Real Estate Research provided analysis of topical research and current issues in the fields of housing and real estate economics. Authors for the blog included the Atlanta Fed's Jessica Dill, Kristopher Gerardi, Carl Hudson, and analysts, as well as the Boston Fed's Christopher Foote and Paul Willen.
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April 5, 2012
Debunking a popular myth about mortgage lending
In their research paper "The New Deal and the Origins of the Modern American Real Estate Loan Contract in the Building and Loan Industry," Jonathan Rose and Kenneth Snowden discuss financial innovation in the mortgage market in the 1930s. The main focus of the paper is the switch among building and loan societies (B&L) from amortization-by-share-accumulation to amortization-by-direct-reduction. To the typical reader—even one interested in the mortgage market—the topic sounds, to put it gently, quite esoteric. But I think this is an excellent paper and highly relevant to anyone interested in the financial crisis.
The authors systematically debunk a highly popular story about the history of mortgage lending in the United States. Rather than explain the story, I will quote Robert Kuttner, who exposited it in The American Prospect in July 2008:
Before the Roosevelt era, virtually all mortgages were short term loans of five years or less, typically interest-only, with the principal due and payable at the end. If the homeowner could not roll over the loan, he lost the house. As foreclosures skyrocketed, the New Deal invented the modern, long-term, self-amortizing mortgage.
Kuttner is not an economist, but most economists are equally fond of the story. As Nobel Prize winner Franco Modigliani wrote, in a book coauthored with industry expert Frank Fabozzi: "Until [the Depression], mortgages were not fully amortized, as they are now..., but were balloon instruments in which the principal was not amortized, or only partially amortized at maturity, leaving the debtor with the problem of refinancing the balance."
Modigliani is not alone, as many economists who discuss the history of the mortgage market repeat some version of the story.1 In fact, it appears that the only historical fact that most economists know about the mortgage market is that the federal government invented the amortizing mortgage during the Great Depression.
The myth of the balloon mortgage
What Rose and Snowden document is that B&Ls, which started lending money to borrowers in the 1830s, had never offered balloon products and had always demanded full amortization from their borrowers. B&Ls were the main source of residential finance on the eve of the Depression, so Kuttner and Modigliani's reading of history is clearly missing something important. I will discuss the sources of their misconception below, but first let me discuss what else Rose and Snowden address in the paper.
Rose and Snowden show that a major and economically interesting change did occur during the 1930s, but it wasn't the switch from balloon mortgages to fully amortizing loans. Rather, it was a change in the way that amortization was done. In the 19th century, the typical B&L mortgage, known as a "share-accumulation" contract, was a combination of a perpetual interest-only loan and a forced-saving scheme. When the accumulated forced saving equaled the balance of the loan, the savings were used to pay off the loan. To the borrower, the share-accumulation contract appeared much like a fully amortized mortgage today, with the borrower making a constant monthly payment until the loan was paid off. There was a difference, however, because the forced saving was not explicitly used to pay down the loan, but rather was invested in shares in the B&L.
In general, these shares were valued at par and paid dividends, which were invested in additional shares in the B&L. The loan was considered to be paid off when the borrower's accumulated investment (deposits plus accumulated dividends) reached the original mortgage balance.
Because of the role that dividends played in the amortization schedule, share accumulation did expose the borrower to some risk. If interest rates fell or credit losses were large, dividends might fall and, if credit losses were severe enough, shares might trade below par. The result was that the timing of the payoff of the loan was random, although until the Depression, it was almost always around 11 or 12 years. Starting in the 1870s, some lenders started allowing borrowers to apply the forced saving directly to the balance of the loan to reduce it. B&Ls slowly adopted the new design, called "direct reduction." Rose and Snowden document that right before the Depression, most B&Ls still used the share-accumulation system, but by the end, virtually all used the direct-reduction system.
Switch to direct-reduction contract not the result of government policy
Rose and Snowden argue that the failure of the share-accumulation model during the Depression, and not government policy, led to its demise. As mentioned above, borrowers were exposed to credit risk through their investment in B&L shares. During the Depression many B&Ls failed, undoing a lot of the amortization that borrowers had done. Rose and Snowden show that the rejection of the share-accumulation system across states was highly correlated with the number of local B&L failures during the Depression.
