1930s banking reform was predicated on the assumption that because commercial banks issue monetary liabilities, it is essential to control the flow of credit – financed by the expansion of the money supply – from banks. In the absence of such control the economy is prone to destabilizing asset price bubbles, because in Anglo-American financial systems there are robust capital markets, and feedback loops can develop between the expansion of the money supply by the banking system and securities prices or real property prices. Given the demonstrated inability in the 1930s of the recently-created Federal Reserve to impose such control through regulation, Congress took a statutory approach and created a compartmentalized financial system. Legislative history makes it clear that preventing the instability associated with asset price bubbles was a motivating force behind the legislation (Senate Report 1933; Sissoko 2018). [Update 2-6- 2019: The link to the Senate Report has been added at the bottom of the post.]
Thus, in the financial reform of the 1930s investment banking was separated from commercial banking and the existing distinction between mortgage lending institutions and commercial banks was preserved. This compartmentalized structure lasted for less than 40 years, as the inflation of the 1970s led to innovations and policy decisions that created deep fissures in the structure of the segmented system. By the 1980s reform was necessary. Both the policy decisions of the 1970s and the reforms of the 1980s were based on a completely different model of the financial system than that on which the 1930s structure had been built.
The discussion of this history will be separated into two parts: (i) the financial reform of the 1930s and the evolution of the segmented financial system through the 1960s, and (ii) the dissolution of that system. This blogpost addresses the early history.
Mortgage lending in the 1920s
In the years preceding the Depression mortgage lending was provided by a wide range of institutions including savings and loan associations, savings banks, mortgage companies, commercial banks and insurance companies. Only the savings and loan associations offered longer-term amortizing loans of up to 12 years. More typical loans were for five years or less and required only interest payments until maturity when a balloon payment of the whole principal was due.
This market structure reflected basic principles of asset-liability matching as they were applied to financial institutions at the time. In order to limit the likelihood of a liquidity crisis, commercial bank loans that were funded by demand deposits were generally short-term and/or callable. Longer term loans, such as mortgages, were funded by savings deposits which often required that notice be given before withdrawal. Thus, commercial banks were actively engaged in mortgage lending, but only with a small portion of their funding, since most of their funding was demand deposits. Even so, commercial banks were prohibited by statute from lending on mortgages of more than 5 years (Eccles 1937: 164). Thus, it was the savings banks and savings and loan associations that put most of their funds into mortgage lending.
The term savings and loan association reflects the concept underlying this cooperative means of mortgage finance. A member in the association was expected to keep his or her savings with it, earning a good rate of return, and in exchange the member was eligible for a loan. Thus, these cooperatives did not intermediate between a group that saved money and a distinct group that borrowed money. Instead, these mutual associations were created because those who were saving money would also need to borrow money to purchase property. Members had an interest in establishing a savings account in order to meet the eligibility requirements of the savings and loan association for a loan, and would often continue placing their savings with the association even after they had paid their loan since a competitive rate of interest was earned while at the same time they were supporting other members of the community.
The 12-year amortized loan was the means by which the savings and loans made it possible for the middle class to afford a home, while at the same time managing the risks of funding these purchases with savings accounts (Weiss 1989: 109). A $5000 home loan at 6% per annum amortized over 12 years results in a monthly payment just under $50 or about the weekly wage of a skilled urban worker. (At 9% interest the payment would be $57 per month.) At the same time even in the first year of a 12 year loan 6% of the principal is repaid, and on average across an evenly spaced portfolio of loans over 8% of principal is paid every year. In short, this was the type of loan that was both a little hard for a savings bank to manage and little bit of a stretch for a lower-middle class consumer at the time. By contrast, 30 year fixed rate loans strongly favor the consumer, and are very difficult for a depository institution to manage: A $5000 home loan at 6% amortized over 30 years results in a monthly payment of $30, just over 1% of principal is repaid in the first year and on average these loans repay 3% of principal every year.
In short, the reason that 30 year mortgages were not offered in the years preceding the Depression is because the savings banks funding mortgages could not possibly hope to manage the risks of lending over that time horizon. With 12 year loans 58% of their funds were committed for more than 5 years. With a portfolio of 30 year loans 83% of their funds would be committed for more than 5 years. Given that their liabilities were all short-term and a lot can change over the course of just 5 years, the 12 year amortized mortgage was considered to be the limit of risk that it was appropriate for a savings institution to take – for good reason.
