The Menace of Mortgage Debts: Lessons from the Great Depression Series: Part IV: Where do we go After the Housing Crash?
As we approach Super Duper Tuesday, a day that is historical in magnitude, we need to reflect on how we got into the current housing mess. It would be easy to say that the mortgage problems simply arrived over night but they have been building up for a decade. This housing crisis is unprecedented; that is until we look at the mortgage mess from the Great Depression. On Saturday, I was digging through journals written during the Great Depression and found an article written by Arthur Holden for Harpers in 1932, four years into the Great Depression. This will be the fourth part in our Great Depression series:
*A story from a lawyers perspective highlighting the societal impacts of foreclosures. Many things are eerily similar to what we are currently entering into.
2. Lessons From the Great Depression: A Letter from a former Banking President Discussing the Bubble.
*With the current corruption on Wall Street and shady rogue traders, you have to wonder when are good bankers going to step up to the plate?
3. Florida Housing 1920s Redux: History repeating in Florida and Lessons from the Roaring 20s.
*Think we can learn from history? Florida already went through what they are currently going through in the 1920s. Read for insight into future trends.
If you are interested in gaining insight into how nationwide real estate crashes unwind, I suggest you read all three articles carefully. With this article, I decided to type up important parts (which was a large part of the article) and if you are looking for perspective, I suggest you read it in its entirety. I will comment throughout the article to offer perspective and insight into today’s current mortgage problems.
The Menace of Mortgage Debts
“As the great depression advances into the fourth year it becomes increasingly apparent that the mortgage crisis involves something more than the “little fellow” struggling to keep his home. It is not only the function of “shelter” that is involved. The mortgage structure is a part of the whole economic scheme, into which is woven the intricate system of social inter-dependability which allows us to live and carry on. When the customary flow of credit is seriously interrupted at any one point many diverse processes are also interrupted upon which we depend for both the comforts and the necessities of life. Since the War the civilized world has experienced the greatest economic upheaval of which we possess a recorded history. The mortgage crisis is perhaps the final phase of this world-wide dislocation of our credit system.”
You could take the above paragraph out of any business section of today’s business journals. We are suffering much like the credit problems of the 1930s. Housing even 76 years ago had a major impact on the overall health of the US economy. This housing mess is much beyond “subprime” since housing is a staple of the American economy and we are seeing even prime loans coming under strain.
“To understand what has happened it is necessary to look at the problem in perspective. In the first place all facts are relative. We cannot understand the menace of the mortgage situation unless we consider the cost of carrying our present mortgage burden in relation to our changed national income. In 1929 the national income for the United States was 85 billions of dollars. By the year 1932 this figure had fallen to 36 billions. The most conservative figure for mortgages that I can find shows that in the year 1929 the combined total of urban and rural mortgages in the United States amounted to at least 46 billions of dollars. It is difficult to determine how much this figure has changed between 1929 and 1932. The first effect of the calling of outstanding loans was to increased the amount of money borrowed against real estate. It is safe to say, however, that any general increase in the total of mortgage loans has since been erased by the calling in of outstanding mortgages and the constant demand for the reduction of principal. I, therefore, assume that the total present mortgage indebtedness is about 43 billions of dollars.”
We already know that wage growth has been stagnant throughout the past decade. However, during the Great Depression national income fell by an astounding figure while mortgage debt remained rather stable. What this did is increased the overall burden of debt servicing with less income. Sounds familiar? We are already given an idea of why it is important to quickly adjust mortgages to current market prices to alleviate some of the burden or we will quickly fall into a similar fate.
“The reduction of the national income has had a drastic effect upon the rents which it has been possible to pay. In other words, the yield of real property has suffered a sharp decline. The best estimates that I am able to gather indicate that this decline amounts to as much as 35 per cent. Yet the fixed mortgage charges have declined hardly at all.”
We are already having predictions of this kind. Merrill Lynch went so far as predicting a 30 percent decline in national real estate. Of course to mention the Great Depression or any historical knowledge is blasphemy in today’s world of 24 hour pseudo-business cable stations. Yet we are already mentioning similar price declines in the magnitude of the 1930s. In fact, this bubble is much larger than any in history including the Great Depression.