It is important to stress here that the switch from share accumulation to direct reduction is not what either Kuttner or the dozens of economists have in mind when they discuss financial innovation during the Depression. The share-accumulation mortgage was the antithesis of a balloon mortgage. The loan never came due, and even when the borrower lost money on the forced-saving scheme, as they did during the Depression, the borrower could keep the loan current by making the interest and forced-saving payment. The failure of large numbers of B&Ls during the Depression shows that short-term balloon payments weren't the main reason for foreclosures.
Commercial banks were small players in Depression-era loans
The historical basis for the story about the role of the government in the expansion of the fully amortized mortgage has to do with commercial banks, comparatively small players in the mortgage market. Commercial banks limited their offering to short-term, nonamortizing balloon instruments, but the banks accounted for only about 10 percent of mortgage lending in the United States in 1929. Their unwillingness to make long-term, fully amortized loans did not result from a failure of imagination or a lack of understanding of household finances but rather from legislation and regulation that forbade them from making long-term loans secured by real estate.2
The Homeowners Loan Corporation, set up by Congress in 1933 and the Federal Housing Administration, which opened its doors shortly thereafter, did insist on the direct-reduction design for all loans originated under their auspices, but Rose and Snowden argue that this had little effect on the B&Ls, which were rapidly moving in that direction anyway. Ironically, to allow commercial banks to do FHA loans, Congress had to amend the National Banking Act. In other words, the adoption of direct-reduction mortgages by commercial banks did not result from the encouragement of policymakers but rather from the cessation of discouragement.3
"Financial innovation" is incremental, not spontaneous
I am particularly pleased to see this paper, as I have been making this point in speeches,4 blog posts and congressional testimony for many years, albeit with much more limited evidence. In the interest of full disclosure, I must confess that I myself had been seduced by the legend of the invention of the amortized mortgage during the Depression, and for many years used it as an example in macroeconomics lectures. It was only when I started researching the history of the mortgage market in 2005 that I looked at the data and found that it wasn't true. Let me say that virtually no economist who repeats the story cites any data or even cites a study that uses data.
Debunking a popular story will get the most attention, but I believe Rose and Snowden have a deeper, more important point to make. That point is that financial innovation does not emerge as a bolt from the blue but typically reflects the accretion of small changes over long periods of time. Rose and Snowden describe that the emergence of the direct reduction mortgage as the dominant contract in the United States in the 1930s was the result of 100 years of incremental innovation. B&Ls, first created in England in the 18th century, came to the United States in the 1830s and were temporary associations in which a group of households would agree to contribute to a pool to provide loans to one another until all the members of the association had homes. Over the next 40 years, B&Ls morphed into permanent institutions but still retained many cooperative features. The direct reduction contract, imported from England like the original B&L idea, appeared in the 1870s in Ohio, which had a particularly innovative B&L industry.
Rose and Snowden argue that the incremental character of financial innovation is similar to that of nonfinancial innovation. They write that:
Rosenberg (1982) provides a useful conceptual framework for explaining the trajectory of innovations in the B&L industry. He emphasizes that the unit of innovation is rarely a single invention; instead, major productivity improvements are driven by the accumulation of incremental changes that follow a path shaped by compatibility with existing practices.
For researchers working on financial innovation, Rose and Snowden's paper illustrates the importance of careful and thorough historical analysis of institutions. Many researchers writing about the crisis that started five years ago make little effort to document institutional facts and instead base theories on speculation and hearsay. In recent years, researchers have argued that until the boom of the 2000s, adjustable rate mortgages, negative amortization, and down payments of less than 20 percent were rare or limited to sophisticated borrowers. Careful analysis of the historical records shows that these loan features were no rarer before the boom than fully amortized loans were before the Depression. Another problematic claim is the popular idea that, during the 2000s, the mortgage market transitioned from the originate-to-hold model, whereby lenders hold mortgages on their books, to the originate-to-distribute model, whereby they sell the loans to investors. Again, the data shows that the originate-to-distribute model was widely used throughout the postwar era and emerged as the dominant model of lending in the U.S. in the 1980s.
