FDR Solves The Mortgage Crisis

Home, mortgage refinancing, dollar sing, graphic of house
This column was written by Andrew Jakabovics.

"Here should be an objective of Government itself, to provide at least as much assistance to the little fellow as it is now giving to the large banks and corporations."--Franklin D. Roosevelt, April 7, 1932

The burgeoning home-mortgage crisis of 2007 bears an eerie resemblance to financial conditions 75 years ago, when FDR realized that only the U.S. government could forestall a wave of home foreclosures by directly helping "the little fellow." Today, homeowners can only hope that something akin to Roosevelt's New Deal answer to the home-loan crisis of the 1930s--direct lending to homeowners--is embraced by policymakers once again.

Today's "exotic" home loans have a lot in common with most of the loans available for borrowers in the 1920s, which were short-term, non-amortizing (interest-only) loans with a balloon payment due at the end. Because the loans were non-amortizing, no equity was built up in the home with the monthly payments. Homeowners would only build up equity through rising house prices.

The mortgage structure through the Roaring Twenties was predicated on the expectation that a refinancing into a new loan would be available at the time of the balloon payment; and until October 1929, it was. Those same refinancing expectations in the first years of the 21st century led many borrowers to take out loans they simply could not afford from lenders who convinced them home prices would only go up. Some of today's troubled borrowers never understood what would happen to their loans. Many others simply trusted that their lenders would never steer them into a loan they would ultimately be unable to pay.

In 1931, when the first batches of three-year mortgages issued in 1928 and five-year mortgages from 1926 came due, few banks were able or willing to issue new loans, leading to 1.4 percent of all U.S. homeowners losing their homes to foreclosure in a single year. Through the end of the second quarter of 2007, according to data from the Mortgage Bankers Association, 1.23 percent of home mortgages newly entered foreclosure, which could mean that by the end of the year, 1.6 percent of all homeowners may well enter foreclosure proceedings.

Those percentages, then and now, may not seem particularly high, but they mask the destruction of wealth in neighborhoods across the country plagued by a proliferation of foreclosure signs. A middle-class house worth $5,000 in 1926 was worth only $3,300 in 1932. As the historian Kenneth T. Jackson noted, "the victims were often middle-class families who were experiencing impoverishment for the first time." Today, homeowners with wealth in their homes and only a few years left to pay on a traditional mortgage suddenly are faced with the prospect of plummeting home values. The culprit is the glut of homes for sale in their neighborhood made available both by lenders selling off foreclosed properties and by neighbors who are facing a rate reset they can't pay. Loans issued between 2004 and 2006 that are resetting this year have an average 42 percent increase in the monthly payment. A $1,500 mortgage payment will jump to over $2,100, and it may go higher with future resets.

History never repeats itself exactly, yet the sudden credit crunch last month and the general tightening of lending standards could well have effects similar to the banking crisis of the Depression. Homeowners counting on the opportunity to refinance suddenly face a payment they can't make. They find themselves on a slippery slope to delinquency and foreclosure as home values shift beneath their feet.

And the historical analogy to the Great Depression's mortgage crisis is apt in more ways than one. Faced with a widespread threat to homeownership, Roosevelt put forth a bold plan, calling for legislation to protect small homeowners from foreclosure and embracing a national policy to preserve homeownership. He learned from President Hoover's ineffectual 1932 Federal Home Loan Bank Act, which created a credit reserve for lenders and yielded only three approved loans out of 41,000 applications, that the solution was not with the creditors, but with direct assistance to homeowners.

FDR's resulting legislation established the Home Owners' Loan Corporation. The HOLC was authorized to issue new loans to replace the existing liens of homeowners in default. Instead of a short-term, interest-only loan, the HOLC loans would be fully amortizing over 15 years, meaning that when the last payment was made, the borrower owed nothing further to the bank and owned the home free of any debt. HOLC was far more patient with borrowers than the banks could have been, and delinquent loans got individualized attention, including debt counseling, family meetings, and budgeting help.