NEW EHES Working paper on “Debt Dilution in 1920s America: Lighting the Fuse of a Mortgage Crisis”

Much like the recent crisis, the U.S. Great Depression saw serious and widespread troubles among banks. Also like the recent crisis, the U.S. Great Depression was preceded by a large nationwide boom in real estate, peaking in 1926. Unlike in the current crisis, however, the interwar link – if any – between the real estate boom and the subsequent bank failures has been far from evident. An important argument against the existence of such a link has to do with the conservatism of mortgage contracts at the time. The average commercial bank mortgage contract had a maturity of only three to five years, and required a down payment of 50 per cent of the property value. This in theory would have significantly reduced both foreclosure risk and the negative consequences of foreclosures for banks.


PhD Candidate in Economic History, 

London School of Economics

In this paper Natacha Postel-Vinay re-examines the question and uncovers the darker side of 1920s U.S. mortgage lending: the so-called “second mortgage system,” one of the most widespread and least well-known forms of debt dilution in the twentieth century. As a majority of borrowers in fact could not make a 50 per cent down payment, they took on a second, junior mortgage from another lender to help with the high down payment. As theory predicts, debt dilution, even in the presence of seniority rules, would have been highly detrimental to original lenders’ health, as it increases default risk on the original loan. In addition, second mortgages’ shorter maturity, higher interest rates and more frequent principal payments requirements created a seniority reversal effect which further impaired borrowers’ ability to repay first mortgages. Through foreclosure, banks would still be able to retrieve 50 per cent of the property value, but often after a protracted foreclosure process – a great impediment to bank survival in case of a liquidity crisis.

Using newly-discovered archival documents and a newly-compiled dataset from 1934, this paper thus sheds new light on a financial phenomenon President Hoover then described as “the most backward segment of [the US’s] whole credit system.” In today’s world of “piggyback” mortgage lending and multi-party over-the-counter trading in credit-default swaps, this paper provides timely empirical support to the idea that debt dilution, or “sequential banking” can be highly detrimental to credit.

The working paper can be found here: