This article examines the history of the U.S. mortgage industry, with a focus on California mortgage lending practices, from the 19th century through the 1970s. Watch for Part II for a history of the mortgage industry during the 1980s through today. 

The seeds of the mortgage industry are with farms 

With historically low rates, record breaking refinances and the sudden reliance on forbearance programs, California’s mortgage industry experienced whiplash in 2020-2021. To better understand the domino effect taking place in today’s mortgage landscape, some background is needed.

The mortgage industry has its roots not in homes or in commercial lending, but in agriculture. Starting in the 1870s, private banks began to lend regularly to farmers, enabling agricultural growth across rural America.

At this time in history, the federal government was not involved in issuing, insuring or guaranteeing loans. Instead, when borrowers defaulted, private farm lenders protected themselves and their investors with “informal arrangements” to demand recourse. Over time, lenders gradually moved to the more standard issuing of mortgage insurance to attract investors to the mortgage market.

Starting in the 1880s, established lenders began issuing covered mortgage bond programs, to later be expanded upon in the urban, residential market.

But even as farm lending grew, access to credit remained vastly unequal, depending mainly on the borrower’s precise location. Interest rates varied significantly from county to county, as did money available to be lent. Naturally, default risk was higher in less established — more rural — areas of the country, and the divergent access to credit reflected that risk.

To even the playing field and increase access to credit, farming organizations lobbied for lending to become more standardized. In 1916, President Woodrow Wilson signed the Federal Farm Land Bank (FFLB) Act into law. Under the Act, farmers were able to access mortgages with lower interest rates and pay them back over longer periods of time, helping small farmers compete with large conglomerates.

Mortgages grow into urban markets

For half a decade, the mortgage market was centered in the rural farm market. However, this was soon to change with the shifting dynamics and demographics of households during the Great Depression.

The Great Depression gripped the U.S. beginning in 1929, lasting for much of the decade that followed. In response to the huge economic losses that characterized these years, the government instituted several social and financial programs, some of which had a profound and ongoing impact on the mortgage market.

As part of the New Deal, the government created the Federal Housing Administration (FHA) in 1934 and the Federal National Mortgage Association (Fannie Mae) in 1938.

The original purpose of Fannie Mae was to create a liquid secondary mortgage market through which mortgages are sold to free up the capital of mortgage lenders so they can originate more mortgages, a process called mortgage warehousing. Fannie Mae primarily bought FHA-insured mortgages and sold them to Wall Street, who then pooled them into mortgage-backed bond (MBB) tranches and sold them to investors. The purpose was to facilitate economic stimulus and recovery following the Great Depression, with housing as the catalyst.

The wartime years helped pull the U.S. out of the Great Depression and proliferate residential mortgages. The variety and availability of mortgage products took on an “hourglass shape” during 1920-1970, as described in a study by the Mortgage Banking Association’s (MBA’s) think tank. In other words, the sudden availability of federally sponsored mortgage products sharpened the mortgage market, eliminating many borrower options. But by the 1970s, the private sector had returned in full force to the mortgage market.

Lenders vs. owner in the recent past

The positions, goals and anticipations of the lender originating a mortgage (or mortgage holder servicing and collecting income from a mortgage) and the owner of real estate are diametrically opposed.

This adversarial relationship stems from business interest, an entrepreneurial trait which is generally what brings both parties to a property in the first place.

California Supreme Court decisions in the 1960s and 1970s brought the confrontation between mortgage holders and owners into sharp focus, as did anti-deficiency legislation in the 1930s.

Property owners took one case of mortgage holder injustice after another to the courts. They challenged the mortgage holders’ right to flex their due-on muscle by raising interest rates at will when the owner of real estate encumbered by a mortgage needed to sell or further encumber the property for funds.

To understand the cause of ongoing mortgage holder-versus-owner battles today, a review of the events in the 1960s and the 1970s is helpful. As case law developed before the early 1980s, important factors included the shifting control of the marketplace from mortgage holders to owners, then back to mortgage holders again, and the often conflicting policies and economies of California and the larger nation.

The early ‘60s: a stable market

The economic boom experienced just prior to the 1965-1967 real estate recession, in 1963-1964, lead to disastrous results for the savings and loan associations (S&Ls) in Southern California.

Much like the lending environment during the Millennium Boom, individual credit was secondary. Anyone, it was said, was able to use the back of an old envelope to sketch a building plan and obtain a lender’s “horseback” commitment for a construction loan. The lender’s objective was to get the funds out to as many borrowers as possible.

Lenders viewed the excess monies on deposit as lettuce about to rot on the shelf. Money had to be lent, quickly. As a result, lenders chased deals to place the funds, a classic prelude to investment error whether practiced by lenders or investors.

Thus, in the early 1960s, builders and buyers selected projects and properties with little concern for the availability of mortgage funds. Funds were readily advanced for the asking. Interest rates were below 7%, and inflation was much lower.

