Beware: Current government mortgage relief efforts may be much costlier compared to similar efforts in the Great Depression
Saturday, October 25, 2008
Great paper by David Wheelock (2008) at the St. Louis Federal Reserve Bank, Government Response to Home Mortgage Distress: Lessons from the Great Depression. Wheelock provides a detailed analysis of the housing market crash during the Great Depression, with a focus on the governments’ – state and federal – responses to the housing downturn.
He concludes that the unmeasured costs of government actions are important: state foreclosure moratoria reduced the aggregate supply of loans, while the federal response - purchasing delinquent mortgages - may have encouraged risky lending. The U.S. economy does not mimic the days of the Great Depression, but nevertheless, the government is moving forward (it has already started) with its response to the housing market crash, and economic costs will result. I suspect that following the election, there will be a more microeconomic response involving similar policies to those taken in the Great Depression to aid delinquent mortgage loans directly. But remember, there are always winners and losers, and as Wheelock (2008) suggests, there may be more losers this time around.
I will highlight some of the points here of Wheelock’s paper, but it is definitely worth a read. Housing market statistics in the Great Depression:
- Home values peaked in 1926 (well before the 1929 crash).
- Between 1929 and 1933, foreclosures rose from 134,900 to 252,400 – almost double.
- Foreclosure rates rose to 13.3% of every 1,000 mortgages in 1933; in 1933, about 1,000 foreclosures occurred every day.
- Between 1929 and 1933, personal income fell 41%, wealth declined 25.7%, and with declining home values, mortgage debt was difficult to pay off and foreclosure rates soared.
Government responses to rising foreclosure rates:
- The first response included encouraging parties involved (borrowers and lenders) to reassess the terms of the loan, but when that didn’t work, the governments stepped in.
- State-level responses included the modification of foreclosure laws and 27 states offered explicit foreclosure moratoria; Iowa was the first to enact a mortgage moratorium.
- Foreclosure rates fell immediately – the desired benefit - and many argue that the social benefit outweighed the economic costs, which include:
- A short-term redistribution of wealth from the lender to the borrower.
- Longer term, lenders restricted loan availability, and mortgage loans became more difficult to obtain at higher rates.
- Among other programs, the federal response to the housing crash was the creation of the Home Owners’ Loan Corporation (HOLC); it was established in 1933 and eventually purchased and/or refinanced 1 million loans during the great depression.
- By 1935, the HOLC held nearly 19% of all mortgage debt on single to multi family homes.
- 20% of the 1 million refinanced mortgages by the HOLC ended in foreclosure, and relative to other lenders at the time, this rate was low.
- The HOLC was initially capitalized by $200 million and turned a profit thereafter.
- There is evidence that the enactment of the HOLC encouraged risky lending, but overall, the program likely improved housing market conditions, although some evidence suggests otherwise.
And finally, a quote from the article:
“However, the Great Depression experience may not be especially relevant for addressing how a taxpayer bailout of delinquent borrowers and their lenders would affect behavior today because of differences in the underlying causes of mortgage distress during the two periods. Conceivably, a bailout would more likely encourage risky behavior in the present situation  (in which lax underwriting was an important cause of the increase in defaults) than during the Depression (when a sharp decline in economic activity was the main cause of defaults). Thus, while the federal response to mortgage distress during the Great Depression provides insights about how the government might respond to the current wave of defaults, the very different conditions underlying mortgage distress during the two periods warns against drawing strong conclusions from the historical experience for the current episode.”
RW: Point: the implicit economic costs associated with a bailout of foreclosures in response to the recent housing downturn may be huge, larger than those of the Great Depression. Beware, because our Democratic Congress is on fire: second stimulus plan, new banking regulation, talk of foreclosure moratoria, buying mortgages at risk of foreclosure, and more.
Wheelock (2008) further reiterates how far from the Great Depression is the current macroeconomy. The stock market crash in 2007/2008 is similar to that in 1929 and serious – second only to the crash that preceded the Great Depression – but the macroeconomy does not incorporate the same stress signals as were present in previous crash environments. The unemployment rate is just 6.1% (it grew to 25% in the Great Depression) and real personal income grew 0.3% over the year (compared to a 41% decline from 1929-1933).
There’s a lot of spare capacity building in the U.S. economy – with more to come in the fourth quarter – and once the labor and housing markets starts to stabilize, the economy will take off. Further, with the help of the Fed and the Treasury to mitigate the near-term recession, when the U.S. economy starts to expand again in 2009 (provided the banking sector continues to stabilize in the near term), the recovery will be quicker than most are speculating because there will be a lot of labor and firm investment just sitting around, ready to produce again.