Securitization in the 1920s

Real estate bond issuance, which accounted for nearly 23 percent of all corporate debt issued in 1925, fell to just 0.14 percent of the debt market by 1934 and some days no bonds traded. The real estate bond market soon vanished.

The financial innovations that propelled the boom and collapse of the commercial real estate securities market in the last decade parallel those of that same market in the 1920s. Issuance of commercial mortgage-backed securities financed the construction of most of the U.S. skyscrapers in the 1920 and led to overbuilding and then widespread vacancies. The price declines in the mortgage-backed securities market in the late 1920s preceded the crash of the equity markets and the start of the Great Depression. Analyzing the events of the earlier crisis can provide insights to regulators and financial institutions struggling with solutions to the current one, according to William Goetzmann and Frank Newman, co-authors of Securitization in the 1920s (NBER Working Paper No. 15650).

The authors observe that "by nearly every measure, real estate securities were as toxic in the 1930s as they are now." Widespread economic optimism after World War I fueled demand for office space, boosting average commercial rents nationally 168 percent from a pre-war base through 1924. That kicked off a speculative commercial real estate construction boom not matched until the mid-2000s.

New York and Chicago were the primary focus of the real estate run-up. More office buildings taller than 70 meters were constructed in New York between 1922 and 1931 than in any other ten-year period before or since, according to the authors' research. "These 235 tall buildings represented more than an architectural movement; they were largely the manifestation of a widespread financial phenomenon." That is, the speculative construction meant building for the express purpose of maximizing rents in buildings with multiple tenants in order to turn a profit. Before that time, office buildings were financed and built by companies primarily for their own use.

In order to feed the demand for capital to finance construction, bond sellers courted retail investors, selling them shares in these commercial ventures as well as bonds backed by the properties -- a precursor to the modern markets' complex forms of securitization. Previously, only institutional investors, such as banks and insurance companies, were the sources of such funds.

Demand was such that a real estate securities exchange was created in 1929 and commercial mortgage-backed securities quickly grew into one of the largest classes of investment assets of the 1920s, raising more than $4.1 billion from 1,090 bond offerings between 1919 and 1931. Among the reasons for this rapid growth was the presence of small investors who, it turned out, relied on poorly supported assertions of asset value provided by a few large intermediaries in a market with little centralization or regulatory oversight. "The public was the obvious but critical third party in the real estate securities boom of the 1920s," Goetzmann and Newman write. "It is not clear whether building companies viewed the public as an attractive (if ignorant) source of capital or as a lender of last resort. Anecdotal evidence suggests the latter, as do the empirical results of this study."

At the market's peak in May 1928, bonds sold at100.10, a premium versus par, according to a commercial mortgage price index the authors created to track the coupon yield spreads on real estate bonds for the decade 1926-35. But rampant development based on easy access to capital led to massive overbuilding and then empty structures, which eventually led to defaults and finally a widespread collapse in bond prices.

Significantly widening yield spreads on real estate bonds versus Treasuries began in December 1928, nearly a year before the stock market collapsed in October 1929. By April 1933, bond prices fell to a low of 24.75 cents on the dollar. And by 1936, at least 80 percent of the outstanding securities issued between 1920 and 1929 were failing to meet their contracts, resulting in widespread defaults. Recoverable value on those same issues ranged from approximately 80 percent for 1920-vintage bonds to less than 40 percent for 1928-vintage bonds.

Real estate bond issuance, which accounted for nearly 23 percent of all corporate debt issued in 1925, fell to just 0.14 percent of the debt market by 1934 and some days no bonds traded. The real estate bond market soon vanished, as did many of the bond houses that created them, among them many of the most trusted names on Wall Street. That was followed by public outrage over institutional corruption.

"Ultimately, the size, scope and complexity of the 1920s real estate market undermined its merits, causing a crash not unlike the one underpinning the nation's current financial crisis, due in part to a commercial construction boom matched only in the mid-2000s," the authors say. "These analyses allow us to conclude that publicly-issued real estate securities affected real construction activity in the 1920s and that the breakdown in their valuation, through the mechanism of the collateral cycle, may have led to the subsequent stock market crash of 1929-30."

-- Frank Byrt