Financial institutions and the Nation's economy


Material Information

Financial institutions and the Nation's economy FINE : compendium of papers prepared for the FINE study
Physical Description:
v. : ill. ; 24 cm.
United States -- Congress. -- House. -- Committee on Banking, Currency and Housing
U.S. Govt. Print. Off.
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Publication Date:


Subjects / Keywords:
Financial institutions -- United States   ( lcsh )
Federal Reserve banks   ( lcsh )
Housing -- Finance -- United States   ( lcsh )
Banks and banking, International   ( lcsh )
federal government publication   ( marcgt )
bibliography   ( marcgt )
non-fiction   ( marcgt )


Includes bibliographical references.
Statement of Responsibility:
Committee on Banking, Currency and Housing, House of Representatives, 94th Congress, second session ...
General Note:
4 parts in 2 volumes.

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University of Florida
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All applicable rights reserved by the source institution and holding location.
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aleph - 025851803
oclc - 02383028
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94th Congress, Second Session

JUNE 1976

Printed for the use of the Committee on Banking, Currency and Housing
The report has not been officially adopted by the Committee on Banking,
Currency and Housing and may not therefore necessarily reflect the views
of its members.

42-7480 WASHINGTON : 1976

HENRY S. REUSS, Wisconsin, Chairman

THOMAS M. REES, California
JAMES 31. HANLEY. New York
District of Columbia
STEPHEN L. NEAL, North Carolina
LES Ai'COIN, Oregon
PAUL E. TSONGAS, Massachusetts
BUTLER DERRICK. South Carolina
NORMAN E. D'AMOURS, New Hampshire

ALBERT W. JOHNSON, Pennsylvania
STEWART B. McKINNEY, Connecticut
RICHARD T. SCHULZE, Pennsylvania
HENRY J. HYDE, Illinois



The House Banking, Currency and Housing Committee together
with the Subcommittee on Financial Institutions Supervision, Regu-
lation and Insurance announced on April 24, 1975 the undertaking
of a major review of the nation's financial institutions and their
regulation by the Federal Government. A project was launched, called
the Financial Institutions in the Nation's Economy (FINE) Study,
encompassing five areas: The relationship between banks and thrift
institutions, and what changes may be desirable in their borrowing,
lending, investment and customer service activities; the adequacy of
federal regulation, as now divided among three government agencies
for banks alone; the structure and operations of the Federal Reserve
System; the operation of U.S. banks abroad, of foreign banks in the
U.S., and of the Eurodollar market; and the operation of bank holding
A team of consultants and Committee staff, under the supervision
of Dr. James L. Pierce, principal consultant to the Committee on the
FINE Study, began an analysis of the major issues affecting our
financial institutions. Working with staff and expert consultants,
the Committee published in November 1975 a set of Discussion Prin-
ciples which contained proposals for the restructuring of our financial
institutions. Extensive hearings followed and ultimately legislation
was proposed.
As a first step in this process, the Committee commissioned for
FINE a number of studies that were conducted by respected scholars
who had published extensively and had experience in advising the
government on policy matters in their respective fields. These studies
provided an independent perspective on financial reform. The papers
present a focused evaluation of important issues which touch on the
many facets of financial reform and are the result of careful study
by individuals who have thought deeply in their chosen area.
The papers contained in this volume represent all of the studies
that have been commissioned for the FINE Study. Four studies that
were completed and in publishable form before the hearings began
were published in a November 1975 volume. The present volume con-
tains those four studies as well as new ones relating to international
banking, bank holding companies, credit unions and additional papers
on regulatory reform.
Besides the studies, an extensive and detailed questionnaire dealing
with the current practices and attitudes of the Federal banking regu-
latory agencies was prepared by the FINE Study Staff and several
consultants. This questionnaire was published in the earlier volume;
in the present volume the questionnaire is reprinted as well as the
replies from the Federal Reserve Board and the Comptroller of the
Chairman, Committee on Banking,
Currency and Housing.
Chairman, Subcommittee on Financial
Institutions Superviion, Regulation and Insurance.


Digitized by the Internet Archive
in 2013


(The same table or contents appears in Books I and II)
Preface ---------------------------------------------------------- II
FINE Study Discussion Principles--------------------------- --------VII
Part 1-Depository Institutions and Housing--------------------------- 25
1. "Housing and Financial Reorganization," by Dr. Craig Swan,
Associate Professor of Economics, University of Minnesota----- 27
2. "A Program to Protect Mortgage Lenders Against Interest Rate
Increases," by Dr. James L. Pierce, Consultant and Director of
the FINE Study-------------------------------------------- 93
3. "Evaluations of Selected Subsidized Housing Programs," by Rich-
ard L. Wellons, Economic Analyst, Congressional Research Serv-
ice, The Library of Congress-------------------------------- 101
4. "Credit Unions as Viable Financial Intermediaries," by Dr. David I.
Fand, Professor of Economics, Wayne State University-------- 117
Part 2-Regulation of Depository Institutions------------------------- 143
1. "The Structure of Federal Regulation of Depository Institutions,"
by Dr. Samuel B. Chase, Jr., Consultant, Washington, D.C ------ 145
2. "Opportunity and Responsibility in a Financial Institution," by
Dr. Donald D. Hester, Professor of Economics, University of
Wisconsin ------------------------------------------------173
3. "Financial Innovation and EFTS: Implication for Regulation," by
Dr. William L. Silber, Professor of Economics and Finance, and
Dr. Kenneth D. Garbade, Assistant Professor of Finance, New
York University------------------------------------------- 193
4. "Bank Trust Departments and Public Policy Today," by Roy A.
Schotland, Professor of Law, Georgetown University Law
School ----------------------------------------------------211
5. "Bank Holding Companies and Public Policy Today," by Roy A.
Schotland. Professor of Law. Georgetown University Law School- 233
6. Questionnaire: Questions on Regulation and Supervision of Banks,
submitted to the Federal Banking Agencies by the Banking, Cur-
rency and Housing Committee and the Subcommittee on Finan-
cial Institutions Supervision, Regulation and Insurance, U.S.
House of Representatives----------------------------------- 285
Answer: Comptroller of the Currency-------------------------- 301
Answer: Board of Governors of the Federal Reserve System------ 463
Part 3-Structure and Operations of the Federal Reserve System-------- 667
1. "The Structure and Operations of the Federal Reserve System:
Some Needed Reforms," by Dr. Thomas Mayer, Professor of
Economics, University of California, Davis------------------- 66
Part 4-International Banking-------------------------------------- 727
1. "Foreign Bank Activities in the United States," by Jane D'Arista.
Professional Staff Member, Banking, Currency and Housing Com-
mittee, U.S. House of Representatives----------------------- 731
2. "U.S. Banks Abroad," by Jane D'Arista. Professional Staff Mem-
ber, Banking, Currency and Housing Committee, U.S. House of
Representatives -------------------------------------------801







94th Congress, First Session


Printed for the use of the Committee on Banking, Currency and Housing
The report has not been officially adopted by the Committee on Banking,
Currency and Housing and may not therefore necessarily reflect the views
of its members.



62-748 0 76 bk. 1- 2


HENRYS. REUSS, Wisconsin, Chairman

WILLIAM A. BARRETT, Pennsylvania
THOMAS M. RE ES, California
District of Columbia
LINDY (MRS. HALE) BOG G S, Louisiana
STEPHEN L. NEAL, North Carolina
PAUL E. TSONGAS, Massachusetts
BUTLER DERRICK, South Carolina

ALBERT W. JOHNSON, Pennsylvania
STEWART B. McKlNNEY, Connecticut
HENRY J. HYDE, Illinois


As a means of insuring the widest possible participation, including
that of consumer, citizen and financial groups, the following set of
Discussion Principles, a result of preliminary discussions with staff
and expert consultants, is submitted as a part of the FINE (Financial
Institutions and the Nation's Economy) Study process.
The broad approach embodied in these Discussion Principles is
deemed essential to insure that proposals for the restructuring of our
Nation's financial institutions clearly promote efficiency of financial
markets through increased competition among financial institutions.
Artificial and outmoded constraints which have served to inhibit
capital formation required of a flourishing economy must be dealt
with comprehensively if the credit needs of this Nation- private
individuals, government, and business-are to be met.
Hearings will now be held on these principles, leading to the con-
sideration of implementing legislation. The Committee encourages the
fullest possible participation, by the submission of suggestions,
criticisms, and supplemental proposals.
Chairman, Committee on Banking,
Currency and Housing.
Chairman, Subcommittee on Financial
Institutions Supervision, Regulation and Insurance.



I. Deposity institutions----------------------------------------- 1
II. Housing----------------------------------------------------- 5
III. Depository institutions holding companies ----------------------- 9
IV. Regulatory agencies ----------------------------------------- 11
V. The Federal Reserve System -----------------------------------15
VI. Foreign banks in the United States ---------------------------- 19
VII. U.S. banks abroad-------------------------------------------- 21

A coordinated approach is needed to strengthen our depository in-
stitutions. Artificial ceilings on interest rates paid to depositors re-
duce the incentive for Americans to save, discriminate against small
savers, and have not succeeded in preventing disintermediation.
All forms of depository institutions need broader and clearer powers
with respect to both sources and uses of funds. More competition, and
better informed depositors, borrowers, and investors, could provide
an appropriate bicentennial for Adam Smith. Regulation, examina-
tion and supervision of depository institutions must be coordinated to
protect depositor and stockholder interests; to provide equitable
treatment of prospective borrowers; and to prevent laxity and waste
of government personnel. The reformed depository institutions
should be treated equally from the standpoint of taxation. All this
requires that the reform of depository institutions be viewed as a
totality, and not a set of disparate actions.
1. Chartering and Conversion
Any federally-chartered savings and loan association that wishes to
convert to a national bank charter would be permitted to do so, pro-
vided capital and other requirements are met. Any mutual savings
and loan association would be permitted to convert to a stock savings
and loan chartered under regulations similar to those adopted by the
Federal Home Loan Bank Board pursuant to the legislation enacted
by Congress in 1974. Mutual savings banks would be permitted to
convert to a national bank, savings and loan, or be permitted to
obtain original chartering from the federal government. Each of
these permitted conversions would be supervised by the Federal
Depository Institutions Commission (See Title IV-Regulatory
Agencies) to assure that there would be no special advantages to
insiders or other abuses arising from the conversion. In order to en-
courage competition, any new depository institutions would be
chartered if capital and other requirements are met.
2. Sources of Funds
All Regulation Q ceiling rates and the prohibition against paying
interest on demand deposits would be removed by the direction of
the Federal Depository Institutions Commission, according to a
schedule which would avoid injury to the depository institutions
affected and to the flow of capital necessary for housing, and accom-
panied by a method of continuing to attract deposits in a period of



rising interest rates. In no event would these ceilings and prohibitions
exist later than five years after the date of enactment of this proposed
There should be no promise of final review of this action before the
ceilings are eliminated, because unless institutions are sure of the
demise of ceiling rates, they will not engage in the portfolio adjust-
ments necessary to allow them to survive in a world without ceilings
on deposit rates. The Federal Depository Institutions Commission,
in consultation with the Federal Reserve Board and the Federal
Home Loan Bank Board, would have standby authority to reimpose
interest rate ceilings, subject to Congressional review, should this be
required by any financial emergency.
Savings and loan associations, credit unions and mutual savings
banks would also be permitted to issue demand deposits and other
third party transfer arrangements. In the case of credit unions, such
demand deposits and third party arrangements will be available to
the general public only in the case of a community credit union in a
low-income area.
3. Uses of Funds
Savings and loan associations, mutual savings banks, and credit
unions would retain their present investment powers, and be permitted
to engage in expanded consumer lending, including the issuance of
credit cards and the establishment of revolving lines of credit. They
would also be permitted to invest in commercial paper, corporate debt
and bankers acceptance. Savings and loan associations would be
allowed to make interim construction loans not tied to permanent
4. Disclosure
To promote competition, the depositors, borrowers, and investors
of depository institutions are entitled to more information than they
now receive. The Federal Depository Institutions Commission would
be required to obtain from depository institutions, and make avail-
able by market area to the public, information respecting the amount
of interest paid on deposits and charged on loans as well as informa-
tion relating to capital provisions, foreign activities, loan losses, and
the impact of holding company operations on a depository institution.
5. Relationship to Federal Reserve System
All federally insured depository institutions would be required to
meet, reserve requirements on their deposit liabilities, and on their
liabilities to other depository institutions. All reserves would be held
at the Federal Reserve. All institutions of a given size would be treated
alike in their required reserves for a given type of deposit, except that
any institutions that did not formerly have required reserves at the
Federal Reserve would have reserve requirements imposed initially
only on the increase in their deposits over and above their level at
the time of introduction of the legislation. Reserve requirements on
this initial level of deposits would be phased in over a five-year period.


All institutions that are required to meet reserve requirements would
have direct, full and equitable access to Federal Reserve services,
including the discount window and wire transfer system. Branches of
foreign banks would have access to the discount window, but they
could not use loans to foreign borrowers as collateral. The designation
of a Federal Reserve "member bank" would cease to exist, because all
federally insured depository institutions would hold required reserves
with the Federal Reserve, thus, "membership" is automatic and
meaningless. The Federal Reserve would continue to administer the
discount window and the discount rate, and to set reserve require-
ments, in accordance with general monetary policy considerations.
(See Title V-The Federal Reserve System.)
6. Regulatory Agencies
All federally insured depository institutions and their holding
companies would be supervised and regulated by the new Federal
Depository Institutions Commission. (See Title IV-Regulatory
7. Housing Incentives
Incentives to depository institutions to encourage an adequate
supply of funds at reasonable rates for low- and moderate-income
housing are explained in Title II-Housing.
8. Taxation
Banks, savings and loan associations, mutual savings banks, and
credit unions would each receive the same treatment under federal
tax laws.
9. Branching
Interstate branching of all federally insured depository institutions
would be allowed if branching did not conflict with state laws. In
those states where there is a conflict, out-of-state federally insured
depository institutions and within-state federally chartered institu-
tions, would be allowed a branch in all Standard Metropolitan Statis-
tical Areas (SMSA's) with populations of two million persons or above.
All branching across state lines would be subject to the approval of
the Federal Depository Institutions Commission, which would be
responsible for assuring that competition would not be reduced by such
branching. Mergers with existing depository institutions to form
branches across'state lines would not be allowed.
10. Trust Activities
At the present time only commercial banks are permitted to engage
in trust activities. In order to increase competition and decrease the
possibility of conflicts of interest, this power would be extended to
savings and loan associations, credit unions, and mutual savings banks.
The Federal Depository Institutions Commission would supervise and
regulate trust activities, and only permit them upon a finding that the
institution was sufficiently large and strong to support a trust de-
partment. Such non-bank depository institutions would, however,



have to avoid business loans and business investments, which continue
to present a conflict of interest problem for banks which engage in
trust activities.
11. Securities Underwriting
Banks would be permitted to engage in the underwriting of state
and municipal securities, including revenue bonds. The present prohi-
bitions on underwriting of corporate securities by depository institu-
tions would be retained.
12. Electronic Funds Transfer Systems
The Congress would await the receipt of reports from the National
Commission on Electronic Funds Transfers before legislating further
in this important area of new payment mechanisms. Existing regula-
tory authority for new payment mechanisms would be transferred to
the Federal Depository Institutions Commission.

