The Mortgage of the Future
The Perezes’ mortgage is typical of the boom era’s excesses, a Pick-a-Payment loan that allowed borrowers to pay less than the full interest due. It came from World Savings Bank, which was later acquired by Wachovia Mortgage, now part of Wells Fargo Bank (WFC). The couple mistakenly believed that because they were making 26 payments a year rather than 24, they were paying off the loan on an accelerated schedule. Instead, unpaid interest was getting added to the principal; they were getting deeper in debt. (Wachovia Mortgage’s lawyer on the Perezes’ foreclosure case did not respond to a request for comment.)
“What’s sad is that I didn’t educate myself,” Rosemarie says on a rainy Thursday evening at the dinner table, having just made the long commute home from her bus route. “I was so naive. I just thought, ‘Everybody does it. It has to be right.’ ” She adds: “We thought we were going to be happy here. I feel like we really failed.”
Up until the 1920s, loans typically were for half the value of homes or less, which was good and bad: Lenders had a thick safety cushion, but creditworthy people were cut off from homeownership. Starting in the 1920s, building and loan associations started offering loans up to two-thirds of the home value as well as second mortgages that raised total lending to 80 percent of home value; by 1929 those institutions dominated the mortgage market.
It was, like the 2000s, a decade of innovation and overleverage. Private mortgage insurers grew rapidly. There was even an early stab at securitization: Collateral trust certificates of participation, as they were called, passed through to investors the cash flows on underlying mortgages. Housing finance was entirely private; there were no government guarantees.
The system came crashing down in the 1930s, destroyed by the bust in home prices and record unemployment that left homeowners unable to keep up payments. Private mortgage insurers failed, building and loans stopped making loans, and participation certificates lost most of their value. ‘When such a delicate structure is once disorganized, it is a tremendous task to get it into a position where it can again function normally,’ Henry Hoagland, a member of the Federal Home Loan Bank Board, observed a few years later.
That’s when things got interesting. FDR concluded that fixing housing was not only merciful but essential to getting the U.S. economy back on its feet. On Apr. 13, 1933, he asked Congress for legislation to protect homeowners from foreclosures and to reduce the burden of mortgage debt.
Congress responded with a speed that modern lawmakers could scarcely imagine. ‘Senate hearings were started after a week’s delay but were terminated after two days to speed action,’ C. Lowell Harriss of Columbia University wrote in a 1951 study of the episode. In pushing ahead, Congress turned aside objections from the New York State League of Savings and Loan Associations, which said ‘every reasonable consideration’ was already being extended to worthy homeowners.
Legislation establishing a Home Owners’ Loan Corp. passed the House 383 to 4 and sailed through the Senate in June 1933 on a voice vote. The new agency bought defaulted mortgages from lenders, generally at 100¢ on the dollar, and replaced them with healthier ones—fully amortizing loans with long terms (originally 20 years) and fixed rates of interest. Down payments were a conservative 15 percent. By 1936, when the Home Owners’ Loan Corp. stopped restructuring loans, it held mortgages on 1 in 10 owner-occupied homes in the U.S.
But to make safer loans possible, the federal government thrust itself into what had always been a private matter—borrowing to buy a house. Lenders were unwilling to make long-term fixed-rate loans without a safety net. So, through new agencies such as the Federal Housing Administration (1936), the government promised it would make lenders whole if borrowers defaulted. That opened the spigot of private credit.
The seat-of-the-pants experiments of the New Deal changed American housing finance forever, mostly for the better. Even today, the U.S. and Denmark are the only countries in the world in which borrowers can pay off their mortgage over a period of as long as 30 years and at an interest rate that never changes. ‘The new long-term mortgage was of course no panacea for U.S. banking problems … but it helped,’ economists Susan M. Wachter of the University of Pennsylvania’s Wharton School and Richard K. Green of George Washington University wrote in a research paper in 2005.
The most innovative ideas for housing finance can’t be categorized as left or right. Figures as diverse as liberal investor George Soros and the GOP’s Scott Garrett suggest that the U.S. adopt some variant of European covered bonds, which are safer than U.S. mortgage-backed securities. The Danish mortgage system dates back to the reconstruction of Copenhagen after the Great Fire of 1795. Unlike American banks that securitize their loans, Danish mortgage lenders retain the full risk of default, giving them an incentive to underwrite cautiously. The loans are packaged into covered bonds. In more than 200 years, there has never been a default on one of these bonds. And though Denmark’s housing bubble was even bigger than the U.S.’s, its foreclosure rate has remained low. One downside is that the system is best suited to long-term mortgages. The system is under strain now that 44 percent of Danish loans are adjustable-rate mortgages.
Want more ideas? Andrew Whinston, a University of Texas at Austin professor of management science and information systems, says securitization could be fixed by making contracts ‘dynamic’ instead of ‘static.’ To make sure lenders have skin in the game, they wouldn’t get paid all at once. Ralph Y. Liu, a Wharton MBA who is managing director of the PeoplesAlly Foundation, promotes a hybrid form of homeownership in which a renter contributes 10 percent of the purchase price in return for a tenth of any appreciation (or depreciation) in the property’s value.