On the other hand, this loan structure – and particularly the fact that many mortgages were insurance company, commercial bank, or personal loans that were only for about 5 years and were not amortizing – meant that a severe recession could cause defaults, foreclosures and declining housing prices. As a result, real estate crises in which many lenders failed were regular events: the late 1890s and mid-1920s are examples. Thus, the housing troubles of the 1930s differed mostly in terms of their severity and the nationwide reach of the crisis. During the Depression housing became a national problem, and it was addressed at the Federal level. Indeed, alongside employment and social security, preserving homes was one of the three goals President Roosevelt announced in his 1935 State of the Union speech.
Mortgage lending: the reforms of the 1930s and their consequences
The Federal Home Loan Bank System was established in 1932 under President Hoover (Pub. L. 72-304). It was modelled on the Federal Reserve System with 12 regional banks and a governing board, the Federal Home Loan Bank Board, in Washington, D.C. It was designed as a mutual association of savings institutions (also known as thrifts), all of which jointly guarantee Federal Home Loan Bank debt issues. These debt issues are used to fund purchases of mortgages originated by member institutions. Thus, the system was designed to serve as a source of liquidity for thrifts, which in 1932 financed over 46% of all residential mortgages.
Unfortunately, the Federal Home Loan Bank Act was a matter of too little, too late and did little to mitigate the housing crisis. Furthermore, like banks, many thrifts failed in 1932 and 1933. Unlike banks, thrifts were not covered by FDIC insurance when it was created in the Glass-Steagall Act of 1933, and as a result over the course of subsequent months savings migrated from thrifts to banks. By 1934 the thrifts’ share in the mortgage market had dropped to 37% (Lea 1996), a dramatic 20% decline over the course of two years.
In 1934 the National Housing Act (Pub. L. 73-479) was designed to stimulate the building trades and promote employment in them by creating both the Federal Savings and Loan Insurance Corporation (FSLIC) to support the thrifts, and the Federal Housing Administration (FHA) to support other mortgage lenders (Cong. Rec. 1934: 11189). The FSLIC was designed to stabilize the thrift institutions, just as the creation of the FDIC had stabilized the banking system a year earlier. The thrifts’ share of the mortgage market would slowly recover reaching 40% in 1952 and would peak at about 55% in the mid-1960s (PC on Housing, 1982; Lea 1996).
The FHA facilitated non-thrift mortgage lending by creating a consumer-friendly long-term amortized mortgage product that commercial banks and insurance companies could invest in. The FHA addressed the fact that these mortgages were not viewed as appropriate investments for banks and insurance companies by providing government insurance to long-term fixed-rate amortizing mortgages that met specified underwriting criteria. The insurance premium of one-half a percent on the principal value of the loan was paid by the borrower on top of an interest rate with a statutory maximum of 6%. At the same time the new law permitted national banks to hold FHA-insured loans despite the general statutory prohibition on loans in excess of 5 years or in excess of 50% of the property value. (State legislatures promptly passed similar enabling legislation for state-chartered banks, Eccles 1937.) Thus, the FHA program served the needs of insurance companies and commercial banks, and their share of mortgages outstanding grew from 10% each in 1932 to about 20% each in 1952 (Lea 1996).
By slowly increasing the participation of commercial banks and insurance companies in the mortgage market and by promoting consumer-friendly mortgages, the FHA almost certainly played a positive role in the recovery from the Depression and from World War II. This, however, came at a cost as the FHA played a dramatic role in shaping not just the structure of US mortgage markets, but also patterns of housing construction and of home-ownership in the US with vast and long-lasting unintended consequences.
America’s urban fabric places great emphasis on suburban living and on cars as means of transportation. Troubled inner-cities surrounded by well-to-do suburbs did not develop by accident, but in no small part because the FHA in its effort to promote the construction industry favored large, new buildings over the existing housing stock and more modest sized homes. Urban construction frequently did not qualify for insurance. The very structure of the typical American subdivision is a product of FHA handbooks, including the preference for strip malls over ubiquitous corner shops (Hanchett 2000; Zuegel 2018).
The FHA also played a huge role in institutionalizing redlining – or racially discriminatory practices – throughout the country and demanded racial and class-based segregation of subdivisions (Hanchett 2000; Brooks & Rose, 2013). And one should remember as one discusses the extraordinary advantages of federal support for housing finance that the groups that were deliberately excluded from these advantages are much less wealthy today than they would have been if the same advantages had been extended fairly to all citizens (Baradaran 2017).
