Debt dilution in 1920s America: lighting the fuse of a mortgage crisis

Abstract

The idea that real estate could have contributed to banking crises during the Great Depression has been downplayed due to the conservatism of mortgage contracts at the time. For instance, loan‐to‐value ratios often did not exceed 50 per cent. Using newly discovered archival documents and data from 1934, this article uncovers a darker side of 1920s US mortgage lending: the so‐called ‘second mortgage system’. As borrowers often could not make a 50 per cent down payment, a majority of them took second mortgages at usurious rates. As theory predicts, debt dilution, even in the presence of seniority rules, can be highly detrimental to both junior and senior lenders. The probability of default on first mortgages was likely to increase, and commercial banks were more likely to foreclose. Through foreclosure they would still be able to retrieve 50 per cent of the property value, but often after a protracted foreclosure process. This would have put further strain on banks during liquidity crises. This article is thus a timely reminder that second mortgages, or ‘piggyback loans’ as they are called today, can be hazardous to lenders and borrowers alike. It provides further empirical evidence that debt dilution can be detrimental to credit.

Reassessing the magnitude of housing price declines and the use of leverage in the Depressions of the 1890s and 1930s

“…From the late 19th century through the 1920s, the median loan‐to‐value ratio among mortgage borrowers at origination was about 75%, and borrowing reached as much 90% or 100% of value, often on a single mortgage. In contrast, previous accounts of this period have described total borrowing as capped at around 80% at most, with first mortgages limited to 50% of value (Green & Wachter, 2005; Postel‐Vinay, 2016).…”

“…Previous scholars have generally described leverage in this period as relatively low. For example, Green and Wachter (2005) state that before the Great Depression “home mortgages typically had very low loan‐to‐value ratios of 50 percent or less.” Jaffee (1975) describes “prudent upper bounds on loans at somewhere between 50 percent and 60 percent of appraised value,” while Postel‐Vinay (2016) caps total leverage at 75–83%. Some scholars describe very restrictive leverage constraints persisting until the 2000s housing boom.…”

Money, Banking, and Old-School Historical Economics

“…Thus, the new literature on financial crises after 2008 devotes much attention to the importance of financial networks and contagion. This approach is mainly based on very detailed archival research on the financial exposures of major banks (Richardson and Van Horn 2009;Accominotti 2012;Postel-Vinay 2016;Straumann, Kugler, and Weber 2017;Richardson and Van Horn 2018), or on microeconomic data allowing to reconstruct the links between networks and financial flows (Richardson 2007b;Carlson and Wheelock 2018;Mitchener and Richardson 2019;Anderson, Paddrik, and Wang 2019;Baubeau et al 2020).…”