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Return of the Incredible HOLC: How a Depression-Era Program Could Help Solve the Housing Puzzle—A Commentary by Ray Brescia ’92

The following commentary was posted on the Huffington Post on September 26, 2011.

Return of the Incredible HOLC: How a Depression-Era Program Could Help Solve the Housing Puzzle
By Ray Brescia ’92

The Obama Administration is struggling to find answers to the housing market puzzle. Interest rates are the lowest they have been in living memory. "For Sale" signs are plentiful on lawns throughout the country. One would think there has never been a better time to purchase a home. Yet the market is in shambles, and credit is frozen. Worst still, with high unemployment and foreclosures looming, homeowners face challenges not seen since the Great Depression.

Nearly 8 million borrowers -- 1 in 11 residential mortgage holders -- are at least 30 days behind on their mortgage payments. Just about 1 in 5 borrowers are "underwater" on their mortgage: owing more than their homes are worth. In addition, the federal government holds roughly 250,000 residential properties in its own portfolio, the wreckage of a mortgage market in free fall.

Even with bargain basement interest rates, just when one would think it would be the perfect time to refinance a mortgage, recent federal data shows mortgage deals are down, especially in communities of color. Lenders are simply too skittish to place faith in housing values and make new loans. And borrowers must continue to make good on loans at interest rates 20-50% higher (or even more) than interest rates available on the market today.

President Obama says he wants to put $2,000 in the pockets of borrowers by encouraging banks to do more refinance deals. But he is dreaming too small. A different plan, modeled on a wildly successful New Deal program, could hit the trifecta: it could save borrowers from inflated interest rates, prop up banks, and preserve housing values, all while turning a profit.

That New Deal program, the Home Owners' Loan Corporation (HOLC for short), functioned extremely well in the depths of the Great Depression, keeping roughly 1 million borrowers in their homes. And it did so through deficit spending. At the end of the day, though, the HOLC paid back all that it borrowed and then some: returning a profit to the U.S. Treasury. Here's how it worked.

In the depth of the economic crisis of the 1930s, HOLC issued bonds (yes, debt), in exchange for loans on the books of those banks still standing. Back then, mortgages were sordid deals, through which borrowers made few payments towards principal during the short life of the loan, and were forced to pay back the entire loan at the end of five years. The expectation that land values would increase well into the future meant borrowers and lenders all presumed that a refinancing deal could be reached before the end of the mortgage term. (Sound familiar?) When property values collapsed after the stock market crash, banks were unwilling to refinance these mortgages, and millions of borrowers were threatened with foreclosure.

HOLC traded its bonds, backed by the federal government, for the mortgage debt on the books of the banks. It paid the banks 4% interest on the debt (roughly twice what long-term Treasury bills pay today). The banks were eager to convert their non-performing loans to government-backed federal bonds. Moreover, unlike with mortgage debt today, there was a robust market for these bonds, and banks could sell them on the secondary market and free up their balance sheets.

Having purchased these loans, HOLC then refinanced them to fixed-rate, 15-year mortgages, at interest rates as low as 5 percent. The spread between the bonds and the mortgages allowed HOLC to operate, and operate at a profit.

HOLC issued roughly 1 million of these refinance mortgages. That may seem like a drop in the bucket today, but that was 1 in 5 outstanding residential mortgages at the time. The equivalent today would be 10 million refinanced mortgages. If even 5 million borrowers were to refinance into mortgages at today's interest rates of 4% or so, that would put billions of dollars back into the pockets of consumers, which would no doubt make it to businesses on Main Street, auto makers in Detroit, and, yes, even banks.

But HOLC did not serve everyone. HOLC could only offer refinancing of up to eighty percent of the appraised value of a mortgaged home. Using some accounting sleight-of-hand, HOLC was generous in its appraisals, using formulas that took into account the value of a home over time, including its value during the Roaring Twenties, which necessarily led to high appraisals. With higher appraisals, HOLC could refinance many more loans while keeping within its loan-to-value ceiling. Still, HOLC could not offer refinance deals to owners of more expensive properties. Indeed, properties that exceeded $20,000 in appraised value ($347,500 in 2011) were ineligible for the program, and loans could not exceed $14,000 on any property ($243,300 today). Even with similar restrictions, many properties in mortgage distress today would easily fall within these inflation-adjusted parameters.

Now, the default rate on HOLC loans was no better than mortgage default rates today. But HOLC had a generous forbearance policy, allowing borrowers to fall behind in the mortgage payments up to a year before HOLC would foreclose. Nevertheless, HOLC did have to foreclose on some properties and it held a fairly large inventory, almost 10% of its mortgaged properties at the peak of its stock. Once it foreclosed on a property, though, it did not dump it on the market immediately. Rather, it held the bulk of the foreclosed properties it repossessed, rented them out, and sold them once property values recovered in the late 1930s and early 1940s.

Even with the generous appraisal policies, the relaxed approach to foreclosures and the large inventory of foreclosed homes in its portfolio, HOLC ended up turning a profit. When it finally closed its books of all properties and mortgages, HOLC paid off of its debt and even returned a surplus to the U.S. Treasury, covering the entire costs of its bonds as well as the seed capital Treasury had invested in it.

Aside from whether the HOLC was a money maker for the U.S. government, which it was, the human and economic toll it helped avoid by keeping roughly one million borrowers in their homes during the height of the Depression is simply incalculable. Moreover, by keeping such borrowers in their homes, these properties did not hit the housing market after foreclosure. Had they, housing values would have taken an even greater hit across the board, reducing the value of homes in the foreclosure pipeline, homes with performing mortgages, and even homes with no mortgages on them at all. Finally, banks that sold their mortgage debt to the federal government got solid investments on their books, and were able to trade such investments for capital on the secondary market.

As described in this white paper, if the Obama Administration is looking for ways to address the housing crisis, it can look to successful programs like the HOLC for examples of programs that have worked in the past. For one, a large scale refinancing program is not out of the question, and several experts in real estate finance have proposed one that could help up to 30 million borrowers through an ambitious program to refinance mortgages at low cost. Furthermore, the Congressional Budget Office has assessed the costs and likely benefits of a large-scale refinance program and found such a program cost effective. There is shortage of ideas, just, perhaps, the political will to get them done.

What might a bonds-for-mortgages program look like today, and how would it function? For starters, the federal government could issue debt to finance the purchase of high interest mortgages that could then be refinanced at lower rates and at loan-to-value ratios that were more consistent with present home values. Fewer homes would hit the market, keeping supply down and strengthening prices. Borrowers would have more money in their pockets. Banks would be relieved of the non-performing loans on their books.

Yes, it would require debt. But this would be an investment. And if history repeats itself, such debt would perform well, and perhaps even turn a profit.

Could such a plan pass Congress right now? Unlikely. Does the Obama Administration need Congressional approval to create such a program within Treasury? Not clear.

There are some unspent funds left in the Obama mortgage modification plan, and pilot projects to field test some of these ideas could be initiated in the hardest hit communities. It's likely that banks would line up to participate. In a steady retreat to safety, many banks are taking their cash on hand and buying up U.S. treasury notes at rock bottom interest rates. Pay them a higher yield and get something out of the exchange instead of just more debt: namely, a path out of the foreclosure crisis. Even if Congressional approval is needed to take the initiative to scale, let self-described deficit hawks stand in the way of bringing real assistance to not only millions of borrowers, but also banks desperate for their own form of mortgage relief.

Ray Brescia is a Visiting Clinical Associate Professor of Law at Yale Law School.