But our focus here is on how the FHA transformed mortgage markets. The FHA played a huge role both in the standardization of mortgages and in the reduction of the costs paid by the homeowner: the 30-year fixed rate mortgage with a maximum 90% loan to value became the norm, as did relatively low interest rates. Prior to the FHA the typical first mortgage was for up to 60% of the home’s value at a rate between 6 and 10% (depending on location) and most borrowers also carried additional mortgages at higher rates (Eccles 1937; FHLB Review 1934: 18). Although the thrifts did much less FHA insured lending, they too extended the terms of their loans and increased the amount they were willing to lend against the value of the home.
The National Housing Act (specifically Title III of the Act) had envisioned that liquidity would be provided to the non-thrift mortgage market through the creation of federally chartered, but privately owned, national mortgage associations that would stand ready to buy FHA insured loans. In fact, not one such association was formed – possibly because the thrifts had successfully lobbied against giving the national mortgage association’s debt the same tax exemption as the Federal Home Loan Banks’ debt (Cong. Rec. 1934: 11181, 11208, 12566). To address this situation in 1938 the government-owned Federal National Mortgage Association (Fannie Mae) was created. In 1948 (Pub. L. 80-864) Fannie Mae was made a federally chartered institution and authorized to purchase in addition to FHA loans the Veteran Administration-insured loans that had been created by the post-War GI Bill (Pub. L. 78-346).
As the economy recovered and Fannie Mae’s role in the mortgage market increased, concerns were raised over an excessive government role in the mortgage market. Transition to private ownership on the model of the Federal Home Loan Banks – that is lenders who sold loans to Fannie Mae had to also hold Fannie Mae stock – was initiated in 1954 (Pub. L. 83-560). In 1964 Fannie Mae was authorized to bundle FHA and VA mortgages together and to sell interests in the bundles. That is, Fannie Mae was authorized to securitize FHA and VA mortgages. At the same time national banks, thrifts, and FHLBs were authorized to invest in these securitizations (Pub. L. 88-560). In 1968, however, Fannie Mae was separated into two entities (Pub. L. 90-448): Ginnie Mae (the Government National Mortgage Association) remained a government-owned entity that packaged together FHA and VA loans and sold the securitizations to private investors; Fannie Mae was transformed into a government-sponsored private corporation that was required to allocate a reasonable portion of its business to mortgages on low- and moderate-income housing and was authorized to securitize mortgages, subject to government supervision.
Observe that, because the thrifts had never relied heavily on Fannie Mae’s facilities, it was a commercial bank and insurance company-owned entity. The thrift industry immediately recognized that if Fannie Mae was authorized to securitize privately-originated mortgages, this could leave the thrifts at a disadvantage, so they lobbied for a similar facility. Thus, in 1970 the Federal Home Loan Mortgage Corporation (Freddie Mac) was created, as an entity owned by the FHL banks and run by the FHLB Board with authority to purchase conventional mortgages (with a limit on the amount and on the loan-to-value of each loan) and securitize them (Pub. L. 91-351). This same law explicitly authorized Fannie Mae to purchase conventional mortgages on the same terms. This had the effect of establishing both a statutory standard targeting low- and moderate-income housing and a statutory prudential limit on the riskiness of the mortgages.
Let’s pause for a moment and consider the structure of US mortgage markets in the post-War years. It was divided into two segments: the non-thrift financial institutions supported by Fannie Mae and the thrifts supported by the FHLB system, FSLIC deposit insurance, and later Freddie Mac. Up to 1968, the non-thrift financial institutions mostly originated FHA and VA insured loans that could be sold to Fannie Mae, and conventional loans (that is, those that were not government insured) were mostly originated by the thrifts. This structure had worked for most of the 1950s and 1960s, because the growth of lending by the thrifts had met the needs of the public and made government-insured loans a decreasing percentage of the mortgage market.
The problematic nature of private institutions funding 30 year loans with short-term deposits was in evidence by 1965 when the Federal Funds rate rose over 4%. Competition between thrifts led them to increase their savings account rates, which raised safety and soundness concerns at the Federal Home Loan Bank Board (Hester 1969). In 1966 Regulation Q, which had long governed the maximum interest rate paid on commercial bank savings deposits, was extended to the savings accounts held at thrifts and authority was given to the FHLB Board to set the maximum rate. The long-term effect of Regulation Q was, however, that as interest rates rose, the thrifts had fewer deposits with which to finance their activities, and through the early 1970s the diminished lending capacity of the Savings and Loans was a growing problem for the mortgage market.
