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(The material submitted by Mr. Neel, previously mentioned, follows:)
MORTGAGE BANKERS ASSOCIATION OF AMERICA,
Chicago, July 13, 1953. Memorandum to: Members of the board of governors and mortgage market stabi
lization committee. Enclosed you will find the latest revision of the proposal for the creation of a secondary market for insured or guaranteed home mortgage loans which has been prepared under the direction of the mortgage market stabilization committee. Yo conclusive action has been taken on the report by the executive committee or the board and the proposal is not for publication, at least at this time, but is furnished you for your information and confidential use only. Any comments or suggestions which you may have to offer will be appreciated.
BROWN L. WHATLEY.
PROPOSAL FOR THE CREATION OF A SECONDARY MARKET FOR HOME MORTGAGE LOANS INSURED OR GUARANTEED BY THE FEDERAL GOVERNMENT
I. WHY A SECONDARY MARKET FACILITY IS PROPOSED
A. THE FINANCING REQUIREMENTS OF THE BUILDING INDUSTRY 1. Homebuilding now a mass industry
During the last 20 years, homebuilding has achieved the status of a major industry. The size of its operating units has grown; the proportion of the total supply built by the larger operators has risen ; and the practice of building for unknown buyers has become a major factor in the market.
Back of the construction organizations, and in many respects a part of the total industrial operation, are the producers and distributors of building materials and equipment. Like the new building organizations, the manufacturers and suppliers have geared themselves to meet a broad and growing demand.
In other words, homebuilding has become a mass-production industry. 2. Dependable source of financing essential
As a result of this development, the financing requirements of the homebuilding industry are similar to those of other mass-producing industries : in order to maintain its operating units and improve its operating practices, it requires it dependable and relatively constant source of funds to finance the construction and sale of new housing.
At the same time, the homebuilding industry is peculiarly dependent upon borrowed funds both to carry its own operations and to finance its buyers. Unlike many industries having large amounts of permanently committed capital, homebuilding has little internal resources, while the mass of its buyers must also depend upon large amounts of credit.
Because of the importance of maintaining fluidity in the used-house market (on which new sales will more and more be dependent), a dependable supply of funds for this market is equally important. Because of the conditions described below, the housebuilding industry has less assurance of the kind of financing it requires than do other mass-production industries.
B. SHORTCOMINGS OF THE HOME MORTGAGE MARKET
1. Lack of constancy in earmarked funds
(a) Savings and loan associations provide the nearest thing to a constant source of home mortgage money. Their investments are almost wholly in home mortgages and they provide annually about a third or more of the total supply of funds for this purpose. This proportion, as well as the absolute amount of mortgage lending, has been increasing during recent years_testimony to the steadiness of this sector of mortgage lending in comparison with the rest. While this circumstance gives, year in and year out, a fairly dependable base for mortgage activity, it still leaves the bulk of the market subject to other influences. Moreover, since most savings and loan institutions do not have sufficient resources to finance large housebuilding developments, this type of operation is generally dependent on other credit sources.
(b) Other institutional mortgage lenders, comprising mainly life insurance companies, mutual savings banks and commercial banks, are mortgage lenders only incidentally to their role as general investing institutions. They usually limit their maximum participation in the mortgage market to some fixed relationship to their total assets, and they also vary the amount of their mortgage lending according to the relative advantage to be gained from other types of investment. Both these characteristic policies result in occasional marked increases or decreases in the amount of mortgage loans currently being made by them, or even in temporary withdrawals from the market.
Other types of investors (trusts, pension funds, and individuals) are less important and less dependable as mortgage lenders.
(C) The result is that the home mortgage market may find itself temporarily restricted in the supply of funds, for reasons that may be wholly unrelated to
e demand for housing. 2. Uncrenncss of regional distribution of mortgage funds
(a) Surpius and scarcity areas are typical of the home mortgage market even in times when funds are generally available from the investors discussed above. In the older areas of the country, notably New England, the Middle Atlantic, and part of the Great Lakes regions, the funds available for mortgages often exceed the demand for loans. On the other hand, the South, the Southwest, and the West chronically are importers of mortgage money.
