News

It was a classic boom and bust.

From Manhattan to the Chicago suburbs and the Florida Everglades, builders put up houses faster than they could sell them.

Rock-bottom interest rates, shaky lending standards and new exotic mortgages added loft to the speculative bubble. Regulators turned a blind eye to the excesses as investors loaded up on mortgage-backed securities.

And then it all came crashing down in a nationwide wave of foreclosures when prices collapsed. The year was 1926.

Academics and policy makers have long forgotten the great real estate bust of the 1920s. It barely ranks as a footnote in the literature on the Great Depression (some of it written by the current chairman of the U.S. Federal Reserve Board, Ben Bernanke).

But a new working paper by Rutgers University economics professor Eugene White for the National Bureau of Economic Research - the official arbiter of U.S. economic cycles - highlights some crucial lessons of this episode.

The parallels between then and now are remarkable, with one telling difference, Prof. White says. The twenties real estate crash never endangered the banking system.

The reason for that offers clues about how to repair today's broken financial system, which began with a real estate bust.

Apparently, it's what policy makers didn't do in the 1920s that saved the system.

"The elements absent in the 1920s were federal deposit insurance, the too-big-to-fail doctrine and federal policies to extend mortgages to higher-risk borrowers," Prof. White concludes.

The U.S. Congress, the Obama administration and the banking industry may be missing the point as they throw themselves into a post-crisis overhaul of financial regulation.

Just look at the response so far. The United States doubled deposit insurance protection (to $250,000 U.S.), demonstrated to everyone that some institutions are too systemically important to let fail and it's still pushing marginal buyers to stay in homes they can't afford, through mortgage modifications.

"Most of the reforms are treating the symptoms, rather than the disease," Prof. White said in an interview.

The classic example is the Obama administration's focus on executive compensation. Wall Street pay is a popular scapegoat, but it's misguided because little is being done to mitigate the main factors that encourage risk, including deposit insurance and the principle of too big to fail, according to Prof. White.

"It's very odd to leave the incentives in place," he argues.

The government also continues to encourage expanded home ownership, which is already near historic highs. The U.S. Federal Housing Administration, for example, guarantees up to 97 per cent of the loan value of most residential mortgages, while offering home loans to low-income buyers.

"I don't see a willingness to challenge the powerful housing lobby," he says.

Prof. White sees similar contradictions in Mr. Obama's message to banks on lending. The President is pushing them to lend more to businesses, while regulators are urging more prudent behaviour. The problem is that, in a recession, most business loans look pretty risky to banks, Prof. White pointed out.

There's also talk about breaking up some of the big banks - a strategy that Prof. White worries does little to alter the incentives, and could make U.S. banks less competitive globally.

All this leaves Prof. White pessimistic about the government's ability to manage the too-big-to-fail quandary. "I can't see how they're going to get it right," he says.

Canadians shouldn't feel smug as they watch Americans grapple with the aftermath of the crisis.

No, there hasn't yet been a housing price collapse. But if Prof. White is right - that the problem stems from misaligned incentives - Canada may have something to learn from the U.S. housing collapse of 1926.

Interest rates remain near historic lows. And Ottawa is giving people more reason to borrow heavily with its Insured Mortgage Purchase Program.

Almost as generous as the FHA, it allows buyers to put down as little as 5 per cent of a home's price and amortize the mortgage over 35 years.

The clear signal is borrow, borrow, borrow. And not surprisingly, Canadians are taking the bait, piling on record mortgage debt.