FDR, Some Cultural History, and the Sub-Prime Crisis

by Sara -- a reconstruction

Sadly, the last version of this disappeared into Typepad Heaven. 

Way back when I was teaching, I used to give students zerox copies of the forclosure and bank sale notices from the local papers from the early 1930's, and send them out to map and describe what they could actually see as the indications (in an almost anthropological sense) about the impact of the Great Depression of the late 20's and early 30's.  What I wanted them to comprehend was less the arguments about what was done about those times, but more about what really went wrong, and ultimately how things were fixed.  In essence, I wanted them to have good pictures in their heads as we evaluated what FDR actually did, and the results, and how we should evaluate those results. 

Virtually every city in the US has an architectual line between late 1920's domestic construction, and what was built in the late 1930's.  Most of the lines are mixed constructions -- you will find 2 story houses with gables and creative lines, mixed in with small, well-built, what we today call starter homes, single story, cape cod or ranch styles, rather simple in design.  This is where the speculative builders of the 20's left lots in between their offerings, and then in the late 30's, with land released by the banks, those who were following the modest income and credit codes of FDR's FHA Mortgage program, built the next generation of houses.  Between the houses of the 20's, and the late 30's is a revolution in Housing Finance as well as ultimately, a considerable cause of the Great Depression. 

Prior to the Depression, the majority of homes were purchased on a short term note.  You got a note for 5 years, with a balloon payment at the end, and then one negotiated with the bank for a new note covering the balloon.  Of course the rate of interest would be adjusted with the new note.  But what happened in the 1920's, at a time when commercial and investment banking were not seperate, was that Banks moved assets into the attractive stock market which was zooming, and then, after 1929, when they went bust in the market, the liquid cash available to re-finance the balloons simply disappeared, and the Banks took back the housing where owners could not meet the balloon or had cash to cover.  It was not at all unusual after 1929 for Banks to repossess homes that were nearly 2/3rds paid up, with all owner-equity being lost.  So families doubled up, tripled up, and tried to keep one note paid up.  None the less the Banks, repossessing acres of property, mostly failed by the dawn of the FDR Administeration.   As an example, the Bank of Akron President Wendell Willkie, eventually, after reorganization, paid .07 cents on the dollar for savings accounts when it became Second National. 

The New Deal contained three elements of a solution to this problem.  First, the division of Banking into two segments, Commercial and Investment, with only small accounts in the commercial segment insured. In addition, the Savings and Loan segment was created, which advantaged small savers with insured accounts, and a small advantage in savings interest rates, but a clear restriction on lending -- limited to local housing that met FHA standards.

What FHA offered was pretty simple, an inspection system that validated whether the construction of a house met all codes, local, and their own, and insurance to the lender if buyers met credit standards.  FHA had a cap on the amount of loans, which was what forced the change in design from the gargoyles of 20's style, to the cape cod or ranch design of the late 30's.  Porches, sun and front were eliminated, Entry Halls disappeared, rooms got downsized, and kitchens became streamlined with the efficent work triangle, but became much smaller. Compared with the 1920's nothing anticipated having household help. 

But financially, these new houses, and all that came after them with VA and FHA insured mortgages, offered relatively low down payments, and 20 year or later 30 year mortgages at a fixed rate.  Over time the cap on loans was raised to accomodate inflation and some additional expectations in what was a basic house, but until the late 1970's the early 1930's reforms held.  Local savings converted into local mortgages, with the lender insured. 

In his second Inaguaral Address, FDR's famous words were about one third of this nation being Ill Housed, Ill Clothed and Ill Fed. FHA which was on the books, but had not yet kicked in, began to deal with the housing problem on the margins.  That's what those older "Starter Homes" really represent that I taught my students to find and mark on maps as an indication of the impact of the Great Depression.  But what made that recovery possible was not white lightening or political rhetoric, it was something we hate to discuss -- pure and simple regulation of the banking and financial sectors of the economy. 

While FDR died in early 45, and Truman retained all his regulatory policy well into the 50's, and Eisenhower did not change much, nor did Kennedy or LBJ, it began to change with Nixon, with moving up the cap on FHA loans beyond the rate of inflation, and then following the Carter inflation, the regulation of Savings and Loans was eliminated, leading to the crash of these institutions in the late 1980's.  Without understanding cause, or the reason for these plain jane savings organizations in sustaining middle and working class home ownership -- Congress just bailed out the lenders who had the wit to reorganize, and let it go at that.  Essentially they financed the next bump in housing inflation, whether it be in inflated prices for existing homes, speculation in lots for tear-downs in good areas, or McMansion housing far from jobs and culture in the exurbs, that requires vast investment in infrastructure on the part of existing home owners and the states.  Essentially we are back to 1928 what with ARM Mortgage arrangements (like the old Balloons) that can be massively increased without any relationship to wages or salary or the economy, and the "right" of the financial institutions (probably foreign speculators in our Real Estate Market) to again foreclose acres and acres of housing.   