(b) Reasons for the unevenness are many. The main cause is that the savings of the country are created in or drawn into the older, more mature regions, and that the more rapidly growing sections of the country find their local resources insufficient for their needs. Metropolitan areas have greater access to funds than small, nonmetropolitan communities, which lack substantial local institutions and present an especially costly servicing problem. States with onerous foreclosure statutes often have greater difficulty in obtaining mortgage money than States in which foreclosure is simple.
(c) The result is that even in times when mortgage money is generally available, areas ranging in size from single small communities to whole regions may have insufficient funds to meet local demands. In times when money becomes generally stringent, these areas appear to suffer earlier and more drastically than more favorably situated localities. 3. Unevenness in economic distribution of mortgage funds
Because of high loan-to-value ratios and limitations on payment periods imposed by State law or supervision, most institutional lenders have been unable, under conventional loan practices, to serve the mass market with first mortgage financing. Consequently, where the market has to rely on conventional lending, risky and costly second mortgage financing usually becomes an unavoidable adjunct to the mortgage system.
C. PARTICIPATION OF THE FEDERAL GOVERNMENT IN HOME MORTGAGE FIXAXCIXG
1. Characteristics of Government home mortgage activities
(a) Scope: The Federal Government, under the direction of the Home Loan Bank Board, maintains a reserve credit system (the Federal Home Loan Bank System), mainly for savings and loan associations, and a system of share account insurance (Federal Savings and Loan Insurance Corporation). The Board also charters Federal savings and loan associations.
The Government operates a number of systems of mortgage insurance through the Federal Housing Administration and a special home loan guarantee and insurance system through the Veterans' Administration. Also through the Veterans' Administration, it provides a system of direct lending for veterans who are unable to obtain private financing within the terms fixed by statute.
Through the Federal National Mortgage Association, it maintains a réserve credit facility of a very limited and specialized character for institutions making FHA and VA loans.
(6) The purposes of these Government agencies are to give stability to mortgage lending activity, to broaden the geographic distribution of mortgage funds, mainly through private financial channels, and to give emphasis to the Channeling of funds to the mass housing market.
The extent to which the agencies have achieved their objectives and the shortcomings they have encountered are briefly described below.
(a) Home Loan Bank Board: The strength and stability to savings and loan associations provided by the Home Loan Banks and the FSLIC have in large measure accounted for the growth of savings and loan institutions. Through use of its chartering power, the Home Loan Bank Board has helped to provide loan sources in some heretofore underserviced areas.
(b) The Federal Housing Administration and the VA Loan Guaranty Seryice, by creating a standard form of low-risk mortgage investment, have increased the geographical and economic ranges of mortgage lending, particularly by life insurance companies and mutual savings banks. They also have augmented local sources of mortgage funds by encouraging commercial banks to make home mortgage loans. These agencies have gone far toward creating a national market in which insured and guaranteed mortgages may be traded. Largely through the influence exercised by these programs and the home loan bank system, complete and regular amortization has become standard practice, thus making unlikely such a collapse of the mortgage structure as occurred in the early 1930's.
(c) The Federal National Mortgage Association, especially prior to World War II, has been helpful in increasing the flow of funds into underserviced areas and in reducing the impact of temporary disruptions in the home mortgage market. 3. Shortcomings of the Federal programs
(a) Limited influence on conventional lending: Aside from the influence exerted through the home loan bank system, none of the Federal programs have had any effect in eliminating deficiencies in the conventional loan area of the market. Instead, they have resulted in the creation of parallel systems of mortgage lending and have developed a national market around these systems.
(6) Limited appeal of Government programs: Only to a limited extent have savings and loan associations participated in the insured and guaranteed loans programs, the bulk of their operations remaining in conventional loans. Major participation has been on the part of banks and insurance companies. In other words, the greatest appeal of the Government programs has been to those institutions which characteristically show the most variability in their mortgage lending policies. As a result, the Government programs have been generally more susceptible to fluctuations in the availability of funds than home mortgage lending as a whole.
