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Debt Dilution in 1920s America: Lighting the Fuse of a Mortgage Crisis

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  • Natacha Postel-Vinay

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    (London School of Economics)

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    Abstract

    An explanation of the Great Depression based on mortgage debt via the banking channel has been downplayed due to the conservatism of mortgage contracts at the time. Indeed, maturities were particularly short compared to today's average terms (around three years), and loan-to-value ratios often did not exceed 50 per cent. Using newly-discovered archival documents and a newly-compiled dataset from 1934, this paper uncovers the darker side of 1920s U.S. 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 on 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 - a great impediment to bank survival in case of a liquidity crisis. This paper 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.

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    Bibliographic Info

    Paper provided by European Historical Economics Society (EHES) in its series Working Papers with number 0053.

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    Length: 33 pages
    Date of creation: Mar 2014
    Date of revision:
    Handle: RePEc:hes:wpaper:0053

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    Keywords: Great Depression; Commercial Banks; Portfolio Choice; Mortgage;

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    References

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    1. Eugene N. White, 2009. "Lessons from the Great American Real Estate Boom and Bust of the 1920s," NBER Working Papers 15573, National Bureau of Economic Research, Inc.
    2. Kenneth A. Snowden, 2010. "The Anatomy of a Residential Mortgage Crisis: A Look Back to the 1930s," NBER Working Papers 16244, National Bureau of Economic Research, Inc.
    3. Alexander J. Field, 2013. "The Interwar Housing Cycle in the Light of 2001-2011: A Comparative Historical Approach," NBER Working Papers 18796, National Bureau of Economic Research, Inc.
    4. Karol J. Borowiecki, 2013. "Agglomeration Economies in Classical Music," Working Papers, European Historical Economics Society (EHES) 0047, European Historical Economics Society (EHES).
    5. Christopher J. Mayer & Karen M. Pence & Shane M. Sherlund, 2008. "The rise in mortgage defaults," Finance and Economics Discussion Series, Board of Governors of the Federal Reserve System (U.S.) 2008-59, Board of Governors of the Federal Reserve System (U.S.).
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    7. Douglas W. Diamond & Philip H. Dybvig, 2000. "Bank runs, deposit insurance, and liquidity," Quarterly Review, Federal Reserve Bank of Minneapolis, Federal Reserve Bank of Minneapolis, issue Win, pages 14-23.
    8. Christine A. Parlour & Uday Rajan, 2001. "Competition in Loan Contracts," American Economic Review, American Economic Association, American Economic Association, vol. 91(5), pages 1311-1328, December.
    9. Leo Grebler & David M. Blank & Louis Winnick, 1956. "Capital Formation in Residential Real Estate: Trends and Prospects," NBER Books, National Bureau of Economic Research, Inc, National Bureau of Economic Research, Inc, number greb56-1.
    10. Holmstrom, Bengt & Tirole, Jean, 1997. "Financial Intermediation, Loanable Funds, and the Real Sector," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 112(3), pages 663-91, August.
    11. LaCour-Little, Michael & Calhoun, Charles A. & Yu, Wei, 2011. "What role did piggyback lending play in the housing bubble and mortgage collapse?," Journal of Housing Economics, Elsevier, Elsevier, vol. 20(2), pages 81-100, June.
    12. Ernest M. Fisher, 1951. "Urban Real Estate Markets: Characteristics and Financing," NBER Books, National Bureau of Economic Research, Inc, National Bureau of Economic Research, Inc, number fish51-1.
    13. J. E. Morton, 1956. "Introduction to "Urban Mortgage Lending: Comparative Markets and Experience"," NBER Chapters, National Bureau of Economic Research, Inc, in: Urban Mortgage Lending: Comparative Markets and Experience, pages 1-13 National Bureau of Economic Research, Inc.
    14. Steven Radelet & Jeffrey Sachs, 1998. "The Onset of the East Asian Financial Crisis," NBER Working Papers 6680, National Bureau of Economic Research, Inc.
    15. Bizer, David S & DeMarzo, Peter M, 1992. "Sequential Banking," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 100(1), pages 41-61, February.
    16. J. E. Morton, 1956. "Urban Mortgage Lending: Comparative Markets and Experience," NBER Books, National Bureau of Economic Research, Inc, National Bureau of Economic Research, Inc, number mort56-1.
    17. Wicker,Elmus, 1996. "The Banking Panics of the Great Depression," Cambridge Books, Cambridge University Press, Cambridge University Press, number 9780521562614.
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