Charters for banks and S&Ls were limited by each state. Charters were granted sparingly, usually only to politically connected owners. Without much competition, the owner of an S&L around 1960 lived a simple “3-6-3” lifestyle. Pay depositors 3 percent interest, make mortgage loans at 6 percent, and hit the golf course at 3 o-clock in the afternoon.

The inflation of the 1970s caused this housing finance system to unravel. As inflation rose, market interest rates rose. Depositors withdrew money from S&Ls, seeking higher returns elsewhere. Money market funds emerged to attract these funds. Meanwhile, home owners held on to mortgages that they had obtained at 6 percent as market rates soared far higher. Even when an owner sold, the mortgage was typically “assumable,” meaning that the new buyer could take on the old mortgage.

By 1980, S&Ls were running out of money with which to meet depositor withdrawals. The principal on their mortgage assets was not being repaid quickly enough. So they had to “securitize” their mortgage loans. That is, they borrowed in capital markets at, say, 9 percent, with the borrowing backed by mortgage loans that earned 6 percent. They were losing money on the deals, but it kept them in business.

Throughout most of the 1980s, policy makers did everything they could to avoid shutting down S&Ls, even though they were insolvent. A number of policies facilitated this “extend and pretend” approach. Regulation Q interest ceilings were lifted, so that S&Ls could compete for consumer deposits. S&Ls were given new “powers” to buy other assets, including junk bonds and debt backed by commercial real estate. But this only worsened the problem, because these investments ended up losing money. Above all, accounting gimmicks allowed S&Ls to delay booking losses while they continued to operate, making riskier decisions and getting deeper in the hole.

By the end of the 1980s, the policy makers gave up on “extend and pretend,” and they closed down the S&L industry with a huge bailout. They took stock of lessons learned.

They decided that backing 30-year mortgages with short-term consumer deposits was unsustainable. They instead encouraged mortgages to be pooled into securities that would be sold to institutional investors.

They decided that in order for regulators to recognize problems in a timely manner, accounting had to follow a “mark-to-market” principle. If a mortgage could only be sold today at a loss, then it could not be kept on the books as if it were still worth its original value.

Another lesson that the regulators learned from the financial crisis was that Federal deposit insurance could not be handed out to institutions that took extreme risks, as the S&Ls had done in desperation in the 1980s. Hence the regulators introduced capital requirements that were based on risk.

These three reforms—securitization, mark-to-market accounting, and risk-based capital—were supposed to prevent a recurrence of something like the S&L Crisis of the 1970s and 1980s. Instead, they contributed to an even worse disaster: the financial crisis of 2008.

Risk-based capital requirements were gamed by Wall Street. Like Rumpelstiltskin, who wove straw into gold, the financial engineers turned subprime mortgage loans into AAA-rated mortgage securities.

When the mortgage securities began to experience defaults that undermined their ratings, mark-to-market accounting forced institutions to sell these securities, even at prices that were below their ultimate value. This only made the crisis worse.

If the “3-6-3” model broke down because it was too simple, the securitization model broke down because it was too complex. Top executives at financial institutions and leading regulators did not understand the fragility of the system nor did they know how to intervene during the crisis. The just threw a lot money into a bailout, passed a huge piece of mostly-irrelevant legislation (Dodd-Frank) whose implementation in turn required mountains of regulations. They made it clear that lenders would be held liable for any future epidemic of mortgage defaults going forward, so that credit standards were tightened, keeping young people out of the housing market.

In The chess game of financial regulation, I wrote,

Regulatory systems break down because the financial sector is dynamic. Financial institutions seek to maximize returns on investment, subject to regulatory constraints. As time goes on, they develop techniques and innovations that produce greater returns but which can also undermine the intent of the regulations.

…Instead of trying to make the regulatory system harder to break, we might think in terms of making it easier to fix…. The best way to make our financial system easier to fix would be to reduce the incentives for high leverage. We promote home ownership by subsidizing mortgage indebtedness. It would be better to provide subsidies and encouragement toward saving for a reasonable down payment. Likewise, in the corporate sector, our tax structure tends to penalize equity finance and to reward debt finance. Changing the system to tilt more in the direction of equity finance would go a long way toward reducing the vulnerability of our economy to crises at banks, insurance companies, and investment banks.