Study of Great Depression Shows Intervention Postpones Foreclosures, But Causes Mortgage Rates to Spike
By William Patalon III
Executive Editor
Money Morning/The Money Map Report
It was January 1934. The Great Depression was five years old – but still had another five years to run.
The carnage was horrific: From 1929 to 1934, U.S. personal income plunged 44%, real output nose-dived 30% and 25% of the American labor force was unemployed.
With the nation’s economic landscape laid to waste, it should be no surprise that home foreclosures were soaring, too: Residential real-estate foreclosures doubled between 1926 and 1929 – before the Great Depression actually began. According to a new study by the Federal Reserve Bank of St. Louis, the foreclosure rate jumped from 3.6 per 1,000 mortgages in 1926 to 13.3 in 1933. In that year, in fact, 1,000 home mortgages were being foreclosed each day.
Indeed, by Jan 1, 1934, as many as half of all residential mortgages were delinquent, putting them at risk of foreclosure.
Clearly something had to be done, elected officials believed. In an attempt to slow that surge, 27 states changed key laws in a way that created a temporary moratorium on foreclosures. Still other state and municipal governments passed permanent measures that made it tough for aggrieved lenders to foreclose on properties whose mortgages were delinquent.
With the benefit of hindsight, it’s not at all clear that the benefits of these moves outweighed the costs – many of which were unintended, says Daniel C. Wheelock, a St. Louis Fed economist and the author of the new research study, “Changing the Rules: State Mortgage Foreclosure Moratoria During the Great Depression.” The study appears in the November/December issue of the St. Louis Fed’s Review magazine, which covers national and international economic developments – especially when there’s a monetary impact.
“Governments cause both immediate and long-term effects when they rewrite the terms of contracts between private parties,” Wheelock wrote. “One immediate effect of mortgage-relief legislation during the Depression was reduced [disclosure rates on farms, which were being hit even harder than the residential real estate sector]. However, over the longer run, foreclosure moratoria and other changes in mortgage laws may have made loans costlier or more difficult to obtain” for future borrowers.
Indeed, the study shows that future borrowers had to face a marketplace where loan capital was in short supply and interest rates were sky high. Lenders made loans tough to get – and then charged a lot for them via high interest rates – because they needed to compensate for the very real possibility that these new laws would restrict their ability to foreclose on delinquent loans.
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Fast-forward 74 years, to 2008. Nearly 1% of U.S. home mortgages entered foreclosure during the first quarter; by the time that three-month stretch came to an end, nearly 2.5% of all U.S. mortgages were in foreclosure.
And the news keeps getting worse. In the July-September quarter, 18% of all properties with a mortgage were “underwater” – that is, worth less on the market than what the owner owed on the loan, data supplier First American CoreLogic Inc. told BusinessWeek. It gets worse. That statistic represents more than 7.5 million properties, and another 2.1 million mortgages were within 5% of shifting “upside down.”
All told, nearly a quarter (23%) of U.S. mortgages were underwater or were in a near-negative-equity position. Nevada (48%) and Michigan (39%) led the nation with the highest percentages of negative equity, followed by Florida (29%), Arizona (29%), California (27%), Georgia (23%), and Ohio (22%).
In late July, U.S. President George W. Bush signed the Housing and Economic Recovery Act of 2008, whose provisions included a $300 billion increase in Federal Housing Administration loan guarantees – which were designed to induce lenders to refinance delinquent home mortgages.
A foreclosure-prevention mentality took hold, with loan modification plans and programs such as Hope for Homeowners becoming increasingly common, HousingWire.com reports. Such states as Massachusetts, as well as some local cities, have sought to put foreclosure moratoriums in place; federal legislators, too, have tried to get in the act.
A tentative Bush Administration plan aimed at keeping as many as 3 million homeowners who are behind on their mortgages from losing their houses will be difficult to administer, and could end up costing the country hundreds of billions of dollars more than the plan’s architects expect, a Money Morning contributing editor and credit-crunch expert says.
