A fascinating story in this morning’s Washington Post about a house for sale in Arlington VA provides a great history lesson on financial innovation – “A House Built With a Milestone”. The house in question was the first to qualify for a 10 percent down payment:
In some ways, the house is a direct product of the Great Depression. Before then, the federal government had followed a strict hands-off policy on housing, relying entirely on the private market to make loans and build. The system had worked pretty well, at least for the affluent, though it had its marked ups and downs during cyclical recessions, even some called “panics.” Many people pioneered their land and built their homes themselves with the help of neighbors and relatives.
But real estate boomed in the 1920s, hitting a record construction level in 1925, as lending standards were loosened. Real estate agents told buyers that prices would rise forever, that they had never fallen. People bought the largest houses they could get, stretching to make the payments by using the three-year or five-year interest-only loans that were customary. Those loans cost less each month because borrowers didn’t need to make any payments toward the principal on the loan.
Consumers felt confident they would be able to refinance at the end of the loan term, and lenders felt secure because on many of the loans, the debt represented only about 50 percent of the value. But what they overlooked was that many people had taken out other loans as well, sometimes two or three, to make up the difference between the primary loan and the purchase price. They had in fact financed their down payments.
“The system was full of holes,” wrote Julian H. Zimmerman, commissioner of the Federal Housing Administration, in 1959, describing the housing market in the 1920s. “Juggling several mortgages was difficult even when the going was good; but when things got rough in the late ’20s it became impossible.”
Workers lost their jobs; then they lost their homes to the banks that held the loans. About one in six mortgages in America went into foreclosure. Even people who remained employed found they couldn’t find buyers for their homes at any price. No lender wanted to refinance short-term loans now seen as risky. President Herbert Hoover watched the downward spiral with horror, immobilized.
Within a month after President Franklin Delano Roosevelt took office in 1933, the Home Owners Loan Corp. was established. The federal agency helped homeowners stave off foreclosure by refinancing about one-fifth of the nation’s outstanding residential mortgages, all of them in default. The Home Owners Loan Corp. was successful and was liquidated later at a slight profit.
Amid a surplus of houses and a paucity of buyers, the real estate market languished. To stimulate the housing and lending industries and help renters and moderate-income people buy homes, the Roosevelt administration developed a new kind of insurance program that would cover the losses lenders suffered if homeowners defaulted on their loans. In June 1934, the National Housing Act was passed, creating the Federal Housing Administration loan insurance program. It permitted borrowers to purchase homes with 20 percent down, financed with low-interest, fixed-rate loans to be repaid over 20 years, with mortgages not to exceed $16,000. Adjusted for inflation, that would be a loan value of about $228,000 today. The government in effect promised lenders they would be reimbursed for any losses; home buyers paid a little extra money each month as insurance to cover that expense.
The system worked. The fixed-rate loan for a 20-year or 30-year period became the national standard.
The first house financed under the new FHA program was in New Jersey, and thousands more began cropping up across the nation. The financial losses to the program were so small — only 35 houses were lost to foreclosure in its first three years, out of 229,300 mortgages insured — that legislators decided to permit an FHA expansion to cover houses purchased with only 10 percent down payments, too.
That amended housing law was enacted in 1938, and the Arlington house was the first structure financed and built under the revised housing act. It was viewed as such an important event in the housing industry that the National Retail Lumber Dealers Association’s members made touring the house a priority item for builders visiting the nation’s capital for the group’s annual conference in May 1938. Many built similar houses elsewhere.
The expansion of the FHA program had its critics. Real estate agent Charles E. Lane, chairman of a New York housing committee, told a Fifth Avenue business audience that he disapproved because the expansion would encourage people to buy homes who were not in a “proper economic position” to do so, according to the New York Times. His concerns were echoed by others, who called a 10 percent down payment “too narrow a margin of safety for the mortgagee,” according to another Times article in 1938. But by May 1938, a record $96 million in mortgages were initiated in a single month, including about 40 percent that involved 10 percent down payment loans.
And, as the saying goes, the rest is history.
Ironically, as the story goes on to point out, the Arlington house is now on the market at a high enough price to not be eligible for FHA financing. To me, this illustrates how we continue to need innovation in housing. I’m not sure the recent financial innovations of interest only loans are the right way to attack the problem of affordable housing. The other innovation embodied in this house was its design. As a two bedroom rambler, it was meant to be the affordable option for the middle-class.
Maybe it is time to return to building for affordability. There are stories on the news about couples trying to unload their McMansions due to the high cost of operation and upkeep. As people attempt to downsize, there should be a great opportunity for new innovations in housing (and finance).
But to make the right policy decisions. As our history lesson shows, the government has a role to play in these innovations – and can either help or hinder depending on how it plays that role.