Real Estate Research

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Real Estate Research provides analysis of topical research and current issues in the fields of housing and real estate economics. Authors for the blog include the Atlanta Fed's Kristopher Gerardi, Carl Hudson, and analysts, as well as the Boston Fed's Christopher Foote and Paul Willen.


« Securitized mortgage loan or not, lenders are not restructuring | Main | Revisiting real estate revisionism: Concessionary mortgage modifications during the Depression »

November 15, 2010


Mortgage relief in the Great Depression

Bemoaning the unwillingness of lenders to renegotiate loans in the current mortgage crisis, critics often point to the "old days" when, they argue, foreclosures were a rarity because of a different institutional setup. John Geanakoplos and Susan Koniak took this view in an op-ed they wrote for The New York Times.

In the old days, a mortgage loan involved only two parties, a borrower and a bank. If the borrower ran into difficulty, it was in the bank's interest to ease the homeowner's burden and adjust the terms of the loan. When housing prices fell drastically, bankers renegotiated, helping to stabilize the market.

Luigi Zingales uses almost the same language to make the same argument in an article in The Economist's Voice.

In the old days, when the mortgage was granted by your local bank, there was a simple solution to this tremendous inefficiency. The bank forgave part of your mortgage….

But what evidence do we have to back up these claims? The authors do not provide any direct evidence, do not provide a source for the evidence, and are not clear about what exactly they mean by "the old days." Until recently, there was little hard evidence on the subject. However, the simple existence of foreclosure crises in the past—in New England in the 1990s, for example, and across the nation during the Depression—is, at least on the surface, evidence that large numbers of mortgages escaped the seemingly win-win solution of modification even in the past.

In the last two years, two researchers, Andra Ghent of Baruch College and Jonathan D. Rose, an economist with the Federal Reserve System's Board of Governors, have gone to the records from the Depression, in one possible definition of "the old days," to see if, indeed, lenders renegotiated on a wide scale. Looking at the Depression gives us a good opportunity to test the theory that our current set of institutions are the problem because the institutional setup was different during the Depression—and if there was ever a profitable opportunity to modify loans, it was the period from 1932 to 1939. The extent of the crisis at the time minimized the information problems that we argue prevent profitable modifications now. Even if some borrowers who received modifications then could have afforded to repay their loans or more than their modified loans, there were so many deeply delinquent borrowers that the gains on the rest should have made up for it.

Comparing the 1930s Home Owners Loan Corporation to today's programs
In this post, we focus on the paper by Rose, who explores the Home Owners Loan Corporation (HOLC), a federal program aimed at transitioning troubled borrowers into new loans. (We will focus on Ghent's paper in the next post.) Many of today's critics have held up HOLC as an example of enlightened government policy; it was the model of the Hope for Homeowners (H4H) program enacted by Congress in 2008. Rose argues in his paper that, contrary to popular belief, HOLC actually did not offer particularly good terms to borrowers and instead focused mostly on assisting banks.

The last time that national housing prices crashed as low as they have over the past three to four years was during the Depression. As with today's crash, the 1930s fall coincided with a rash of mortgage defaults and foreclosures. According to Wheelock (2008), by 1933, 13.3 of every 1,000 mortgages in the United States was in foreclosure, and by the beginning of 1934, almost half of all outstanding urban home mortgages were delinquent. To stem the rising tide of foreclosures, the Roosevelt Administration created HOLC in 1933. Over the following three years, HOLC purchased and refinanced more than 1 million delinquent home loans. Although 1 million loans may not seem like that many, keep in mind that the U.S. mortgage market was significantly smaller 80 years ago and that current government programs have permanentlymodified or refinanced far fewer than 1 million loans during this crisis.

HOLC was a voluntary program that aimed to prevent foreclosures by refinancing troubled borrowers into mortgages that were more affordable. The program accepted applications from borrowers from June 1933 to November 1934, and then again from May to June 1935. Rather than paying cash for the mortgages, HOLC exchanged its own bonds for the lender's claim on the underlying house. The tax-exempt bonds were essentially equivalent to U.S. Treasury securities and thus could be considered very low-risk assets, especially relative to mortgage debt at the time. After HOLC purchased the loan from the lender, it would issue a new 15-year, fully amortizing mortgage at an interest rate of between 4.5 and 5 percent. The HOLC loans contained no prepayment penalties and had an interest-only option for the first three years. Thus, in most cases, a HOLC refinance gave the borrower a more affordable mortgage by lowering the interest rate and stretching out payments. Like modification programs today, HOLC tried to help borrowers in financial duress, discouraging applications from borrowers who just wanted a lower interest rate or borrowers for whom a refinance from a private lender was a viable alternative.