“But the prosperity of the nation depends upon its ability to make economic use of what is capable of producing; that is, it must either consume what it produces or sell it abroad. If because of fixed contracts, real estate levies too large a tool on the national income, the amount of income available for the consumption of commodities contracts also. As a result we have industrial stagnation, followed eventually by hunger and suffering.
Production cannot be generally resumed until credits are liberated to restore the purchasing power of the people. Credits cannot be liberated for the purchase of commodities, in appreciable quantity, so long as current funds are being drained off for the liquidation of capital obligations. Increased lending for refinancing purposes will only make matters worse, because on the one hand it draws off additional funds which might otherwise have gone into compensating producers, while at the same time it reestablishes debt burdens which we acknowledge we are unable to carry. “
This is a major rub for our current economy. At least during the Great Depression, we had a larger agricultural and industrial base. The amazing thing of today’s modern economy is that we essentially had an economy that was built on trading, building, financing, and flipping real estate. Our manufacturing base is nearly obsolete due to off-shoring. The center of our economic machine was trading houses to one another in the pyramid climb to larger and bigger homes. How we went on this long is simply amazing.
“Bankers are not free agents. They are frequently compelled by law to resort to foreclosure proceedings in the interest of the beneficiaries of trust funds in cases where it is apparent that foreclosure will not only cause further misadjustments but perhaps ultimately bring a burden instead of a benefit to the mortgagee. So long as they exercise a diligence in following the prescribed legal procedure, trustees are held harmless in the eyes of the law, quite irrespective of the social consequences their actions.”
You can simply replace trustees here we hedge funds. With the Hope Now Alliance and all these ill advised “help plans” they haven’t done much since the problem isn’t just sub-prime borrowers but the “little fellow” who has good credit but is finding it ever more difficult to service their debt. Now with unemployment rising and so many people dependent on a perpetually increasing housing market, we are seeing our economy severely contract.
“For example, two friends purchased adjoining identical houses in 1926 for $30,000. A certain bank placed a $15,000 mortgage on each. In 1929 the first owner paid off $10,000 on his mortgage. The second owner, when asked to do likewise, requested a reappraisal of his property. When a value of $40,000 was placed upon it he was able to induce the bank to lend him an additional $2,000, which he explained he needed in his business. In 1932 when both mortgages again fell due the bank needed liquid capital and, therefore, asked for full payments. Neither owner was able to meet this call. A reappraisal indicated that the value of the houses had fallen to $16,000 each. On one, the bank held a mortgage for $5,000, on the other for $17,000. What did the bank do? It commenced foreclosure proceedings on the strong mortgage fro $5,000 and allowed the weaker to stand. Why? It could readily transform the smaller mortgage into an asset on its books, whereas the larger mortgage would inevitably show a loss if the property were taken over.”
You mean people were doing cash out refinancing back in the 1930s? Many mortgage brokers thought they were at the vanguard of mortgage financing but that game has been done, and nothing is new under this housing sun. I think you know how that game ended and there is nothing to stop history from repeating itself.
“It is often forgotten that real estate is a capital asset, not a commodity. Loans which are secured by capital assets are very different in their nature from loans which are secured by commodities.
Real estate for example is not consumed, it is used. Never in one year are the capital requirements of the nation bought and paid for. When a loan is made against capital the lender in a sense purchases an interest in the property, limited by the conditions of the contract. In the case of real estate he purchases a share in the property secured by a mortgage.”
How many times have we read on housing or economic blogs that housing is not a commodity? I’m surprised that somehow rules that applied seventy years ago were no longer applicable in the financial engineering models of today. A house still has four walls and a roof. Quickly we are realizing that these “outdated models” do have some fundamentals behind them.
“When dollars being to rise in value, that is to say when prices in general being to fall, fixed obligations such as bonds and mortgages and other forms of notes offer an opportunity for a quick profit. This is a phenomenon that has long been common knowledge among shrewd investors. If, however, the fall in prices continues to the point where general earning capacity is inadequate to meet fixed obligations, then these special advantages begin to break down.”
Bernanke has all but abandoned this point and remember that he is a student of the Great Depression. In his mind’s eye he feels that the Fed didn’t do enough quick enough to stop the Great Depression. His 125 basis point cut shouldn’t come as a shock to those of you who have read his research. Expect more rate cuts as he is now able to put his hypothesis to the true test in reality. This is not a trial run. The article goes on to offer 3 suggestions for fixing the current mortgage mess:
“Three ways have been suggested to take us out of our dilemma. These are:
1. Inflation of the currency in the hope of raising prices to such a basis that the nominal income in dollars will be adequate to meet fixed contract obligations, which at present seem insurmountable. There are grave technical complications which tend to offset what the uninformed consider easy advantages of inflation. For real estate these complications would be ruinous.
