There Was A Time…
when many people in the United States were not homeowners. Those that did buy houses and farms either did so with cash, or very short-term loans with downpayments of 40 to 50%. Even then, the payments were typically interest only and paid twice a year. When the loan matured, usually in five years, a new loan was acquired with a small origination fee. The mortgage banker originated the mortgages through lending insitutions that could located be hundreds of miles away. Most established lending institutions were in the eastern part of the United States and most lending was done primarily on farms in the newly expanding west.
Mortgage bankers were king when it came to small farm lending. There weren’t many savings and loans and the National Banking System, in existence from 1863 until 1913, didn’t allow federally chartered commercial banks to make real estate loans.
The Early Days of Finance
In 1913, the Federal Reserve System was established. Under the Federal Reserve, banks could originate a 5-year loan with 50 percent down. State banks also issued short-term loans that were interest only. The default risk on these loans was higher because the value of the property would be less than the value of the loan balance, particularly if a second or third loan was acquired.
Growth during the “Roaring Twenties” was very rapid. Banks engineered ways around government rules restricting growth and rules barring entry into lending. The building and loan banking model was in rapid growth between 1900 and 1930. A total of 5,356 institutions began the 1900’s and reached a pinnacle of 11,777 by 1930. Total assets grew from $571 million to $8.8 billion. Money was abundant and lending was easy and accessible for homeownership. As a result, property values climbed. It was fast, it was furious, it was…short-lived.
In 1929, the banks collapsed; the money was gone. Many of those short-term interest only loans fell into default, of course. The country fell into the Depression. Foreclosures increased overall, as much as 21.1 percent during the height of the turmoil. Of this percentage, 28.1 percent was on the non-amortizing loan and 17.8 percent was on the amortizing loan. Property values fell and real estate lending was about to change forever…or so it seemed.
The Depression Years
Foreclosure moratoriums became commonplace in many states which lasted until the 1940’s. Chaotic response to loss of personal income, withdrawal of cash from banks, and the banking industry’s lack of funds prompted the federal government to step in.
Under Herbert Hoover, the Reconstruction Finance Corporation (RFC) was established. This was a vehicle that allowed the government to bailout savings and loans and mortgage companies to the tune of $500 million during between 1932 and 1937.
The Hoover administration also established the Federal Home Loan Bank System (FHLBS) in the summer of 1932. Twelve Federal Home Loan Banks were established which then chartered federal banking institutions. State banks could also become members. Through this system over $200 million was lent to thift companies between 1932 and 1937.
By the time Franklin D. Roosevelt was elected President, 13,000,000 people were unemployed, totalling nearly 24% of the labor force. Roosevelt believed in an approach to homeownership that helped develop a strong middle class and at the same time provided access to housing by the poor. During this time of chaos, the government had to take steps to reestablish trust in the banking system. He expanded the finance policies of Hoover and began his New Deal program to pull the country out of depression.
The Home Owners Loan Corporation (HOLC) was established in 1933 with money from the US Treasury. The government guaranteed up to $4.75 billion in 4% notes to be issued through HOLC. More than $3 billion was loaned to homeowners who had their mortgages held by typical lending institutions: thrift companies, commercial banks, and mortgage companies. The HOLC allowed homeowners to re-negotiate their mortgages with more favorable terms as long as the outstanding balance was 80% or less of the total property value. By 1936, HOLC was out of capital and no longer lending money.
The National Housing Act of 1934 established the Federal Savings and Loan Insurance Corporation (FSLIC). This helped to shore up confidence in lending institutions by insuring loan deposits at thrift institutions. The FSLIC was abolished in 1989 after the Savings & Loan debacle and its duties passed to the Federal Deposit Insurance Corporation. The FDIC now insures deposits at all federal banking institutions.
The National Housing Act established the Federal Housing Administration (FHA) which was an insurance hedge against mortgage default. Government backing gave credibility to the institution and banks were quick to respond. The FHA insured loans under the condition that the loan-to-value was 80 percent and and loans were long term amortizing loans. The length of term started out at 15 years, but eventually stretched from 20 to 30 years. The result of a long-term loan exchanged default risk to interest rate risk. You can imagine that fluctuating interest rates over a long period of time and limited funds for lending created some issues for banks and their bottom line.