R. Shah Gilani, a retired hedge-fund manager and Money Morning contributing editor who is emerging as an expert on the worldwide financial meltdown, noted that the plan was apparently still that – a plan. Even so, he said that “any bailout plan that directly addresses foreclosures is political posturing that will ultimately be overwhelmed by inevitable economic realities.”
The plan – which would be part of the $700 billion banking-system rescue package the government approved early this month – would cost $40 billion to $50 billion, with the money being used to cover future losses on loans that are deemed eligible for federal support.
The New York Times carried the first reports of the Bush Administration’s new housing rescue proposal last Thursday. According to the newspaper report, this program would be the most sweeping and direct government initiative aimed at home-loan borrowers since the financial crisis started last year.
Unfortunately – at least with respect to the contentions made by the St. Louis Fed study – this program is a classic foreclosure-moratorium initiative.
As proposed, the federal government would incur half the loss on a home loan if the mortgage company that controls the loan agrees to lower the borrower’s monthly payment for at least five years. On any given loan, the mortgage company would reduce the payment borne by the homeowner by writing off part of the loan balance, reducing the loan’s interest rate or changing other loan terms, sources told The Times.
In this case, the devil truly will be in the details: Trying to take a massive rescue plan – and matching the benefits up with individual homeowners – may be just too much to ask, Money Morning’s Gilani says.
“Who will be eligible, how will that be determined, what will happen when prices continue to fall and mortgage holders eventually walk away” are just some of the tough questions a workable plan would have to answer, Gilani said. Plus, “is the government going to shackle them to their mortgages the same way they’re shackling taxpayers to all these other ill-begotten bailout schemes?
When it comes to the idea that money from the federal government’s Troubled Assets Relief Program (TARP) may be used to manage a bailout of troubled mortgages, all options are still on the table, and the plans under consideration have been stuck in the negotiating room for some time, HousingWire reported.
In a story earlier this week, The Wall Street Journal suggested that “disagreements over how to structure a federal foreclosure-prevention program are complicating and potentially delaying what is likely to be the Bush Administration’s last attempt to forestall sliding home prices.”
According to another HousingWire report, one plan that may be gaining some support is the idea of a federal subsidy for troubled borrowers. On Sunday night, a source near the Pennsylvania office of U.S. Sen. Robert P. Casey, D-Pa., provided the housing news service a copy of a memo that’s said to have sparked some of the ongoing negotiations now taking place.
The memo outlines the mechanics of a mortgage bailout that would cost as much as $441 billion, relying primarily on a three-year subsidy for troubled borrowers that would be repaid in five years, with interest. At that point, the participants would likely be able to sell their homes or refinance the mortgages at amounts that would enable them to repay the loan.
The subsidy plan reportedly represents the thoughts of Assured Guaranty Ltd. (AGO) Chief Executive Officer Dominic J. Frederico, who had been asked by legislators to provide his thoughts a few weeks earlier.
Other proposals are being studied, as well.
No matter what shape or form they take, however, Wheelock, the economist, warns that there will be a price to pay. There’s something to be said for allowing the marketplace to work – and an operational free market includes defaults and foreclosures, with the end result being that only the strongest borrowers remain in the end.
It’s a lesson we should have learned during the Great Depression, Wheelock says.
Wrote the St. Louis Fed economist: “The [foreclosure] moratoria reduced … foreclosure rates in the short run, but they also appear to have reduced the supply of loans and made credit more expensive for subsequent borrowers. The evidence from the Great Depression demonstrates how government actions to reduce foreclosures can impose costs that should be weighed against potential benefits.”
News and Related Story Links:
- Federal Reserve Bank of St. Louis:
Review Examines Foreclosure Relief during Great Depression. - Federal Reserve Bank of St. Louis:
Changing the Rules: State Mortgage Foreclosure Moratoria During the Great Depression.