2. The laissez-faire method: to let contract which cannot be executed go by default. To real estate this means widespread foreclosure with properties passing into the hands of the prior mortgagee, or, where unsatisfied tax liens exist, into the hands of local governmental units. As has already been pointed out, such as method produces chaotic uncertainties and dislocations.
3. The third method offers the substitution of new machinery for the adjustment of contracts which cannot be carried out in their original terms. In brief, this means the establishment of legal sanctions to permit the waiving of accepted foreclosure proceedings in the public interest, on condition that all parties to the contract enter into new agreements which are equitable in the light of changed conditions.”
Number 1 is all but abandoned and the Fed has taken the dollar to the gallows. Number 2 isn’t happening either since we have the prospect of higher caps, massive drops in rates, and government programs such as FHASecure and the Hope Now Alliance. And the intervention hasn’t stopped yet. The third method offered the best solution in the 1930s and offers the best solution today. The only difference today is people are intentionally foreclosing and the pride of homeownership isn’t a ubiquitous phenomenon. This doesn’t change the fact that for those who still want to live in their home, laws should be allowed for cram-downs and mortgage restructuring. Good luck getting this passed with second lien holders standing to lose their entire principal. We are in for years of legal wrangling. This was addressed in the 1930s as well:
“Although legally there is nothing between strict adherence to the contract and the pleasure of the mortgagee, our great insurance companies, finding that they cannot enforce either the letter of the contract or the letter of the law, have commenced the granting of mortgage moratoriums. The situation is developing so rapidly that it is impossible to tell how far adjustments will have gone by the time this paper appears. As I write, bills have been offered in several State Legislatures providing for moratoriums on mortgage indebtedness and even on local taxation. A bill has already passed the House of Representatives in the Congress which is designed to permit a debtor to apply to the courts for the appointment of a custodian looking to “a composition or an extension of time to pay his debts.” After acceptance by a majority in number of creditors, including a majority in amount of secured claims, the court may confirm this composition.
What the nation as a whole needs is the recognition of the principle that debt claims cannot exact a higher rate of interest than the product of labor will yield. Our debt obligations, like our tax obligations, are consuming far too large a share of the nation income to-day.”
What is unfolding today seems to be an end to a super-cycle. A once in a lifetime credit bubble that permeates the entire economy. What we have here ironically is at the helm of the Fed, someone who studied deeply the Great Depression and is facing a very similar circumstance to that of 80 years ago. His hypothesis is that monetary policy could have stopped or at least mitigated some of the pain of the Great Depression. We are now seeing the theory go into practice. So far it is not working and if anything, the law of unintended consequences is showing that banks and Wall Street are benefiting more than the little fellow. You have to wonder if he is thinking, “maybe my thesis is wrong” but knowing how unwillingly many people in power are able to admit their mistakes, don’t bet on it.
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14 Responses to “The Menace of Mortgage Debts: Lessons from the Great Depression Series: Part IV: Where do we go After the Housing Crash?”
Great article. One source of confusion for me though was with regards to the solution offered by the article, particularly solution # 1. I believe the intent of the original article write on solution # 1 was that inflating the currency could bring price/wage levels in line with debt levels, since inflation reduces debt burdens, although with grave technical complications, as the article writer indicates. However, your blog post indicates that the Fed has all but abandoned solution # 1 (inflating the currency). However, I don’t think that is true, as lower interest rates will continue to devalue the dollar and lead to inflation.
That is downright spooky. Great analysis.
Wonderful. Deja Vu all over again! A thought here. We were on the gold standard at the time and real interest rates were quite low, maybe 2%. The article states that at the beginning of the Great Depression our GNP was 85 billion and the value of outstanding real estate mortgages $46 billion. I believe the ratio is higher than that today as are real interest rates. If I am correct about this, and given that installment debt was relatively new and credit card debt unknown, might we be paying even more for debt servicing today, as a percentage of national income than our grandparents were in 1929? If so, then any contraction in GDP or collapse in asset values would not have to be as large as in 1929 to set in motion the same type of bank failures and credit strangulation that occured in the years following the stock market collapse.
