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increased sharply in late 1958 and in 1959, advances fell below expectations until the rate structure declined. There are limits to which mortgage rates can be pressed without discouraging a significant number of buyers and builders. Consequently, the effects of the money and capital markets do get transmitted through the advance mechanism without, however, causing abrupt, discontinuous shifts in lending. Since 1957, the Federal Home Loan Bank Board has permitted insured institutions to buy mortgage participations from other insured institutions. Initially, the program started slowly. Acquaintance with the techniques involved grew gradually. While only about $2 billion has been traded under this program, last year alone $800 million was transferred among insured associations, an increase of 60 percent from 1961, and almost four times the volume in 1959. Almost 60 percent of the sales originated in the San Francico district, which includes California where the demand for mortgage money has been particularly strong for some years.

Not all of the sales by associations in the San Francisco district leave that area. From 20 to 30 percent of the participations are purchased by associations within that district, reflecting shifts of funds among associations within the region. There are nine States, I believe, in that region. The remainder are widely distributed. The strongest net buying areas are the Boston, New York, Chicago, and Topeka districts, each of which bought more than $50 million net last year.

Linked with the program on advances, the participation mechanism becomes a very efficient transfer mechanism. Associations in regions requiring more income opportunity can borrow from a Federal home loan bank to acquire participations when yields are attractive. The net effect is to cause substantial shifting of funds among regions.

Yet, these two programs have not completely eliminated rate differentials among different markets. Quick references to FHA and VA mortgage quotations will demonstrate that FNMA, given its acknowledged success, has not eliminated rate differentials for insured and guaranteed mortgages. There are costs to transferring money and servicing instruments at a distance. Money will not move unless there is a differential. Theoretically, the differential is compressible to the zero point. Practically, this may not be so, particularly in the mortgage market. Purchase and servicing costs, foreclosure laws, and variations in risk, real or imagined, reduce the need for a differential. Even in the market for business loans, which is exceedingly fluid, rate differentials exist among regions despite the willingness of many banks to lend over extensive geographical areas.

It is possible that the flow of funds alone cannot cure rate differentials among regions. Aside from frictions which can only be overcome at a cost reflected in rates, there exist congeries of other market factors that require exploration and evaluation. Particularly where we deal with a highly differentiated instrument such as a mortgage loan or a business or consumer loan, there may be factors that cannot be erased merely by transferring money among regions. This does not mean that we should ignore the problem. Certainly, the freedom of transfer that does exist has helped reduce rate differentials in all our markets. But, perhaps, we should not grasp too readily a promise to do more without very substantial demonstration of the cost of the new or revised transfer mechanism.

Perhaps one more comment on yield differentials is merited. Saul Klaman, in his "Postwar Residential Mortgage Market" (pp. 96–97), cites a very substantial decline in rate differentials between 1890 and 1940. Somewhat pesimistically he pointed out that the one-half point yield difference between Philadelphia and Los Angeles which existed in 1940 still existed in 1956, and listed several factors which act as a bar to complete elimination of rate differentials.

It might also be helpful to look at what is meant by primary and secondary markets and see how they function. Most simply, a primary market is one in which a new security or loan instrument is sold or negotiated. For example, the primary market for stocks and bonds is the new issue market which has a price yield structure that varies from an existing market. The primary market for mortgages is the lender who makes the loan originally or who agrees to purchase the loan from an agent. A secondary market, on the other hand, is one in which existing securities or loans are traded.

In the operation of each of these markets we can identify two classes of buyers or sellers. A participant in the market may be a portfolio buyer or seller or a nonportfolio buyer or seller. The portfolio buyer is one who purchases with the intent of holding for some substantial period and who will sell only if this assessment of the instrument, relative to others in the marketplace, changes substantially or his financial needs change. The nonportfolio buyer may be a broker, dealer, or speculator or a combination of the three.

When we deal with homogeneous securities such as a given issue of Government bonds, corporate bonds, or common stocks, we find both portfolio buyers and nonportfolio buyers entering the market for original issues. The portfolio investors in these types of instruments are a quite varied group drawn from many different economic pursuits with different market orientations. Ths alone leads to a basis for trades as assessments change over time. The nonportfolio buyer acquires securities to meet demand from customers or to trade in and out quickly for a quick gain. It is because of the existence of heterogeneous groups of portfolio investors, that nonportfolio trades come into the picture. If portfolio investors bought and rarely sold, the secondary market would be inconspicuous and no middleman would be required. Therefore, the existence of brokers and dealers is dependent upon a need by portfolio investors to trade with sufficient frequency to make the broker or dealer function economically rewarding.

