« Frida Kahlo and Immigration--Skeel | Main | More Cancer--Stuntz »

Beware of the Home Owner's Loan Corporation Mirage--Skeel

As the Bush administration begins its defense of the new Treasury Department proposal to revamp U.S. financial regulation, Democrats are arguing, rightly in my view, that the more urgent concern should be to directly address the mortgage crisis. Unfortunately, Democrats increasingly are coalescing around a proposal by Congressman Frank and Senator Dodd to pump billions of dollars into the Federal Housing Administration to guarantee new mortgages that would replace troubled borrowers’ current mortgages. Proponents cite the Home Owners’ Loan Corporation, which was set up at the outset of the New Deal, as shining precedent for the Frank-Dodd plan.

The HOLC certainly sounds like a remarkable governmental success story.

Established in June, 1933, in the early months of Franklin D. Roosevelt’s first term, it handled slightly more than 1 million mortgages. Rather than simply guaranteeing the mortgages, as under the Frank-Dodd proposal, the HOLC bought them from lenders in return for a government-guaranteed bond that paid (in the end) 4% interest. Not only did the HOLC enable hundreds of thousands of borrowers to keep their homes, actually made a “small profit,” returning $16 million to the government when it shut down in 1951.

I should confess that, while I’ve done a fair amount of research on New Deal reforms, I knew little about the HOLC before all of the excited recent talk about its success. The history sounds almost too good to be true, so I’ve begun to scratch around a bit. Consider this post a very preliminary report.

In some respects, the glowing accounts of the HOLC are indeed too good to be true. Although some commentators have gushed that the HOLC saved more than a million homes, in reality nearly 200,000 of the homes (194,134 in all) later defaulted and were acquired by the HOLC, roughly half of these by early 1936. In addition, although the HOLC did return money to the Treasury, the profit and expense numbers do not take account of a variety of factors, such as the facts that the HOLC had free use of the mails, that the bonds it supplied to lenders were tax exempt, and its that financial data did not include the borrowing cost of the initial $200 million that funded the program. But these are quibbles. Even if claims about the HOLC are often exaggerated, it seems to have been a remarkably successful program.

My real worry is not with the HOLC itself, but with the repeated suggestion that a similar program promises the same or better results in our current environment. There are at least three reasons to doubt that we could expect anything like the success of the original HOLC. First, the HOLC was established at one of the bleakest moments in the Depression. Not only were roughly half of all mortgages in default, but the banking system was crippled. Hundreds of banks had failed. Indeed, according to the classic history of the HOLC, 121,391 of the loans were acquired from 6,316 closed banks that were under governmental control. Failed banks weren’t in a position to drive a hard bargain. One effect is that this enabled the HOLC to acquire troubled mortgages on very good terms. (The average HOLC mortgage, for instance, secured a repayment obligation that amounted to only 68.8% of the current value of the property– a equity cushion that surely could not be replicated in our own crisis). As bad as our current condition is, by contrast, relatively few lenders have failed, and the financial services industry clearly is strong enough to drive a hard bargain, both politically as Congress debates the enactment of legislation, and practically when it negotiates with the FHA after enactment over the terms of the mortgage reductions to be traded for FHA guarantees.

Second, the HOLC seemed to have benefitted from very favorable interest rate conditions. The short term rates at which the HOLC itself borrowed were very low during the period when it purchased most of the mortgages (1933 to early 1936), while long term rates were higher. Although interest rates currently are low, we obviously do not know whether this will continue.

Third, the HOLC benefitted from a strong rebound in property values after the depths of the Depression, both during World War II and when the GI’s returned to buy houses afterwards. The fact that the borrowers who did not default early on owned property that was significantly appreciating in value in the final decade and a half of the program surely contributed to the HOLC’s success. Perhaps U.S. property values will once again begin a steady march upward, but we cannot assume this.

Of the three factors I have mentioned, the first worries me most. The Roosevelt administration’s success in completely revamping the banking industry was only possible because of the almost unfathomably dire economic conditions of the Depression. In that unique moment, banks as an industry were weak enough to permit real reform. The financial services industry is simply not weak in the same way now. My nightmare is that some version of the Frank-Dodd proposal will be passed under a President Obama or a President Clinton, and that the analogy to the HOLC will prove to be a mirage. Rather than rescuing homeowners while disciplining lenders, it will bail out lenders, most obviously by giving the lenders sweetheart deals on the old mortgages. Not only would this reward the lenders who helped to create the crisis, but the government intervention could prolong the process of returning to normalcy in the credit markets. I hope I’m wrong, but I hope even more that lawmakers will think twice about passing legislation based on an analogy to an earlier success under conditions vastly different from our own.