Did HOLC inflate home appraisals to encourage lenders to modify loans?
Until Rose did the research for his paper, a lack of data—other than a handful of aggregate statistics—prevented us from knowing much about HOLC activities. However, Rose was able to obtain loan-level data for a sample of HOLC loans from New York, New Jersey, and Connecticut.1 His goal was to analyze how HOLC encouraged lenders to part with their loans—after all, although HOLC bonds were much less risky than the mortgage debt that lenders held on their portfolios at the time, the bonds also carried lower interest rates. Thus, some 1930s lenders could have decided to take their chances with their old mortgages and refuse participation in the government's program. One key factor affecting the lender's decision was the amount of mortgage debt that HOLC was willing to refinance, which because of a combination of law and HOLC policy, was only 80 percent of the value of the property as estimated by a HOLC appraisal. If the amount of the new HOLC mortgage was lower than the old mortgage, then a participating lender would receive a "haircut" on the loan and the borrower would receive a principal reduction in addition to a lower interest rate and longer maturity schedule.2

Rose's main finding is that HOLC seems to have recognized that placing a low value on the house would make it more likely that the lender would have to offer a principal reduction, so that a low appraisal would reduce the chance that the lender would participate in the program. As a result, Rose argues, HOLC tended to place high values on properties in its appraisal process. This practice was good for lenders, who, in many cases, were paid in full for their mortgages. But high appraisals were bad for borrowers, because they made principal reductions less likely.3

A strength of the Rose paper is a careful explanation of how HOLC appraisals came to be relatively high. The HOLC appraisal formula consisted of three components. The first was the estimated present market value of the property, as in today's appraisals. The second was the  estimated cost of purchasing the lot and constructing a similar structure. The third component was capitalizing the estimated monthly rental value of the property over the past ten years over a ten-year period assuming no discount rate. HOLC averaged these three measures to determine the final appraised value.

Because of the dramatic decline in housing values at the beginning of the Depression, the second and third measures were typically higher than the first one, the market-based measure, which resulted in appraisals being higher than market values on average. According to Rose's data, which consists of loan applications that HOLC accepted and mortgages that they refinanced, the appraisals exceeded the market-value estimates almost 74 percent of the time and equaled the market-value estimates approximately 8 percent of the time. The value that came out of this process was not necessarily the actual value the organization used, however. HOLC performed two additional reviews (at the district and then the state level) on each application to guard against any obvious errors. These two reviews were highly subjective. HOLC's policy was that these reviews could lower the final appraisal without bound but could raise the appraisal only by 10 percent. According to Rose's analysis, the final appraisal exceeded the market value estimate in 58.5 percent and equaled it in 10.6 percent of the cases, showing that the review process was proactive in adjusting the values that came out of the three-component appraisal formula. Even more compelling is the fact that almost one-third of the HOLC refinances had amounts that exceeded 80 percent of the estimated market value of the property, while HOLC regulations meant that none had amounts that exceeded 80 percent of the final appraisal.

Inflated appraisals helped keep Depression-era banks solvent, at the expense of homeowners
We view these findings as convincing evidence that HOLC was inflating appraisals in order to increase lender participation rather than directly reducing principal or trying to make lenders take write-downs. Rose takes this reasoning a step further and concludes that the inflated appraisals were motivated by the desire to keep banks and other lending institutions solvent, at the expense of mortgage borrowers. While he cannot offer a straightforward way to confirm this interpretation, Rose does offer some tantalizing contemporaneous quotations to support it. For example, he includes this quote from one of the HOLC loan examiners:

There seems to be a deliberate effort made by the Connecticut officials to make high appraisals with the purpose of holding up real estate values. We have had this suspicion confirmed in a recent interview with the State Counsel, Mr. Tierney. This gentleman, during a call in our office last month, stated that they believed it necessary, to prevent depreciation of realty value as much as possible so as to maintain the soundness of the banks and other financial institutions which had made mortgage loans during the past 5 years, to make high appraisals. His opinion was that many of these financial institutions would be today in an unsound condition if their mortgage loans were appraised on a basis of today's realty values. This statement is illuminating when appraisals by our Connecticut offices are being analyzed. (p. 19)

One potential problem with Rose's interpretation is that it assumes HOLC didn't negotiate to the fullest possible extent with lenders. That may be true, but it's also possible that lenders were unwilling to substantially write down loans, which would have forced HOLC to maximize lender participation by paying high prices.

What does the HOLC experience teach us about the current foreclosure situation?
Lenders today still seem reluctant to modify large numbers of troubled loans. In the Depression, HOLC solved the problem of lender reluctance with high appraisals and by essentially transferring a large amount of mortgage credit risk from the private sector to the public sector. By contrast, in today's Home Affordable Mortgage Modification (HAMP) program, government payments encourage a modification only when the modification is determined to be a win-win proposition for both the borrower and the lender. The small number of modifications to date may suggest that the number of win-win modifications is low. In other words, just as in the Depression, today's lenders may be willing to take their chances with existing mortgages rather than offer generous concessionary modifications to borrowers.

We find the HOLC policy of refusing to directly reduce mortgage principal to be potentially informative to the current modification debate in another way. Principal reductions appear to have been as rare in the 1930s as they are today (more on this in our post about the Ghent paper). Many have blamed securitization by private institutions for this pattern today, but if securitization were the real culprit, how do we explain a similar lack of principal reduction in a period when securitization was basically nonexistent?

By Chris Foote, senior economist and policy adviser at the Federal Reserve Bank of Boston, and Kris Gerardi, research economist and assistant policy adviser at the Federal Reserve Bank of Atlanta

1 While these three states are not necessarily representative of the entire country, they were among the worst hit by the foreclosure crisis of the 1930s.


2 HOLC could purchase the loan at full value from the lender and extend the borrower a principal reduction, but Rose shows that HOLC never did this.

3 Of course, even borrowers who did not receive principal reductions were helped because they could swap their short-term balloon mortgages with longer-term HOLC loans. A longer amortization period tends to lower monthly payments, which make homeownership more affordable. Borrowers who could not roll over balloon mortgages when they came due no doubt found HOLC mortgages particularly helpful in preventing foreclosure.

November 15, 2010 in Housing prices, Loan modifications, Mortgage default | Permalink

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