Tag Archives: contracts

Mutuality and Financial Innovation

The New Deal and the Origins of the Modern American Real Estate Loan Contract in the Building and Loan Industry

Jonathan D. Rose (Federal Reserve Board) (jonathan.d.rose@frb.gov)

Kenneth Snowden (University of North Carolina at Greensboro)(snowden@uncg.edu)

URL a href=’http://ideas.repec.org/p/ris/uncgec/2012_006.html

We treat the direct reduction loan contract as an instance of financial innovation and describe its adoption within the building and loan (B&L) industry beginning in the 1880s and culminating in the 1930s. A long chain of complementary innovations at B&Ls gradually reduced the costs of adoption, leading to moderate use by the 1920s and potential for far greater use. In the 1930s, extreme dissatisfaction with other contracts radically altered the adoption calculus, as did new competition from FHA-insured lenders. Federal savings and loan charters built upon the accumulated innovations at B&Ls by emulating the small segment of the industry that had adopted direct reduction lending by the 1920s. Other policies helped restructure the liabilities of B&Ls to accommodate the loss of credit risk sharing and mutuality inherent to older contracts. New Deal policies therefore built upon and facilitated the ongoing process of financial innovation that brought the familiar modern loan contract to the conventional loan market.

Keywords: New Deal; Building and Loan

Review by Bernardo Bátiz-Lazo

When Mark Billings and I edited the special volume for Business History – Volume 54, Issue 3 (New perspectives on not-for-profit financial institutions: Organisational form, performance and governance), we were overwhelm with the response of proposals. The paper by Rose and Snowden is witness to this and the fact there are interesting questions to be answered when revisiting why, where and when mutuality and co-operativism offer superior corporate governance to deal with particular risk/reward transactions within retal finance.

Jonathan D. Rose

Their paper was circulated by NEP-HIS on 2012-05-22. Its stated aim is to explore the origins of the direct reduction loan contract (i.e., fully amortized loans with equal monthly payments) and why measures during the New Deal led to its widespread adoption. Rose and Snowden convincingly argue that even though it offered more certainty to borrowers, “widespread adoption of this contract did not follow immediately after its inception, nor did it necessarily appear inevitable ex ante“.

Rose and Snowden take us back to the origins of the building and loan (B&L) society in the USA circa 1830’s, a mutual retail financial institution which was imported from the UK (where it was born in the Midlans circa 1780). These offered share accumulation loans where a borrower committed to make monthly purchases of equity shares until them plus retained dividends equalled the value of the loans. All savers eventually became borrowers and the society was terminated when everyone had received/paid their monies.

Kenneth Snowden

The share accumulation contract was to dominate B&L well into 1893 and it was until the 1920s and 1930s when it was abandoned as its risks became more apparent. New Deal institutions strongly favoured direct reduction contracts and very much help for its widespread adoption. But to get to this stage there was a long process of transformation which included the emergence a sinking fund as well as the so-called “permanent societies” (which Rose and Snowden prefer to call “non serial”).

Rose and Snowden’s is a fascinating account of financial innovation which has touched on a point largely overlooked by the literature on mutuality and certainly by studies of British building societies. One is thus left wondering why share accumulation loans lasted so long in the UK as well as offers a framework to revisit the demutalization debate.