In conclusion, it is remarkable that despite the paucity of data and the fact that anyone alive with direct knowledge of pre-Depression era lending is a centenarian, Rose and Snowden know far more about mortgage markets in 1925 than many economists doing research on the mortgage market today do about mortgage markets in 2005.
By Paul Willen, senior economist and policy adviser at the Boston Fed (with Boston Fed economist Christopher Foote and Atlanta Fed economist Kristopher Gerardi)
1 Rose and Snowden list five examples in addition to the two I cite, but there are literally dozens more. Back
2 Adam Gordon, "The Creation of Homeownership: How New Deal Changes in Banking Regulation Simultaneously Made Homeownership Accessible to Whites and Out of Reach for Blacks," 115 The Yale Law Journal 186 (2005): 194–96. Back
3 Ironically, history would vindicate pre-Depression-era regulators' concerns about long-term fixed rate mortgages. Excessive reliance on long-term fixed rate mortgages bankrupted the savings and loan industry when interest rates rose in the late 1970s. Back
4 See slides 4–5 of this presentation at Harvard Business School in 2009. Back
March 17, 2010
Demand for subprime credit or higher housing prices: Solving the conundrum of which came first
The process of securitizing mortgages has received a lot of negative attention during the financial crisis. An oft-made claim is that by collateralizing risky subprime mortgages, securitization drove an unprecedented expansion of mortgage credit to borrowers with bad credit histories. This increase in available credit fed the housing bubble, which ultimately burst after the expansion of subprime credit had run its course. The implication is that without Wall Street's insatiable appetite for mortgage-backed securities (MBS), less bad credit would have been extended, housing prices would not have soared so high, and the subsequent housing bust would not have been so bad.
On the surface, a link between securitization of subprime mortgages and the housing bubble seems both intuitive and plausible. After all, the vast majority of subprime mortgages were sold by originators to private institutions, not the government-sponsored housing-finance agencies like Freddie Mac and Fannie Mae. These private institutions operated in the secondary mortgage market, where loans are securitized and sold to investors around the world. Figure 1A in Mayer and Pence (2008) provides a nice illustration of this pattern.
Higher housing prices, not MBS, may have encouraged subprime lending
But the arrow of causality may not run from the expansion of securitized subprime credit to higher housing prices. Rather, expectations of higher housing prices may have encouraged more lending to subprime borrowers, whose loans were subsequently securitized. (Any loan is a good loan if prices are rising, because the collateral that backs the loan is getting more valuable over time.) Both interpretations are equally validated by aggregate data. To answer the chicken-or-egg question of what comes first in the logical chain—higher housing prices or increased subprime securitization—you need to perform a more disaggregated analysis.
In a recent paper, Taylor Nadauld of Ohio State and Shane Sherlund of the Federal Reserve Board of Governors attempt to solve this identification problem. Their analysis is based on a change in regulations that could have affected the level of securitization but was plausibly unrelated to either housing prices or the demand for subprime credit. Consequently, by examining the effects of this regulatory change, the authors can ask whether changes in securitization had true, causal effects on the amount of credit extended to subprime borrowers.
Did capital requirements reduction increase the demand for MBS?
The regulatory change at the heart of the paper involves the required capital levels at five broker-dealers: Bear Stearns, Morgan Stanley, Goldman Sachs, Lehman Brothers, and Merrill Lynch. By some accounts, the rule reduced capital requirements at these five institutions by up to 40 percent. Specifically, in April 2004, the Securities and Exchange Commission amended a series of rules that had the effect of reducing capital requirements for the five broker-dealers (hereafter referred to as consolidated supervised entities, or CSEs). The change was made in response to the European Union's Conglomerates Directive that required U.S. broker-dealer affiliates to show proof that their consolidated holding companies were subject to supervision by a U.S. regulator. The rule change established an alternative method of calculating capital requirements for the CSEs, which were not already subject to consolidated capital regulation from a regulatory authority. Basically, the CSEs could use their own internal risk-based models to calculate a capital adequacy measure consistent with those put forth by the Basel Committee on Banking Supervision. (For further detail, see the Nadauld and Sherlund paper.)
