have a broad, potential sales market for every mortgage taken into its inventory. And, there is the rub.

The proposed marketing corporations would surely find ample opportunities to purchase mortgages. As the experience of the Federal National Mortgage Association has shown, generating purchases is not a problem so long as funds to purchase the mortgages are available. Sellers anticipating the necessity of selling newly originated mortgages to the proposed marketing corporations will not be dissuaded by discounts. In Fannie Mae's case, for example, discounts as large as 5 percent failed to discourage sharp increases in sales of mortgages to Fannie Mae whenever monetary restraint tightened the mortgage market. The proposed marketing corporations can reduce the ability of sellers to pass on discounts and avoid abuse of their facilities by restricting purchases to existing mortgages. As private firms, they can partly regulate purchases by permitting buying prices to rise when offerings are low and to fall when offerings increase. However, they cannot discourage offerings by arbitrarily pricing mortgages below prevailing market prices without distorting their original purpose. They can neither refuse to buy, nor arbitrarily price themselves out of the market. under these conditions, the volume of offerings to the proposed marketing corporations will vary according to market conditions. Nevertheless, the market portfolio adjustments made by investors during the postwar years indicate that the proposed marketing corporations will have no difficulty in building and maintaining their mortgage inventories.

However, selling mortgages from inventory is another matter for the scene changes from a broad offerings market to a narrowly segmentized sales market. In the existing market structure, for example, suppose that 80 percent conventional mortgages are purchased from savings and loan associations on the west coast. To whom can they be sold? By statute, commercial banks, most life insurance companies, and all mutual savings banks are cut off from the sales side of this market. All savings and loan associations beyond a hundred miles of the original sellers' locations are cut off from this market. So, for these particular mortgages and for the proposed 90 percent mortgages as well, the resale market is restricted to very narrow limits around the sellers' locations. Even if marketing corporations purchased FHA mortgages in Los Angeles, their sales markets would be curtailed by the fact that existing practices generally keep two major segments of the institutional lenders-commercial banks and savings and loan associations-out of the FHA market. This dichotomy of a potentially large purchase market and a segmented resale market has been the principal roadblock to the entrance of the market maker.

Of course, compartments that have thwarted the development of a resale market in the existing structure would be altered by the ABA plan. It proposes to create a 90 percent privately insured conventional mortgage which would be made eligibile for purchase by federally chartered commercial banks and is already eligible for purchase by savings and loan associations. However, Statechartered commercial banks, life insurance companies, and mutual savings banks would still be excluded and savings and loan purchases would still be limited geographically. Rather than generating a national market, new compartments would be created and the hazards of market making enlarged.

Proponents of the plan place considerable emphasis on the insurance feature as a catalyst for bringing about changes in laws and regulations that would overcome this problem by widening the market for the new mortgage instrument by permitting State-chartered commercial banks, mutual savings banks, and life insurance companies to invest in these mortgages. This may be the result, but there are gnawing doubts. It will be many months, perhaps years, before enabling legislation is passed permitting all types of institutional lenders to deal in this new mortgage instrument over broad geographic areas. Even then, what unforeseen variety of compartmenting qualifications will the various States hitch to their respective enabling acts? Even then, how long will it be before investors accept the new instrument?

Keeping in mind the fact that today's market, with savings pressing on a limited demand for mortgages has not been and is not likely to be a permanent condition, widespread acceptance is likely to take many years. With the resources of the Federal Government behind the FHA mortgage, it was many years before investors accepted the insurance principle and traded FHA mortgages. Moreover, savings and loan associations have not been strongly attracted to the greater risks involved in holding 90-percent conventional mortgages, despite the existence of permissive legal authority since 1959.

Of course, it is not unreasonable to hold that the marketing corporations can sustain their operations by dealing in FHA and VA mortgages until the necessary enabling legislation is passed. Then, the crux of the matter will be the ability of 100 percent insurance to instill confidence and, thereby, to perform its catalytic function. The feasibility of private insurance will be dealt with later, but it must be noted that Federal insurance and guarantee has not preempted the residential market from uninsured conventional lending.