(c) Aggravation of variability in the flow of funds: The ordinary tendency of the guaranteed and insured programs to be subject to greater than normal fluctuations has been intensified by the insistence on maintaining maximum interest rates lower than what the market will accept on a par basis.
(d) Inadequate reserve credit facilities: The original purpose of the Federal National Mortgage Association was to provide a stabilizing force in the market by: (1) reaching new investment funds through the sale of its debentures; (2) providing a market for loans in underserviced areas; and (3) offering a source of liquidity to institutions carrying on large insured loan activity. Prior to World War II, the Association served fairly well in meeting these objectives.
Recently, however, the purpose of FNMA has been directed to providing a market for economically dubious loans and to suporting the fixed, submarket interest rates.
D. PROBLEMS TO BE SOLVED
1. Improvements in conventional financing
The conventional loan system could be made a much more flexible and useful instrumentality if State laws regarding foreclosure and investment practices were amended so as to make possible a better geographic and economic distribution of mortgage funds. To the extent that this could be accomplished, the excuse for the Federal programs would diminished
The difficulty is that the conventional loan system is in reality 51 systems as created by State and territorial law, and the task of effecting the desirable improvements is a formidable one.
While this task should not be neglected, it seems also desirable, pending such action, to improve the functioning of the insured and guaranteed systems. The principal steps that could be taken to achieve this end are given below.
2. Flexibility in interest rates
The greater part of the difficulties in the distribution of mortgage funds would be eliminated if interest rates on FHA and VA loans could be set in accordance with the relation of the supply to the demand for funds in the market as of the time and place in which the loans were initiated. Such flexibility in rates is essential if the insured and guaranteed systems are to be an integral, dependable feature of the mortgage market, and if we are to maintain a market of nationwide scope. 3. Secondary market facilities
Although it is not possible, so long as submarket interset rates are allowed to persist, to measure the need that might otherwise exist for additional reserve credit facilities, it seems likely that not even a completely free interest rate would remove all the friction in the maket mechanism. It would still be doubtful that Hawaii and Massachusetts would have equal access to mortgage funds or that the transitory irregularities in mortgage funds would be entirely eliminated. On this probability there would still remain a place for a secondary mortgage market facility.
From a practical viewpoint, it would be most feasible to confine the operations of such a facility, at least at the outset, to transactions in Government-insured or guaranteed mortgage loans, which offer the minimum of difficulty in ultimate disposal to investing institutions.
If successful experience should warrant an expansion of the function of the facility to encompass other types of loans, that could be considered at a later occasion. In the meantime a greater degree of stability would be given to a sector of mortgage activity that has been represententing annually 26 to 36 percent of all home mortgage lending and which now comprises 44 percent of all outstanding loans on 1- to 4-family dwellings.
II. NATURE AND FUNCTION OF A SECONDARY MARKET FACILITY
A. WHAT A SECONDARY FACILITY SHOULD AND SHOULD NOT DO
The purpose of a secondary banking facility for the home mortgage market would be to provide a reserve source of funds. To this end its purpose would be similar to that of the home loan banks. Its scope in one respect would be narrower in that it would deal only in Government insured or guaranteed loans. On the other hand, the scope would be wider than that of the banks in that it would deal with all types of institutional makers and holders of FHA and VA loans, and would be enabled to discount mortgage paper without, as well as with, recourse and to sell its holdings to other institutions as advantageous opportunities presented themselves. Like the banks, however, its character as a reserve, or last resort, source of funds should be clearly established.
The facility should be enabled to overcome shortages of funds occasioned by adjustments in institutional loan policies and by other transient conditions in the general financial markets. It might also temporarily serve to help make a market in remote or rapidly growing areas where the customary facilities for one reason or another were unable to meet the reasonable requirements for mortgage funds. It should, within specified limits, offer lending institutions a means for obtaining liquidity and, hence, add to the attractiveness of mortgages as an investment.