It is not possible to consider meaningful reform of depository insti-
tutions without confronting the problem of housing. Existing housing
programs are clearly deficient, as evidenced by the wild swings in
housing starts that continue to plague the economy and by the large
quantity of remaining substandard and deteriorating housing.
A keystone to housing policies has been the existence of specialized
depository institutions that were created to devote most of their
resources to granting and servicing mortgage loans. These institutions
have been protected from inter-depository institutional competition
for funds by interest rate ceilings on their deposit accounts. These
interest rate ceilings prevent small investors from receiving a fair
return on their savings. And they have not succeeded in insuring a
stable flow of funds into thrift institutions. Because savings and loan
associations hold almost exclusively mortgages which yield a fixed
interest income, it has not been possible for them to afford to pay high
enough interest rates on their thrift accounts to maintain a steady
inflow of funds.
Yet if thrift institutions are to be allowed to invest a significant
proportion of their resources in assets other than mortgage loans,
there is the danger that the mortgage market and hence housing would
suffer in the process. While thrift institutions could afford to pay a
higher interest rate on their liabilities if they could hold more diversi-
fied portfolios, there is no assurance that housing would be any better
off in the process. The Hunt Commission and the supporters of the
Financial Institutions Act have gone to great lengths to demonstrate
that if thrift institutions were allowed greater investment powers, and
if ceiling rates on their deposits were removed, a miracle would occur-
housing and the mortgage market would be better off. But the sole
basis for this rosy conclusion is a questionable series of simulations of
sophisticated econometric models. Stronger measures than wishful
thinking are required to assure an adequate flow of funds into housing.
The proposals that follow are designed to aid low- and moderate-
income housing without using the depository institutions as the whip-
ping boys of a housing program. While the depository institutions
would continue to play a key role in financing housing, they would
receive incentives to participate rather than be coerced. The incentives
would be applied in such a way that broader uses of funds would be
possible, and interest ceilings on thrift accounts would no longer be
1. Alortgage-interest tax credit.-Any financial institution would be
eligible for a mortgage-interest tax credit, along the lines proposed in
the Financial Institutions Act of 1975 with one important exception.
Eligible mortgages would be restricted to those on property destined
for dwellings for low- and moderate-income owners and renters. This
restriction will reduce the estimated $725 million annual cost


significantly w-hen the program is fully operative. There is no reason
to subsidize housing for upper income people, as the Financial In-
stitutions Act of 1975 proposes.
2. Federal Home Loan Bank Board.-The Federal Home Loan Bank
Board would be empowered to lend directly to any depository in-
stitution, provided that the proceeds were used for purposes of grant-
ing mortgage loans for low- and moderate-income housing. Con-
struction loans for rental units to house low- and moderate-income
families would be included as well as mortgage loans on these struc-
tures. The maturity of the loans from the FHLBB would be determined
at the discretion of that institution and could be up to the maturity
of the mortgage loans granted by the depository institution. The
interest rate charged to the mortgagor by the mortgage lender would
have to reflect the lower interest rate the mortgage lender obtains
from the FHLBB.
The FHLBB as reorganized under Title IV would raise its funds
through the capital markets under the auspices of the Treasury. In this
lending program two factors would have to be determined: the amount
of lending that would be made to depository institutions and the
interest rate they would be charged. During periods in which it is
desirable to stimulate mortgage granting activities of depository
institutions, a relatively large volume of funds would be lent at a
subsidized rate, i.e., the FHLBB would charge depository institutions
a rate below what it must pay to borrow in the open market. The
lower rate would be passed on to eligible mortgage borrowers because
of the requirement that mortgage lenders add only a fixed charge to
their borrowing costs from the FHLBB. The cost of this subsidy (the
difference between borrowing and lending rates) would be met from
general revenues, and would have to be the subject of prior Congres-
sional budget and appropriation procedures.
The FHLBB would be guided in its lending program by a co-
ordinating committee comprised of the Chairman of the Federal Home
Loan Bank Board, the Secretary of the Department of Housing and
Urban Development, the Secretary of the Treasury and the Chairman
of the Federal Reserve Board. The Chairman of the Federal Home
Loan Bank Board would be required to issue an annual report de-
scribing the planned lending program for the coming year and describ-
ing how the execution of the program over the previous year accorded
with the program that was planned.
3. Mortgage Reserve Credit.-The Federal Reserve Board would be
given authority to provide reserve credits to all depository institutions
on new and outstanding low- and moderate-income housing and
construction loans for all depository institutions. All depository
institutions that are required to hold reserves at the Federal Reserve
would be eligible for the credit.
.Thus for each dollar of reserves held at the Federal Reserve, each
institution would receive a reserve credit against these reserves equal
to a fixed percentage of its new and outstanding dollar volume of
mortgage and icsidential construction loans. The reserve credit would
enhance the attractiveness of mortgage and construction loans relative
to other assets because the act of granting these loans would free re-
serves that could be used for investment purposes. The credit would
also ease the burden on those depository institutions that would ex-
perience large reserve requirements for the first time.


The Federal Reserve Board would set the percentages for the
credits at a percentage of qualifying loans that would, generally
speaking, allow an institution truly specializing in low- and moderate-
housing loans to substantially escape the new reserve requirements
on time deposits. The only restriction would be that net required
reserves (required reserves less the reserve credit) would have to be
positive for all institutions.
Because of the obvious influence that the reserve credits would
have on the nation's housing program, the Federal Reserve would
have to be guided by the coordinating committee described in Title
II, 2.


The general statutory framework that provides for depository
institutions holding companies' regulation and places limits on their
activities should be retained. Both statutory amendments and im-
proved regulation are needed to reduce the possibility that relation-
ships between and among depository institutions and their non-
financial affiliates can impair the soundness of the depository in-
1. Federal Depository Institutions Commission.-The Federal De-
pository Institutions Commission would have authority for supervis-
ing, regulating and examining bank holding companies and holding
companies involving savings and loan associations.
2. Competition.-In order to promote healthy competition among
depository institutions, holding companies would be subject to the
jurisdiction of the Federal Depository Institutions Commission so
as to prevent the acquisition of bank or savings and loan subsidiaries
which would tend to lessen competition in a financial market.
3. Avoiding Confusion.-Naming of holding companies, other sub-
sidiaries of the same holding companies, and their affiliates in a way
sufficiently close to that of a financial institution so as to cause public
confusion would be prohibited. Any liability issued by a non-financial
subsidiary would clearly state that the liability carries no guarantee
by any depository institution in the holding company system, or by
the U.S. government.
4. Prohibited Transactions.-The Federal Depository Institutions
Commission would determine, before permitting any action by a
depository institution with a holding company, a subsidiary, or an
affiliated non-financial institution, that such action would not weaken
the depository institution in question. Present limitations on the
amount of loans between and among affiliated depository institutions
and the requirement that they be secured, would be removed, thus
treating these transactions as similar to inter-branch bank transac-
tions. Transactions, other than routine deposit transactions, would be
prohibited between a depository institution which is a subsidiary of a
depository institution holding company and any investment company
(including real estate investment trusts) which it manages or advises.
5. Public Information.-The Federal Depository Institutions Com-
mission would obtain, and make publicly available by market area
on a periodic basis, information concerning loans and other financial
transactions between and among depository institutions, their holding
companies, their non-financial affiliates, and institutions such as real
estate investment trusts which obtain advice from a non-financial
6. Independent Directors.-The Board of Directors of each financial
institution in a holding company system, as well as the important
committees thereof, would be required to have at least one-third their
members independent-having no affiliation with the holding com-
pany or any of its nonfinancial affiliates or subsidiaries.

In a speech to the American Bankers Association Convention in
October, 1974, Chairman Arthur Burns of the Federal Reserve Board
characterized the present bank regulatory system as "a jurisdictional
tangle that boggles the mind."
This tangle of confusing, overlapping, and sometimes conflicting
jurisdictions and policies, Chairman Burns noted, has resulted in a
"competition in laxity" among the regulators that poses a grave
danger to the public interest.
The alarm sounded by Chairman Burns echoed past admonitions
by knowledgeable officials. As far back as May, 1962, the former
Vice Chairman of the Federal Reserve Board, Governor J. L. Robert-
son, warned that the tripartite bank regulatory system tends to reduce
the standards of supervision "to the level of the lowest or most lenient."
Hearings by committees of the Congress have disclosed a wide-
spread increase in dubious bank practices approved by regulators
who are supposed- to be guided by principles of soundness. These
questionable practices include excessive foreign currency speculation,
extensive bank involvement in unsound loans to real estate invest-
ment trusts, and enormous expansion of banks through bank holding
companies and in operations overseas. The collapse of three major
U.S. banks, suggests that the quality of bank regulation may be
In part, the deficiencies in the present regulatory apparatus can be
attributed to the jerrybuilt nature of its construction. Until the
National Bank Act of 1863,. all banks were regulated solely by the
states, which continue to play an important supervisory role. A
superstructure of federal regulation has developed on top of state
regulation. The Comptroller of the Currency supervises nationally-
chartered banks; the Federal Reserve Board supervises state-chartered
member banks, all bank holding companies, and so-called Edge Act
Corporations (international banking subsidiaries of U.S. Banks); the
Federal Deposit Insurance Corporation (which insures nearly all
banks) supervises state-chartered banks that are not members of the
Federal Reserve system.
Within this three-headed structure, anomalies abound. The Federal
Reserve, for instance, regulates bank holding companies, but usually
does not regulate the bank involved. The Federal Reserve has sole
authority over Edge Act corporations, but often does not regulate the
bank with which the Edge Act corporation is associated. The Federal
Reserve has sole authority to supervise the overseas operations of
U.S. banks, but in many cases does not regulate the domestic opera-
tions of the same bank.
As early as 1937, the Brookings Institution called for consolidation
of regulatory and supervisory responsibility. Since then, the Hoover
Commission in 1949, the Commission on Money and Credit in 1961,
and the Hunt Commission in 1971 all have made extensive recom-
mendations for reform.




Clearly today's complicated financial world cannot afford to run the
risk of recurrent crises before adopting safeguards. The present system
must give way to a single, strong Federal Depository Institutions
Commission that will better serve both the public interest and the
interest of the financial community here and abroad.
1. Creation of a Single Agency
A single Federal Depository Institutions Commission would be
created, which would draw together the activities of the Comptroller
of the Currency, and the regulatory and supervisory functions of the
Federal Reserve System, the Federal Deposit Insurance Corporation,
the Federal Home Loan Bank System, and the National Credit Union
Administration. The Commission would be phased in over a three-
year period.
Under this proposal the Office of the Comptroller of the Currency
and the National Credit Union Administration would cease to exist.
The agencies that presently provide federal insurance to depository
institutions would be combined into a single agency under the aegis of
the Federal Depository Institutions Commission.
The Federal Reserve Board would be responsible only for the
conduct of monetary policy, as described in Title V-The Federal
Reserve System. The Federal Home Loan Bank System would receive
a new charter which would include the authority to administer the
Federal Home Loan Mortgage Corporation and to administer a
program of housing finance that would utilize all depository institu-
tions as a source of mortgage funds for low- and moderate-income
housing, as described in Title II-Housing.
Creation of a single agency would make it easier to upgrade the
quality of bank examination, supervision, and regulation by enhancing
he prestige of the agency and by concentrating resources on better
training and recruitment of personnel. It would also result in sub-
stantial savings through elimination of duplication.
2. Composition of Commission
The Federal Depository Institutions Commission would be com-
prised of five commissioners including the Deputy Attorney General,
a commissioner of the Securities and Exchange Commission (selected
by the Chairman of the SEC), the Vice Chairman of the Federal
Reserve Board, and two representatives of the public interest, one of
whom would be Chairman. The representative of the public interest
and the Chairman would be appointed by the President and confirmed
by the Senate. They would serve six year terms, except that the
initial term of the non-chairman public Interest representative would
be for four years.
3. Duties of Commission
The Commission would be responsible for the chartering, conversion,
mergers, examination, supervision and regulation of foreign banks as
well as all federally chartered depository institutions (including Edge
Act corporations) and their holding companies. The Commission
would also be responsible for the examination, supervision and regula-
tion of state chartered banks, savings and loan associations, credit
unions, mutual savings banks and the overseas branches of U.S. banks.
This responsibility could be delegated by the Commission to state


supervisory authorities upon a finding that the state authority was
doing an adequate job.
Depository institutions not insured by the federal government
would be omitted from the jurisdiction of the Federal Depository
Institutions Commission. The Commission would also respect and
observe the elements of the dual banking system in its examination,
supervision and regulation of state chartered depository institutions.
4. Structure of Commission
The Federal Depository Institutions Commission would have a
dual charge: to encourage the soundness of depository institutions,
and to encourage competition among them.
To accomplish this, the Commission would be composed of two
(a) One unit would pursue the examination, supervision and
regulation functions relating to the soundness of depository
(b) The second unit would be responsible for promoting
competition. It would do this through analysis and recommenda-
tions with respect to mergers, new charters, holding company
activities, and disclosures of relevant information.
The Commission would be required to submit a public report and
testify at least once a year before the appropriate committees of
Congress with respect to its efforts to improve the competitive
performance of depository institutions and its efforts to promote

The impact of the Federal Reserve System's conduct of monetary
policy on economic growth, jobs and inflation has grown enormously
since the system was established in 1914. Yet the structure of the Fed
has never basically changed. It remains, in important ways, essentially
a "banker's bank," its control largely in the hands of American
financial and industrial interests.
Member banks own the stock of the 12 Reserve Banks. Two-thirds
of the directors of each Federal Reserve Bank are elected by member
banks, the remaining one-third by the Board of Governors. The
Boards of Directors then elect the presidents of the Reserve Banks,
who in turn wield important influence on the Federal Open Market
Committee, which sets monetary policy.
Congressional and public involvement in monetary decisions which
affect all Americans has been peripheral, and easily ignored. In con-
trast with fiscal policy, which is hammered out on the forge of public
debate and in give and take between the executive and legislative
branches, monetary policy is shaped largely in secret.
In its virtually complete control over monetary policy the Fed can
largely offset the effects of fiscal policies determined by democratic
process. The Fed can-by either intent or by error-precipitate
inflation or recession. The experiences of 1966, 1969, 1973, and 1974
bear witness to this power.
The removal of monetary policy from public pressure is both a
virtue and a vice. It allows monetary policy to be flexible in a way
that is virtually impossible for spending and taxation policy. It
exempts monetary policy from narrow political considerations. But the
balance between independence and public accountability is tipped too
far in one direction. The Federal Reserve has become almost a fourth
branch of government, exempt from the system of checks and balances
written into the Constitution for other areas of public policy.
The recommendations that follow are designed to bring the Federal
Reserve more into the public realm, more responsive to the needs of
all major constituencies of American society. At the same time, the
Federal Reserve would retain the scope for flexibility in policy, and a
measureof independence great enough to insulate policy from transi-
tory political considerations.
Due to the transfer of certain responsibilities now vested in the
Federal Reserve Board to the Federal Depository Institutions Com-
mission, the present Board of Governors consisting of seven governors,
would be replaced over time by a five member Board which would
continue to be appointed by the President and confirmed by the
Senate. The governors would serve staggered terms of ten years, with
a new term available every two years. This is the same turnover rate
that currently exists with seven governors and fourteen year terms. In



order to effect an orderly transition from a seven member board to a
five member Board, the first two terms to expire after the enactment
of this legislation would not be filled.
The President would select a Chairman of the Board from among
the five Governors, subject to confirmation by the Senate. The
Chairman's term would be for four years, and would be co-terminous
with that of the President.
The operations of the Federal Reserve System, except for monetary
policy and for transactions on behalf of foreign central banks, would
be subject to audit by the General Accounting Office.
A. Responsibilities
Regional Federal Reserve Banks would have no regulatory respon-
sibilities, because the responsibilities would be transferred to the new
Federal Depository Institutions Commission. The stock of the Reserve
Banks would be retired, and the banks would become purely a govern-
ment institution. Reserve banks would continue to perform their
current functions of discount facilities, check clearing, funds transfers,
coin and currency distribution, research, and public distribution of
data and special analyses. The Federal Reserve Bank of New York
would continue to conduct open market operations and foreign
exchange activities on instruction from the Board of Governors.
B. Presidents
The presidents of the reserve banks would be appointed by the
President of the United States, subject to confirmation by the Senate.
They would have a term of five years and would receive salaries
equal to those of Governors.
Reserve bank presidents would be phased in as existing presidents
reach the end of their present five year terms- of office. They would
be required to be highly qualified to advise the Board of Governors
on monetary policy, as well as to conduct the functions of the banks.
The present Boards of Directors of the Reserve Banks would cease
to exist, and the present function of the Boards in bringing diversity
to monetary policy making (in terms of geography, business sectors,
and other constituencies) would be met through the changes proposed
in this Title.
Each Reserve Bank president would present written reports of the
Advisory Committees mentioned below, as well as reports of their
own views, to the Board of Governors. All such reports would be
promptly distributed by the Board to the general public.
The Reserve Bank presidents would not vote on monetary policy
actions, but would advise the Board of Governors on policy and would
be present at meetings dealing with policy. The Board of Governors
would promptly inform them of all policy actions.
C. Depository Institutions Advisory Committee
Each Federal Reserve District would have a Depository Institutions
Advisory Committee appointed by the Federal Reserve Bank president
comprised of representatives of those institutions-banks, savings and
loan associations, mutual savings banks and credit unions-holding
required reserves at that Reserve Bank. Members of the Depository
Institutions.Advisory Committee would make their views known con-
cerning Federal Reserve regulations that directly affect them, such as



the levels of reserve requirements for different kinds of liabilities and
for different size institutions, the discount rate and administration of
the discount window, operations of the Federal Reserve's funds
transfer system and other functions of the Fed.
The Committee would be comprised of twenty to thirty members,
as determined by the Reserve Bank president, selected from large,
medium-sized and small institutions, and giving fair representation to
each type of institution. The Committee would advise the Reserve
Bank president in open meetings, and would present appropriate
reports and comments to the Reserve Bank president.
D. Monetary Policy Advisory Committee
Each Federal Reserve District would have a Monetary Policy
Advisory Committee appointed by the Federal Reserve Bank presi-
dent comprised of individuals residing in the Reserve District. The
Committee would have twenty to thirty members, as determined by
the Reserve Bank president, giving fair representation to finance,
industry, farming, labor, and education, and the general public. All
reasonable efforts should be made to appoint a Committee that is
representative of the population characteristics of the Federal Reserve
The Committee would serve as the eyes and ears of the community
and would evaluate local conditions in the district. It would present
to the Reserve Bank president in open meetings its views on how
monetary policy actions are affecting the local communities and the
A. Responsibility
At present, the three tools of monetary policy-open market
operations, reserve requirements, and the discount rate (the rate
which the Federal Reserve charges banks who borrow from them)-
are wielded by three different authorities. The Federal Open Market
Committee decides the extent of purchase or sale of government securi-
ties, which influences interest rates and the availability of money and
credit in the economy. The Board of Governors establishes reserve
requirements, which influences the money, credit and interest rates in
different ways.
Applications for changes in the discount rate are approved by the
Board, but the recommendation for such changes comes from the
boards of Directors of the 12 reserve banks. This "system" is not
only incoherent, but it also fails to pinpoint responsibility for monetary
The regulation of financial institutions would be removed from the
Federal Reserve System and placed in the hands of the Federal
Depository Institutions Commission, as described in Title IV. This
would make monetary policy the full-time responsibility of the Board
of Governors of the Federal Reserve. Monetary policy would be
centered in this one responsible group, operating with the advice of
Federal Reserve Bank presidents and the Two Advisory Committees
described above.