In any event, the marketing corporation's problem of balancing ample opportunities to purchase with restricted opportunities to sell mortgages would not be entirely resolved by enabling legislation permitting all investors to hold 90percent conventional mortgages. Differences in State laws affecting foreclosure costs, equity of redemption periods, "doing business" by foreign corporations, and franchise, income, or capital stock taxes would continue to cause some institutional investors to shun some States, and indeed, would probably cause the marketing corporations to avoid purchasing mortgages secured by properties in the same States. Unpredictable changes in FHA and VA interest rates would not be entirely escaped by dealing in the new conventional mortgage. Funds that are attracted or repelled by the level of FHA and VA rates are readily shifted. Therefore, if the new conventional mortgage became widely held, its market determinated yield would not be isolated from the effect of changes in the FHA and VA rates. As Mr. J. Stanley Baughman, president of the Federal National Mortgage Association and the Nation's most experienced buyer and seller of mortgages, has pointed out, “A secondary mortgage market will need the support of statutory and regulatory modifications which will facilitate the free flow of such mortgages between national lenders and investors."

Admittedly, then, developing a ready market for mortgages is faced with serious handicaps that will not be entirely resolved by the ABA formula. Without more extensive reform in the organization of the primary mortgage market, the proposed marketing corporations are likely to become mortgage repositories rather than market makers. But, isn't this an improvement in the market organization? As repositories, the marketing corporations, it is claimed, would make indirect mortgage investments attractive to smaller commercial banks, pension funds, and other investors that tend to shun mortgage investment. Although the total volume of funds raised by this route would not be a net addition to the flow of savings into mortgages, it would be an addition.

It is true that a significant number of smaller commercial banks do not invest in mortgages and, therefore, do not fully meet the credit needs of their communities. However, the projected picture of such banks originating and servicing mortgages that they have sold to marketing corporations ignores the reasons why a significant number of smaller banks have avoided mortgage investments. The problem turns upon the interest and ability of the staff of the small commercial bank to underwrite conventional, or even FHA and VA mortgages. If the proposed marketing corporations, and especially the insurance corporations, are to do their job well, they must be assured that the initial underwriting is done in accordance with industry standards. Therefore, they, like FHA and VA, though perhaps not to the same extent, must invoke certain rules and regulations and must be involved in a certain amount of redtape in order to protect themselves from purchasing or insuring poorly underwritten mortgages. Accordingly, the smaller commercial bank will have to develop an adequate, trained staff to do the underwriting. The community being served would have to support this staff with an adequate demand for mortgage credit. After nearly three decades, the FHA mortgage has not motivated the small banks to resolve these problems, even with FNMA support. To expect the marketing corporations and appropriate enabling legislation to effect any significant change in this area is, therefore, somewhat heroic.

Pension funds, on the other hand, have been drawn into mortgage investment through issues of debentures and collateral trust notes that relieve pension fund managers of the home office chores of managing a mortgage portfolio. The proposed marketing corporations could further this development, but it would be a mistake to anticipate a major breakthrough. The possibility of subsuming all of the differentiating characteristics of the mortgage instrument in a single marketable debenture has long been attractive to proponents of improved market arrangements. Unfortunately, the marketable debenture does not necessarily eliminate these differences. If a single debenture were issued for each mortgage, it would be evident that the differentiating characteristics and risks would be carried over to the debenture. By issuing debentures against a group of mortgages, the risks are reduced to the extent that diversification is achieved.

But this averaging procedure is already available to large pension funds and large financial institutions through direct investment in mortgages without diverting a part of the return to the cost of issuing and marketing debentures.

It appears, therefore, that the principal advantages of converting mortgages into debentures are the diversification of risk for smaller investors and a shifting of the burden of reinvesting amortization payments and servicing from the investor to the issuing agency. Even for this purpose, the debenture must provide a yield that is competitive with comparable securities but less than the return on the mortgage collateral. It is unlikely that a large number of issuing agencies, as implied by the ABA plan, can achieve the necessary leverage. Nevertheless, a single area remains where marketing corporations can contribute to the growth of the private mortgage market through the conversion principle. It can tap the growing pool of savings in pension and similar funds by privately placing debentures with pension and similar funds that are tailored to meet their needs. At best, the early years of the proposed marketing corporations would be filled with tribulations. So much so, that it is difficult to conceive of the source of equity capital. After all, the notion of private marketing corporations is not new. Between 1934 and 1948, Federal legislation provided for chartering of national mortgage associations to buy and sell FHA mortgages and to issue their own obligations. No private associations were formed, ostensibly because of the limited volume of FHA mortgages, the threat of excessive competition from a potentially unlimited number of mortgage associations, and, finally, the creation of Fannie Mae in 1938. Analogous problems confronting the proposed marketing corporations provide little encouragement that equity capital would be forthcoming.

