Writing in the December 2008 issue of Vanity Fair, Ferguson says that only a minority of Americans owned their homes prior to the 1930s, and that home financing was mainly facilitated by local savings and loans (S&Ls). Indeed, federal law restricted S&Ls to accepting deposits from and making loans to customers who lived within a 50-mile radius.

Then came the Great Depression. Unemployment soared and home ownership rates dropped sharply. President Roosevelt esponded with the New Deal, which included a landmark provision directing the Federal Housing Administration to back mortgage lenders. This effectively transferred risk from lenders to taxpayers, giving lenders the confidence to begin offering the types of high-ratio, long-term mortgages that are the norm today.

In 1938, a new Federal National Mortgage Association—nicknamed Fannie Mae—was created to establish a secondary market for mortgages to keep liquidity flowing. In 1968, the Government National Mortgage Association (Ginnie Mae) was added to serve low-income borrowers, and the Federal Home Loan Mortgage Corporation (Freddie Mac) was set up two years later to provide competition for Fannie Mae.

For decades, the New Deal mortgage system worked as planned. S&Ls took deposits and made loans. Politicians continued to trumpet the value of home ownership, and home ownership rates continued to rise.

The other credit crisis
However, in the late ’70s, S&Ls were hit hard by record high inflation and interest rates. They were losing money on long-term, fixed-rate mortgages, while also losing deposits to high-yielding money market funds. The antidote? Deregulation. By the early ’80s, S&Ls were permitted to raise interest rates on deposits, make commercial and consumer loans, remove restrictions on loan-to-value ratios, and invest in whatever they liked, not just local long-term mortgages.

S&Ls grew rapidly, building up substantial portfolios of stocks, junk bonds, and speculative real estate. But by 1989, a combination of mismanagement and malfeasance within the industry brought the party to a crashing halt. Nearly 300 S&Ls collapsed and another747 were closed or reorganized under direction of the U.S. Congress. The S&L crisis left the traditional mortgage system in tatters.

Enter Wall Street. It was 1983 when bond traders created the first Collateralized Mortgage Obligations (CMOs)—bond-like instruments backed by bundles of mortgages. Since most of these mortgages were implicitly guaranteed by the government-sponsored trio of Fannie, Freddie, and Ginnie, the bonds were considered “investment grade,” regardless of the creditworthiness of the underlying borrowers. In 1980, only 10% of home mortgages were packaged and sold as part of a CMO, but by 2007, 56% of them were.

This innovation helped fuel a new rush of liquidity, and everyone benefitted: lenders and brokers earned outsized fees, investors scored above-market yields, and homeowners cashed in too. According to the Case-Shiller national home-price index, a $100,000 investment in the U.S. property market back in the first quarter of 1987 would have been worth almost three times as much by the first quarter of 2007.

We had entered an age when “house flipping” was prime time entertainment and a respected vocation. The traditional social ties between S&Ls and their customers were reduced to little more than a quaint memory. Under-regulated lenders approved just about every mortgage application that came across their desks as investors clamored for more high-yielding CMOs. The rest, as they say, is history.

Our view
Corporate and household balance sheets will suffer more damage before the healing can begin. Foreclosures will continue and credit will remain tight. However, we believe that once economic stability returns, owning a home will remain as quintessential a part of the American Dream as the white picket fence itself. //