TrackBack

TrackBack URL for this entry:
https://apps.law.upenn.edu/weblog/mt-tb.cgi/187

Comments ( 6 )

Not sure that this is the right answer but it is a step forward.

The program would probably work well in most respects, but possibly isn't the best alternative. It's certainly essential to rescue these bad contracts (subprime ARMs) so that both the homeowners and the lenders survive if the default is due to the poor terms. Note however, that the plan will not work if the idea is to make the homeowners in default qualify under FHA guidelines, since few will qualify. My recommendation is that instead of using taxpayer's money to assume bad contracts and replace them with more reasonable ones, Congress should just use brute legal power to suspend foreclosures of subprime ARMs that defaulted due to interest rate resets, and modify them in a way that's fair to lenders and borrowers (fix reasonable rates for 3-5 years, credit excess interest payments to principal or future interest), and hope the homeowners can carry the modified loans long enough to sell or refi. Give the borrowers and lenders a chance to make good on what were originally bad contracts under new more reasonable terms. That shouold also rescue the subprime mortgage backed securities since there would be immediate certainty of somewhat uniform new terms that borrowers would be much more likely to meet. For full details of my plan see my post of 4/6/08 regarding Skeel's article about Sen. Durbin's plan to revise the BK code to allow judges to modify mortgage principal.

Actually, this 1933 plan included "huge events" (per Orwell) which included sealing off the largest country in Europe, stealing all the assets of its citizens including their food, and selling these on world markets at discount prices.

The collateral loss of 10 million lives due to starvation has yet to appear on any balance sheet.

When this along with things like Yalta are included, we find that all of FDR's efforts were incredibly depraved.

http://cybercossack.com/?p=1099

It seems as if HOLC would have been able to get the properties at distressed prices, since the Depression caused widespread deflation due to the Fed's policy of reducing the money supply. In addition, the ethics of that era are sadly missing today. Debtors have no problem walking away from an overvalued house with a mortgage they can't pay, something that would have been horribly shameful in the 1930s.

The situation is more like the RTC's efforts after the S&L debacle in the 1980s. There were more toxic loans like the "cash for trash" deals in those property packages. I think we lost a lot of money on the RTC.

C. Harriss Lowell's definitive work* on the labours performed by the HOLC should be read and reread to understand what really happend in 1933. It is ridiculous to post a warning such as this without citing this masterful work. Or more simply Don't Shoot Your Mouth Off Until You know What Your Talking About!!!!

* Ref ISBN: 0-870-14142-2

I do not think this will work at all!! Like Skeel said ths came to the banks with nothing left to lose, for the most part the government was already in control of those loans or the other banks would have gone belly up had they not got them removed. Skeel made a bunch of good points, but one HUGE thing he missed: Most of those loans they gave those people had low rates (which we could do,) and "long" terms. These "long" terms were 20-25 years, that is not long any more, they stretched those peoples payments out that long. well now wiht the majoryt of people either on a interest only, or a 30 year amoritization that wouldn't work, you can't stretch the loan out longe enough to provide any real payment relief. I guess like everyone says something could/should be done, but I have no idea what that would be. I say audit the banks ( like they are supposed to anyway,) and find out truly how much good/ bad and ugly they have on their books or that they are on the hook for. Then go in there based on average delinquincies and other factors, Figure out what they need to have for reserves to make sure loans in default are ok. If there is enough great, and if not take over the bank asap, before anyone can parachute out or sell their stock or pull any more crap to cover up the fact that their numbers are cooked before it is too late. save some money and take it from the people who milked it. I will say this though, there is plenty of blame to go around everywhere, from Bill Clinton, democrats, republucians, Iraq, GEorge Bush, banks, title companies, mortgage people, borrowers, and non borrowers. Most everyone rode this wave the last 8 years and profited from it, either directly or indirectly, so we do have to be careful as to whom we should point the finger at.