Investment banking: the reforms of the 1930s
As was noted above, 1930s financial sector regulation was constructed on the premise that commercial banks are special because their primary liabilities and thus their primary sources of funding circulate as money. Commercial banks, like the savings and loan associations, had developed because the same businessmen who often had positive cashflow – and thus money to put in the bank – also were very aware that sometimes they had negative cashflow and that short-term loans could be very valuable under these circumstances. These businessmen kept their money with their local bank, not because the were “savers,” but because by doing so they could also rely on the bank to advance them money when they needed a short-term loan. The commercial bank was thus a coordination device that converted the local money supply into a source of short-term funding for local businesses. That a bank-based money supply expands the working capital available to the business community was a fundamental precept of monetary theory at the time.
In short, in the 1930s money was understood to be a network phenomenon that – to a limited extent – the banks could expand at will without affecting prices. Of course, if the money supply expanded beyond a certain threshold, it could cause either localized inflation, for example when a particular type of long-term asset was being financed by the issue of bank money, or general inflation when an excessive monetary expansion was not so targeted. In short, in the 1930s monetary expansion was understood to be the cheapest way to fund productive activity both for the banks and for the economy as a whole as long as the coordination problem of not issuing too much money and thereby setting off inflation and instability could be addressed (Schumpeter 1939). For 1930s regulators the challenge of financial regulation was to harness the extraordinary power of monetary finance and at the same time control it.
The 1929 stock market crash had been fed by commercial banks offering accounts that invested in stock market margin loans paying as much as 10% per annum – for an overnight, overcollateralized loan – despite the jawboning of the Federal Reserve and influential Congressmen (Senate 1933). In short, the stock market crash had made it clear that the Federal Reserve did not have adequate control over the commercial banking system and the use of funds created by expansion of the money supply (Sissoko 2018). 1930s policymakers decided to turn the monetary system into one that was susceptible of control.
Because of the ease with which the commercial banks can expand the money supply and because of the tendency for bank finance of long-term assets to result in asset price bubbles as had occurred in 1929, the most important aspect of this control was the structural separation of the commercial banks from the investment banks. The Senate Report on the Glass Steagall Act clearly identifies the asset price bubble in the stock market as a consequence of a feedback mechanism generated by bank finance of margin loans (Senate 1933; Sissoko 2018. See also Adrian & Shin 2010). Thus, when the Senate Report summarizes the ills that the Glass-Steagall is designed to address, the first point is “bank loans and their uses” and the Report goes into some detail into how the legislation is designed to control and restrain the use of bank loans. In short, the legislative history is crystal clear: the Glass Steagall Act was passed for the purpose of controlling the flow of bank money. (Note that real estate finance was already for the most part a structurally separate activity and thus was not directly addressed in the bills reforming the commercial banking system.)
While it is generally understood that the Glass Steagall Act separated commercial banks from investment banks (or broker-dealers), the full impact of the Act on the banking system is underestimated. The Glass Steagall Act was designed to protect deposit-taking institutions by (i) preventing them not just from acting as broker-dealers, but also from intermediating security-backed loans to broker-dealers; (ii) empowering the Federal Reserve (a) to regulate the quantity of security-backed loans held by banks as well as interest rates paid by them on deposits, and (b) to replace bank officers and directors who fail to comply with banking laws or to respond to safety and soundness warnings; (iii) prohibiting a bank from lending to its own executive officers, and limiting loans to affiliates and investments in bank premises; (iv) setting capital requirements for all Federal Reserve member banks; (v) creating the FDIC to provide federal deposit insurance to commercial banks; and finally (vi) prohibiting broker-dealers from receiving deposits and requiring state or federal examination and supervision over any deposit-taking institution. For national banks the Act also imposed limits on the interest rate that could be charged on loans; as the limit was the higher of the state usury limit or 1% over the 90-day commercial bill rate, presumably the goal was to limit the risk involved in any national bank loan.
In short, the Senate’s concern with the use of bank loans and their destabilizing flow into securities markets was addressed from every angle. Federal Reserve member banks were forced to spin off any affiliates whose principal activity was broker-dealing (“the issue, underwriting, or distribution of securities”). And broker-dealers were prohibited from taking deposits. And member banks were prohibited from having an officer or director who was also an officer, director, or manager of a broker-dealer. And directors, officers, and employees of any bank organized or operating under the laws of the US were prohibited from being at the same time the director, officer, or employee of a business that makes loans secured by the collateral of stocks or bonds. And every deposit-taking institution was required to be subject to either state or federal examination and regulation. And Federal Reserve member banks were prohibited from intermediating non-bank loans to the broker-dealers if they are backed by securities. And the Federal Reserve was required to set limits on direct bank lending to broker-dealers that is secured by stock or bond collateral.
