It was January 1934. The Great Depression was five years old – but still had another five years to run.
The carnage was horrific: From 1929 to 1934, U.S. personal income plunged 44%, real output nosedived 30% and the unemployment rate soared to 25% of the American labor force.

With the nation’s economic landscape laid to waste, it should be no surprise that home foreclosures were soaring, too: Residential real-estate foreclosures doubled between 1926 and 1929 – before the Great Depression actually began. According to a new study by the Federal Reserve Bank of St. Louis, the foreclosure rate jumped from 3.6 per 1,000 mortgages in 1926 to 13.3 in 1933. In that year, in fact, 1,000 home mortgages were being foreclosed each day.

By Jan 1, 1934, as many as half of all residential mortgages were delinquent, putting them at risk of foreclosure.

Clearly something had to be done, elected officials believed. In an attempt to slow that surge, 27 states changed key laws in a way that created a temporary moratorium on foreclosures. Still other state and municipal governments passed permanent measures that made it tough for aggrieved lenders to foreclose on properties whose mortgages were delinquent.

With the benefit of hindsight, it’s not at all clear that the benefits of these moves outweighed the costs – many of which were unintended, says Daniel C. Wheelock, a St. Louis Fed economist and the author of the new research study, “Changing the Rules: State Mortgage Foreclosure Moratoria During the Great Depression.” The study appears in the November/December issue of the St. Louis Fed’s Review magazine, which covers national and international economic developments – especially when there’s a monetary impact.

“Governments cause both immediate and long-term effects when they rewrite the terms of contracts between private parties,” Wheelock wrote. “One immediate effect of mortgage-relief legislation during the Depression was reduced [disclosure rates on farms, which were being hit even harder than the residential real estate sector]. However, over the longer run, foreclosure moratoria and other changes in mortgage laws may have made loans costlier or more difficult to obtain” for future borrowers.

Indeed, the study shows that future borrowers had to face a marketplace where loan capital was in short supply and interest rates were sky high. Lenders made loans tough to get – and then charged a lot for them via high interest rates – because they needed to compensate for the very real possibility that these new laws would restrict their ability to foreclose on delinquent loans.

Fast-forward 74 years, to 2008. Nearly 1% of U.S. home mortgages entered foreclosure during the first quarter; by the time that three-month stretch came to an end, nearly 2.5% of all U.S. mortgages were in foreclosure.

And the news keeps getting worse. In the July-September quarter, 18% of all properties with a mortgage were “underwater” – that is, worth less on the market than what the owner owed on the loan, data supplier First American CoreLogic Inc. told BusinessWeek. It gets worse. That statistic represents more than 7.5 million properties, and another 2.1 million mortgages were within 5% of shifting “upside down.”

All told, nearly a quarter (23%) of U.S. mortgages were underwater or were in a near-negative-equity position. Nevada (48%) and Michigan (39%) led the nation with the highest percentages of negative equity, followed by Florida (29%), Arizona (29%), California (27%), Georgia (23%), and Ohio (22%).

In late July, U.S. President George W. Bush signed the Housing and Economic Recovery Act of 2008, whose provisions included a $300 billion increase in Federal Housing Administration loan guarantees – which were designed to induce lenders to refinance delinquent home mortgages.

A foreclosure-prevention mentality took hold, with loan modification plans and programs such as Hope for Homeowners becoming increasingly common, HousingWire.com reports. Such states as Massachusetts, as well as some local cities, have sought to put foreclosure moratoriums in place; federal legislators, too, have tried to get in the act.

A tentative Bush Administration plan aimed at keeping as many as 3 million homeowners who are behind on their mortgages from losing their houses will be difficult to administer, and could end up costing the country hundreds of billions of dollars more than the plan’s architects expect, a Money Morning contributing editor and credit-crunch expert says.

R. Shah Gilani, a retired hedge-fund manager and Money Morning contributing editor who is emerging as an expert on the worldwide financial meltdown, noted that the plan was apparently still that – a plan. Even so, he said that “any bailout plan that directly addresses foreclosures is political posturing that will ultimately be overwhelmed by inevitable economic realities.”

The plan – which would be part of the $700 billion banking-system rescue package the government approved early this month – would cost $40 billion to $50 billion, with the money being used to cover future losses on loans that are deemed eligible for federal support.

The New York Times carried the first reports of the Bush Administration’s new housing rescue proposal last Thursday. According to the newspaper report, this program would be the most sweeping and direct government initiative aimed at home-loan borrowers since the financial crisis started last year.

Unfortunately – at least with respect to the contentions made by the St. Louis Fed study – this program is a classic foreclosure-moratorium initiative.

As proposed, the federal government would incur half the loss on a home loan if the mortgage company that controls the loan agrees to lower the borrower’s monthly payment for at least five years. On any given loan, the mortgage company would reduce the payment borne by the homeowner by writing off part of the loan balance, reducing the loan’s interest rate or changing other loan terms, sources told The Times.

In this case, the devil truly will be in the details: Trying to take a massive rescue plan – and matching the benefits up with individual homeowners – may be just too much to ask, Money Morning’s Gilani says.

“Who will be eligible, how will that be determined, what will happen when prices continue to fall and mortgage holders eventually walk away” are just some of the tough questions a workable plan would have to answer, Gilani said. Plus, “is the government going to shackle them to their mortgages the same way they’re shackling taxpayers to all these other ill-begotten bailout schemes?

When it comes to the idea that money from the federal government’s Troubled Assets Relief Program (TARP) may be used to manage a bailout of troubled mortgages, all options are still on the table, and the plans under consideration have been stuck in the negotiating room for some time, HousingWire reported.

In a story earlier this week, The Wall Street Journal suggested that “disagreements over how to structure a federal foreclosure-prevention program are complicating and potentially delaying what is likely to be the Bush Administration’s last attempt to forestall sliding home prices.”

According to another HousingWire report, one plan that may be gaining some support is the idea of a federal subsidy for troubled borrowers. On Sunday night, a source near the Pennsylvania office of U.S. Sen. Robert P. Casey, D-Pa., provided the housing news service a copy of a memo that’s said to have sparked some of the ongoing negotiations now taking place.

The memo outlines the mechanics of a mortgage bailout that would cost as much as $441 billion, relying primarily on a three-year subsidy for troubled borrowers that would be repaid in five years, with interest. At that point, the participants would likely be able to sell their homes or refinance the mortgages at amounts that would enable them to repay the loan.

The subsidy plan reportedly represents the thoughts of Assured Guaranty Ltd. (AGO) Chief Executive Officer Dominic J. Frederico, who had been asked by legislators to provide his thoughts a few weeks earlier.

Other proposals are being studied, as well.

No matter what shape or form they take, however, Wheelock, the economist, warns that there will be a price to pay. There’s something to be said for allowing the marketplace to work – and an operational free market includes defaults and foreclosures, with the end result being that only the strongest borrowers remain in the end.

It’s a lesson we should have learned during the Great Depression, Wheelock says.

Wrote the St. Louis Fed economist: “The [foreclosure] moratoria reduced … foreclosure rates in the short run, but they also appear to have reduced the supply of loans and made credit more expensive for subsequent borrowers. The evidence from the Great Depression demonstrates how government actions to reduce foreclosures can impose costs that should be weighed against potential benefits.”

Source: Study of Great Depression  Shows Intervention Postpones Foreclosures, But Causes Mortgage Rates to Spike