- HousingWire.com:
Feds May Be Considering Subsidy on Troubled Mortgages. - HousingWire.com:
History Warns Against Foreclosure Moratoria: Study. - BusinessWeek.com:
Lots of homes ‘underwater’ on mortgages in U.S. - Money Morning News Analysis:
Credit Crisis Expert Says Proposed Plan to Bail Out Delinquent Homeowners May Face Too Many Problems to Succeed. - The New York
Times:
Government Said to Be Discussing Plan to Aid Homeowners. - Money Morning News Analysis:
Banking Bailout Becomes Law With House Vote, Bush Signing. - Money Morning Credit Crisis Investigative Series:
Heads They Win, Tails You Lose: Why the Bailout Plan Will Fail U.S. Taxpayers. - Money Morning Special Investigation of the Credit Crisis (Part I):
The Real Reason for the Global Financial Crisis…the Story No One’s Talking About. - Money Morning Special Investigation of the Credit Crisis (Part II):
The Credit Crisis and the Real Story Behind the Collapse of AIG. - Money Morning Special Investigation of the U.S. Credit Crisis (Part III):
How Complex Securities, Wall Street Protectionism and Myopic Regulation Caused a Near-Meltdown of the U.S. Banking System. - Money Morning Special Report: How to Fix the Credit Crisis (Part IV):
Dear Hank: Here’s How to End the Credit Crisis at No Cost to Taxpayers. - Money Morning Special Investigation of the U.S. Credit Crisis (Part V):
Heads They Win, Tails You Lose: Why the Bailout Plan Will Fail U.S. Taxpayers. - Money Morning Special Investigation of the U.S. Credit Crisis (Part VI):
Credit Crisis Update: An Inside Look at the Commercial Paper Debacle. - Money Morning Special Investigation of the U.S. Credit Crisis (Part VII):
Inside the Credit Crisis: How the Fed’s Efforts to Lower the Fed Funds Rate May Leave it Powerless to Stop the Financial Meltdown. - Money Morning Special Investigation of the U.S. Credit Crisis (Part VIII):
How U.S. Missteps Triggered a Spiral of Worldwide Margin Calls and Deepened the Financial Crisis.
- Money Morning Special Investigation of the U.S. Credit Crisis (Part IV):
Fears of Mortgage Rate Re-Sets May Fuel LIBOR Manipulation and Mask Deeper Banking System Problems.
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Comment by Joe L. Henderson on 6 November 2008:
Despite the 74-year should not hindsight, a little digging will show the nation came very close to revolution, coup, civil war, call it what you may. WPA and CCC along with other measures helped choke off the brown shirt rallies. So if we adamantly stay with no interferece policies we may well risk a return to those times.
Comment by Bill Zielinski on 12 November 2008:
The government’s response to the mortgage crisis has since the beginning been uncoordinated and ad hoc. The latest brainstorm to modify delinquent mortgages will probably be counterproductive in many ways and only serve to prolong the write offs and housing slump. There is a significant moral hazard in this program since it will be very tempting for the 12 million households that are now in a negative equity position, but current on their mortgages, to stop paying or demand concessions on their rate and loan balance. This situation could open the floodgates to every larger loan modifications causing further asset destruction and more mortgage write downs.
There could be significant social backlash from the 40 million homeowners who own their homes free and clear and who will see the loan modifications for others as inherently unfair and a cost that they wind up paying.
For a nation overwhelmed with debt on every level, the loan modification program serves to legitimize debt repudiation. If mortgages can be written down, what’s next in line? Debt destruction and asset destruction go hand in hand; wealth will continue to evaporate on a massive scale thus guaranteeing further economic problems.
If the government believes that a 34% or 38% debt ratio is the most that can be handled without a risk of default, then by extension, no mortgage should be approved by Fannie or Freddie or the FHA, etc. where the borrower’s front end debt ratio exceeds this level. Yet, everyday, I see borrowers being approved at debt ratios far in excess of 38%, thereby producing the next crop of “loan modifications” and more loan write offs.
Like many good intentioned government programs, the current rush to modify millions of loans will in the end probably result in more harm than good.
Pingback by ------ THE SKY IS FALLING ------ - Page 371 - The Environment Site Forums on 24 December 2008:
[...] then had mortgages & insurances to pay It seems history was ignored in this statement …. Study of Great Depression* Shows Intervention Postpones Foreclosures, But Causes Mortgage Rates to S… With the nations economic landscape laid to waste, it should be no surprise that home [...]