I don't know that Obama has said anything at all about this -- Hillary wants a 90 day moritorium on forclosures.  Neither discuss re-regulation of the Finanial Institutions so as to protect capital dedicated to working and middle class home ownership, which is what will be necessary.   FDR did it by inventing FHA Insurance (good home and good credit was insured) and by banking regulation that isolated small private and insured savings for the home ownership market.  What worked is his legacy well into the late 1970's.

 

   

 

Comments

[emptypockets]

Typepad also ate the comments to Sara's previous post on the Daley family links to the Kennedys and, now, to the Obama campaign. To comment on that post, please go here.

[emptypockets]

I haven't understood exactly what happened in the current banking crash, and I'm trying to link up what little I know to what's given here.

My vague understanding, from the newspapers, was that the way that banks handled mortgages changed -- rather than holding the mortgages themselves they would bundle them and sell them to third-party investors. That practice obviously separated the party who evaluates the quality of the loan applicant (the bank) from the party who is interested in being sure the loan is repaid (the third-party who holds the mortgage). Since it wasn't in the banks' direct interest any more to ensure the loans could be repaid, they began getting increasingly sloppy and lowering the bar on who could receive a loan -- since they weren't going to be holding that loan in the end, anyway. (This view of it is similar to what happens with the CEOs of some of these companies, who collect enormous salaries and bonuses, run the company into trouble, and then get out and keep the cash while leaving employees and investors holding the bag.)

So, two questions -- first, is this summary about right? And if not, what's missing, or if it is, what part of the un-done New Deal reforms described above would have prevented it?

[Minnesotachuck]

Great historical perspective, Sara. I'd sort of wondered in the back of my mind sometimes why some older neighborhoods were so diverse, but it never came near enough the front burner of consciousness to motivate me to look into it.

While on the subject of not appreciating what had until we've lost it (in this case sensible regulation of the financial sector), If you've got a few minutes I'd appreciate it if you could take a loom at the "Empowering Workers" page at my website, and pass along any comments you might have, and especially any suggestions on how to move the ball forward.

[Sara]

Actually, what happened in the Banking and Finance sector is quite like what happened in the 1920's, though of course what existed then and recently and now are different in many significant ways.

Pre FDR and the emergence of FHA, when housing was financed with renewable short term notes, investment in those notes which generally ran 5 years would have been considered a medium term investment. Bankers would have looked at such investments in terms of profit in comparison to, for example a stock or bond investment, or city bond issue, or any other investment vehicle, and made a housing loan if the likely profit from the loan compared favorably with other possibilities.

In the 1920's, with the Stock Market on Speed, banks shifted cash into the market -- which offered excellent short term returns between about 1926 and the early fall of 1929, but then came the crash, and they lost their shirt, tie, pants and underwear. Thus funds for renewing housing notes dried up, and banks stopped renewing notes. Since the notes were short term, by about 1931 half of the outstanding home mortgages were being called.

What FDR did, by establishing the Savings and Loan Financial Industry as seperate from Commercial and Investment banking, allowing it to pay a slightly higher interest rate to small savers, but regulating it so that it could, for all practical purposes, invest only in housing that met FHA, and later VA quality standards, was to create a housing finance institution that was NOT directly in competition with other investment vehicles.

Until the mid to late 1970's, the Savings and Loans were strictly regulated. They had a cap on the size of Mortgage they could write, (which essentially put a cap on the size of middle class houses), and both the rate of interest they could pay savers, and the rate they could charge borrowers was regulated. For the most part Savings and Loan companies served their local area -- or possibly a region, thus capital created in a community more or less stayed there in the form of investment in new housing sold to people who likely also put their small savings into the local Savings and Loan Company.

With deregulation, Savings and Loan companies could invest outside the housing sector, and outside their region, and in the 70's you began to see the results of this. They looked for greater and faster profits, financing resorts, tennis clubs, commercial facilities (malls for instance), and they competed with each other in the CD market (Certificate of Deposit) -- selling this Government insured paper on medium term basis at higher and higher interest rates. (and not to forget the free toaster that went along with buying a 2000 dollar CD). It took a little less than ten years for the Savings and Loans to crash and burn in this deregulated market -- The end of the Reagan years and the Bush I administration saw the Government have to bail out the S&L's, at the cost to the taxpayers of billions. (Afterall, the paper they were selling was insured up to a hundred thousand.) In the meantime, the Housing Market inflated, in part as a function of putting Housing back into the same financial market with all other potential investments. So -- back to square one, in a way -- back to the situation that existed pre-FDR in the 20's and early 30's, except this time the Government (taxpayers) were on the hook to cover the insured savings.

The last stage of de-regulation took place under Bush II. The seperation of Commercial Banking from Investment Banking ended when Congress was persuaded to abolish the Glass-Stegall Act of 1933, meaning that Commercial Banks could now play in the more risky Investment Banking arena. And yes, one thing they did was to create mortgage backed securities that could be traded on the National and International Market in the same way stocks in widgets are traded. The end result is really no different from the late 20's and 30's -- since the value of low or non-performing loans has crashed, and since the value of the underlying asset is no longer increasing (housing prices dropping), Capital in the hands of Banks is simply leaving the housing sector, not unlike the instinct of Banks in the late 20's not being at all interested in renewing mortgage notes.