As a result of this structure the flow of funds from banks that had access to the Federal Reserve discount window into securities-based lending was strictly regulated by the Federal Reserve, and this was an essential part of the structure designed in the 1930s to stabilize the financial system. While federal deposit insurance, statutory capital requirements, constraints on self-dealing, and the additional authority over banks granted to the Federal Reserve surely also played a role in the decades of financial stability, it is a mistake to forget that the first goal of the Act was the firewall it constructed between deposit-taking institutions and securities markets.
Overall, the goal of the segmented structure created by the Glass-Steagall Act was to support a liberal flow of bank money – which monetary theory at the time viewed as playing a crucial supporting role in the circular movement of economic activity – while preventing that liberal flow of money from playing a significant role in the finance of capital market assets or real estate. This structure remained intact through the 1960s, until the inflation of the 1970s coincided with a shift in monetary theory that no longer viewed the flow of commercial bank money as both essential and in need of control. Thus, the 1970s were years of dramatic financial innovation that set the financial system on a very different path from that laid out in the 1930s. The history of this evolution is the topic of the next post.
 Mortgage companies were intermediaries that sold whole loans or covered bonds – that is, bonds guaranteed by the mortgage company – to investors including commercial banks and pension funds.
 See Michael J. Lea, Innovation and the Cost of Mortgage Credit: A Historical Perspective, 7 Housing Pol’y Debate 147, 154-59 (1996); Marc A. Weiss, Market and Financing Home Ownership: Mortgage Lending and Public Policy in the United States, 1918-1989, 18 Bus. & Econ. Hist. 110, 111-12 (1989); Daniel Immergluck, Private Risk, Public Risk: Public Policy, Market Development, and the Mortgage Crisis, 36 Fordham Urb. L.J., 447, (2009); David Min, Sturdy Foundations: Why Government Guarantees Reduce Taxpayer Risk in Mortgage Finance (Working paper: 2012).
 I am simplifying here by describing the situation with respect to the maximum term of a savings and loan mortgage of the 1920s.
 Note that another similar predecessor of the FHLB system was the Federal Farm Loan Act of 1916 (Pub. L. 64-158) which established 12 Federal Land Banks which were mutual associations owned by national farm loan associations and supervised by the Federal Farm Loan Board, and was designed to provide fairly priced credit to farmers. It was restructured in 1933 under the Farm Credit Administration which also refinanced mortgages for farmers. The Farm Credit System still operates today. See Quinn 2016.
 The crisis was also addressed in 1933 by two additional programs, the Home Owners Loan Corporation and the Reconstruction Finance Corporation, which purchased respectively defaulted mortgages and the stock of bankrupt banks and thrifts. Because these programs did not continue, they are not relevant to our discussion. Note also that the federal charter for savings and loans was created by the 1933 Home Owners Loan Act.
 This statutory maximum stayed in place until 1968 (Pub. L. 90-301).
 As the spouse of an architect, let me add that the real estate industry’s focus on square footage over quality living spaces has meant that the whole housing stock is of remarkably low quality in terms of the use of space and quality of life. Visitors from Europe sometimes remark on this. The FHA favored the “efficiency” of large operations over small craft builders (Hanchett 2000).
 Note that in 1959 Fannie Mae’s statutorily permitted investments had been expanded to include “obligations which were lawful investments for fiduciary, trust, or public funds” (Milgrom 1993: 83).
 William Osborn of the National League of Insured Savings Associations testimony March 5, 1970 to the Senate Subcommittee on Housing and Urban Affairs of the Committee on Banking and Currency, Hearing on Secondary Mortgage Market and Mortgage Credit p. 284 (“The National League has no objection to the establishment of a secondary market for conventional mortgages in FNMA as long as a similar facility is made available through the Federal Home Loan Bank System.”)
 For example Wicksell (1898: 135) wrote: “But money, which is the one thing for which there is really a demand for lending purposes, is elastic in amount. Its quantity can to some extent be accommodated—and in a completely developed credit system the accommodation is complete—to any position that the demand may assume.” See also Willis, American Banking 3-4 (1916); Dunbar 1909 13-14, 18.
Update 2-6-2019: Link to Senate Report on Glass Steagall Act: 1933 S Rpt on Banking Act