The authors hypothesize that the reduction in capital requirements increased the institutions' demand for purchasing subprime mortgages from the primary market for the purpose of securitizing them either to sell to other investors or to hold themselves. That is, lower capital requirements either increased their demand to invest in subprime MBS themselves or increased their capacity as intermediaries to securitize the mortgages and sell to other investors.
Authors use two-stage strategy to support findings
The authors use a two-stage econometric strategy to identify the impact of this exogenous increase in the CSEs' demand to purchase subprime mortgages to securitize, which would have raised the supply of credit to subprime borrowers. In the first stage of their analysis, they verify that the regulatory event did indeed raise secondary-market purchases at the affected institutions. In particular, they ask whether securitization activity among the five institutions increased by more than the securitization activity of institutions that were not affected by the regulatory event. The answer is yes. According to data on privately securitized mortgages from FirstAmerican LoanPerformance, the CSE banks securitized about 32 percent more loans on average than did their non-CSE counterparts after 2003.
In the second stage, the authors ask whether the increase in CSE securitization is linked to an increase in subprime credit supply. For this step, they obtain ZIP-code–level data on mortgage originations and securitization activity from Home Mortgage Disclosure Act data and then merge these data with the LoanPerformance data. Essentially, in this stage, the authors ask whether ZIP codes that experienced higher CSE securitization activity (relative to non-CSE securitization activity) also experienced higher levels of subprime mortgage originations. The answer again is yes. The authors interpret their findings as evidence that increased demand for the CSEs to securitize mortgages resulted in increased access to subprime mortgage credit at the household level.
Analysis may need refinement
In our opinion, this paper is one of the few that has come up with a reasonable way to identify the effect of the secondary mortgage market on the ability of households to obtain mortgages. But the paper needs to address two issues in order to offer a more convincing analysis.
The first issue concerns the authors' measure of subprime credit supply. They use the ratio of subprime mortgages originated to total housing units in a given ZIP code. But this is a measure of mortgage credit issued in equilibrium. Many factors could create cross-sectional variation in this variable (across ZIP codes) that have nothing to do with differences in access to credit. For example, differences in homeownership rates, the fraction of homeowners with a mortgage, and wealth and income differences could all affect the quantity of mortgage lending in a ZIP code without explaining differences in access to credit. Of course, the authors try their best to control for such factors in their estimates, but ultimately it is impossible to control for all of them.
The second substantive issue concerns the link between the regulatory event and demand and supply for MBS in the secondary market. The authors argue that the regulatory event could have affected the secondary mortgage market through two channels. First, they argue, relaxing capital requirements may have increased the CSE banks' demand for highly rated subprime MBS. We know for certain that the five CSE institutions were heavily involved in the supply of MBS to other investors, but we also think that these institutions were investors as well. It shouldn't be too hard for the authors to find evidence of this connection, but what would be even more convincing, and perhaps more difficult, would be to review whether the CSE banks substantially increased their holdings of subprime MBS after the regulatory event.
The second potential channel involved relaxing the constraints associated with the supply of subprime MBS. In this case, capital is needed to warehouse mortgages during the process of creating securities. In addition, most deals required over-collateralization, which usually meant that the issuer would take the first-loss position. If these constraints were binding for these institutions before the regulatory event (that is, the secondary market had pent-up demand for subprime MBS), then the relief on capital requirements after the event may have resulted in increased supply. This hypothesis seems a little far-fetched to us, not to mention virtually impossible to test in the data, so the authors may be better off focusing on the demand-side effects.
By Kris Gerardi, research economist and assistant policy adviser at the Atlanta Fed (with Boston Fed economists Christopher Foote and Paul Willen)
Note: The authors were given an opportunity to respond to this blog posting. As of this publishing, the author has not commented.
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