To no one’s surprise, builders funded by lenders created excess inventory. By 1966, vacancy rates and foreclosures soared. Mortgage lenders had lent and sellers had sold to unqualified builders and buyers, soon triggering defaults and increasing foreclosure rates.

Suddenly, the real estate industry became mired in its own excesses, having grown too fast in the absence of financial safeguards on mortgage lending. Turnover rates for owners and tenants dropped, and home sales volume fell naturally.

By the late 1960s, lenders started looking for ways to protect themselves from insolvency, and, with administrative governmental assistance in a rampant series of institutional mergers, regained control of their mortgage investments.

Lenders amass their forces

In 1964, the California Supreme Court modified the common-law application of the due-on clause. While receiving little fanfare at the time, this case was the first in a series of rulings relating to the mortgage holder’s use of a mortgage’s due-on trust deed provision. [Coast Bank v. Minderhout (1964) 61 C2d 311]

Common law had rendered due-on clauses void and unenforceable. The due-on clause, simply read, limited the free use and disposition of any property ownership interest — known as a restraint on alienation. [Calif. Civil Code §711]

Related article:

The due-on threat prevents seller carrybacks

In Coast Bank, the law of restraints on alienation was judicially altered, becoming more permissive with regard to a mortgage holder’s use of the due-on clause. But it came with one warning: the enforcement of the clause was to be “reasonable.”

As a result of this new reasonable enforcement test, the lower courts and attorneys for mortgage holders began carving out purposes for a mortgage holder’s use of the clause which were arguably reasonable under circumstances surrounding the mortgage.

If reasonable circumstances — a jeopardized security position or increased risk of default, for instance — existed to justify a mortgage holder’s call, then the due-on clause was enforced. Payoff of the mortgage balance was demanded, but rate increases were offered as an alternative. However, if the rate increase was not agreed to, foreclosure proceedings were initiated for failure to pay off the mortgage.

The late ‘60s: marketplace instability

In 1965, mortgage rates increased and the money supply tightened. Availability of mortgage funds decreased significantly and inflation soared.

Portfolio lenders did not foresee this massive inflation, which began to adversely affect their solvency. Their cost of funds rose while their portfolio assets were fixed rate mortgages (FRMs) with 30-year amortization schedules.

During this time, approximately a quarter of the S&Ls in California were in serious financial turmoil. The S&Ls had lent to everyone secured by anything — and had done so at rates inadequate to cover the risk of inflation reflected in their cost of funds — interest paid on deposits.

The result was property foreclosures by the thousands — and by entire tracts — as well as the collapse of many large California-based S&Ls. Real estate owned (REO) became common jargon in the language of the real estate broker. Mortgage holders acquired property in foreclosure which had to be sold, and insolvency ran rampant. Thus, a rapid succession of mergers occurred.

As a result, the big got bigger. As struggling lenders merged into bigger, stronger institutions, the ranks of the brokerage business and the real estate trade organizations were decimated.

Sympathy for lenders in some courts

To top off the bad economic climate of the late 1960s for the real estate industry’s non-lending segments, California appellate courts decided two due-on-sale cases in favor of the beleaguered mortgage holders.

It thus became reasonable — and possible — for mortgage holders to use the due-on clause as a profit center. They were permitted to adjust their portfolio yields to reflect higher market yields when a property owner subject to their trust deed lien decided to sell their property. [Cherry v. Home Savings & Loan Association (1969) 276 CA2d 574; Hellbaum v. Lytton Savings and Loan Association of Northern California (1969) 274 CA2d 456]

Although the Supreme Court repudiated the reasoning of one case (Cherry) two years later, it took nearly another decade for the legal confusion caused by the reasonableness doctrine of these cases, starting with the earlier Coast Bank case, to be put to rest judicially in Wellenkamp v. Bank of America. [La Sala v. American Savings & Loan Association (1971) 5 C3d 864]

Disclosure: Fred Crane, firsttuesday’s Legal Editor, was the attorney of record for property owners on the two leading due-on enforcement cases of the time, Wellenkamp v. Bank of America (1978) 21 C3d 943 and Fidelity Federal Savings & Loan Assoc. v. de la Cuesta (1982) 458 US 141.

The California Supreme Court decision in Wellenkamp simply stated what knowledgeable real estate lawyers already knew — California Civil Code §711 made it illegal for mortgage holders to use a due-on clause for profit when the transfer of secured property to a buyer did not place their security interests in danger of impairment.

Any lender or mortgage holder interference with a sale was prohibited, except when it was reasonably necessary to protect the mortgage holder’s security interest in the transferred real estate. The California Supreme Court put a stop to the mortgage holders’ use of the due-on clause to unilaterally adjust their mortgage terms. This brought an end to the era of automatic due-on clause use as a tool to adjust portfolio yields, setting the stage for the growing legal high ground held by owners against lenders — and the sudden reversal of federal mortgage law in the 1980s.

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