Mortgages, however, are a differentiated instrument. Oliver Jones and Leo Grebler in their volume, "The Secondary Mortgage Market," specify a formidable set of reforms which they consider as a prerequisite to the organization of a successful secondary market. They recommend standardizing mortgage terms, adopting a uniform mortgage code by all States, grading mortgages, and other complex changes. In effect, Jones and Grebler are attempting to endow the conventional mortgage with at least as much homogeneity as exists in VA and FHA mortgages. Yet, even in the case of VA and FHA mortgages, the trading is not of the same character as in the security markets. Many purchasers of VA and FHA loans reserve the right of inspection and rejection of each individual loan. The lack of homogeneity of mortgage investments compels our attention. It raises issues that

need to be carefully explored. Can we expect the relative volume of trading in mortgages that exists in securities?

The original purchasers or markers of mortgages are almost entirely portfolio investors. Mortgage companies do make mortgages which they resell. Most frequently, however, they have a firm commitment from a buyer before the mortgages are made. What is more, portfolio investors in mortgages are much less varied than portfolio investors in other securities. Savings and loan associations and mutual savings banks have few alternatives. Only commercial banks and insurance companies have an extensive list of alternatives to mortgages.

Except for the type of motives in the participation program or other similar sales, which reflect shifts of funds from surplus to deficit areas, the motives for buying or selling mortgages are likely to result in a herdlike performance. Portfolio investors in mortgages are likely to have similar motives at any given time for holding, acquiring, or disposing of mortgages. The FNMA experience tends to confirm this bandwagon effect.

This has been a long prolog to the discussion of the bills. What do they propose to do? S. 810 proposes to set up mortgage insurance corporations which would make conventional instruments more homogeneous, and it also would create mortgage marketing corporations to purchase and sell mortgages to make the market more liquid.

In attempting to trace how this set of devices would operate, we discovered some serious ambiguities of both a legal and economic type. Our comments on the legal problems are contained in the Board's report to your committee, as soon as they are cleared by the Budget Bureau, which we hope will be today.

At this juncture, I would like to look at the process through the borrower's eyes.

If I buy a home, do all mortgagees require me to pay an additional one-half percent over and above the interest rate to cover insurance, or only some selected mortgagees? It doesn't seem likely that all mortgagees might do this. Let us assume I am a strong borrowerthat is, one with a good downpayment seeking less than a maximum maturity, might I not avoid those lenders who want the extra half percent? I don't think it would help to argue that those lenders who require insurance would charge a sufficiently lower rate of interest to remain competitive. If they did, they would have to reduce their return on all their mortgages in order to be able to sell a few someday. The borrower, therefore, is not going to be very interested in insurance unless he must agree to pay for such insurance to induce a lender to loan to him. Would this lead to a process of adverse risk selection for the insurance corporation?

Looking at the process from the lender's position, what might his reaction be to the sale of mortgages to a marketing corporation, if he had to pay a premium to get the mortgages insured plus the going discount to induce the marketing corporation to buy them? If the lender were of any size with connections or correspondents in a number of places, he might be able to seek out his own purchaser and avoid the whole superstructure suggested in S. 810.

The preceding comments cast doubt on the claim that the market mechanism would be improved and the cost of mortgages reduced.

The increased efficiency still needs to be demonstrated. If the mechanism includes an insurance premium, not now required, and a marketing corporation which has to cover its cost and earn a profit to attract capital, may not the increased efficiency be more than offset by the cost of the new instrumentalities?

Among other questions posed by S. 810 is the nature of the marketing corporation. One such corporation, with a $5 million capitalization could borrow $100 million. Is this to be a marketing corporation or a mortgage bank? We should bear in mind that dealers and brokers in securities, especially long-term securities, carry very small, even inconspicuous inventories of securities.

At the end of June this year, marketable Government securities of more than 5-year maturity outstanding totaled about $60 billion. Dealers in Governments, however, held inventories of only $80 million, or about thirteen ten-thousandths of 1 percent. The total of mortgages on one- to four-family units outstanding at the end of June was about $175 billion.