First of all, this is very different situation than the Great Depression. We are tied to worldwide markets (and visa-versa) to levels never before (in 1920 we were largely isolationists). Further we have much less trade protection in place. This means that businesses can weather a US housing downturn as we export (while in the ’20’s businesses looked internal to the US for markets). This will allow businesses (such as the one I work at) to weather the storm, probably quite well.
Bernanke is a small player in the scheme of housing. The banks’ benefiting is certainly Bernanke’s spectrum of influence. After all if the spigots are not open, people can’t drink. Right now the spigots of loans are largely closed and the banks need to see risk lowered and profits higher to open those spigots. So he is doing that right.
But don’t let that take away from the contraction the housing market needs to correct (or everybody here in LA needs a 100% wage increase). I figure that about 30% to 40% of the housing increase can be pegged to both lower rates and inflation. The remaining are attributed to an overall breakdown in loan industry:
1) Consumer’s expecting unrealistic returns & bidding houses up (further amplified by the Variable rate loan)
2) Loan brokers pushing people into these products, I’m certain many time very fraudulently
3) Lenders not doing the due-diligence on the paperwork (i.e. credit checks)
4) Bond market allowing crazy re-packaging of the securities
The remaining % housing price run-up due to this needs to be wiped off the face of the market to establish a firm Housing market. When that occurs I’m buying a house!
If the Fed really wants to fix the problem and not excerbate it they should get the government to eliminate all taxes on gasoline, fuel and heating oil, reduce by a percentage all wages paid to government employees, and stop playing games with the money system.
It’s true that we are much better off this time with the threat of bank runs removed. The most interesting feature for me of then and now is the mass hysteria both before, during, and after. Social creatures that we are, we not not change on this note.
But other factors are coming to bear that were not back then, peak oil being the biggest. The price of fuel is a factor in nearly everything we buy (not counting the crazy ethanol policy we have helping drive farm prices up) so barring a recession large enough (and it would have to be world-wide to have enough effect) we are going to have inflation. Low unemployment+rising prices+recession = ? We need a new term. Stagworkflation?
Bernanke’s tools are not the right kind for this situation and he doesn’t have any precedent. He’s holding a hammer when he needs a set of jewelers’ tools and a magical flashlight.
But, like you say, the little guy is going to be left holding the bag. That is if he doesn’t fight tooth and nail to force congress to hand it to someone else. On your blog roll the Bubble Markets Inventory Tracker author is watching most of these inflated sales with an eye toward revealing the fraud there. It would really bite if the criminals got bailed out on the backs of the taxpayers (or the way the government budgets now, our taxpaying grandchildren).
How do you find time to research and write all this stuff? Great article!
I’m a lawyer by training, so I tend to focus on psychological reactions on an individual-by-individual basis. I now work as an executive in a relatively old, very conservative financial services outfit. We have been watching newer outfits dropping like flys for over a year now. We also had our first customer bankruptcy in everybody’s memory in 2007.
I was out to drinks with a vendor who also had business with our competition, and got my head bitten off (figuratively) for merely suggesting that we are seeing the current troubles expanding out into the broader economy. This is from a vendor dependent on my company for business! It appeared to be a stress reaction, but I did not know where it was coming from at the time.
The young man later bragged about the 3700 sq ft home he bought last year in the hills above the city. Go figure. His market is shrinking and he bought a big ‘ol house before August 2007. I’d say that’s stressful. this is also a good example of how poor decisions snowball. I’m now watching this vendor carefully for signs of instability and actively evaluating his competitors. I don’t take anything personally, but this guy is on the edge and is showing poor judgment.
The Big Depression
Remember that in 1929 The USA was the world’s largest exporter of manufactured goods and a rising power. In the early 20th Century the USA superficially occupied the position in the global economy that China now holds. The fact that the global economy moves faster now than it did in 1929 cuts both ways. It does not mean it was not a global economy in 1929. The USA’s problems spread around the world within a few years back then. Because of the faster interplay we will see new dynamics in play, but the problem is still the same. Lack of trust and transparency in business transactions. the answer to the problem is leadership. If you think you can provide it at any level, from the household to the national level, please step up. That means putting your interests second to those of the nation, business, neighborhood or your family.
Somebody has to be George Bailey. We can’t all be Sam Wainwright.