B. Employment Objectives
The Federal Reserve Act would be amended to explicitly make the
Federal Reserve responsible for helping achieve the objectives of the
Employment Act of 1946: to' "promote maximum employment,
production and purchasing power."
C. Economic Reports
The Board would be required to issue an annual economic report
similar to that required of the President. It should be issued following
consultation with the President and review of the Administration's
fiscal policies and at the same time, or shortly after, issuance of the
President's report. The report would explain in detail basic monetary
policy plans for the coming year, and how the Board has conditioned
its plans to the relevant fiscal proposals of the President. The Board
would provide its economic forecast for the coming year and explain
how its policies would help achieve the results forecast. The report
would also describe how its policies have been chosen in light of the
Board's obligations under the Employment Act of 1946.
D. Congressional Testimony
The Board would be required to present annually its report to the
Congress in order to present Congress with the formalized opportunity
to express its views on the monetary policies contained therein. The
Board would continue to report to the Banking Committees of the
Congress every three months on the progress of monetary policy, as
set forth in House Concurrent Resolution 133.


The growth in foreign bank operations in the U.S. has been one of
the more significant developments in banking activity in the last
decade. U.S. assets of the 78 foreign banks (with 180 U.S. offices)
exceed $57 billion, up from $7 billion ten years ago. Foreign banks
now hold 6.5 percent of total U.S. commercial bank assets, and 9
percent of all business loans.
Foreign banking here is conducted by very large banks. Forty-
seven-or approximately three-fifths-of the foreign banks engaged in
banking operations in the United States are among the top 100 banks
world-wide. Only 18 U.S. banks are among the top 100 in size of
Foreign banks here have five major advantages over U.S. banks.
These advantages result from the absence of any federal regulatory
controls over foreign banks, which leaves jurisdiction to the states.
First, they can engage in full-service banking operations in more
than one State, a privilege denied domestic banks under the McFadden
Act of 1927.
Second, through subsidiaries and affiliates, they may underwrite
and deal in corporate securities in addition to their banking business.
These activities are prohibited to domestic banks under the Glass-
Steagall Act.
Third, foreign banks can hold equity investments in U.S. com-
mercial companies or U.S. subsidiaries of foreign commercial compa-
nies, while U.S. banks and bank holding companies are barred from
such equity investments in commercial companies.
Fourth, foreign banks are not subject to the "closely related to
banking" restriction of the Bank Holding Company Act of 1970.
Fifth, foreign bank branches and agencies escape the restrictions
of member bank reserve requirements. The branches and agencies,
which control some 80 percent of total foreign bank assets here, have
been able to tap the Eurodollar market for purposes of lending in
the U.S. without posting reserves. Domestic banks, on the other
hand, have reserve requirements imposed on their identical Euro-
dollar borrowing. In the period July-October, 1974, when money was
tight and domestic banks had a reserve requirement of 8 percent on
the use of Eurodollais for domestic )purposes, foreign agencies and
branches brought $1.8 billion of Eurodollars into the United States,
and lent $1.4 billion to credit-starved U.S. corporations and $.4
billion to banks willing to pay as much as 13 percent for short-term
funds. As the Federal Reserve Board has recognized, this freedom
from reserve requirements for foreign banks doing business in the
United States seriously hampers the Board's monetary policies.
Because the recommendations which follow, together with the
other Titles, treat foreign banks generally like domestic banks,
"grandfathering" would not be permitted, subject to a phasing out



1. Interstate Branching would be allowed for foreign banking sub-
sidiaries and branches, subject to the approval of the Federal Deposi-
tory Institutions Commission, and subject to the same conditions
which would apply to interstate branching by domestic banks.
2. Underwriting.-Foreign banks chartered in the U.S. would be
permitted to engage in the underwriting of state and municipal
securities including revenue bonds. The present prohibitions on
underwriting of corporate securities by depository institutions would
be extended to foreign banks, which would have an appropriate in-
terim period to phase out existing operations.
3. Corporate Equity Investment.-Foreign banks, branches and
holding companies (chartered in the U.S.) would, like domestic banks,
be prohibited from holding equity investments in commercial
4. Bank Related Activities.-Foreign banks would be subject to the
"closely related to banking" restrictions of the Bank Holding Company
Act of 1970.
5. Reserve Requirements and Deposits.-Foreign bank subsidiaries
(chartered in the U.S.) could engage in all activities allowed domestic
banks and would be subject to the same reserve requirements as are
domestic banks, including reserve requirements on Eurodollar bor-
rowings from their parent banks and other foreign deposits. Foreign
bank branches (whose parents are not chartered in the U.S.) could not
accept deposits in the U.S. from individuals, partnerships, corpora-
tions, states and municipalities, because deposit insurance is not now
legally available, and would be difficult to supervise if it were. These
branches would have reserve requirements imposed upon their bor-
rowings from other depository institutions in the U.S. and upon their
Eurodollar borrowings.
6. The Federal Depository Institutions Commission.-The Commis-
sion would be responsible for the chartering, conversion, mergers,
examination, supervision and regulation of foreign banks operating
in the United States.


Overseas networks of branches and subsidiaries have been a major
factor in the expansion of U.S. banks over the last decade. In 1964
there were only 11 U.S. banks with 181 overseas branches. Now there
are 125 banks and 732 branches overseas, and branch assets have.
grown from $6.9 billion in 1964 to $155 billion currently. At year end
1974, assets held by U.S. banks in their foreign branches were 14 per
cent of total domestic and foreign assets of all U.S. commercial banks.
An additional volume of assets is held overseas in subsidiaries and
affiliates. This extraordinary expansion has created a reserve-free and
largely unregulated international banking market.
1. Capital Adequacy.-The Federal Depository Institutions Com-
mission would be authorized to impose such capital requirements, in
addition to the present capital requirements, on banks currently
engaged in foreign activities upon a finding that their capital is not
sufficient to support such activities.
2. Overseas Departments in U.S. Banks.-To promote competition
among banks of different sizes in international financial markets, U.S.
banks would be authorized to establish overseas departments in their
domestic offices. These departments would be allowed to engage in the
same activities as foreign branches of U.S. banks. They could raise
funds from abroad and lend to foreign residents without being subject
to the restrictions placed on the bank's domestic activities.
3. Examination.-United States banks would only be permitted to
establish branches in those countries which permit periodic examina-
tion of the branch, and complete access to its records, by the Federal
Depository Institutions Commission. The Federal Depository Institu-
tions Commission would determine the degree of examination of
subsidiaries and joint banking ventures which would be required to
insure that the parent bank's capital would not be endangered, and
would only permit these activities in countries where such examination
was allowed.
4. Branches, Subsidiaries and Joint Foreign Banking Ventures.-U.S.
banks would be prohibited from investing in joint foreign banking
ventures, from acquiring a financial interest in a bank operating
overseas, or from establishing a foreign subsidiary without advance
approval by the Federal Depository Institutions Commission. Subsid-
iaries and joint banking ventures would be allowed to the extent
that the Federal Depository Institutions Commission determined that
such activities would not endanger the bank's capital. Joint ventures
overseas between U.S. banks would be governed, as now, by U.S.
anti-trust law. Federal Depository Institutions Commission approval
of joint ventures between foreign banks operating in the United States
and U.S. banks would also be governed by U.S. anti-tiust law.
5. Federal Reserve Privileges.-Federal Reserve discount and borrow-
ing privileges would be extended to U.S. banks only on domestic paper.



62-748-76--bk. I---3

(By Dr. Craig Swan*)
This paper tries to make some simple points. Unfortunately to
understand the interactions between housing and financial markets
often involves rather complex interrelationships. The basic thesis of
the paper should not be lost sight of and should be emphlia.ized from
the beginning. The case for financial reorganization is very strong and
compelling. It is only natural, because of the importance of mortgage
financing, that concerns about housing get involved with questions
about financial reorganization. Looking at the way housing has been:
financed only strengthens the general case for financial reorganiza-
tion. There is some uncertainty about how specific plans for financial
reorganization will affect housing markets. The appropriate response
to this inherent uncertainty is not to oppose financial reorganization,
but rather to consider complementary policy responses that will work
to mitigate any adverse impact on housing and mortgage markets.
The traditional ways of financing housing have worked well in nor-
mal times but not so well in periods of large movements in interest
rates. This volatility in interest rates has characterized the last ten
years and there is no good reason to believe it will not continue to be a
major factor in financial markets into the future. Further, the develop-
ment of new technology, related to the widespread use of computers,
is giving rise to new ways of managing money that tend to blur and
erase the traditional distinctions between financial institutions. Fin-
ally, some of the past responses of public policy to these two develop-
ments are not without their serious and unfortunate side effects. These
public policy responses, primarily the regulation of deposit rates, have
in some measure been designed to preserve existing institutional dis-
tinctions. While they might have had their intended effect in the short
run, their long run impacts have been much less beneficial, if not per-
verse. Changing the financial structure would allow one to eliminate
these artificial restrictions as well as providing the resulting financial
institutions with the means to cope with volatile interest rates and
new technology.
There have, of course, been other policy responses that have been
valuable additions to the working of mortgage markets. Their further
development should be continued following financial reorganization.
Examples of these sorts of responses are the elimination of the Federal
National Mortgage Association from the federal budget, the develop-
ment of GNMA guaranteed mortgage backed securities and a whole
host of initiatives by the Federal Home Loan Mortgage Company
to broaden and stabilize the sources of mortgage financing.
*.AqQnesiate Profesor of Eeonomie.. University of 3Minnesota. A paper prepnrad for the-
FINE Study, October 1975, revised February 1976.


What does financial reorganization mean for housing? Unfortu-
nately, no one can forecast the impact of financial reorganization on
housing and mortgage markets with certainty. There are at least three
aspects of housing markets one might be concerned about: the long
run size of the housing stock, cycles in homebuilding, and the distribu-
tion of the housing stock.
S'Ce of the;n, Stork
Co0,'ern about the long run size of the housing stock usually trans-
lates into a coni-ern about, the impact financial reorganization will
have on nmotitgage rates. The concern is not so much with what will
haippvn to m,'-'rt-age rates next. year or the year after that, but rather
w-ith what w\ll hl.prn to the average of mortgage r-.tes over a longer
period of time. VWill mortgage rates, and hence the cost of housing,
Ie ] ili,,,r or Iower ? We simply do not know.
There are several econometric simulations that attempt to ascertain
the impact of financial reorganization on the mort.g8ge rate and the
stock of houses. These models are discussed below. By and large these
simulation results suggest that financial reorganization will have little
or no adverse impact on the size of the housing stock or the mortgage
rate. There are, however, still questions, not only about the specific
simulations and models but also about the basic methodology that sug-
gest one should not accept these findings uncritically. In particular, I
would conclude that the simulations do not offer convincing evidence
of a beni ,'n impact and that one should, instead, conclude that the
impact of financial reorganization on the housing stock and on mort-
gage rates is still unklmown.
HouIns'g Cycers
With reward to the question of housing cycles, neither of the two
simulations reviewed below looks at the question of cycles in home-
building and what impact financial reorganization would have on
themi. One point should be made cle:r from the beginning. Given
dramatic increases in interest rates, cycles in homebuilding are to a
large extent ilnherent in the nature of lHoium Houses are the epitome
of long-li(ved, dIrab)le goods. The purchase of such goods is eCsily
postponed temporarily when interest rates rise. If inflation continues
to fluctuate and if monetary policy continues to bear a major burden
for stabilization Ipolicy, then one would have to expect that we would
continue to see periods of dramatic increases in interest rates
and associated declines in homiebuilding with or without financial
There is the further question of whether, with financial reorganiza-
tion, these declines will be as severe as they have been in the past. There
is a large body of work that suggests that ait times of tight credit
markets swings in the availability of mortgage credit have exacerbated
tlie swing(rs iin obilding. A Aiajor element in this view is related
to households reallocating their savings away from thrift institutions
fnd toward the direct purchases of market securities at times when
short-term interest rates rise. Thrift institutions in turn have fewer
funds to lend as mortgages. At tlhe same time, yields on mortgages do
not look as attractive as the yields on alternative assets, as the increase


in mortgage rates usually lags the increase in other interest rates.
Institutions with portfolio flexibility slow down their accumulation of
mortgages preferring instead to acquire other, higher yielding
How will financial reorganization affect this process? Under most
plans for financial reorganization there are two potentially offsetting
effects. Which effect will be stronger is unclear a priori. A major
feature of most plans for financial reorganization is the elimination of
ceilings on rates paid on savings deposits and an expansion of invest-
ment powers for thrift institutions. Thus, in periods when interest rates
rise, thrifts will be able to raise their deposit rates and continue to
compete for savings. Expanded investment powers work to shorten
the effective maturity of assets held by thrifts. Thus their earnings
will respond more quickly to an increase in interest rates, enabling
them to pay higher deposit rates. To the extent that thrifts can main-
tain deposit inflows in periods of high interest rates, they may be able
to soften the decline in mortgage lending. On the other hand, to the
extent that they have portfolio flexibility, it may be at precisely these
same times that other assets, offering more attractive yields than
mortgages, induce thrifts, as well as other instituttion.z to make fewer
mortgage loans. It should be clear that this shift out of mortgages. is to
some extent self limiting. The allocation of funds away from mort-
gages would be expected to re.sult in higher mortgage rates and lower
yields on the favored assets. Thus at some point the portfolio shifts do
not continue to look so profitable. However, at what point the shift
out of mortgages would stop is not at all clear. The magnitude, and,
thus the net impact of these two effects, the competition for deposits
and the subsequent portfolio allocation decisions. is difficult to meas-
ure. As a result there is a great uncertainty about the impact of
financial reorganization or cyclical patterns of mortgage lending.
Dhi.tNbution of the Housing Stock-
The final area of concern has to do with the distribution of the
housing stock, in particular the cost and availability of housing for
low and moderate income families. I do not see that financial reorgani-
zation has any special implications for the distribution of the hous;jing
stock other than its impact on mortgage rates. To the extent that
financial reorganization raises or lowers mortgage rates, there will
be effects on the cost of housing for everyone, including low and
moderate income families. To the extent that housing expenditures
form an especially large fraction of expenditures for low and moderate
income families, these families will be affected more than most fami-
lies by a rise or fall in the mortgage rate. As regards the prospects
of homeownership, to the extent that moderate income families are
the marginal mortgage borrowers who gret loans when interest :rates
are low and who do not get loans when rates rise. either because they
choose not to buy at times of high rates or are simply rationedl out
of the market on non-price terms, then financial reorganization will
have large impacts on them as it raises or lowers the average mortgage
rate and through its impacts on cycles in mortgage lending.
To briefly summarize, there are several aspects of houtsin" markets
that may well be affected by financial reorganization, but the specific
impacts of financial reorganization are unclear. One can make plausi-


ble a case for different impacts. The appropriate response in this sit-
uation is not to oppose financial reorganization-the other gains from
reorganization are too great-but rather to consider the design and
implementation of alternative public policy measures that will work
to complement the aims of financial reorganization and at the same
time guard against untoward impacts on housing markets or specific
income groups.
The paper also includes a discussion of some possible policy re-
sponses: (1) do nothing more, (2) mandatory credit allocation, (3)
mortgage income tax credit, (4) interest rate insurance, (5) an ex-
panded role for the Federal Home Loan Mortgage Company, (6)
variable rate mortgages.

