The First Time Mortgage-Backed Securities Failed

During World War I, as cities pulled every young man who wasn't a doughboy into their factories, the U.S. became an urban nation.

After the war, there was a sharp and short depression in 1920 from which the cities quickly recovered, but rural America did not. That year, the census recordeed more people living in cities than in the country. Returning soldiers looked for work in the cities rather than return home. And all those people needed somewhere to live.

Thus was born the great housing boom of the 1920s. The wartime demand for city housing and businesses drove rents and prices as high as skyscrapers.

How would all the mortgages for these apartments and houses be funded? Lenders simply followed the people. For decades, urban investors had bought stakes in farm mortgage bonds. With the agricultural economy in such straits and the urban economy booming, groups such as the Farm Mortgage Bankers Association of America (which later dropped the "Farm" from its name) reoriented their sights on the cities, looking for ways to lend to these new urban dwellers, bringing their experience in turning mortgages into bonds.

Urban mortgage lenders in the 1920s stopped relying strictly on savers' deposits to fund home mortgages. They developed a bond to fund them, just like bonds had been used to finance farm mortgages. This "participation certificate" (or PC) wasn't marginal. At its peak, real-estate bonds funded one-quarter of all urban mortgage debt, equal in volume to the bond debt of industrial corporations.

The PC worked like a bond. An investor bought it from a mortgage company (called a bond house) or a small bank and received a monthly interest payment. At the end of a set time, usually a few years, the principal of the bond could be redeemed.

But unlike normal bonds, which were backed by the government or a corporation, these were guaranteed by mortgage payments -- usually balloon mortgages of homes or rental properties. The PC lacked the slicing and dicing used to securitize debt in more recent times, but the basic idea was the same: The mortgage holder received a monthly payment and then paid the PC investors.

Time magazine reassured readers in 1926 that "real estate bonds are by no means jeopardous investments. In fact, they should be the best of all securities, for they are backed by tangible buildings and real estate."

Such reasoning reassured investors then, as now, about the inevitability of rising house prices.

Banks loved the new invention because it allowed them to skirt regulations. Although the Federal Reserve regulated the proportion of savings that could be lent as mortgages (half of savings deposits) there were no restrictions on mortgages funded by bonds. These bonds, however, had a maximum length of five years, forcing the mortgage debt to be refunded, at minimum, every five years. But since the balloon mortgage, so popular in the 1920s, was refinanced every three to five years, there shouldn't have been a problem as long as more investors could be found.

Investors loved the bonds because they were issued in small denominations. Most PC buyers, unlike the sophisticated buyers of corporate bonds, had never purchased a bond before. Usually a salary man or a union man, the investor lived modestly and a $100 bond fit neatly in the annual budget. Every month, the investor received a complimentary magazine from his bond house that mixed in investment advice on the virtues of their bonds over the competition. Small men felt like big shots.

Yet though they looked like regular corporate bonds, PCs were not the same. Unlike corporate bonds, there was no secondary market. Most commercial banks refused to accept real-estate bonds as collateral; PCs were born toxic. But this mattered little to small investors because they intended to hold the debt to maturity.

Whether enough money was available at the bank to refinance the balloon mortgages of all those urban homeowners depended on whether the PC investors decided to reinvest their money. In good times, when it seemed like mortgage borrowers could make their payments, the PCs seemed like a reliable investment.

By 1925, however, things began to look more dubious. Those who wondered at the surge in property values were, according to the New York Times, condemned by developers as "unpatriotic." Developers paid their architects and contractors in mortgages, rather than cash, promising them a piece of the action down the line, putting none of their own money at risk. The system worked out fine for a few years, as rising rents propped up profits and the buildings themselves. New construction hit $690 million in North America in 1926.

After 1929, as home prices fell and the unemployment rate rose, such investments became more precarious. Without another round of investors, the underlying balloon mortgages couldn't be refinanced. Houses could be foreclosed on, but then who would buy them? As those PCs came due, skittish investors stopped reinvesting and the amount of money available for mortgages dried up. Whereas through the 1920s homeowners could easily refinance their balloon mortgages, banks now demanded they pay off the loan or face foreclosure.

Investor anxiety fed on itself and very quickly the U.S. mortgage-bond market was dead.

The housing crisis of the Great Depression wasn't caused by job loss as much as by the structure of the underlying financial instruments that anticipated rising asset values and easy refinancing, neither of which held after the Crash of 1929.

The Home Owners' Loan Corporation, inaugurated in 1933, slowed the collapse of the mortgage markets, but couldn't save the PC. After 1931, no more real-estate bonds of this type were issued. By 1935, about 80 percent of the $10 billion in real-estate bonds outstanding were in default. The restrictions against real-estate bonds in the federal securities legislation of 1933 and 1934 mattered less, in a contemporary economist's view, than the "distaste already acquired by investors for real estate bonds."

And until 1970, when Fannie Mae issued its first mortgage-backed security, that distaste remained a powerful force. Let's hope we can better remember this time around.

(Louis Hyman is an assistant professor of history at Cornell University and the author of "Borrow: The American Way of Debt." The opinions expressed are his own.)

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