Great post, Doc. Let’s take a quick glimpse into the crystal ball: the resets hit with full force in March, just as the “walk away” practice becomes commonplace. Unexpectedly, a bank fails in mid-summer. This creates a sensation in the media and suddenly people are talking about a ‘bank run.’ The government hurries in with ’emergency assistance’ and it seems that all will be well.
But then the unemployment numbers go through the roof because both finance and construction sectors collapse at the same time. Everyone realizes that we are over a cliff, and nobody is buying houses during the summer ‘buying season.’ Defaults surge. Fannie Mae goes bankrupt. Now people are terrified because nobody can get a house.
The final act: the government goes into full bailout mode. A four trillion dollar bailout package is approved. Inflation goes absolutely out of control. I don’t know that happens next, but it can’t be good.
“Only Yesterday,” one of the books you reference on the Depression (a very good one, in fact) is available online, courtesy of the University of Virginia, at
http://xroads.virginia.edu/~HYPER/ALLEN/cover.html
If we eliminate all taxes on gasoline, we will have to charge pretty hefty tolls on all interstates.
Perhaps that would be the way to get people to cut consumption of fuel….drop all fuel taxes and just finance the roads directly, by charging tolls on all limited access roads in the U.S. The tolls will have to be very high to carry these roads, especially if we also no longer fund them from the general budget.
I’ll bet that after a rough transition period, we would no longer need to subsidize public transit. Half the motorists would be out of their cars, especially teenagers. Others would look for places to live much closer to work. The forty-mile commutes would end very soon.
Now, if we can stop throwing $14 Billion a year in direct subsidies at the commercial airlines, the railroads might blossom again, too, with no help. Short-hop air travel would be prohibitively expensive without subsidies.
There are many places where we could make large cuts in our national budget, many of them in places the public would never miss. TIF districts and other tax funded “gimmes” for the developers of redundant commercial retail are obvious targets. My city has 190 TIF districts that are diverting billions of dollars in future taxes away from city services and into the back pockets of developers. Then, there are the pure-waste projects that are soaking up hundreds of billions more.
Pat,
I think there is one problem with your thesis that US businesses can do OK by exporting. Our manufacturing base has done nothing but shrink in recent years. What are we going to export?
@Comment by Warren
If the Fed really wants to fix the problem and not excerbate it they should get the government to eliminate all taxes on gasoline, fuel and heating oil, reduce by a percentage all wages paid to government employees, and stop playing games with the money system.”
(1) Eliminate taxes on gasoline? Oh wonderful idea- you have just increased the DEMAND for more oil from countries that hate us. Better to increase it and suppress demand.
(2) Heating oil? Okay that is good.
(3) Why do people always want to cut the pay of teachers, police and firefighters? The 3 person staff that run our village only make $14-15 an hour – and this in a place where the median list price is $389,000. In fact, during the Great Depression, the only stable incomes where from such jobs and they were the only people who had any money to spend. Why not cut the wages of CEOs who make 364 times the average worker as compared to the 40::1 ratio of 1980. Easy to do – just tax any CEO earnings above the 40::1 ratio at 100% and invest in infrastructure.
@Comment by Pat
“First of all, this is very different situation than the Great Depression. We are tied to worldwide markets (and visa-versa) to levels never before (in 1920 we were largely isolationists). ”
Pat you are confusing international affairs policy and economic policy. The US was most certainly NOT isolationist in economic matters in the 1920s or 30s. Exporting goods was an enormous part of the economy. Problem was that the crash was international because of global trade and the linkage of currencies. The gold standard tied the US dollar to every other currency and international agreements prohibited cutting the dollar so as to cause inflation. In order to inflate the currency, FDR took the US off the gold standard.
@@@ For those not trained in the history of the Great Depression, I always recommend “Freedom from Fear: The American People in Depression and War, 1929-1945” (Oxford History of the United States) by David Kennedy as a good comprehensive 1 volume start on learning more.
BTW Pat would do you suggest we export? Vacations? Bric-brac junk bought from junk for resale? What does the US actually make (and don’t say ‘financial services advice’ which is were the growth has been the past 15 years or more) If WWII occurred today, we would all end up speaking German as we don’t have a 10th of the manufacturing capacity in operation now that we did then.
I’d accept a pay cut if I only had to work 9/12 of the year, how bout you?
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