Debt dilution in 1920s America: lighting the fuse of a mortgage crisis

Natacha Postel-Vinay

LSE Research Online Documents on Economics from London School of Economics and Political Science, LSE Library

Abstract: The idea that real estate could have contributed to banking crises during the Great Depression has been downplayed due to the conservatism of mortgage contracts at the time. For instance, loan-to-value ratios often did not exceed 50 per cent. Using newly discovered archival documents and data from 1934, this article uncovers a darker side of 1920s US 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 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. This would have put further strain on banks during liquidity crises. This article 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.

JEL-codes: F3 G3 N0 (search for similar items in EconPapers)
Pages: 27 pages
Date: 2017-05-01
New Economics Papers: this item is included in nep-his, nep-pke and nep-ure
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Published in Economic History Review, 1, May, 2017, 70(2), pp. 559 - 585. ISSN: 0013-0117

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Persistent link: https://EconPapers.repec.org/RePEc:ehl:lserod:68127

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