To attract private capital, indeed, to succeed, the mortgage marketing corporations must be financially feasible. Unfortunately, there are no existing private institutions or firms performing the combined functions of (1) buying and selling residential mortgages and (2) issuing debentures and other obligations against the security of mortgage holdings. The Federal National Mortgage Association does not provide a basis for comparison, because it deals only in federally underwritten mortgages, is seriously circumscribed by statute, and is backed by the U.S. Treasury. In fact, it is more of a primary lender than a secondary market facility.

Having no established basis for comparison, the financial feasibility of mortgage marketing corporations can only be approximated. Still, estimates must be made, if consideration of the proposed marketing corporations is to be brought into focus. The estimates made here rely upon industry rules of thumb, practices, and fees, as well as statistics on mortgage yields and borrowing costs. They deal with a hypothetical marketing corporation. Another analyst would undoubtedly use other estimating gages, but it is not likely that the results or conclusions would be altered materially.

For purposes of analysis, the serious doubts just outlined concerning the ability of the proposed marketing corporations to develop an adequate volume of business on both sides of the market are set aside. Therefore, a maximum volume of business is assumed to be possible during the first year. Having no rationale for estimating the mix between mortgages held for sale and mortgages held as security against the marketing corporation's obligations, estimates were made for the two possible extremes. In the first, it is assumed that the marketing corporation becomes a true market maker entirely devoted to buying and selling mortgages and holding no mortgages as long-term investments against debenture issues. In the second, it is assumed that the marketing corporation becomes solely a mortgage repository, issuing debentures against its portfolio. In the first instance, all borrowing can appropriately be placed in commercial banks as, in effect, inventory loans. The capital market would not be used, because of the undue exposure to shifts in long-term rates while conducting a short-term operation. Thus, he total borrowing capacity of the mortgage marketing corporations will be materially influenced by the prevailing ratio of bank loans to mortgages held. With a leverage of 20 times the $5 million paidin capital required by statute, the marketing corporation would have a maximum borrowing capacity of $100 million only if commercial banks were willing to lend in amounts equal to 100 percent of the mortgage security. As commercial banks scale down their lending ratio, the marketing corporation's borrowing capacity is reduced more than proportionately because the difference between 100 and 90 percent or 80 percent must be made up by the marketing corporation's fixed capital base of $5 million. If the bank's lending ratio were 90 percent, for

example, the total borrowing capacity would be reduced to $45 million; if it were 80 percent, borrowing capacity would be $20 million.

Current practices in mortgage warehousing do permit a 100-percent borrowing ratio, but only when the borrower has substantial capital and the mortgage security is insured or guaranteed by the Federal Government and accompanied by a permanent takeout commitment on the part of an institutional investor. The ratio is scaled down when these conditions are not met or credit is tight. Therefore, it is conservative and optimistic to assume that borrowing on the security of an unproven mortgage without a takeout commitment would command no more than a 90-percent ratio. Thus, a first approximation of the marketing corporation's borrowing capacity would be $45 million. With a borrowing capacity of $45 million and capital set at $5 million, the corporation's average mortgage inventory would be $50 million. However, allowances must be made for necessary fixed and liquid assets. If the ratio of fixed and liquid assets to mortgages is permitted to be as low as the 1-percent ratio maintained by Fannie Mae a very liberal assumption-only $4.5 million of the corporation's capital would remain available for mortgage lending and, accordingly, borrowing capacity would be reduced to about $41 million and the corporation's average monthly inventory would be $45.5 million.

