James Narron and David Skeie
During the decade prior to 1772, Britain made the most of an expansion in colonial lands that required significant capital investment across the East and West Indies and North America. As commodities like tobacco flowed from colonial lands to Britain, merchandise and basic supplies flowed back to the colonies. With capital scarce in the American colonies, colonial planters were eager to borrow cheap capital from British creditors. But because planters often maintained open lines of credit through multiple trade channels, creditors had no way of knowing a particular planter’s indebtedness. So when two banks in London failed, contagion spread and the credit boom suddenly ended. In this edition of Crisis Chronicles, we learn the perils of private indebtedness and offer an inverse comparison of today’s “originate-to-distribute” mortgage market.
A Dual-Trade System Leads to Two Types of Credit Provision
Regional conditions and British trade policy drove two distinct types of trade systems that led to two different types of credit provision. On the one hand, trade policy enforced a reciprocal flow of goods between British merchants and plantation owners. Large planters consigned crops to British merchants who sold the crops through a commission system, purchased goods and supplies for return to the planters, and then charged the plantation owners for any deficits on open credit accounts, usually interest free for one year. In a separate system called a merchant-factor system, mostly Glasgow-based merchants traded commodities, goods, and supplies directly with colonists by way of agents in the colonies. Those agents operated from local stores in the colonies that served as a convenient outlet for British goods. Likewise, the agent stores also provided one year of interest-free credit. Evidence suggests that the merchant-factor system was more heavily used by medium-sized planters, and by 1772 it grew to overshadow the original commission system by three to one.
Planters Struggle to Repay British Merchants as Credit Tightens
Favorable trade and tax policy further fueled trade growth and thus credit expansion between Britain and the colonies, creating a credit boom from 1770 to 1772. The credit crisis of 1772 began in June with the closing of two London banks. As bankruptcies rose in London, contagion spread across England and Scotland, and then on to Dutch banks, before existing central banks calmed the markets.
The credit boom came to an abrupt end, and the ensuing crisis harmed the East India Trading Company, the West Indies in general, and the North American colonial planters specifically. In the American colonies, planters struggled to repay British merchants from commodities sales as prices declined. Bills of exchange, which we describe more thoroughly in our previous post on the Commercial Crisis of 1763, became scarce and untrusted, with Virginia being particularly hard hit as it owed substantially more to Britain than other colonies. To meet creditor demand, Virginia planters were selling tobacco against a declining market with tobacco prices falling so low that revenue from commodity sales was often insufficient to cover debts. And because planters typically maintained open lines of credit with several merchant-factors, creditors had no way of knowing a particular planter’s indebtedness—that is, debts were private. Given the falling commodity prices and creditor uncertainty over each planter’s indebtedness, credit became further constrained. In the end, the merchants, their agents, and planters worked their way out of the crisis as planters worked down their credit exposure over the period of a couple of years.
Losing Track of Your Creditors
Of course, much has been done to understand credit exposure since the late 1700s. Credit rating agencies provide these services for both corporations and individuals today. But what if you no longer know who the creditors are? Years ago, mortgage loans were local affairs and the lender kept the mortgage until it was paid off. But commercial practice changed as banks transformed from an “originate-to-hold” to an “originate-to-distribute” model, as we noted in our post on Tulip Mania. Today, the initial lender often sells the mortgage to a buyer (such as another lender) and that buyer may engage another party to “service” the mortgage—collect payments and interact with the borrower. And the mortgage may be transferred more than once. To further complicate matters, mortgage borrowers in the United States are almost always required to sign two documents—one is an obligation to repay the debt or loan and the other is a security agreement encumbering the real estate (the mortgage).
This division and fractionalization can cause significant confusion, particularly during foreclosure proceedings, so the process of selling mortgages requires some method of determining the person entitled to enforce each particular loan. When a mortgage is created, the initial lender will typically record the mortgage in the appropriate real estate records based on the location of the property. However, when the mortgage loan is sold and the mortgage is assigned, in many cases the purchaser of the loan will not record the assignment of the related mortgage. Sometimes, the original lender, knowing that it intends to sell the loan, will register the mortgage in a tracking system called the Mortgage Electronic Registry System, or MERS, so that assignment of the mortgage can be followed when the mortgage is transferred. But the MERS model was challenged during the financial crisis and, in any event, relies on laws that may no longer adequately support modern financial practice. So the Uniform Law Commission and Congress are working to address some of these issues—both the House and Senate proposed government-sponsored-enterprise reform bills in 2013 that included the notion of a national mortgage registry.
Economies of Scale Drive Mortgage Service Consolidation
And while division and fractionalization are driving one set of legal complexities, economies of scale are driving consolidation among mortgage servicers, with the top five mortgage servicers now responsible for over 60 percent of the mortgages serviced. And every one of the five is owned by a major, federally supervised bank holding company. But increased regulation shouldn’t displace the benefit of the “originate-to-distribute” model, which increases the amount of credit available from local and national sources, is more efficient, lowers costs, and makes credit available for those who have lower incomes.
So how do you strike the right balance between the legal and regulatory complexities of the “originate-to-distribute” model with its benefits? Let us know what you think.
The views expressed in this post are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.
David Skeie is a senior economist in the Bank’s Research and Statistics Group.