Combine this pattern with the energy crisis -- remember an underlying premise of Exurban and Suburban Housing is two cars in every garage, two chickens in every pot -- and you can see how vastly complicated this problem will become. Can an Exurban home owner get to work in a Suburban Office Park without a car? (a second or third one perhaps in a two income family?) In otherwords there are many more complex assumptions involved today related to the Housing Market than there were in the early 1930's, and it will take great creativity to deal with them. It clearly will involve creating a new regulatory system, but unlike what was done in the 1930's the new system will have to accomodate the Global Market for Capital -- created so that Capital could move at the click of a mouse to the highest returns.

I await the Housing Market version of Al Gore -- what we need is a power-point presentation understandable by the voting public that will clearly illustrate the problem just as Gore's slides on Global Warming informed so many, and got people convinced of the necessity for action. In this case, it is about smart regulation. I would hope such a presentation would also recapture the pre-Great Depression structures, and the long term pain of the depression -- because all that was forgotten history in the 1970's and 80's when the great deregulatory damage was done that has now caused the current sub-prime crisis. This is something I really blame on Reagan and Bush -- all alone I suspect Carter and Clinton would have deregulated, but would have done it in a much smarter way. Regulation that advantages long term fixed rate mortgages (such as built the post war suburbs) and encourages equity building by home owners should have tax advantages, whereas speculation using short term financing should be disadvantaged. Today, the guy with a jumbo ARM gets the huge tax deduction advantage. And of course, this also contributes to the National Debt.

[emptypockets]

Thanks!

So if I understand it, the "subprime" part of the subprime crisis was made possible most directly by the removal of the mortgage caps in the 70s, and the conflation of the commercial and investment banking sectors in the last decade -- allowing bigger loans, in the first place, and more high-risk high-return structures for them, in the second. Is that the idea?

[Sara]

Yes, deregulation resulted in making middle class housing no different from any other commodity you can day trade if you want, or buy at a broker's office. You can probably buy some ARM backed securities today at pennies on the dollar if you want. (don't really recommend).

In contrast, a New Deal principle was that safe, sanitary and adequate shelter needed to be protected from the ups and downs of raw Market Capitalism. (Public Housing plus FHA). Remember, FDR saved Capitalism -- he didn't destroy it. He just evolved some rules of good behavior.

[AnneG]

Thanks for making the mess more comprehensible to me. You confirm my instincts with facts.

[greenhouse]

Thanks Sara so much for biting the bullet and reposting this great post. Small but important correction. Although in the 80s regulators began allowing exceptions to Glass Steagall, it wasn't till 1999 that then Treasury Secretary Robert Rubin (now CEO of Citigroup) and President Clinton got Congress to repeal it outright, permitting financial supermarkets like Citigroup to operate any kind of financial business they desired, and profit from multiple conflicts of interest.

[bluebird]

Thank you Sara. This has been a fascinating history lesson.

[rita]

To understand the push towards deregulation in the financial industry and the gradual erosion of Glass-Steagall, you should take into account the entry of non-regulated companies, primarily insurance companies, into traditional commercial finance. And other unregulated non-bank banks. Banks felt that they were not competing on a level playing field. And the rise of global capital markets finance, with structured financings, aided in the push for deregulation because a lot of those instruments looked like investments and were made under the limited investment authorities.

[helverings nag]

Sara, thank you so much for this post. Like people remember where they were and what they were doing when they heard Kennedy had been shot, I remember where I was the first major repeal of Glass-Stegall passed - working in a small West-Texas bank note department. I looked around at the loan officers in the exterior wall offices and knew we (Americans) were going to be so screwed. Even though these were generally nice guys and this was a small bank, it was no different than handing the keys to a race car to a 15 year old boy who thinks he knows how to drive and can't wait to get behind the wheel. Nothing good was going to come out of it.

Eight or nine failed banks later, I was working in loan operations in an S&L that survived one of the largest RTC restructures. The junk in that S&L's asset portfolio was unbelievable - largely because deregulation allowed S&Ls to use their own wholly owned appraisers, title companies, etc., for the loans they made and direct investments.

My point is that the "Enron Guys" have always been there and are always going to be there. They are reckless because they lack any real knowledge of the history behind regulation and have a lack of respect for regulation. When stripped down to the eseentials, they see regulation as rules arbitrarily set down by the "meanest Mom in the world." We can't afford to keep handing these guys the keys to the family car - not without some ground rules Mister.

[SanFranciscoJim]

Great stuff, thanks for the history lesson!

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It’s sad how some people are facing foreclosure. While they are in the verge of losing their dream homes, I think they have to seek help as much as they possibly can about what to do. But may I suggest that one way to avoid foreclosure is to undergo financial counseling first before making any major financial decision. That would help us become more aware and knowledgeable. With more knowledge, we can make better, wiser decisions thus avoiding any future trouble.

[VA refinance]

Thanks for the history lesson Sara, I just wish others really understood how and why we are in this mess. we will get out of it it is just going to take a lot of time and problem solving and I would have to stress Pain!!!

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