Abstract: Debt Dilution in 1920s America: Lighting the Fuse of a Mortgage Crisis

Natacha Postel-Vinay


An explanation of the Great Depression based on mortgage debt via the banking channel has been downplayed due to the conservatism of mortgage contracts at the time. Indeed, maturities were particularly short compared to today's average terms, and loan-to-value ratios often did not exceed 50 percent. Using newly discovered archival documents and a newly compiled dataset from 1934, I uncover the darker side of 1920s U.S. mortgage lending: the so-called second mortgage system. As borrowers often could not make a 50 percent 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 percent of the property value, but after a protracted foreclosure process—a great impediment to bank survival in case of a liquidity crisis. This paper is thus a timely reminder that second mortgages, or ''piggybacks'' as they are called today, can be hazardous to first lenders. It provides further empirical evidence that debt dilution is detrimental to credit.