In short, the purpose of the facility would be to provide a measure of breadth, stability, continuity, and confidence to the market for insured and guaranteed loans which might not otherwise prevail. 2. Limitations
Equally important to the delineation of the purposes of a secondary facility are the limitations that should be imposed on it if it is not to be misdirected from its proper task. The resources of a secondary facility should be used neither to finance a speculative expansion of the housing market nor to bolster a market that is already glutted with oversupply.
A proper functioning of the facility presupposes interest rates that either are free to move with the market or are administratively set in a true relationship to current market conditions. Under no circumstances should the facility be used as a means for supporting interest rates lower than those at which persons of good credit are generally able to borrow money.
The facility should be used with great caution as a means for supporting specialized programs.
The readiness of the market to handle most of the financing of World War II defense housing without the intervention of FNMA indicates that special programs can be financed if interest rates and other ternis are in line with market conditions.
B. METHOD OF OPERATION 1. Criteria
The organization, the basic powers, and the operational procedures of the facility should all be designed with the view to accomplishing the purposes of the proposed institution within the limitations prescribed for it. This is obviously a difficult achievement. Since there are no fully reliable indicators of economic trends, it cannot be possible to write into legislation any formula that will assure that the appropriate action will be taken at a crucial time. Much must be left to judgment, as is true with the operation of the Federal Reserve System; and the best that legislation can do is to delineate as clearly as possible the areas in which judgment will be exercised, and to provide an administrative framework which will enable knowledgeable and competent men to exercise their judgment free of passing political pressures. 2. General policies
To assure the last resort character of its operations and to prevent its misuse for speculative purposes, the facility should deal only with the makers and holders of FHA and VA mortgages and never with mortgagors; and it should ordinarily impose a penalty on those who deal with it.
While the principle of buying cheap and selling dear should be maintained, even this need not be invariably adhered to at all times. Flexibility and maneuverability should be the keynotes of policy. In order that rigidity of practice be not mistaken for sensitive and responsible administration, the widest range of judgment should be permitted and encouraged in establishing discount rates and other conditions in connection with its transactions and in determining extent and location of its activities, 3. Organization
To avoid exposure to such pressures as made FNMA a prime instrument of inflation during the late 1940's, the facility should be organized as an independent corporate entity with a governing board with staggered terms of office. No official of either FHA or VA should be a member of the board, nor should these operating agencies otherwise be in a position to dominate the policies of the facility.
It would of course be desirable that the facility be privately financed. Although it is probable at the beginning that it would be necessary to employ Government capital, as was the case with both the land bank and home loan bank systems, provision should be made for its replacement with private funds at the earliest time practicable. The method of accomplishing this has been carefully considered. A purely voluntary method of subscription would not likely be successful, because the yield on the stock is not the primary interest of a true secondary market institution. A compulsory membership arrangement, like that of the Federal Reserve System, would hardly be feasible, because of the difficulty in determining the basis for membership in an institution of this kind. A method of subscription on the basis of the extent to which the facility is availed of, as is followed in the Land Bank System, appears to be the method most adaptable.
Because of the influence that mortgage lending has on the whole credit structure of the country, it is important that a close relationship prevail between the secondary market facility and the central monetary authority. Although this relationship does not have to go so far as to involve administrative supervision of the facility, the discount rate and other broad policies should be determined only after receiving the advice of the Federal Reserve Board.
Consideration has been given to the possibility of making the facility an adjunct operation of the Home Loan Bank Board instead of giving it independent administrative status. Here the problem is the domination of the Home Loan Bank Board and System by a single group of mortgage lending institutions, the savings and loan associations, whose reserve, liquidity, and stabilization problems differ in many respects from those of other mortgage lenders. It is conceivable, however, that, if the nature of the Board were broadened to correspond to that of the Farm Credit Administration (which administers such diverse