In 1938, the Federal National Mortgage Association (FNMA) was established to help banks maintain liquidity. Liquid funds for the banking industry insured that new homes could be financed. FNMA was able to borrow directly from the US Treasury and could sell FNMA shares to banking institutions. Loans guaranteed by the FHA were purchased when interest rates were high so that banks would have funds to lend. When rates went down, FNMA would sell the loans. The US Treasury covered any losses. In 1960, FNMA became a private company and in the 1990’s became a major player in the secondary mortgage market.
Post War Blues
After the shake out of the 30’s and 40’s, each decade had it’s own particular real estate finance characteristics. The 1950’s were relatively stable. Financial institutions held most of their own mortgage debt. Unfortunately, this arrangement would eventually cause a negative profit for lending institutions.
Assume thrift A lent borrower B $25,000 at 5%. Depositor’s received 3% for deposits in savings accounts. The 2% spread covered costs, operating expenses, and return on investment to the bank. Let’s say over time that depositors expected higher interest rates for their short-term deposits–6%, for instance. The thrift can lend money for mortgages at 7%. Those with a 5% mortgage have no incentive to refinance, so they keep paying their payments. During the 50’s, loans were typically assumable, so if the homeowner were to sell, the buyer would most likely just assume the old loan at 5% rather than obligate to a 7% loan. The revenues at the bank would stay the same, but their expenses would increase. The true exposure of risk wouldn’t become evident until the 1970’s.
The Vietnam war resulted in a rise in inflation during the 1960’s. By the end of the decade, inflation has increased by 75% before settling at 6.1 percent. Interest rates started to rise and a credit crunch was evident by mid-decade. Two new federal mortgage agencies were put in place so that the secondary mortgage market could expand and provide further liquidity. The 1968 Housing and Urban Development Act established the Government National Mortgage Association which guarantees bonds for FHA and VA mortgages. Fannie Mae was privatized through the same legislation.
The 70’s ushered in more inflation, as high as 13.9% by 1979. The fixed rate mortgage became a problem for the banking industry because of rising long-term interest rates. Banks were paying low short-term interest rates while the Treasury rate was growing. The secondary market became very important for bank liquidity. The Federal Home Loan Mortgage Association (Freddie Mac) was created in 1970 to issue bonds to purchase conventional mortgages. As interest rates rose, lenders began to sell their mortgages to the secondary market through FNMA, GNMA, and FHLMC. This began the steep rise in the secondary market.
By the 1980’s Fannie Mae, Ginnie Mae, and Freddie Mac held or guaranteed over 20% of all outstanding mortgage debt. All of the older, assumable mortgages became a bargaining tool for the sale of housing. Lenders eventually eliminated the assumable mortgage by instituting a due-on-sale clause in the mortgage contract. Creative financing increased, and deregulation allowed lenders to assume more risk. As a result, lending institutions began to face insolvency.
Liquidity wasn’t a problem for banks, the profit spread was. In order to avert problems, banks took even more risk hoping to grow out of insolvency. Finally, by the end of the decade, the house of cards fell and thrifts began to fail. In 1989, Bush (the senior) had FIRREA (Financial Institutions Reform, Recovery, and Enforcement Act) enacted into law.
The Secondary Market Takes Center Stage
The secondary mortgage market dominated real estate lending during the 1990’s and early 2000’s. Fannie Mae, Ginnie Mae and Freddie Mac became increasingly powerful as mortgage bankers originated loans exclusively for sale in the secondary market. The mortgage banker began the 1990’s by originating a third of residential loans and ended the decade with loan originations of nearly sixty percent of all loans. By 2002, sixty percent of all loans were securitized in the secondary market.
Fannie Mae and Freddie Mac were the most active participants in mortgage securitization among the government sponsored entities. Ginnie Mae only guarantees timely payments to investors, but does not purchase mortgages for securitization. For this reason, Fannie Mae and Freddie Mac have been hard hit by the sub-prime mortgage meltdown of 2007.
Deregulation and low mortgage standards have culminated in an eerie repeat of the activity leading to the Great Depression. Foreclosure rates are now what some consider historic rates, however, from a percentage perspective, the rates haven’t reached the highs from the 1930’s. The secondary market shakeout and subprime mess is creating a stir in the media and on Capitol Hill.
Historically, the government has been steadily interfering with the mortgage markets. Sometimes it’s been good and sometimes it’s created even greater chaos. The bailout of Bear Stearns, and now Fannie Mae and Freddie Mac, has done nothing to calm the fears of the free market. The future of the real esate finance industry will be on hold for now while the markets figure out what to do next.