If the same inventory allowance can be used for mortgages, the total of such an inventory would be $233 million. It should be noted, however, that we are equating mortgages with Government securities of 5-year maturity because inventory data are not broken down any finer. The comparable inventory if we based it to 10-year, or longer, Governments, would probably be much smaller. Also, trading in over 5-year Governments is probably as active, in relative terms, as stock market trading and clearly more active than might be likely for mortgages under the most favorable conditions. It may not be reasonable to compare highly homogeneous, relatively easily marketable securities with mortgages.

In any event, one marketing corporation would be permitted to hold an inventory almost half as large as the total that results from a liberal inventory allowance. Several such corporations could hold much more. Is this reasonable? Does the bill propose marketing corporations which would be true dealers, or is it developing mortgage banks? Even if all marketing corporations held $200-$500 million in mortgages, they would add to the supply of funds much less than savings associations alone supply to the market in 1 month.

Nor can the question of the adequacy of trading in mortgages be ignored. Dr. Klaman, on page 208 of the volume already mentioned, estimated that true secondary mortgage trading in conventional mortgages, during 1950, averages about 2 to 4 percent of outstanding home mortgages. This is small and may not have grown in the interim. But last year trading in common stocks on the New York Stock Exchange totaled only 13.67 percent of the outstanding value of securities listed on that exchange. Can we say that the present degree of trading in mortgages, given their lack of uniformity and the limited types of portfolio investors, is indeed inadequate? This seems to be a most cogent question.

There are other questions relating to cost. It has been stated the marketing corporation might be able to borrow at a BAA bond yield. Those bonds on existing issues now yield about 4.85 percent. The effective yield on conventional mortgages for new home purchase in August was 5.9 percent. On the surface, this appears to be a more than sufficient margin. This, however, would need to be demonstrated

more clearly and more precisely than any figures we have seen thus far.

What would happen if the demand for mortgages rose sharply? How would the marketing corporation react? Would it dispose of mortgages in its portfolio if it saw no opportunity to replace them? This question becomes important for reasons stated by the Chairman of this subcommittee in a speech to the National Mortgage Conference last May. If the marketing corporation sells its mortgages and can find no replacements, how would it invest its funds if it could not retire or call its securities? It seems that this question must be answered in a more explicit manner than has so far been attempted. Another argument made by proponents of the secondary market plan is that it would attract funds particularly from pension funds. This again raises the question of whether the plan is for a true dealer in mortgages or for a mortgage bank.

It is argued that pension funds do not favor mortgages because of the complexities of handling a portfolio of such instruments. The historical records, at first glance, appears to support this view. Private noninsured pension funds held, at the end of 1962, about $1.5 billion in mortgages out of assets of about $35 billion. In 1962, they invested about $273 million in mortgages out of a total flow to pension funds of $3.6 billion. This is clearly a modest preference for mortgages relative to their total assets. We should note, however, that pension funds already invest each year as much in mortgages as a liberal inventory allowance for the marketing corporation would absorb on a nonrepeating basis.

It also should be recognized that direct investment in mortgages is possible through correspondents or mortgage companies eliminating any involvement in servicing or other recordkeeping problems which, it is argued, keep pension funds from playing a greater role in the mortgage market. The resistance of pension funds to mortgages is due in large measure to the greater attractiveness of other instruments. There has been a marked shift by pension funds from concentration in governments to emphasis on high-grade corporate bonds and common stocks. Yet, in the past 3 years, pension funds have shown increasing interest in mortgages. Investment has grown substantially and various pension funds have announced intentions to explore the field more intensively.

Another issue is whether or not pension funds would purchase securities of a secondary market corporation. No definitive answer can be supplied, since the terms, conditions, quality, and yield of the instruments is unknown. Past practices of pension funds indicates that they are buyers of high-grade securities. It seems uncertain that they would be much interested in an instrument simply because it is backed by mortgages and offers a better return than the bonds they now hold. There is no evidence that pension funds now buy lower rated corporate bonds in order to get higher yields. The ABA proposal suggests the secondary market corporation would have securities in the so-called BAA rated category, an area which pension funds have not entered to any great extent.

The yield on BAA bonds is sufficiently smaller than that for mortgages that, if pension funds were sufficiently interested in rate of return, they would pursue direct mortgage investments. By choosing

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