The Congress has a long standing concern about the housing condi-
tions of American citizens. This concern is hardly surprising and led
in 1949 to a declaration of national housing policy:
The Congress hereby declares that the general welfare and security of the
Nation and the health and living standards of its people require housing pro-
duction and related community development sufficient to remedy the serious
housing shortage, the elimination of substandard and other inadequate housing
through the clearance of slumnis and blighted areas, and thle realization as soon
as feasible of the goal of a decent home and a suitable living environment for
every American family, thus contributing to the development and redevelop-
ment of communities and to the advancement of the growth, wealth, and security
of the Nation.
Congressional concern with housing predates the 1949 declaration
and is reflected in forms of direct aid-public housing programs estab-
lished in the thirties and other forms of subsidized housing in the
sixties-as well as policies designed to influence the provisions of mort-
gage credit-FI[A mortgage insurance. VA mortgage guarantees, the
Federal Home Loan Bank System, and a host of other specialized
mortgage n market institutions.
The close connection between housing decisions and mortgage fi-
-nancing is ablo not surprising. Buyinm a home is the larg-est financial
decision most families make. For most families their ability to buy a
home is strongly affected by their ability to secure mortgage financing.
The importance of financiing to individual homebuyers, as well as to
the development of rental property, is the reason why concerns about
lhousing- enter into any discussion of changes in the. structure of finan-
cial instit ut ionls.
Tie development of financial institutions and their regulation, in
part icular tie development of savings and loan associations and the
Federal Home Loan Bank System, have reflected a concern on the
part of the Congress to insure that an adequate supply of mortgage
,Iedit be available. In the last ten years there have been three dramatic
dle,-lines in tle amount of new lhonwebuildin,(, 1966. 1969-1970, and
1974-1975. All of these (declines have been associated with a decline in
s:,vi,,,gs flows tl, tlirift institiittions and a consequent reduction in mort-
r;,,re lendin by these institutions. It is not surprising then that pro-
posals to 111ange, thle structure of thrift institutions, specifically to
weaken their relianceo on mortgage lending by broadening their invest-
ment. opportunities, should give rise to a concern about the implications
of .-,uIh a change for housi.ngr markets.

The general case for restructuring of financial institutions receives
overwhelming support among academic economists. The professional
training of academic economists teaches them that competition is good.
In a search for higher profits, firms are led to adopt lower cost tech-
nology and the forces of competition pass these lower costs on to con-
sumers in terms of lower prices. A major thrust of the proposals for
restructuring financial markets, the Hunt Commission and the Fi-
nancial Institutions Act, is to introduce more competition into finan-
cial markets primarily by eliminating interest rate ceilings on savings
accounts, allowing thrift institutions to offer checking accounts of one
form or another, and allowing thrift institutions wider investment
powers. These proposals would find support among academic econo-
mists on general grounds of competition leading to increased efficiency.
Beyond the general case for more competition, events of the last
ten years strongly suggest that the traditional forms of organization
may run serious risks in what appears to be a new environment for
financial markets. These changes in the environment reflect the com-
plex interaction of high and variable rates of inflation, a more vigorous
role for monetary policy and the development of new technologies for
handling money. There is good reason to believe that this new environ-
ment calls for a reorganization of financial institutions, especially
thrift institutions.
High and variable rates of inflation and the more vigorous use of
monetary policy in the last ten years have had dramatic impacts on
interest rates. These factors have had an especially dramatic impact
on the normal relation between short term and long term interest rates.
The technical term for the relationship between short- and long-term
interest rates is the term structure of interest rates. The discussion
below is organized as follows: first the impact of the term structure,
particularly changes in the term structure, on thrift institutions is
examined. Then the relationship between the term structure of interest
rates, on the one hand, and inflation and monetary policy, on the other,
is discussed.

As mentioned above the development and regulation of thrift insti-
tutions has reflected a concern to provide adequate sources of mortgage
financing. By tradition savings and loan associations have been special-
ists in mortgage lending. These tendencies to specialize in mortgage
lending have been strengthened by regulation and tax advantages, so
that currently the assets of savings and loan associations are almost
exclusively mortgages. At the end of 1974, savings and loan associa-
tions held almost $250 billion of mortgages, over 84 percent of their
total assets.' Holdings of savings and loan associations were over 44
percent of total residential mortgages outstanding at the end of 1974.
From 1970 to 1974 savings and loan associations placed almost 83 per-
cent of the increase in their assets in mortgages and accounted for over
51 percent of the net increase in residential mortgages. Considering
mutual savings banks as well as savings and loan associations shows
1 These numbers understate to some de ree the attachment of savings and loan associa-
tions to the mortgage market. Savings and loan associations hold mortgages indirectly by
holding GNMA. -guaranteed, mortgage backed securities and FHLMC participation certifi-
cates. These holdings are not reflected in the figures above.


that at the end of 1974 the two thrift institutions held 56.6 percent of
the residential mortgage debt outstanding. The two thrifts provided
58.3 percent of the net increase in residential mortgage debt from 1970
to 1974.
For a long time the provision of long term mortgage credit by thrift
institutions worked smoothly but recent developments, especially since
1965, have exposed some fundamental weaknesses. Thrift institutions
have basically borrowed short-savings deposits that are for all prac-
tical purposes withdrawable on demand-and lent long-home mort-
gages with initial contract maturities of 25 to 30 years and effective
maturities of perhaps 10 to 15 years. This sort of business was profit-
able and not very risky as long as (1) short term rates in general were
lower than long term rates and (2) rates on short term assets that com-
peted for household funds were not significantly above rates paid by
thrift institutions. .
Sinec late 1965 the relationship between short and long term interest
rates has changed dramatically. Table 1 illustrates the behavior of
the spread between long term and short term rates since 1950. From
1950 to 1964 long term rates were consistently above short term rafe.s.
In 1966 and 1969 the traditional positions of short and long term
interest rates was reversed as short term rates exceeded long term

(long-short) of differential
Private b Public Private Public
1950-1954.......................................... --------------------------------------- 90 113 29 24
1955-1959 ---------------------------------------- 55 79 49 50
1960-1964 ....--------------------------------------- 83 104 35 31
1965-1970.......-------------------------------------...... ..... -81 -2 45 38
1970-1974....... --------------------------------------- 62 29 154 103
SYield on corporate bonds (Moody's Aaa) minus yield on 4-6 month, prime commercial paper.
b Yield on taxable government bonds minus yield on 3-month treasury bills.
Standard deviation=(l ,'5(S,-S))1"
where S;=yield spread for particular year
S=5 year average of S,.
Source: 1975 Economic Report of the President, Table C-58.

The period 1970-1974 may appear to have. reestablished traditional
yield differentials. IHowev'er looking at the differentials on a year by
y(.ir ,bs.isi ole '(ees t'relliildoiis variation in thle yield spreads. In
1970 yield spreads were low by historical standards. 1971 and 1972
yield spreads were ainonA tlhe highest, of the period. Finally in 1973
:tild 1971 yieldl spreads retistored their largest negative dif'erentials
of 1i1w' )Priod. This trelllendotls roller coaster variation in yield
spi,'::,1 I .- -,' 'u In i 1, stand;i'rd deviations of the yield spreads that
are also pre-.tiifed iI 'T;i1ade 1. For the period 1970-1974 the variation
i, yield sprle1ids, as nieIsu re('l by the standard deviations, is two to
t ', tim largee ,as anv of the ("!Irlier periods.
The yield spre:d( is of tremendous importance to thrift institutions
l,(,:1,se t]Iyv are 1)0or1owimi ng short and lending long. When short term
market int, r'evt rates rise above riat(s paid( on deposits, hotiuseliolds find
that market securities offer more attractive yields than savings ac-


counts at thrift institutions. It is not surprising that many households
then reallocate their savings away from thrift institutions and toward
the purchase of direct market securities. This interest sensitivity of
savings flows is well documented. See for example Hamburger, Modi-
gliani, Gramrnlich and Hulett, and W. Gibson (Gibson suggests
that savers may be becoming even more sensitive to interest rate
The problems of thrift institutions are compounded when short
term rates rise above long term rates. Not only do deposits at thrift
institutions look unattractive but also thrift institutions find them-
selves hard pressed to remain competitive by offering higher deposit
rates. Their earnings come from long term assets and do respond
quickly to movements in short term rates.
One might argue that when short term interest rates rise. above
long term interest rates that thrift institutions should be expected to
raise their deposit rates to remain competitive, even if it means that
thrifts are paying out more than they are currently earning on their
mortgages. Such a situation is part of the natural risk of intermedi-
ating between long and short term rates. If thrift institutions are
efficient at predicting future interest rates then over the long run
their earnings from long term assets, mortgages, should be sufficient
to cover expenses based on a sequence of short term interest rates.
High deposit costs relative to mortgage earnings in one year would
be expected to be off-set by lower deposit costs in another year.2
However three things appear to work against this outcome. One,
the competitive effects of inter-institutional competition may work to
put a floor under deposit rates and hinder any reduction in deposit
rates when market rates decline. Two, thrifts may simply be bad
forecasters. Three, the historical sequence of interest rates in the re-
cent past suggests that the last ten years have been exceedingly diffi-
cult times to forecast. In particular, recent fluctuations in the yield
spread between long and short term interest rates have not been
around an unchanged level of interest rates. Over the past 25 years
the general structure of interest rates has risen. This rise has been
particularly dramatic in the last ten years. A plausible argument can
be made that these increases in the structure of interest rates, especi-
ally since 1965, have to a large extent been unexpected by almost
What explains the change in the behavior of interest rates over the
last ten years, in particular the increase in the level of rates and the
increase in the variability of the yield spread between short and long
term rates? Economic theory suggests three major causes: (1) high
and variable rates of inflation, (2) strong aggregate demand, and (3)
a more vigorous use of monetary policy. My subjective weihting puts
most emphasis on (1) and (3), inflation and monetary policy.
Before discussing these factors in more detail a distinction should
be made between what economists call real and nominal interest rates.
2 This is essentially the position argued by both Tobin and Kaufman.


Nominal interest rates are what most people think of when they think
of interest rates. They are agreements to pay back so many dollars
tomorrow for the use of money today. If, before these dollars are paid
back inflation occurs, then the dollars that are paid back will have less
purchasing power than the original dollars that. are lent.
Economic theory suggests that lenders should be concerned with their
real returns, that is the purchasing power they will get in the future
in return for lending, and hence not purchasing, today. Thus if lenders
expect inflation they will want to charge a higher nominal interest
rate in order to compensate themselves for the expected loss in pur-
chasing power from inflation. If borrowers also expect inflation then
they will agree to the higher nominal interest rates. Their higher
future nominal incomes will enable them to pay the higher nominal in-
terest rate without affecting their real returns. Thus when borrowers
and lenders expect inflation, an economist expects that nominal interest
rates will increase in their expectation of inflation. Real interest rates
are then a construct to take out the effects of inflation on interest rates.
Measured after the fact, by subtracting the actual rate of inflation from
the nominal interest rate, they tell one what the real return to the
lender, and hence the real cost to the borrower, was. Measuring real
interest rates before the fact is exceedingly difficult as one needs to
know the expectations of borrowers and lenders about future inflation.
With a distinction between real and nominal interest rates, let us
turn now to a brief discussion of the change in the behavior of interest
rates over the last ten years. Economists expect. that nominal interest
rates will reflect inflationary expectations. While we do not measu-re
inflationary expectations directly, we do know that. actual rates of in-
flation have been high and variable in the last ten years. Comparing
the period 1965-1974 with 1955-1964, one finds that the average rate
of inflation as measured by the implicit GNP price deflator rose from
1.96 percent per year to 4.58 percent per year. The variation of the rate
of inflation, as measured by the standard deviation, also increased dra-
matically from .87 to 2.19 percent. To repeat, these figures measure
actual inflation, not necessarily expectations of inflation. However, if
market expectations of inflation were very accurate then these figures
would also be good proxies for movements in expectations of inflation.
Indeed, Eugene Fama in a recent, paper concludes that ". . one
. . cannot reject the hypothesis that all variation through time
[r1953-1971] in one- to six-month nominal rates of interest mirrors
variation in correctly assessed one- to six-month expected rates of
change in p)urtchllasing power. (Faiia, p. 282.) While there is not yet a
consensus among academic economists as to Fanmia.s conclusion that
changes in expectations of inflation explainll all the variation in short
teril interest rates, there i" lln(loubt(lly a con.sentl.,is that expectations
of inflation are responsible for a large slhare of the variation.
Aggqregate Demand
Shifts in basic demand and supply factors can lead to changes. in
interest rates. As aggregate (ldenand in real terms rises economists
would expect that real interest rates would also rise. (The increase in
aggregate demannd may also give rise to inflation inducing yet a further
rise in nominal interest rates.) The period 1966-1969 was a period of
extremely high levels of aggregate demand relative to potential or full
employment output. It would not be at all surprising that the expan-


sion of aggregate demand would be accompanied by higher real rates
of interest.
Monetary Policy
The final important influence on interest rates has to do with the
actions of the Federal Reserve System. Whether measured by changes
in the growth rate of the money supply or interest rates, the last ten
years have seen a much more vigorous use of monetary policy.4 This
more active role for monetary policy reflects to some degree the fail-
ure to implement countercyclical fiscal policy.
This more vigorous use of monetary policy in place of fiscal policy
has interesting implications for interest rates. Conventional macro-
economic theory suggests that temporary restraint on aggregate de-
mand can be achieved by the use of either monetary or fiscal policy.
Even if both policies are successful in restricting the level of output,
they will have different implications as regards interest rates. The
use of monetary policy means that restraint is accompained by in-
creases in interest rates. The use of fiscal policy means that restraint is
accompanied by a reduction in interest rates. Thus the primary use
of monetary policy instead of fiscal policy for stabilization goals over
the last ten years has contributed to the recurring episodes of dramatic
increases in interest rates.
Similarly the use of monetary policy to achieve more or less perma-
nent reductions in the level of aggregate demand would also be ex-
pected to move the level of interest rates up while the use of fiscal
policy would be expected to move the structure of interest rates down.
As suggested above, the effects on thrift institutions of unforebeeii
changes in interest rates is essentially asymmetric. Reductions in the
level of rates lowers their costs, by lowering deposit rates. The reduc-
tion in receipts is less immediate as it requires the turnover of the
existing portfolio of mortgages. On the other hand, increases in in-
terest rates have very imnniediate and dramatic effects, putting upward
pressures on costs immediately while revenues respond only slowly.
The above three are the major factors that economic theory suggests
should influence interest rates. By 1964 there was little indication that
inflation would become so persistent, aggregate demand would ri.e so
dramatically, and that monetary policy would be called on to shoulder
such a large part of the burden of countercyclical policy.
Besides the term structure impacts, an unexpected increase in the
level of interest rates also has unfortunate implication for thrifts.
With a predictable level of interest rates, past and/or future earnings
from mortgages should have been sufficient to enable thrifts to cope
with a temporary reversal of traditional yield spreads, such as occurred
in 1966. However, when the structure of rates did not return to its
expected level, but instead, was higher, thrifts found themselves with
large holdings of older, lower yielding mortgages that put an effective
ceiling on their ability to offer higher deposit rates.
3 It is p^r-ible that an increase in aggregate dri-mand emold be nceoninahipd by lower, not
higher real rates of interest. If monetary expansion Is the original stimulus to aggregate
demand, then most economists would expect an initial lowering of interest rates which
In turn induces the higher level of aggregate demand. Again the higher level of agerecate
demand could give rise to inflation and induce a subsequent rise in nominal Interest rates.
4Comparing the period 1955-1964 and 1965-1974 shows that the average absonlute
change in the semi-annual rate of growth of the money supply has increased from .J2
percent to 1.3.5 percent. The standard deviation in the semi-annual growth rate of the money
supply rose from .98 percent to 1.2 percent. Analogous conclusions hold for interest rates.