The marketing corporation's principal sources of revenue would be interest earned on the mortgages while in inventory and a profit on transactions. For estimating purposes, it is assumed that the marketing corporation would have a mortgage mix proportional to the relative volumes of conventional, FHA, and VA mortgages outstanding and earn interest at the 1962 average yields. On this basis, the weighted average yield would have been 5.83 percent in 1962, permitting a revenue of $2,653,000 on a $45.5 million portfolio. If the corporation turned over its portfolio twice a year, a frequency commensurate with prevailing experience, and earned an average of 0.5 percent on its transactions, transactions income for the year would be 2 times 0.5 percent times $45.5 million or $455,000. Total gross income would be $3,108,000.

On the expense side, industry experience indicates that the marketing corporation will pay for servicing at about 0.5 percent of the outstanding balance and incur a home office expense at about 0.16 percent. Figuring an annual turnover rate of 2, the home office expense would be applicable to $91 million in mortgages. In 1962, the cost of warehousing varied from the prime rate of 4.5 percent to the contract rate of the mortgage security. Inasmuch as commercial banks would be dealing with unproven corporations and unproven mortgages a 5-percent interest charge would be a conservative estimate. Applying these estimated rates (0.5 percent+2×0.16 percent+5 percent) to a $45.5 million average inventory, total gross expenses would be $2,648,000 in 1962. This would leave after-tax profits of $221,000 or a 4.4-percent rate of return on capital; interesting, but not very attractive for a new venture.

The only promising variable for increasing income under the assumptions that have just been made would be a more rapid turnover of inventory, but this would require a secondary market of great breadth for an untested mortgage instrument. In view of the doubts raised earlier, therefore, the greatest hope for success of a marketing corporation lies in basic market reform that will provide a broad market for the resale of mortgages, not a further compartmentalization, not the creation of a hybrid mortgage.

In pursuing the other extreme, a mortgage marketing corporation that is solely a repository for mortgages, a maximum borrowing capacity and mortgage portfolio of $100 million can be assumed. For the sake of simplicity, it was also assumed that average borrowings equaled average mortgage holdings. Thus, it is necessary only to compare yields and borrowing costs as they are applicable to the same base amount.

To allow for a portfolio mix that is largely conventional, the net rate of return on mortgages reported by insured savings and loan associations between 1957 and 1961, adjusted for the fact that the marketing corporation would incur servicing and have office expenses, was used. The net rate of return reported by mutual savings banks, similarly adjusted, was used to view the effect of a portfolio mix that was largely federally underwritten. Thus, alternate rates of return are provided.

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Estimated average rate of interest earned by a hypothetical mortgage marketing

These rates of return were compared directly with the yield on corporate securities rated Aaa and Baa. Differences found were adjusted for tax payments and the net, after tax rate of return capital was computed to obtain alternative estimates, as follows:

Estimated net rate of return on capital, after taxes, hypothetical mortgage marketing corporation

In the period from 1957 to 1961, a marketing corporation holding largely conventional mortgages and borrowing in the capital market at yields returned by Aaa corporate securities would have earned an average of 6.7 percent on its invested captial. It would have paid higher costs than savings institutions for mortgage funds, and to the extent that funds were attracted from other uses, expanded the mortgage market. If the marketing corporations had been able to borrow on the same basis as Fannie Mae, they would have increased their rate of return. However, the marketing corporation is private and unable to borrow from the Treasury or to risk borrowing in the short-term market while holding long-term investments. Moreover, the promising results found when a market rating of Aaa is assumed is overly optimistic, yet not markedly attractive for equity investors in the marketing corporation. Alternatively, if the corporation should only command a rate near the Baa rate for corporate securities, it would have entailed losses in each of the years between 1957 and 1961, regardless of the type of mortgage held.

Though approximations, the above estimates make it clear that financial feasibility-assuming all other doubts are removed-will rest upon the market corporation's ability to avoid becoming a mortgage repository. It is improbable that any marketing corporation will be large enough to bargain for larger discounts, higher mortgage yields, or lower bank rates. Thus, the only promising variable for increasing income would be a more rapid turnover of mortgage inventories, but this will require an active secondary market where purchases could be matched with sales within a reasonably short period of time.

Even more serious doubts appear in the appraisal of the financial feasibility of the mortgage insurance corporation—and yet these are the catalytic keystone of the ABA formula. The nature of the insurance that is being proposed is really an insurance against a serious decline in the economy. Indeed, this is exactly