Much like the
recent crisis, the U.S. Great Depression saw serious and widespread troubles
among banks. Also like the recent crisis, the U.S. Great Depression was
preceded by a large nationwide boom in real estate, peaking in 1926. Unlike in
the current crisis, however, the interwar link - if any - between the real
estate boom and the subsequent bank failures has been far from evident. An
important argument against the existence of such a link has to do with the conservatism
of mortgage contracts at the time. The average commercial bank mortgage
contract had a maturity of only three to five years, and required a down payment
of 50 per cent of the property value. This in theory would have significantly
reduced both foreclosure risk and the negative consequences of foreclosures for
banks.
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NATACHA POSTEL-VINAY is aPhD Candidate in Economic History,London School of Economics |
In this paper Natacha Postel-Vinay re-examines
the question and uncovers the darker side of 1920s U.S. mortgage lending: the
so-called “second mortgage system,” one of the most widespread and least
well-known forms of debt dilution in the twentieth century. As a majority of
borrowers in fact could not make a 50 per cent down payment, they took on a
second, junior mortgage from another lender to help with the high down payment.
As theory predicts, debt dilution, even in the presence of seniority rules, would
have been highly detrimental to original lenders’ health, as it increases
default risk on the original loan. In addition, second mortgages’ shorter
maturity, higher interest rates and more frequent principal payments
requirements created a seniority reversal effect which further impaired borrowers’
ability to repay first mortgages. Through foreclosure, banks would still be
able to retrieve 50 per cent of the property value, but often after a
protracted foreclosure process - a great impediment to bank survival in case of
a liquidity crisis.
Using newly-discovered archival
documents and a newly-compiled dataset from 1934, this paper thus sheds new
light on a financial phenomenon President Hoover then described as “the most
backward segment of [the US's] whole credit system.” In today's world of
“piggyback” mortgage lending and multi-party over-the-counter trading in
credit-default swaps, this paper provides timely empirical support to the idea
that debt dilution, or “sequential banking” can be highly detrimental to credit.
The working paper can be found here:
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