Thie situation was further compounded by the fact that in such an
'environment any new or smaller thrift institution had a substantial
advantage over older, larger institutions. The newer, smaller institu-
tions would not have a large overhang of low yielding mortgages. As
they attracted deposits and grew they could put virtually all of their
funds into newer, higher yielding mortgages. Similarly depository in-
stitutions with asset holdings of shorter maturities were able to com-
pete more aggressively. Their shorter maturities meant their earnings
would reflect the new higher level of interest rates more quickly than
the earnings of thrift institutions.
To summarize, the changed environment since 1965, specifically
higher and more variable interest rates, has threatened the tradi-
tional role of thrift institutions and exposed them to potential insol-
vencv. If sufficient numbers of depositors had demanded their funds,
thrift institutions would have been forced to liquidate their holdings
of mortgages. High market rates of interest work to lower the market
value of existing assets with lower rates of interest. It is not incon-
ceivable that the market value of the mortgage portfolio of a good
number of thrift institutions has at times been insufficient to cover
their total deposit liabilities.
Thus the continuation of old ways of doing business-borrowing
short and lending long-in a changed environment-higher, more
variable and unpredictable interest rates-has the potential of threat-
eninjr the solvency of a number of thrift institutions and by extension
the stability of the whole financial structure. Just because we have had
these. problems in the past is no guarantee that they will continue in
the future, but neither is it a guarantee that they will never reappear.
There is a need to consider alternative forms of organization that will
behive well in both good times and bad.
Another element of the changing environment of financial markets
lhas important implications for the organization of depository institu-
tions: The development of electronic funds transfer systems. I want to
make. two major points here. (1) The development of new technology
for money management is blurring traditional distinctions between
tiime and demand deposits, and (2) these new technologies offer
promise of a significant reduction in the costs of managing money,
reductions that should be passed on to consumers. It is the forces of
competition that economists would rely on to see that these savings are
ind(leed passed on to consumers in terms of lower transactions costs and
higher yields on account balances.
In summary, the changing environment is making traditional forms
of organization and regulation obsolete. Changes in the level and
vanratioll in interest, rates pose problems of possible instability. New
terhi lolo.zy is ,breaking down old distinctions.
'l'e d(evelopmnets of the last ten years have not occurred in a vac-
uiuim. 11The pl rinriois position of savings, and loans and the pro-
no, nced cycles in mortgage lending and homebuilding have prompted
public policy responses. h however, the continual discussion of the need

for financial reorganization strongly implies that past responses have
not been sufficient. A brief discussion of the major aspects of past
responses is useful for getting some perspective on what should and
should not be continued.

Controls on deposit rates were introduced in 1966 in response to
the sorts of pressures described above. High short term interest rates
made direct market securities more attractive than deposits at thrift
institutions; commercial banks, and some smaller savings and loan
associations, were becoming more aggressive in competing for savings
deposits. Larger thrift institutions found themselves in a difficult
position. Higher interest rates and aggressive competition were pres-
surizing them to raise their deposit rates yet their earnings were to
a large extent predetermined by their holdings of mortgages made
at lower interest rates. It was in this environment that controls over
deposit rates were extended to thrift institutions in September 1966."
Deposit rate controls do work to limit inter-institutional competi-
tion for deposits but they do not eliminate the competition betweeii
deposits and direct market securities. The term intermediation means
the use of specialized financial institutions as intermediators between
wealth holding units-i.e., households-and debt units-borrowers,
some of whom may b. other households. Disintermediation means
the disruption of this process as wealth holding units lend directly
to debtor units. One way of lending directly is to buy credit market
securities directly. Thus deposit rate controls cannot be expected to
limit disintermediation. In fact deposit rate controls may accentuate
disintermediation as financial institutions are limited in the response
they can make to high market interest rates.
Academic economists are close to unanimous in their condemnation
of Regulation Q ceilings on savings deposits. There are two major
thrusts to this condemnation. (1) The ceilings produce distortions
that work to limit the amount of credit to some sectors. Units that
see a diminished supply of credit are those that traditionally borrow
from depository institutions that are constrained by the regulation,
i.e., households. (2) The ceilings have unfortunate distribution effects
as wealthier savings units have the resources and sophistication to
get around ceilings. As a consequence, poorer, less sophisticated sav-
ings units are left paying the price of regulation by getting lower
returns on their savings.
That households have been sensitive to interest differential is beyond
dispute. Numerous econometric studies of household savings behavior
have found the allocation of household savings to be responsive to
interest rate differentials. The data in Table 2 illustrate this point.
The importance of direct market securities in the savings plans of
households shows marked swings, swings that are attributable to inter-
est rate differentials. While deposit rate controls have limited inter-
institutional competition they have had no impact on the competition
of direct market securities. At times of high market interest rates
households have directed a substantial portion of their savings away
r See Jaffee (1973) for a more complete discussion of the adoption of deposit rate


from depository institutions in general, and thrift institutions in
particular, and purchased general market securities instead.

[In percent]

Credit at financial Deposits Yield on Yield on 3 mo
market institutions at thrift deposits at Treasury
Year instruments plus currency institutions S. & L.'sS bills

1960-65.............................. ------------------------------ 14 86 43 --.-....----......--....
1966--------------------------------................................. 42 58 18 4.48 4.881
1967---------------------------------................................ 6 94 34 4.68 4.321
1968.... ---------------------............................. 22 78 24 4.71 5.399
1969................................----------------------------- 82 18 19 4.81 6.677
1970 -------------------------------........ -2 102 31 5.14 6.458
1971---------------------------...............................- --- -12 112 56 5.30 4.348
1972---------------------------------................................. 9 91 61 5.37 4.071
1973.------------........--.....------------------...... 27 73 26 5.51 7.041
1974 -------------------------------- 26 74 25 5.96 7.886
19752 .......---------------------------------.................. -1 101 60 6.16 5.637

I Deposits plus credit market instruments from flow of funds statistics.
2 First 6 mo.
3 Effective interest/dividend rates paid by FSLIC-insured S. & L.'s.
Source: Cols. (1), (2), (3) based on flow of funds data, Federal Reserve, col. (4) "Federal Home Loan Bank Board Jour-
nal," October 1975, col. (5) "Economic Report of the President 1975," "Federal Reserve Bulletin."

The ability of households to engage in these asset switches is to some
extent determined by the. sophistication of the households in question
and the size of their portfolios. Larger portfolios mean lower trans-
actions costs and are generally associated with more sophisticated
savers. Kane (1970) presents evidence from the 1962 Survey of Fi-
nanr'ial Characteristics of Consumers that shows that market securities
form a much more important part of the asset holdings of higher
income households. The clear implication is that higher income house-
hold(s have the means, experience and sophistication to get around
deposit rate ceilings and obtain higher yields by direct purchase of
market securities. It is the poorer, less sophisticated saver who is stuck
with lower returns on his savings deposits.
Given the failure of initial deposit rate controls to stop disinterme-
diation, there were further public policy responses. However, these re-
sponses-the elimination of interest rate ceilings on large denomina-
tion savi-ngs certificates and the institution of large minimum
(denominations on certain types of public securities-have only erected
further barriers between the options open to poor and rich savers.
Trlese responses also illustrate a more general principle: controls often
require additional controls as individuals attempt to get around the
original controls. The first type of response-the elimination of ceil-
ings on large denomination certificates---enabled depository institu-
fions to offer competitive rates of return to savers with large amounts
of funds, thus linliting tlhe incentive for these savers to move their
funds. The second type of response-minimum denominations on
'lrensllry ltblls and FINMA de)entures-mlade it. more (lifficlllt, for
smaller savers to invest directly in market securities, thus confining
them to (depository institutions with below market rates of return. As
Kane says. "It is shocking to realize how hard the federal government
hlias worike(l to prevent the small household saver from sharing in the
hiigh interest rates of the past five years." (Kane, 1970, p. 513.)


Market developments have illustrated yet another general point and
that is the tendency of controls to become less effective over time as
new institutions are developed to get around the controls. The new
institutions in this case are the money market mutual funds that
developed in 1974. These funds pooled the funds of smaller savers in
order to buy large denomination instruments like government securi-
ties, certificates of deposits and commercial paper. These funds offered
savers high short term interest rates, interest rates that in late 1974
topped 12 percent. Investments in these funds were available essen-
tially on demand. The funds limited their risk by holding assets that
were extremely short term and quickly marketable if necessary. They
thus avoided the term structure problems that thrift institutions got
The popularity of these money market funds obviously depends on
relative interest rates, the differential between their offerings of short
term market rates and the rates available on savings deposits. However
such funds appear to be relatively easy to start up and close down as
rate differentials change. In subsequent periods of high short term
interest rates these money market funds can only pose more serious
competition for thrift institutions. The next time around households
may have learned from past experiences and be even quicker to reallo-
cate their funds.
There is one additional effect of deposit rate controls that should be
discussed. As mentioned above, deposit rate control has not eliminated
competition with direct market securities. Some thrift institutions have
at times found themselves hard pressed to meet past mortgage com-
mitments and/or demands for savings withdrawals. Their response has
been to borrow from the Federal Home Loan bank system through the
advances mechanism-loans by Federal Home Loan banks to member
savings and loan associations-established to cope with temporary
In recent years the use of advances has developed into a major source
of funds for savings and loans in times of high short term interest
rates. This use of the advances mechanism has several implications. The
availability and use of advances does appear to have protected the
profits, as measured by reserve accumulations, of savings and loans in
times of high short term interest rates. In the absence of deposit rate
controls one would expect that thrift institutions would raise their
deposit rates to meet competition and dip into past earnings, if neces-
sary, in order to pay these higher rates. As Tobin says:
Over the years this sum [reserves] had been withheld from the owners of the
institutions (mostly mutual associations) to protect them against just such
contingencies as occurred in 1966-69. And was it so used? No.... There can be
no justification for holding dividend rates down, and interest rates in competing
institutions too, so that the undistributed nonprofits of savings and loan associa-
tions can grow at their normal pace. (Tobin, p. 10)
Another implication. of the use of advances surrounds the financing
of the advances themselves. The Federal Home Loan banks first must
raise the money they use to lend to savings and loan associations. They
do this by issuing their own securities in general credit markets. To
some extent selling their own liabilities works to raise general market
interest rates. Some critics have argued that due to the effects of the rise
in general market interest rates, the use of advances is to a large extent


self-defeating.6 As short term interest rates rise and savings inflows
drop off, savings and loan associations turn to the Federal Home
Loan banks for advances. However, as the Federal Home Loan banks
raise the money in credit markets to lend to the S&Ls, their borrow-
ings tend to raise interest rates even more, leading to even lower sav-
ings flows at savings and loan associations and ani increased demand
for advances.
The critics charge that the necessity of first raising the funds to lend
works to raise interest rates in general, produces more disintermedi-
ations and works to offset tlhe direct effects of the advances. Higher
interest rates induce still larger deposit outflows (see Kwon and
Thorton (1971) and (1972)). Higher rates on general market securi-
ties make mortgages less attractive to institutions with portfolio
flexibility. As a result these institutions reduce their mortgage lend-
ing. Some critics have asserted that the net effect on homebuilding of
advances is zero (see Arcelus and Meltzer (1973)).
These adverse effects are, in theory, present to some extent. However,
there is still the question of their empirical magnitude. Do they in
fact mea:i no n,'t impact on housing? A number of observers have
argued that particular aspects of the above works may be bad esti-
mates of the maffnitudes involved. (See Grebler (1973), Van Hornme
(173), and Sw.-m (1973b)). Swan (1975) has surveyed the results of
three econometric models that attempt to account for these effects and
concludes that Federal Home Loan Bank advances do have a substan-
tial impact in the short run. Homebuilding activity is raised from
wleat it otherwise would have been for about one year.7
Te,..ardless of the effects of advances there remains the more funda-
mental question of whether the elimination of deposit rate regulation
in the first place might be even more beneficial. As mentioned above
most academic economists would be inclined to argue that the elimina-
tion of deposit rate ceilings would be more beneficial in total. Elimina-
tion of the ceilings would eliminate the interference with market
alloc.atin of credit; as well as benefiting small savers in terms of
]higher yields. If one were still dissatisfied with the implications for
cycles in housing there would still be the option of attempting to
channel more money into mortgages either by direct government pur-
clase, or by expanded pullrchlases by FNMA. In principle, an appro-
priate amount of FXMA purchases would have exactly the same. im-
pacts on hoiisinir and mortgage markets as Federal Home Loan Bank
advances (See S\'an 1973a.)

Developments since, 1965 have given impetus to a number of develop-
ne its t1ait have worked to restructure the mortgage market. The
development of tliese new institutions and new instruments have
worked to break down the isolation of the mortgage market from
general capital markets. Tliese developments are to be applauded.
ISlTilnir Niilirt] Mortiigagi, Association (FNMA). Before purchasing mortgages, FNMA must first
Issii. its own ,.I fiilt,.K to ral4e time funds to buy mortgages.
T 14m11n11illdliiLg Is subsequently depressed by less.,er amounts for a longer period of time.
Tlims sii <|,itriit dipre'smlon arises because one would not expect advances In any one year to
winNl. 11t1 (,ffl'.vt on the equilibrium size of the housing stock In the long run. As n result.
more, bumilIng in one .yir has to b e offset by less building than otherwise would have
ofvirrt.d in sui.ibs.ri.nt yvnar. Swan found snlmilar Impacts for FNMA purchases. For more
details see Swan (1975).


Financial reorganization should not imply the elimination of these
changes. Further development and extensions are to be encouraged.
Among the changes that have been made mention might be made of:
(1) The splitting of the original Federal National Mortgage Associ-
ation into two parts, the Government National Mortgage Association
(GNMA) and FNMA. This split separated the two functions of the
original FNMA, subsidy support to specific mortgages, now
handled by GNMA, and general support to the mortgage market
through the purchase of mortgages, now handled by FNMA.
(2) The removal of the new FNMX and the Federal Home Loan
Bank System from the federal budget. FNMA was established as a
government sponsored, private corporation. The Federal Home Loan
Bank System retains its role as independent regulatory agency. Their
removal from the federal budget means that their portfolio decisions
are not as directly restricted by political concerns about the possible
impact on the federal government budget as they were before 1968.
(3) The establishment of the Federal Home Loan Mortgage Cor-
poration (FHLMC). FHLMC has acted much like FNMA for con-
ventional mortgages. In addition, FHILMC participation certificates
work to improve the inter-regional flow of mortgage credit coming
from savings and loan associations.8
(4) The development of GNMA insured, mortgage-backed securi-
ties. These securities have allowed for the repackaging of a group of
-mortgages to make them more attractive to investors who otherwise
might not be interested in mortgages. Both bond-type and pass-
through type securities have been developed. Data on initial investors
suggests that these securities have been purchased by non-mortgage
oriented investors at times that they have offered attractive yields.
(See Marcis.)
Other important developments include the development of an auto-
mated mortgage market information network, the development of
private mortgage insurance, the development and increased involve-
ment of state and local housing finance agencies, and the develop-
ment of a futures market for G NMA backed mortgage securities. All
these developments have the effect of breaking down the barriers of
isolation that have traditionally separated the mortgage market from
other capital markets. This breakdown has been accomplished by de-
veloping new institutions and instruments that intermediate between
the mortgage market and other sectors of capital markets, by increas-
ing the flow of information about the mortgage market, and the intro-
duction of elements of standardization across what are essentially very
heterogeneous instruments. These developments are to be applauded
and encouraged.

