American housing finance history according to HUD: Part 1
“And you gotta get a good start before you finish.”
Part 1: Introducing US housing history
Ever wonder how the
Commissioned primarily for an international audience[, it] identifies those pivotal events in the development of the housing finance market, such as the creation of the Federal Housing Administration (FHA) in 1934, that helped to structure the current system, and it highlights lessons from the US experience that may assist policy reform efforts in the development of emerging mortgage markets. (Introduction, page v)
Prepared in April, 2006 for PD&R by unnamed authors from Integrated Financial Engineering, Inc. (whom I cannot find on the Web!), the paper is “the views of the contractor [
Let’s add just a drop of hyperbole, shall we?
Nevertheless, and despite its numerous weaknesses (discussed below), the paper is useful especially as it provides a condensed summary of US housing practice from our nation’s founding, which it breaks into four eras:
· Era of Exploration (pre-1930s)
· Era of Institutionalization (1930s to 1960s)
· Era of Securitization (1970s and 1980s)
· Era of Automation/ Computerization (1990s to present)
(Page 3)
HUD provides a very nice chart (page 4 of the report) illustrating parallel evolution of institutions, products, and risks or shocks, which we here reproduce:
Formal housing financial systems are as old as the
The first institutional arrangement to finance housing in the
This savings-circle approach (which is also the antecedent of today’s modern credit unions) is universal throughout the world, sometimes done in kind (the barn-raising) and sometimes in capital.
We can chip in our money, or our labor
From the pooling of capital to its institutionalization in a savings and loan or building society is merely evolutionary:
More often than not, the members controlled credit and funding risks among themselves. A TBS ceased to exist once all members received the loans.
The authors relegate to a footnote a very funny cautionary tale:
[In fact, the first mortgage made by the first building society, the Oxford Provident, went into default. The members negotiated a transfer of the property to another member who eventually repaid the loan.] (Page 3)
Aren’t there huge important lessons in that throwaway line?
1. Credit has no friends. You can’t trust your neighbor any more than you can trust a stranger.
2. Asset management matters as much as underwriting. Don’t lend unless you’re prepared to foreclose and to recover the collateral.
HUD’s history lecture rolls on:
And as you can see, football promotes homeownership
In this era, the maturity terms for most loans were 6 to 10 years, payments were semiannual with no or partial amortization of principal, interest rates were variable, and the maximum loan-to-value ratio was about 50%. (Page 3)
Here again we see another important financial-ecosystem evolutionary principle: first movements into undefined credit space are cautious — low leverage, short maturity. That means capital flows slowly, and inefficiently:
The deposit certificates instituted in the 1890s increased the inflow of savings into lending institutions, which improved the liquidity of the system. (Page 3)
Better capital provision accompanied the emergence of a new form of financial institution, the mortgage bank:
During the 1870s, mortgage banks were formed to lend in the expanding Midwestern and Western states. Banks were formed mostly by former agents of insurance companies and other financial institutions in the Northeast. These institutions originated and serviced loans with the funds raised by selling mortgage-backed bonds (MBB’s), modeled after the practice in
That paragraph highlights three important principles of ecosystemic evolution:
Hey, ma, I’ve got three principles!
3. Evolution is interdependent. Products and producers arise contemporaneously and interdependently. In this case, a new financial instrument (the bond) and new financial intermediary (the mortgage banker) begat each other.
4. Ideas transmit laterally and down-market. Ideas flow from more advanced financial markets to emerging ones.
5. Liquidity arrives after origination. The mortgage-backed bond arose second, in response to a pileup of good loans held on the originators’ balance sheet. Secondary markets emerge after primary ones are working. (I’ll return to this later.)
Additionally, the form of liquidity provision owed nothing to modern securitization: it was a pure aggregation and resale, without tranching, of whole loans or portfolios:
Under this intermediation process, investors took on the credit risk of bond issuers and were compensated through a premium in the interest rate. Through MBBs, investors were able to diversify regionally or nationally, which was important to their financial stability. (Page 5)
Sounds great, doesn’t it? Or are there new things to worry about?
What, me worry? I’m a mortgage investor!
The principal-agent problem in mortgage intermediation generates another incentive issue. Although the unbundling and automation of origination, funding and servicing processes increases operational efficiency, they [sic] can also raise potential principal-agent problems such as moral hazard in data and document verification, adverse selection of good-quality loans (by originators) instead of passing them along to secondary market outlets, and outright fraud.
“I know more than you do, and our interests are not the same.”
Perhaps we should state it as a lesson:
6. Ecosystemic evolution increases risk typology. As an ecosystem evolves, it becomes more efficient and specialized (good!), more complex and therefore more robust (also good!), but also more separated and disaggregated. Disaggregation of functions is good in cost-efficiency terms, but creates new types of risks, and it normally takes a while for regulatory and risk-mitigation systems to catch up.
What triggered the day of reckoning? The Panic of 1893:
In the panic, the buildings weren’t tall enough to jump out of
During the recession of the 1890s, however, MBBs defaulted in large numbers. The lax risk screening by the agents (mortgage companies) at the time of underwriting (i.e. determining whether and under what conditions a loan should be made) caused high defaults during the economic downturn, imposing significant costs to the principals (investors). (Page 5)
Risks insignificant and benign in sunny times became deadly when the economy slowed:
As revealed in the mortgage-backed experiment in the late 1800s, this principal-agent risk can be toxic, leading to the demise of a certain type of intermediary, and calls for a proper due diligence by both public and private institutions. (Page 20)
The result was a temporary extinction:
The incident, which exemplifies the classic ‘principal-agent problem,’ also resulted in the demise of the mortgage companies, and this particular 19th century experiment of liquidity enhancement ended unsuccessfully. (Page 5)
(The mortgage companies would later return, certainly after World War II if not before, to become an essential species in the ecosystem today.)
[Continued tomorrow in Part 2.]
