Mortgage Insurance

Early Developments

Mortgage lending in the 19th and early 20th centuries was generally limited to the local community in which the lender operated. Notwithstanding the fact that this limitation was imposed by various state laws prohibiting lenders from making interstate loans, lenders preferred the local market, whether a town, borough, or city, because lenders could easily communicate with borrowers who were members of the local community and better manage risk by keeping a close eye on the real estate. Building and loan associations, first appearing in Philadelphia in the 1830s, relied on this lending strategy as a means to provide local citizen-borrowers the opportunity to purchase homes and promote borrower accountability to fulfill their obligations. Sometimes formed as mutual savings associations or cooperative banks, building and loan associations were organized by citizens of the local community who, as members, purchased shares in the association. The shares were then placed in deposit accounts on behalf of the members and, depending on the availability of deposits and the value of a member's equity in shares, the building and loan association would make short-term (typically up to 5 years), fixed-rate mortgage loans to qualifying members to purchase homes. As was the usual case in 19th-century loan arrangements, the maximum loan amount was 50% to 60% of the purchase price, payments were interest only, and repayment of the principal was due as a lump sum or balloon payment at the end of the term. The interest rate earned by members for their share deposits was balanced against the interest earnings on outstanding mortgages. In order to ensure financial viability when deposits were inadequate to cover outstanding loans, a building and loan association's board of trustees could enforce rules limiting member withdrawals and requiring additional share deposits in order to mitigate insolvency risks. In effect, building and loan associations were self-insuring entities relying on the good faith of their members, both as depositors and borrowers, to do the right thing as a matter of community pride. The only means to replenish deposits from a member's bad debt would be to foreclose on that member's mortgage.

Innovative mortgage lending schemes employing intermediaries began to appear in the late 19th century. An intermediary based in a region would establish a broker relationship with an investor and would then either facilitate investments in local mortgage companies or make direct loans to purchasers. In the 1870s, intermediaries brokered farm loan investments between both American and European investors and mortgage companies operating in the American West. Loans originated by these brokers [Page 477]were later bundled, securitized, and sold on the bond market. Beginning in the 1880s, other mortgage brokers replicated and expanded the building and loan lending model using their intermediary relationship with investors and lenders, which enabled them to broaden the concept of local home mortgage lending over several states within a region. By the 1890s, the mortgage credit industry created by the unregulated intermediaries was overextended and undercapitalized, a situation compounded by the fact that their local mortgage company partners lacked the capacity to enforce loan repayments. These factors largely contributed to the mortgage lending crisis, which resulted in the financial failure of the majority of intermediaries and major losses to their investors whose investments, after all, were not insured.

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