There are at least three aspects of housing markets that Congress is
rightfully concerned about: what are the implications of financial re-
8 Both FNMA and FHLMC now have authority to purchase all types of mortgages al-
though FNMA has traditionally dealt with FHA and VA mortgages. FITLMC de:.l<
primarily with conventional mortgages. Giving FNMA and FHLMC authority to buy all
types of mortgages is a good idea. However to the extent that discounting is an effective
Way of making effective FHA and VA mortgage rates behave like market determinpid rates
and borrowers choose between FHA. VA and conventional financing on the basis of effective
interest rates, it makes less difference what type of mortgages are purchased by FNMA
62-748-76-bk. I---4


form for: (1) the size of the housing stock, (2) the distribution of
the stock and (3) cycles in homebuilding. The discussion below ad-
dresses itself to these three concerns. In addition inflation has im-
portant impacts on housing markets. Some of the impacts are direct
and others arise because inflation has such strong impacts on interest
rates. This section concludes with a brief discussion of the impacts of
inflation on housing markets.
Concern about the size and distribution of the housing stock reflects
Congress constitutional concern about the general welfare of Amer-
icans. Economists view the size and distribution of the housing stock
as reflecting the workings of individuals' demands for housing and the
provision of houses and housing services by builders and landlords.
Over a long period of time an economist expects that the size and
distribution of the housing stock will reflect the demands of indi-
viduals for housing. (In technical terms, in equilibrium individuals
will be on their demand curve for housing). Major determinants of
individual demands for housing are income, the price of housing
relative to the prices of other goods and certain demographic char-
acteristics, such as family size. (The relative price of owning or
renting has important implications for the form of tenure.) Financial
reorganization would not be expected to have major effects on either
income or family characteristics. The major impact of financial re-
organization would be expected to be on the cost of housing, spe-
'ifically the cost and availability of mortgage credit.
Will financial reorganization raise or lower mortgage rates? There
is no precise answer to this question. For one thing, the exact form of
reorganization is yet unknown. All major proposals do forsee broader
investment powers for thrift institutions. To the extent that thrifts
exploit these new powers, there will be a reduction in the supply of
mortgage credit for a given size of thrift institutions. Such a reduc-
tion would be expectedT to raise mortgage rates. However most pro-
posals for reform also incorporate expanded powers to attract de-
posits: the elimination of Regulation Q ceilings and the ability to
offer some form of checking accounts. Further, it has been argued that
some expanded asset powers, specifically the ability to make consumer
loans, may interact with expanded liability powers, the ability to offer
clicking accounts, and produce even larger increases in the size of
Slirift, institutions. To tlie extent that the increase in the size of thrift
institutioiis means additional mortgage lending one would expect a
rn.le .tion in mor gage rates. Whichl set. of forces will be dominant?
How will ti lings come, out in the wash ? We simply do not. know for
sure. So many of the crucial magnitudes for determining the overall
rs p~os lel)%(l 111)eon the behavior of ind(lividtials and( institutions in
Ia raMlONTr diiverent elnvirolnient. There are several simulations of large
','oloni(fric ,1od'ls tlhat suggest. that financial reorganization will
l,:ave. little, or no impact on mnortgage rates. These simulations even
rP:ise lhe le possibility that mortgage rates may decline. However, there
are so me teclinivi:il questions and fundamental issues that. suggest a
lO.^ <'alit(0ll1s <'oonllusion. Tlihe more technical questions about the
Flr-Jaffee and H1endershott studies are discussed in the attachment.


Both of these studies use econometric models, modifying them in an
attempt to reflect financial reorganization, and then simulating them
over a period of history to see what would have happened if financial
reorganization had occurred earlier. While attempts are made to rec-
ognize changes in behavior, in a very fundamental sense the models
still project past modes of behavior and response into the new en-
vironnient of financial reorganization and the past may simply be a
poor guide to future behavior in a new environment.
There is another fundamental notion that users of these simulation
results should be aware of. The original econometric estimation pro-
vides the basic structure for the simulation exercises. The numerical
coefficient that make up this structure are themselves estimates, sub-
ject to some likely margin of error. The. corollary to the margin of
error in the underlying coefficient estimates is a confidence interval
surrounding any prediction. One would not bet all his money that
actual outcomes will match the model's prediction exactly. Normal
estimation errors and the stochastic nature of econometric models
imply that we cannot know the future exactly, but plus or minus some
error term. Thus any forecast is subject to a margin of error, the
technical term is confidence interval. However simulation results are
usually reported as the singled value outcomes of the solution of the
mathematical equations of the model. The plus or minus extent of the
confidence interval is rarely reported, partly because it would be ex-
ceedingly complex and difficult to compute. What this all means in
practice is that there is a wide range of possible outcomes, not just
the one reported outcome, that would be consistent with the under-
lying model. This wide range of outcomes undoubtedly contains ad-
verse as well as favorable impacts on mortgage rates. It would seem
to be a reasonable step for public policy to recognize this uncertainty
about the impact of financial reorganization on mortgage rates and
to consider appropriate policy actions should the impact be adverse.

Cycles in homebuilding have been especially prominent in the last
ten years. The primary cause of these cycles is the fluctuations in
interest rates that have occurred over the past ten years. Increases in
interest rates, particularly mortgage rates, lead to movements back
along the demand curve for housing. This movement along the de-
mand curve for housing implies an even sharper reduction in home-
building activity. This conventional story of static, market clearing
responses may be complicated by two other factors. During periods of
high mortgage rates families may temporarily postpone the purchase
of a home and/or developers may temporarily postpone the construc-
tion of new projects to avoid what are expected to be temporarily high
mortgage rates. Further the impact of higher mortgage rates may
be compounded by credit, rationing, the allocation of mortgage credit
on non-price terms. Credit rationing implies an even larger drop in
housing activity than would be implied by simply looking at con-
sumers' demands at quoted mortgage rates.
The cause of this reduction in mortgage lending and increase in
mortgage rates, in fact the way increases in interest rates in general
get transferred to increases in mortgage rates, is from portfolio re:allo-
cations induced by high market interest rates. Households reallocate


some of their savings away from depository institutions, especially
thrift institutions, and toward the direct purchase of market securi-
ties. These institutions in turn have less money to lend. Similarly,.
financial institutions with portfolio flexibility reduce their accumu-
lation of mortgages in favor of other, high yielding securities.
During times of high interest rates people simply demand fewer
new homes. Houses are very long lived assets. Economic theory sug-
gests that interest rates form a larger part of the cost of owning
longer lived assets. Thus fluctuations in interest rates have very strong"
impacts on the costs of owning a home. Economic theory also suggests
that people demand less of a commodity as its price increases relative
to other prices. Housing should be no exception. Finally, for espe-
cially durable commodities, like houses, price effects that might lead
to a small reduction in demand ,for the stock of the good can have
very large impacts on the rate of accumulation of the good which
is itself usually only a small proportion of the total stock.9
The argument discussed above and the estimate in the footnote as-
sume that individuals respond to new interest rates as if they expect
them to remain unchanged. If individuals form expectations of inter-
est rates, the outcome is a bit more complicated. If, during periods of
high interest rates, people expect that interest rates will return to
lower, more normal levels, one would not expect as large a decline in
the basic demand for housing but there may be as large an effect on new
construction as individuals simply postpone purchases that would lock
them into expensive long term financing arrangements. By waiting
three or six months they expect to be able to arrange much more favor-
able terms.
These effects of interest rates on individuals' demands for houses are
not related to the institutional structure that provides mortgage fi-
nancing. These responses are the normal responses an economist ex-
pects when considering very long lived assets. Changes in the financial
structure could not be expected to have much of an impact on the
interest sensitivity of the demand for housing and new homes. Thus
eycles in home-building are likely to continue to exist with or without
financial reorganization.
While one should expect that cycles in homebuilding will continue,
with or without financial reorganization, it is not clear whether these
cycles will be more or less pronounced than before. Housing cycles
could be more or less pronounced because of subsequent events entirely
unrelated to financial reorganization. For example, if inflation were
reduced to rates of 2 to 3 percent per year, I would expect much smaller
8 This discussinn can be given a more rigorous formulation. Tmnagine a stock demand, 11, and a stock ad-
just mnit process where RC = y(i-H- i)+0 I -i. RC(' iscurrent new construction; 11-1 is the stock at the end
of the, previous period; A Is the rate of depreciation: and y is the coelliclent of adjustment. H Is a function,
amonl other i hit1s! of the user cost of tnils of I. The response of new cost ruct ion to a change in interest
ratf., R, is dRf( /drll =-ydf1/d R. Expressed as elasticities fltrR= Irn*,.r v i r.t IT'/RC, where ERC,R is
the elasticity of construction with resp Lct to a clihing in interest rates; eii',c is the elasticity of the stock
d,,mand with respect to a change In Ilhe usr cwsL: aiidl evr..n i, tlhe elastiit v or tihe user cost with respect to
is change In inttrrpst rates. tH.,'r has brin estimated hy numerous invesigat-ors to he about -1.0. tr,rp.
approaches 1 0 as the Ufe of Ih asset iprouIheles 0 and cnuild Iw approximated for a finite lifetime, on the
asisunption of onei-hoss hay dleprerintlon. hv the response of the payment on a fully amortized loan to a
chatIge in the interest late. For a lifetime of 50 years this is about .5 at real interest rates of 4 percent. Muth
etlni-ats -y to he about .3. New conqtriiclion has been about 4 percent of the ,rock. or (II/RC)=25. Putting
all these i pices together sugi(ests that tR'. could be as high as -3.75= (.3)(- )(.M5)(25). Thus a very small
increase In real interest rates can have dramnliic Impacts on homebuildingn. Imagilie an Increase in Interest
rates from 8to9 percent. Assumrne half of this increase Is an increase In real interest rates from 4 to 4.5 percent.
Use of the above estimates Implies a reduction in residential construction of .17%.


fluctuations in interest rates and much smaller cycles in homebuildings,
independent of any changes in financial organization. The important
question is what effect will financial reorganization by itself have on
housing cycles? It is impossible to give a definitive answer to this
question. However, it is possible to discuss the important factors that
will determine the outcome. I would identify two factors as being of
crucial importance: the response of mortgage lending to a change in
interest rates and effects on credit rationing.
Under current institutional arrangements a rise in general market
interest rates has two major effects on the supply of mortgage credit.
One effect works through the reduction in savings inflows at deposi-
tory institutions, primarily thrift institutions. Thrift institutions,
especially savings and loan associations, virtually turn deposits into
mortgages. When their deposit inflows drop off, so does their mort-
gage lending. The other major effect on the supply of the mortgage
credit works through portfolio adjustments by institutions with port-
folio flexibility. When market interest rates rise relative to mortgage
rates, those institutions with wider investment powers slow down
their accumulation of mortgages in favor of other, higher yielding
Financial reorganization has implications for both of these factors.
By removing deposit rate controls and broadening the liability base of
thrift institutions it is hoped that the swings in deposit inflows, in
response to a rise in market interest rates, will be moderated. Without
deposit rate ceilings and with wider investment powers it is expected
that thrift institutions will respond to an increase in market interest
rates by raising their deposit rates in an effort to maintain deposit
inflows or, at least, moderate their decline. This argument suggests
that financial reorganization would moderate cycles in mortgage lend-
ing, and hence cycles in homebuilding, by maintaining mortgage lend-
ing and keeping mortgage rates lower than they otherwise would be.
On the other hand, the wider investment powers, that are designed
to enable thrift institutions to pay high deposit rates, give thrift insti-
tutions the opportunity to engage in the same sorts of portfolio
switches that other financial institutions can do now. This asset switch-
ing ability raises the possibility that cycles in mortgage lending could
be made more severe.
Which of these two forces will be the dominant influence is diffi-
cult to say a priori. Simulation experiments might shed some light on
the question. However, neither of the two simulation studies reviewed
above address themselves directly to the question of cycles. Further,
any simulation exercise is subject to serious inherent limitations. All
this suggests that we cannot be sure what effect financial reorganiza-
tion will have on cycles in homebuilding.
The second important factor for cycles in homebuilding is credit
rationing. The effect of credit rationing is to moderate the movements
in quoted mortgage rates for the given swings in mortgage lending.
That is, credit rationing implies that mortgage rates do not rise suf-
ficiently to equate demand to a reduced supply. Instead some bor-
rowers are rationed out of the market on non-price grounds, perhaps
by a change in non-rate terms, perhaps by simply a polite, but firm,


If financial reorganization were able to eliminate credit rationing
as an important influence, I would expect two things, quoted mort-
gage rates and the volume of mortgage lending would be higher at
the trough of lending cycles. What implications would these two de-
velopments have for cycles in homebuilding? Higher mortgage rates
would normally mean less homebuilding, while more mortgage lend-
ing would mean more homebuilding. Again, which effect would be
dominant? One could argue that currently, with credit rationing as
an important phenomena, quoted mortgage rates actually understate
effective mortgage rates. A natural way to estimate the effective mort-
gage rate would be to use the rate that would equate demand to supply,
a rate that would be above quoted rates. See Jaffee, 1925, for an ex-
ample of this procedure. Viewed in this way, the increase in quoted
mortgage rates resulting from the elimination of credit rationing
would actually be a decline in effective rates. Thus one would expect
that the elimination of credit rationing would moderate cycles in
What implications does financial reorganization have for the exist-
ence of credit rationing? The answer to this question is not at all clear.
To the extent that credit rationing is in part the result of specialized
mortgage lending institutions whose investment options have been
effectively isolated from general capital markets, then financial rM-
organization, by helping to break down that isolation, may help to
make mortgage lending more responsive to movements in general capi-
tal markets and thus reduce factors which have made for credit ration-
ing. On this view, financial reorganization would work to reduce the
impl)ortance of credit rationing which in turn could work to moderate
cycles in homebuilding.

Inflation has pervasivee influences in many sectors of the economy.
Housing is no exception. Tle inflation in housing costs is of special
concern because of the importance of housing as a basic necessity.
Financial reorganization will have no direct impact on the inflation
in housing costs. Further financial reorganization should not be ex-
p)ected to solve problems caused by inflation in housing costs. The next.
few paragraphs briefly discuss the recent inflation inll housing costs and
solimc of its implications.
Housing costs have increased along with most prices and nominal
i'coimes. A detailed of these increases can be found in
App)end(lix II, Housing Pries and Income. Generally speaking, house
prices increased at alotl tlh sane. rate. as prices in general, and less
tlihani income, from 1965 to 1970. When one considers land prices, as
well as stuictulre prices, ho iuse prices may have increased slightly
faster than prices in general. From 1970 to 1974, however, house
prices-botlh structuretir and land-increased substantially more than
prices in general. Their increases exceeded the increases in several
popular jmieasiires of incole(le.
Actual selling prices, which are a combination of the pure inflation
in prices and changes in the characteristics of houses and lots, increased
faster tlhan prices in general from 1965 to 1970 and less than prices in
general froi, 1970 to 1974. Mortgage payments, which reflect move-


ments in selling prices and mortgage terms, showed substantial in-
creases in both periods as the effect of increases in sales prices was
compounded by the increase in mortgage interest rates.
What has the increase in house prices done to the ability of most
Americans to buy a house? This question is exceedingly difficult to
answer, primarily because there is little agreement as to what sort of a
house people should be able to afford. The tax advantages of owning
a home depend on individual circumstances and the effect of capital
gains is difficult to handle. When realized, capital gains work to reduce
a family's real housing costs, but when buying a particular house,
future capital gains have a large uncertain element. Some of the prob-
lems in doing such a calculation are discussed in Appendix III, Who
Can Afford a New House? This discussion also presents some rule-of-
thumb calculations using data for new homes financed under FHA
section 203. These calculations ignore tax and capital gains questions.
This exercise suggests that there has been little change over the last
twenty-five years in the proportion of the population that can afford a
new FHA home. Data for 1974 show a drop in the proportion of the
population that, using twenty-five percent of its income for housing,
could afford a new section 203 home. However data for this one year
may reflect the temporary influence of the beginning of the current
recession with its associated drop in income. At the present time it is
impossible to tell whether there has been a fundamental change in the
ability of Americans to buy their own home or whether we are ob-
serving the very real, but temporary, effects of the recession.
The calculations in the Appendix suggest little change over the last
20 years in the proportion of families that can afford new FHA houses.
The other side of that coin is that there has been little, if any, decline
in the still substantial proportion of the population that has trouble
finding decent housing for a reasonable percentage of its income. With-
out meaning to deny the importance of this need, one should not ex-
pect financial reorganization, per se, to solve the problem.
Inflation in both housing and other prices, through its effects on in-
terest rates, has had other important impacts on housing markets.
To the extent that variable inflation has been responsible for the large
variability in interest rates, inflation shares a large part of the respon-
sibility for the recent boom-bust cycles in housing and the associated
problems of thrift institutions. This impact of inflation on the term
structure differential and the associated impacts for thrift institutions
and housing markets has been a major theme of the whole paper.
In addition, inflation, through its effects on interest rates, has
strong impacts on the timing of real and nominal outlays when buying
a house. Briefly, to the extent that interest rates reflect the expectation
of inflation before it occurs, families face increased mortgage costs
now, before their income rises along with general inflation. Tliese
families will face smaller real mortgage costs in the future as their
mortgage payments will remain unchanged while their nominal in-
come rises along with prices in general. A full discussion of these
effects is beyond the scope of this paper. The interested reader is re-
ferred to the series of papers written under the HUD-MIT contract
on alternative mortgages (see New Mortgage Designs for Stable Hous-
ing in an Inflationary Environment) and "Inflation Induced Distor-


tions of the Real Economy: An Econometric and Simulation Study of
Housing and Mortgage Innovation," an unpublished Ph. D. thesis by
James Kearl.

