Sara at Next Hurrah Looks at Foreclosures and FDR

Reader Andrew sent a link to this post by Sara at the Next Hurrah which I’m going to excerpt heavily:

Way back when I was teaching, I used to give students zerox copies of the forclosure and bank sale notices from the local papers from the early 1930’s, and send them out to map and describe what they could actually see as the indications (in an almost anthropological sense) about the impact of the Great Depression of the late 20’s and early 30’s. What I wanted them to comprehend was less the arguments about what was done about those times, but more about what really went wrong, and ultimately how things were fixed. In essence, I wanted them to have good pictures in their heads as we evaluated what FDR actually did, and the results, and how we should evaluate those results.

Virtually every city in the US has an architectual line between late 1920’s domestic construction, and what was built in the late 1930’s. Most of the lines are mixed constructions — you will find 2 story houses with gables and creative lines, mixed in with small, well-built, what we today call starter homes, single story, cape cod or ranch styles, rather simple in design. This is where the speculative builders of the 20’s left lots in between their offerings, and then in the late 30’s, with land released by the banks, those who were following the modest income and credit codes of FDR’s FHA Mortgage program, built the next generation of houses. Between the houses of the 20’s, and the late 30’s is a revolution in Housing Finance as well as ultimately, a considerable cause of the Great Depression.

Prior to the Depression, the majority of homes were purchased on a short term note. You got a note for 5 years, with a balloon payment at the end, and then one negotiated with the bank for a new note covering the balloon. Of course the rate of interest would be adjusted with the new note. But what happened in the 1920’s, at a time when commercial and investment banking were not seperate, was that Banks moved assets into the attractive stock market which was zooming, and then, after 1929, when they went bust in the market, the liquid cash available to re-finance the balloons simply disappeared, and the Banks took back the housing where owners could not meet the balloon or had cash to cover. It was not at all unusual after 1929 for Banks to repossess homes that were nearly 2/3rds paid up, with all owner-equity being lost. So families doubled up, tripled up, and tried to keep one note paid up. None the less the Banks, repossessing acres of property, mostly failed by the dawn of the FDR Administeration. As an example, the Bank of Akron President Wendell Willkie, eventually, after reorganization, paid .07 cents on the dollar for savings accounts when it became Second National.

The New Deal contained three elements of a solution to this problem. First, the division of Banking into two segments, Commercial and Investment, with only small accounts in the commercial segment insured. In addition, the Savings and Loan segment was created, which advantaged small savers with insured accounts, and a small advantage in savings interest rates, but a clear restriction on lending — limited to local housing that met FHA standards.

What FHA offered was pretty simple, an inspection system that validated whether the construction of a house met all codes, local, and their own, and insurance to the lender if buyers met credit standards. FHA had a cap on the amount of loans, which was what forced the change in design from the gargoyles of 20’s style, to the cape cod or ranch design of the late 30’s. Porches, sun and front were eliminated, Entry Halls disappeared, rooms got downsized, and kitchens became streamlined with the efficent work triangle, but became much smaller. Compared with the 1920’s nothing anticipated having household help.

But financially, these new houses, and all that came after them with VA and FHA insured mortgages, offered relatively low down payments, and 20 year or later 30 year mortgages at a fixed rate. Over time the cap on loans was raised to accomodate inflation and some additional expectations in what was a basic house, but until the late 1970’s the early 1930’s reforms held. Local savings converted into local mortgages, with the lender insured.

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While FDR died in early 45, and Truman retained all his regulatory policy well into the 50’s, and Eisenhower did not change much, nor did Kennedy or LBJ, it began to change with Nixon, with moving up the cap on FHA loans beyond the rate of inflation, and then following the Carter inflation, the regulation of Savings and Loans was eliminated, leading to the crash of these institutions in the late 1980’s. Without understanding cause, or the reason for these plain jane savings organizations in sustaining middle and working class home ownership — Congress just bailed out the lenders who had the wit to reorganize, and let it go at that. Essentially they financed the next bump in housing inflation, whether it be in inflated prices for existing homes, speculation in lots for tear-downs in good areas, or McMansion housing far from jobs and culture in the exurbs, that requires vast investment in infrastructure on the part of existing home owners and the states. Essentially we are back to 1928 what with ARM Mortgage arrangements (like the old Balloons) that can be massively increased without any relationship to wages or salary or the economy, and the “right” of the financial institutions (probably foreign speculators in our Real Estate Market) to again foreclose acres and acres of housing.

Sara goes on in the comments section of that post…

Pre FDR and the emergence of FHA, when housing was financed with renewable short term notes, investment in those notes which generally ran 5 years would have been considered a medium term investment. Bankers would have looked at such investments in terms of profit in comparison to, for example a stock or bond investment, or city bond issue, or any other investment vehicle, and made a housing loan if the likely profit from the loan compared favorably with other possibilities.

In the 1920’s, with the Stock Market on Speed, banks shifted cash into the market — which offered excellent short term returns between about 1926 and the early fall of 1929, but then came the crash, and they lost their shirt, tie, pants and underwear. Thus funds for renewing housing notes dried up, and banks stopped renewing notes. Since the notes were short term, by about 1931 half of the outstanding home mortgages were being called.

What FDR did, by establishing the Savings and Loan Financial Industry as seperate from Commercial and Investment banking, allowing it to pay a slightly higher interest rate to small savers, but regulating it so that it could, for all practical purposes, invest only in housing that met FHA, and later VA quality standards, was to create a housing finance institution that was NOT directly in competition with other investment vehicles.

Until the mid to late 1970’s, the Savings and Loans were strictly regulated. They had a cap on the size of Mortgage they could write, (which essentially put a cap on the size of middle class houses), and both the rate of interest they could pay savers, and the rate they could charge borrowers was regulated. For the most part Savings and Loan companies served their local area — or possibly a region, thus capital created in a community more or less stayed there in the form of investment in new housing sold to people who likely also put their small savings into the local Savings and Loan Company.

With deregulation, Savings and Loan companies could invest outside the housing sector, and outside their region, and in the 70’s you began to see the results of this. They looked for greater and faster profits, financing resorts, tennis clubs, commercial facilities (malls for instance), and they competed with each other in the CD market (Certificate of Deposit) — selling this Government insured paper on medium term basis at higher and higher interest rates. (and not to forget the free toaster that went along with buying a 2000 dollar CD). It took a little less than ten years for the Savings and Loans to crash and burn in this deregulated market — The end of the Reagan years and the Bush I administration saw the Government have to bail out the S&L’s, at the cost to the taxpayers of billions. (Afterall, the paper they were selling was insured up to a hundred thousand.) In the meantime, the Housing Market inflated, in part as a function of putting Housing back into the same financial market with all other potential investments. So — back to square one, in a way — back to the situation that existed pre-FDR in the 20’s and early 30’s, except this time the Government (taxpayers) were on the hook to cover the insured savings.

The last stage of de-regulation took place under Bush II. The seperation of Commercial Banking from Investment Banking ended when Congress was persuaded to abolish the Glass-Stegall Act of 1933, meaning that Commercial Banks could now play in the more risky Investment Banking arena. And yes, one thing they did was to create mortgage backed securities that could be traded on the National and International Market in the same way stocks in widgets are traded. The end result is really no different from the late 20’s and 30’s — since the value of low or non-performing loans has crashed, and since the value of the underlying asset is no longer increasing (housing prices dropping), Capital in the hands of Banks is simply leaving the housing sector, not unlike the instinct of Banks in the late 20’s not being at all interested in renewing mortgage notes.

I don’t know enough about the era to comment much. Your thoughts?