Modern HOLC May Be Answer for Bailout

Posted September 23, 2008 at 2:45pm

Last December, my American Enterprise Institute colleague Alex Pollock, a veteran banker and former head of the Federal Home Loan Bank of Chicago, wrote a fascinating piece detailing the story of the Depression-era Home Owners’ Loan Corp. The HOLC was created by Franklin D. Roosevelt in 1933 to deal with a housing finance crisis that makes our current situation pale by comparison. About half of all mortgage debt was in default (compared with 3 percent or so today).

[IMGCAP(1)]The HOLC bought distressed mortgages from banks using bonds it issued equal to $2 billion, or 10 times its initial capital, with the bonds having maturities of up to 18 years (the corporation was in fact dissolved after 18 years, in 1951). Banks took a loss on many of the mortgages they unloaded to the HOLC. The corporation then moved to refinance loans to distressed homeowners, to try to enable them to weather the storm and stay in their houses.

As Pollock noted, “During its life HOLC made more than 1 million loans to refinance troubled mortgages — about 20 percent of all the mortgage loans in the country. By 1937, it owned almost 14 percent of the dollar value of outstanding mortgage loans.” Fourteen percent of the dollar value of loans today would be worth about $1.4 trillion!

HOLC did not give a blank check or wildly permissive terms to homeowners. In fact, it turned down about 46 percent of applications, and despite its best efforts, ended up foreclosing on about 200,000, or 20 percent, of its loans. But given that all the loans it dealt with were in default when it bought them, that was a pretty solid performance. When it closed its books and went out of business in 1951, it had a surplus of $14 million, which it turned over to the Treasury.

The HOLC was designed to do two things: help out distressed banks that were frozen in their ability to operate because of the hits to their capital from the housing crisis, and help out distressed homeowners who were at sea at the same time. It worked better than almost anyone might have imagined. And it was done with a legislation that was three and a half pages of text.

Many Members of Congress expressed interest in Alex Pollock’s observations when his article emerged, and Sen. Chris Dodd (D-Conn.) announced that he would draft a piece of legislation to provide a smaller-scale, modern, parallel effort. But nothing happened beyond that, as Congress (and the administration) turned their attention to other things and other stop-gap ways of dealing with the mortgage problem. Sidestepping the continuing problem banks had with a roster of nonperforming loans, or loans that could not be classified and therefore not priced, leading to a capital crisis, helped contribute to the suddenness of the crisis over the past week or 10 days.

Now we are on an even faster track to enacting a response to our economic turmoil than we had in 1933, with a draft bill from the Treasury Department much shorter than the title of the Home Owners’ Loan Act that created HOLC. Congress does need to act quickly, but it also needs to stop and take notice of what happens when a rush to judgment eliminates the kinds of checks and balances that are needed in the system. Sen. Patrick Leahy’s (D-Vt.) warning of what happened right after 9/11 is spot-on; the unease of principled conservatives like Rep. Mike Pence (R-Ind.) deserves to be heard by Treasury Secretary Henry Paulson, President Bush and the leaders in Congress; the ideas being floated by Rep. Brad Sherman (D-Calif.) and Dodd also need to be heard and in many cases heeded.

A plan like the HOLC — a better model, in my judgment, than the Resolution Trust Corp. created at the time of the savings and loan scandal — could not be up and running quickly. But that does not mean we should drop the idea in the name of immediate action. Another of my AEI colleagues, Vincent Rinehart, believes that we need to pass a streamlined plan now, which can be revisited in the new administration after January — but he also says that having Treasury acquire equity stakes in the firms that sell it distressed assets can be a part of the program.

So too can be limitations on the financial rewards available to executives whose behavior helped cause and accelerate this meltdown, a serious independent board to oversee and constrain Treasury as it dispenses $700 billion of our money, and other provisions, including adjusting bankruptcy rules. The latter might be unnecessary if we can get some modern-day version of the HOLC in the legislation.

I accept fully the need to act swiftly to enable banks and other financial institutions to take a one-time hit on their balance sheets, get back to square one, replenish their capital bases and enable the system to move on. We could have done some of this months ago, but it is not too late to cleanse the system and begin to price at market levels the exposure to mortgages. But there should be the appropriate level of urgency to do this right, not a mad rush to act that will either unduly limit a new president via an irreversible fait accompli or leave a huge mess to clean up afterward.

Norman Ornstein is a resident scholar at the American Enterprise Institute.