Assuming that some form of financial reorganization is enacted
and given a concern about the effects of reorganization per se on
housing and mortgage markets, what sorts of responses might be
considered? I will discuss six proposals. I cannot offer a systematic
justification of why only six or why these six except the pressures of
time and the results of circumstances. All six proposals are really aimed
at the mortgage market and would be expected to have impacts in hous-
ing markets as they raised or lowered mortgage rates on average and
as they affected cyclical swings in mortgage lending.

One course of action would be to do nothing as regards special
arrangements for housing and mortgage markets in general. VWhat is
being suTested here is to do nothing as regards the general impacts
of financial reorganization on housing Mand mortgage markets. One
might still want to consider housing subsidy programs of one sort
or another to aid specific groups of people with specific hoisinf prob-
",m.s. but on this view one would do nothing as regards general inter-
vention in mortgage markets.10
There are probably a fair number of academic economists who would
naree with this policy position. They might, well argue that the present
predicament of thrift institutions is due in some, or perhaps large,
degree to past government regulation. In particular tax inducements
and regulatory constraints created the set of institutions that borrow
short and lend long. When these institutions got in trouble it was fur-
ther government regulation-deposit, rate control-that perpetuated
the old ways of doing business and perhaps added to the magnitude of
recent cycles in homoebuilding when savers began investing in direct
market seculrities.11 To simply eliminate deposit rate controls and ex-
pon these institutions to the forces of competition for deposits would
l1, ill advised if these institutions were still forced to invest virtually
all their assets in mortgages. However, if they are also given expanded
inve- nient powers then one might wonder what else needs to be done.2
If, as has been suggested, the futuTre continues to see periods of dra-
matic reversals in the term structure of interest rates, well. the past has
Warned ev'ervblodv that scl things can happen and financial reorga-
ilization This given these instit it ions the opportunity to diversify their
])port folios in order to cope with such periods.
I' Tn fact none "f thi other pronoqln (1i.o.p1 lielow are mennt to h e viewd'ri nq hniilnz
il,,:Ii,,- nr',ir'qm All ofTfr Lenral sn-nmort frr thie mnrtLnc, mnrlt nndl nre o rnnl.tpnt with
or rllhniitf nlitinncil Mna liliep. nlimed at vtippiefie rrnin. TIowovpr. some of the programs
coildl emIlly lip modified to offer lfTprentlInl limnpt fit io lower Ineomp groups.
11 ITn i.rilit i'nnO l ',' i n0 l without 41,',,,, t rnte erlln,]|". lonrl finds that thp ImnonRitlon
rf rPllnaq mnakep for hi1liher pa'ks nnil lower tronmgh. Th, eonclideq. ". It would annonr
l )it .vi ', 1.iI1. the vr lliiw.:s w r iltunllYv slglitly deNtIalt Izing In the effects on lhouglng."
il't-nir. i '271.)
7 A i 1vif'tps of tl0i- fri.o. 11 nr'L' l it ld tmaurket po ,nll4ton vrotl1d. Tpriimnnldy alo nr-ii, not
Nlii't for itl'r.r Invtnt ent imw\,rz' hut. morr f"ndrimpntnlly. no rnptreftlonn on nnv Invps-.
mont tTflonr. Three mnav he n ornnition prolilem nq tlhe riilps of thbp rnmp Pre elinnpeed.
1.''oTo, Rnv nro fre t lilonillv i ,r'n"l nhonut -iili pr' ielpmi r fprrlrn' 1nftend tn tf lk nhmint
op"',Iliirilim witfl fl;o |*w ril',q Thi,-n frnnrtflnq nrno'lpne --tho ep0stinu ponrtolIo of low
vIh.llin' mo-rf :'';iVh- nT1clit i,1-tlf\' ','irui :ort of o'Pnornrpv ,ihs.-'d epnoInllyv If dotn.nlt
rnt eoitfrol.- w'ore pldi fnti,-'l s.'il-utlv. The i',tif" $ V for a c-iihill. becomes less if the
explratli n ,f 1. i o; ,it rate con I rol. Is fixel now for some line In lhe future.


As for the question of what would happen to mortgage rates in such
a world, proponents of this view might well respond, "what does it
matter whether mortgage rates go up or down?" Higher mortgage
rates would eventually mean a smaller housing stock in the aggregate
and lower mortgage rates would eventually mean a slightly larger
housing stock, but who is to say that the housing stock or the mortgage
rate should be such and such a number.
Housing concerns for special groups are apt to remain whether
we have financial reorganization or not, whether the mortgage rate
goes up or down. The special needs of these people should be met by
direct subsidy of one form or another. It would be a great mistake
to reject financial reorganization, with its associated benefits for wide
groups of people, because of uncertainty about its possible adverse
impact on a smaller group of people. One should not expect financial
reorganization with its associated implications for the ecicncy of
financial markets to solve the housing problems of low and moderate
income families. There is a strong presumption that their needs can
be more efficiently met by direct subsidy.
Whatever the mortgage rate ends up to be will reflect the market's
impersonal determination of the rate necessary to balance the forces
of supply and demand. One would not expect the mortgage rate to
get far out of line from other interest rates, adjusted for the differen-
tial risks and costs of servicing mortgages. If mortgage rates did rise
way above other rates adjusted for differential costs, then profit
opportunities would exist for some institutions to make mortgages.
Believers in the market mechanism would expect this opportunity to be
As for high mortgage rates today, who is to say mortgage rates of
9 to 9.5 percent are high when inflation is occurring at rates of 10 to 12
percent a year and when corporate bond rates also are 9 percent. From
1955 to 1964, mortgage rates averaged almost 150 basis points higher
than the Aaa corporate bond rate. That differential has now dropped
to around 50 basis points. That is, the increase in mortgage rates on
both a percentage and absolute basis has been less than the increase in
corporate borrowing rates. In other words, corporate borrowers have
seen a larger increase in their costs of borrowing than households.
Proponents of this free market position would also not be surprised
to see cycles in homebuilding in the future. Such cycles are inherent in
the long lived nature of houses. Whether these cycles would be more or
less pronounced than before is hard to say and, some proponents might
argue, beside the point.
I must admit that there are some strands of the above argument
that are quite appealing to me as an economist. However implicit in
the whole argument is basic faith that minimizing government regula-
tion and constraints will enable the free play of markctt forces to allo-
cate credit to housing in the most socially desirable way. One may
simply be skeptical of that argument. Past problems with the mort-
gage market may not be entirely the result of mismanagement by the
government, but instead may be almost inherent in the nature of mort-
gage lending. If the latter is the case, then freer markets may not
necessarily solve all the problems of mortgage markets and appropriate
government policy actions may be needed. Along these lines the pro-
posal for expanded operations of the Federal Home Loan Mortgage
Corporation may deserve special attention.


A key feature of the Financial Institutions Act is the mortgage
income tax credit (MIITC). This provision of the bill would give a
tax credit to anyone holding qualifying residential mortgages. The
magnitude of the tax credit is related to interest income from qualify-
ing loans and, for financial institutions, the magnitude of qualifying
loans in the institution's total portfolio. Early versions of the MITC
worked as follows: If an institution has 10 percent of its assets in quali-
fying loans, it can reduce its taxes by 1.5 percent of its mortgage
interest income. The magnitude of the credit increases until, when
qualifying loans total 70 percent or more of assets, the reduction in
taxes is 3.5 percent of mortgage interest income.
Discussion surrounding the MITC suggests that the tax credit is
expected to help achieve three objectives: (1) to broaden the supply
of mortgage credit and moderate cyclical fluctuations; (2) to provide
reduced borrowing costs for homeowners; (3) to allow uniform taxa-
tion of different financial institutions. The tax credit works to raise
the after tax return to an institution making mortgage loans, assuming
it meets the minimal mortgage holding requirements to qualify. Thus
the credit is expected to make mortgages more attractive and to induce
more mortgage lending. It is hoped that the forces of competition
will work to pass on some of this tax subsidy to homeowners in the
form of reduced mortgage rates. Finally, the MITC is tied up with
other tax changes that will hopefully work to make taxation of finan-
cial institutions more uniform. Currently there are, in essence, differ-
ent tax provisions for different types of financial institutions. Adoption
of the MITC and the elimination of current differing tax procedures
would allow for uniform taxation. While few would argue with the
desirability of the objectives mentioned above, there are serious ques-
tions about, the ability of the MITC to achieve these objectives, espe-
cially the first two, and about the associated costs.

The MITC is expected to make mortgages more attractive to lenders
by raising the effective after tax yields on these loans. It is expected
tfliat this increase in yield will affect tlihe behavior of institutions with
tax liabilities and portfolio flexibility; specifically commercial banks
and mutual savings banks.
The cyclical impacts of tlie VITC are a bit unclear. There is nothing
counter cyclical in the MITC that could work to offset existing cy-
clical forces. Tlie MITC would be in effect at all times. Only by
attracting thle new lenders wlio would continue to make mortgage
lo:mns tliriurh thick and thin could the MITC work to moderate
cyclical fluctuations in lending.

In 1-ie niretrrate commercial banks currently hold just less than
nine p.,'.eeit of tleir assets in mort(rages. Ten percent holdings are
tli mininimn requirement to be eligible for the. tax credit. For banks
just below the ten percent floor, the one percent additional mortgage
lending makes them eligible, for the tax credit on the whole of their

mortgage holdings. Thus these institutions have a powerful incentive
to increase their mortgage lending. However, for banks with only 2
or 3 percent of assets in mortgages the gains are much smaller. Table 3
illustrates this point.13 For a bank holding 9 percent of its assets in
mortgages, and using the assumed mortgage rates, the effect of the
tax credit is to transform the 9 percent before tax return on the
.additional 1 percent of new mortgage lending to a 11.2 percent return.
However for a bank holding only 3 percent of its assets in mortgages,
:the increase in effective yield for the additional 7 percent of lending
is only 35 basis points.
Mortgage holdings of commercial banks average 8.9 percent of as-
sets. However one would not expect mortgage holdings in the aggre-
gate to rise to ten percent of total assets as there is a substantial amount
.of bank assets in banks with very low mortgage holdings. As shown
in Table 3, the MITC offers very little incentive to these banks to
increase mortgage lending. In particular, large banks in New York
'City and Chicago hold over 19 percent of total commercial bank
assets, but only 3.1 percent of their assets are in mortgages. Also
there are a substantial number of banks that one would presume
currently hold more than ten percent of their assets in mortgages. In
particular, non-large member banks and nonmember banks, which
account for 51 percent of total commercial bank assets, currently
hold 11 percent of their assets in mortgages. As a class these banks
would have a much smaller incentive to increase their mortgage lend-
ing. Thus, some banks, but certainly not all, would have a strong
incentive to increase their mortgage holdings to the ten percent of
assets level.
Once a commercial bank reaches the 10 percent of assets level there
is a small incentive to continue to expand mortgage holdings. Addi-
tional mortgage lending beyond the 10 percent floor does earn the mort-
gage credit and, further, each additional one percent of mortgage
holdings enables an institution to earn a slightly higher credit on
all its mortgage holdings, not just the new loans. The magnitude of
this effect is relatively small, ranging from 31 to 42 basis points as
the proportion of mortgages in total assets rises from 10 to 20 percent.
Much o,f the tax credit would be paid for mortgage loans currently
on the books. One wonders exactly how much additional mortgage
lending would be stimulated by the increase in yield? A casual
survey of existing econometric investigations of commercial bank
portfolio behavior raises serious questions as to how much. Most of
these investigations have used time series data on commercial bank
portfolio behavior. It is not uncommon to find only a limited response
of commercial bank mortgage holdings to changes in the mortgage
rate. For example, see Bosworth-Duesenberry. In fact, some investi-
gators have been unable to find any significant response of commercial
banks' mortgage holdings to mortgage yields. See Hendershott and
Valliani, Silber, and Swan. All this suggests that there may be only
a minimal response by commercial banks to the increase in effective
mortgage rates implied by the MITC.
'"It should be noted that the response to the Interest differential resulting from the
MITC tends to eliminate the differential. Increased mortgage lending would be expected
to reduce the mortgage rate. Switches out of other assets would be expected to raise those
Interest rates.


[Assumptions: Rate on new mortgages = 9 percent. Average rate on existing mortgages = 7.5 percent. Marginal tax
rate = .48. Mortgage interest tax credit = 1.5 percent]

Tax credit
Percent Volume of Before tax After tax on existing
assets in new lending return on return on Tax credit mortgages Equivalent
mortgages (percent of new new on new per new Total after before tax
beforee) assets) mortgages mortgage a mortgage b mortgage e tax return d return

9--.---.- ----- 1 9 4.68 0.135 1.013 5.828 11.207
6 ---......----------- 4 9 4.68 .135 .169 4.984 9.585
3.............. --------------7 9 4.68 .135 .048 4.863 9.35Z

* (1 Tax rate) (Mortgage rate)
b (.015) (Moit-age rate).
e (.015) (income from existing mortgages) + (volume of new mortgages).
d sum of 3 previous columns.
S(Total after tax return) (1 Tax rate).


The effect of the MITC on the behavior of thrift institutions is not
at all obvious. Savings and loan associations are currently holding
about as many mortgages as they can. Few people would expect them
to hold more. Further, holding additional mortgages, by increasing
their dependence on mortgage,-. would only intensify their problems
as regards changes in the term structure of interest rates. The thrust
of other proposals for financial reorganization is to lessen the de-
pendence of thrifts on mortgage lenllding. Mutual savings banks hold
sliglitly less than 70 percent of their assets in mortgages. Based on
the assumptions underlying Table 2, the MITC would have the effect
of raising" the effective before tax yield on mortgages from 9 percent
to about 9.9 percent for an average mutual savings bank. However,
for both savings and loan associations and(l mutual savings banks it
would be possible and profitable to reduce their federal income tax
liability by reducing their mort gage holdings slightly and holding a
lir.ited amount of tax free municipal securities instead.
Consid(ler a thrift institution of a given size. Consider whether it
should make an additional mort(racre loan or byv a tax free municipal
security. Under the MITC a mutual savings bank would have an after
tax return of about 5.14 percent from making an additional mortgage
loan. A savings and loanl association would have an after tax return
of about 5.0 percentt.4 Either thri 't it4 it lution could, at current yields.
earn a, before and after tax return of over 7 percent by buying tax free
municipal securities.'5
Not, only are. tax free seI'ritie. a good investment ulit they work
to redlce1 tax liabilities. In fa't, it is possible for a thrift institution
to increase its after tax income and avoid all income taxes by holdinr
an appropriate almomit, of tax fi'e minictuipals. Table 4 illustrates this
(poitt for savings a1d l(o, as.11iiti1.. For an institution of a given
size all a gi'vel( dep()sit rte, (dep()-it costs are fixed and unaffected
by its p portfolio deci'-ions. As\ -l switcli betw'eell mortgages and

Th, flifTfironn' In vl'lMldR reflv(t,4 iiin frnet thnt. on avernge. ntiitnl Ravines hanks ark
below the' 70 prw-rcpnt MITC limit. Thiu, fiirthie'r rnort,'n pe invvstmpnts not only earn a tax
'r', .lil li 1t i li" iJ ioiili riik. fhli' ii'a iili''. if the 1.'itillt on Ill xi..thI..r niit-tnr-zP lhil tt-
Incr-. The .irm pn[rIl.-,i, of nfter fix -yillvlk I lah..rnevt. from ni-sovlited spervicinrg cost. Includling
sLich costs wn'i lriw r the' rut ift'vr I;x return ,!i 1IortvI: s.
oA p rtfolif)o rf niiintinlipal .ei, uritie.s lians .int(, servicing costs, but they are surely lower
thanii th i,., ol," ii jort ..i Irtl',iilli.


