Taking mortgage finance back to the 1930s

Our country’s history makes clear what this conservative vision of mortgage markets would look like. Prior to the 1930s, the United States had a purely private mortgage system in which the government played only a negligible role. This system failed the vast majority of Americans, as mortgages were extremely limited and hugely expensive, and only available to the wealthiest homebuyers.

Residential mortgages prior to the 1930s had many of the same features as the unregulated subprime and so called Alt-A mortgages of the 2000s — they were short term, carried a variable rate of interest, and featured “bullet” payments of principal at term. These loans also required high down payments, often more than 50 percent, and despite their highly lender-friendly features had interest rates that were extraordinarily costly by today’s standards.

Because home mortgages were scarce, expensive, high risk, and effectively limited to a narrow band of the wealthiest Americans, homeownership was far less attainable than it is today, with the middle class effectively shut out of the market.

Despite its heavily lender-friendly features, the purely private system of the 1930s was not even good for banks. A lack of regulatory oversight to prevent excessive risk-taking by banks during housing booms, as well as the absence of a lender of last resort to provide financing during housing downturns, meant that this system regularly experienced extreme bubble-bust cycles that wiped out banks and caused massive wealth destruction every 5-10 years.
 
Many conservatives claim that the evolution of financial markets since the 1930s means a purely private mortgage system could work this time around. They point to the so-called jumbo mortgage markets for expensive homes, which have been well served in the past by private mortgage financing, as evidence that the private sector can serve the mortgage needs of American households without government support. But this ignores the enormous size of the U.S. mortgage market, which currently has some $14 trillion in residential mortgage debt outstanding. The fact that purely private markets may be able to meet the mortgage needs of a narrow slice of the wealthiest homeowners does not mean that the markets will be able to meet the mortgage needs of all American homebuyers.

This argument also ignores the limited demand for long-term debt — the type of debt that funds home mortgages — in the absence of a government backing. Investor demand today for long-term government-backed debt is enormous, totaling many trillions of dollars for U.S. Treasury notes alone, and this demand funds most mortgages in the United States.

In the absence of government backing, it is unimaginable that there would be sufficient private investment capital to fund the $14 trillion in U.S. residential debt outstanding — let alone for the long-term mortgages (such as the 30-year fixed-rate loan) that are the mainstay of U.S. mortgage markets.

The argument for a purely private system also fails to address one of the fundamental weaknesses in mortgage lending — the unavailability of mortgage credit during downturns, when lenders become highly risk-averse. This lack of credit can quickly lead to a “vicious circle” where the lack of mortgage financing and housing market declines feed into each other, turning economic recessions into housing-driven depressions.

Our current mortgage system depends on government-backed institutions to provide such mortgage financing during economic downturns. It’s no accident the housing crisis of 2007-2008, which led to the Great Recession, did not instead lead to the second Great Depression. In the absence of any government role in the mortgage markets, our housing markets would be highly vulnerable to a lack of “countercyclical” lending. 

The conservative vision for homeownership financing would raise the cost of mortgages, restrict the availability of mortgage finance to the wealthy, and destabilize the housing markets — turning the American Dream into a nightmare.

David Min is associate director of financial markets policy at the Center for American Progress, a non-partisan think tank in Washington D.C.