municipals has a magnified effect on taxable income-reducing
tax liabilities substantially-but a much smaller effect on the
MITC. The large reduction in tax lial)ilities is balanced off against
the small loss in the tax credit until tax liabilities in fact disappear. At
the same time the tax free return of municipal securities helps to raise
after tax income. In the example shown in Table 4, based on 1973
data, savings and loan associations would be able to raise their after
tax income and eliminate their tax liabilities by switching 22.7 billion
dollars worth of mortgages into tax free municipals. This asset switch
reduces their mortgage holdings from 85 to 77 percent of total assets,
a ratio that still qualifies them for the maximum tax credit.
The advantage of this particular asset swap depends on relative
interest rates. Currently these sorts of asset swaps are especially
attractive. Yield spreads may in the future move in a way that miti-
gates the profitability of such swaps. However, ignoring servicing
costs on both assets, municipals have had a higher after tax return
than mortgages would have under a MITC plan for almost the past
twenty years. Including servicing costs would surely work to make
municipals even more attractive as their servicing costs are quite likely
.-maller than those for mortgages.
[Assumptiors: New mortgage rate, net yield: 7.5 percent.* Tax free municipal rate, net yield: 7 percent]

Reduce mortgage
Simulated 1973 holdings by
with MITC $22.7 bil

1 Total assets------------ -----------------------$264.4 (bil) 264.4
2 Mortgages_. ------------------------------------------ 225.7 1-22. 7 203
3 Ratio--------------......----.--- --------.--... --------------- ..... .... 85 .77
4 Taxable income -------------------------... ------------- 2. 655 [-.075(22.7)1 .953
5 Mortgage interest income. ------------------------------ 15.180 [-.09(22.7)1 13.137
6 Taxes based on taxable income. ---------------------------- 1.274 .457
7 MITC --------------------------------------------- .531 .460
8 Taxes owed... ----------------------------------------- .743 0
9 Tax free income -----------------------------------.. -- 0.0 [-+-(22.7X.07)] 1.59
10 After tax income------------ ------------------------- 1.912 2.543
gross mortgage yield, 9 percent, minus servicing costs, 1.5 percent.
Simulated 1973 lines 1-5: Actual data, FHLBB; line 6: (.48)(line 4); line 7: (.035)(line 5); line 8: line 6-line 7;
line 10: line 4-line 8 + line 9.
Reduced mortgage holdings lines 2, 4, 5, 9 reflect arithmetic shown; lines 6, 7, 8, 10 as above.

It is possible to reduce tax liabilities by switching municipals for
*assets other than mortgages. The profitability of different potential
switches would depend on the particular structure of all interest rates
and the magnitude of holdings of assets other than mortgages. Mutual
savings banks do hold substantial assets in forms other than mort-
gages. Savings and loan associations, however, simply do not hold
many other assets that they could switch for tax free securities.
To summarize, the impact of MITC on thrift institutions' holdings
of mortgages is ambiguous. The MITC raises the before and after tax
return on mortgages, and for that reason may make mortgages more
attractive to mutual savings banks. However the associated changes
in taxation also make it possible for both mutual savings banks and
savings and loan associations to raise their after tax income and
reduce their tax liability by holding tax free municipal securities.


The exact magnitude of the asset switching effect, and in particular
its impact on mortgage holdings, is difficult to predict, but it has the
potential for reducing mortgage holdings by thrift institutions, es-
pecially savings and loan associations.16
The MITC is apt to have only minimal impacts on life insurance
companies and pension funds. These institutions pay little or no income
taxes and thus the tax credit has little value to them.

How much, if any, of the mortgage tax credit will get passed on to
homeowners in the form of lower mortgage rates? This is a complicated
question with several different aspects. While all qualifying mort-
gage debt would be required to have residential property as collateral,
not all this debt need be incurred in order to buy a home. To the extent
that the tax credit makes mortgage loans more attractive to financial
institutions there will be an incentive to change the form of other
borrowing to that of qualifying mortgages. Thus. effects of the tax
credit may diffuse as a subsidy to general lending. The precise magni-
tude of this effect is impossible to know. Some abuses are sure to
occur, their magnitude is, however, uncertain.
The decline, if any, in mortgage rates following the enactment of
the MITC would depend upon the slopes of the demand and supply
curves for mortgages as well as the shift in the supply curve induced
by the MITC. The exact nature of the shift in the supply curve is com-
plicated by the existence of deposit ceilings, the differential impact of
the MITC on different institutions due to differing portfolio percent-
ages and the tax considerations discussed above. See Kane (1974) for a
more extensive discussion of some of these points. Several of Kane's
conclusions should be noted. In the absence of deposit rate ceilings,
Kane concludes that ". . specialized mortgage lenders eligible for
the minimum tax-credit percentage . would be able to drive insti-
tutions eligible for lower tax credit percentages completely out of the
market for residential mortgages." (p. 8) In this case "every dollar
of tax revenue surrendered by the Treasury on new loans would be
passed through to borrowers . However, competitive deposit and
mortgage markets frustrate a second objective of the legislation by
perversely reenforcing incentives for maintaining the existing pattern
of institutional specialization in mortgage loans." (p. 10)
In the case of noncompetitive markets, as for example with deposit
rate ceilings, a different result emerges. The magnitude of the decline
in the mortgage rate is strongly influenced by the size of the tax credit
available to the marginal lenders, who are apt to be commercial banks.
Further the differential between the low and high tax credit lenders
would accrue to the lenders, not the borrowers. Thus Kane concludes,
"The lower the tax-credit percentage enjoyed by the marginal lender,
the higher would be the mortgage rate paid by the borrower and the
16The above analysis is clearly a partial analysis and Is only meant to be suggestlvP.
The complete general equlllbrum responses are difficult to compute. In particular, If tlhee
asset swops took place one would expect that mortgage rates would rise and the rate on
munleipals fall. If these swaps Increased after tax profits and If deposit rates were not
controlled, then there would be competitive pressures to raise deposit rates.


greater proportion of Treasury revenue losses on new loans that would
flow as a windfall to higher tax credit lenders in the financial
Kane also argues that the tax loss to the Treasury is apt to be quite
substantial, significantly exceeding figures prepared by the Treasury.
Kane's figures do not include the possibility of avoiding a substantial
part or all of any remaining tax liability by holding taxfree municipal
securities. This latter possibility suggests that the tax loss could be
even greater.
In conclusion, the precise impact of the MITC on the mortgage rate is
difficult to determine. There seems to be a presumption that the MITC
will reduce the mortgage rate. It is not clear how large any reduction
will be. It might be quite small. To the extent that the demand for
mortgages by household remains strong and lenders with low tax cred-
its are needed to provide the final dollars of mortgage credit, there will
be a smaller reduction in the mortgage rate and a larger element of
windfall gain to high-tax-credit thrift institutions. Finally the cost
to the treasury in terms of lost revenue is apt to be quite large and
in excess of earlier official projections.

Proposals for credit allocation are a recurrent theme. Most recently
proponents of credit allocation have proposed schemes as a way of
helping low and moderate income housing, state and local governments
and small businesses. There is probably a general agreement among
economists that a program of credit allocation could have the intended
effects of increasing lending to the favored sectors and decreasing lend-
ing to other sectors. However most academic economists probably show
a strong dislike for credit allocation schemes, if not an open hostility.17
This generally negative reaction arises because of serious questions
about the magnitude of the effects on lending, the associated costs of
an effective program and thus the desirability of any program of credit
Since money is to some extent fungible, to what extent would favor-
able loans be used for unfavored purpose? Sectors of the economy that
were denied credit would have an incentive to develop procedures that
circumvented the credit allocation restrictions. The question is to what
extent would these procedures be able to offset the original restrictions?
.-Slightly ? Substantially ? Completely? If controls were imposed on only
a subset of lenders, for example, commercial banks, the resulting mar-
ket forces would provide strong incentive for other financial institu-
tions to fill in the lending gap that would then exist and thus circum-
vent the original controls. How strong would these forces be? Pro-
ponents of credit controls tend to view the problems of possible
circumvention as small and manageable. Opponents, on the other
hand, tend to view these problems as substantial.
All of these problems of circumvention could to some extent be
limited, and perhaps eliminated, by more finely drawn regulation and
more careful and complete reporting and administration. However all
these attempts to limit the leakages would require a more cumbersome
w The subsequent discussion Is strongly Influenced by a recent paper by Thomas Mayer
and refers to a program of mandatory credit controls.


and costly bureaucratic structure of administration. Further they are
apt to have unintended and unforeseeable side effects as they increase
the regulation and limit the freedom of innumerable special financial
arrangements that, particular borrowers and lenders have arranged.
The question that, needs to be answered is whether the costs of admin-
istration are worth the benefits that might flow from such a program.
Unfortunately there is no precise way of determining exactly what
these costs and benefits will be. Consequently proponents and oppo-
-,ents are left to rely on their basic intuition and prejudices in estimat-
ing what the costs and benefits are likely to be. Again proponents see
.Jmall costs and large benefits while opponents see large costs and small
A recent paper by Rao and Kaminow investigates the possible im-
pacts of a system of asset reserve requirements. Asset reserve require-
ments are only one form, although a popular one, that credit controls
mi.rht take. Rao and Kaminow argue that their results are of broader
significance and will be essentially unchanged for any credit alloca-
tion policy that operates by affecting the portfolio preferences of fi-
narIcinl institutions for different types of assets.
After investigating their theoretical model where portfolio deci-
sions by individuals and institutions are influenced by what happens
to interest rates, Rao and Kaminow conclude that "selective credit
controls will have the impact on interest rates that policymakers
would generally anticipate." However they go on to note that the
niagnitude of the effects depends upon a variety of factors and it is
possible that the controls would not have the desired effects on real
investment. In other words, it is possible that while controls would
lower mortgage rates, and raisebusiness borrowing rates, actual home-
building would decline.
Rao and Kaminow talk of four conditions which make selective
credit controls more effective. One condition is what they call "special-
ization", or the sensitivity of demands for particular ty)es of assets to
particular borrowing rates,. Selective credit controls are more effective
if the demand for hos 0s do('es not respond to interests rates other than
the minortgarge rate and if the demands for other assets are similarly not
influenced by the mortgage rate.
The second condition is called "dichotomy." Selective credit controls
are more effective if the demand for houses is less responsive to the
returns from holding other assets and if the demand for other assets is
less responsive to the returns from holding houses. Economic theory
suggests that individuals allocate their wealth among a variety of
assets depending upon the relative rates of return on different assets.
In particular the asset demand for houses would in theory depend not
only upon the returns from holding houses, but also the returns from
holding other assets. Rao and Kaminow find that the effectiveness of
selective credit controls is largest if the demand for houses is not
affected by other, competing rates of return.
The third condition hlias to do with the breadth of coverage of con-
t rols. Controls are more effective if they extend to all financial institu-
tlons. Controls are less effective if they exclude some financial
The fourth condition hlas to do with thlie financing of business invest-'
men t by issuing securities directly to households. Most of the Rao-


Kaminow paper assumes that both mortgage lending and business
lending is done by financial institutions. The possibility of bypassing
financial intermediaries and borrowing directly from househllolds
weakens the effect of selective credit controls on financial institutions.
This situation also gives rise to the possibility of the perverse result
where the controls would have their intended effect on interest rates
but need not have the desired effects on actual investment.
It is analysis such as that illustrated by the Rao-Kaminow paper
that underlies a general feeling that selective credit, controls such as
credit allocation schemes could have their intended effect. However
most economists would point to the limited nature of this conclusion.
First, the. Rao-Kaminow paper explicitly details the situations under
which selective credit controls are apt to have a smaller impact-the
possibility of direct financing by non-favored sectors by issuing securi-
ties to households directly; the existence of financial institutions out-
side the scope of the direct controls; the sensitivity of the demand for
any one asset to rates of return on assets in general; and finally the
sensitivity of the demand for any one asset to a variety of interest
rates as they offer alternative ways of financing investments.
Second, the Rao-Kaminow paper does not explicitly consider a num-
ber of other objections to selective credit controls. In particular, there
is no explicit recognition of the costs of administration. One element
of this cost is the explicit costs of both private institutions reporting
compliance and regulatory agencies monitoring compliance or the
lack thereof. Another element of this cost is the implicit cost in terms
of loss of freedom and the extension of government control. In addi-
tion, the Rao-Kaminow paper does not have any formal treatment of
how the existence of selective controls might alter the basic institu-
tional environment. For example Rao and Kaminow do discuss how
the impact of selective controls would be lessened if a portion of rele-
vant financial institutions were excluded from the controls, but they
do not discuss how controls on all current financial institutions might
by themselves induce the creation of new institutions that would be
outside the controls.18
There are a number of other objections to credit allocation schemes
that should also be mentioned. It is difficult to define precise categories
of loans to be either favored or disfavored. There are inevitably grey
areas between categories of loans. Thus, specific regulations are apt
to do two things. One, they may cause a real inconvenience to in-
dividuals or institutions with legitimate credit needs who would pre-
fer to finance activities in relatively unconventional ways. Second,
they provide strong incentives for individuals and institutions with
disfavored needs to change the form of their borrowings to forms that
accommodate to regulation.
The existence of grey areas may also have undesirable effects from
the dynamics of the politics of establishing and maintaining a pro-
gram of credit allocation. The definition of privileged sectors may
need to be expanded to such an extent as to become meaningless in
order to gather enough political support to initiate a program of
credit rationing. Subsequently, to the extent that the program is in
fact successful and reduces the availability of credit to some sectors
18 The development of money market mutual funds is an Illustration of precisely this
62-748--76--bk. I---5


there will be continual pressures on the Congress and/or the enforce-
ment agency to again expand the privileged sectors. Drawing a lesson
from the histories of a number of regulatory agencies, a large major-
ity of economists would not be optimistic about the possibility of
maintaining distinctions as between privileged and less privileged
Another frequent objection to schemes of credit allocation is that
they are apt to interfere with the efficiency of the economy overall
and the financial sector in particular. How much weight individual
economists put on this point depends for the most part on how much
they believe that markets work like textbook competitive markets.
With competitive markets funds go to borrowers who are willing to
pay the highest price, borrowers who by definition can use the funds
most productively. If financial markets are reasonably competitive
and credit allocation schemes are effective, they must reallocate funds
away from more productive users to less productive users and hence
the efficiency of the economy as a whole suffers.
Similarly, financial institutions develop expertise in the types of
lending that they can do most efficiently. If credit allocation schemes
are effective they will force some or all institutions to engage in types
of lending they would not otherwise engage in, types of lending they
are less efficient at.
Obviously how much weight one places on these arguments depends
on one s prior conception of how competitive and efficient existing
markets are. I want to make two points concerning this question. One,
economists probably believe that markets are more competitive and
efficient than do non-economists. Two, financial markets are severely
limited and constrained by government regulation, and thus may not
closely approximate the textbook notion of competitive markets. Some
forms of regulation and control exist to give the government control
over the, money supply and to insure the stability of, and hence con-
fidence in, the financial structure. However, in the view of runny
economists other regulations have the effect of restricting competition
and exacerbating the problems credit allocation are designed to help.
If this view is correct, then it is not at all obvious that adding new
controls-credit allocation-to undo the effects of old regulations is
the preferred course for public policy. One could simply eliminate the
original outdated controls.

A number of observers have suggested that variable rate mortgages
(VITM's) should be considered as a possible solution to tlhe problems
of thrift inistittitions.19 There are perhaps as many VRM schemes as
there are proponents of the idea. To attempt a systematic (liscussioll
of all the proposals is simply infeasible. The common underlying fea-
tivre is that the interest rate paid by a borrower would not be constant
IDVarlablo rnte mortgnges are only one of severalni possible variantions In trnditionnl
iiiiimrtgiii. thUlit one miighit wn t to ronslder. In partliulnAr. theri, has been discussion of
prive levpl adjusted mortgages and graduated pnyment mortgages. Time and cirenmstanc'e
r,,strict the dlitinsim lihere to vnrlnable rate niortnogePq. For n more complete diseus'Ion of
other nltrnnintlvM sapt, Modiglliit n (nd Lessard. N wu' Mortiyage Designa . .and Kenrl's
..1tud1y of IlOiisin. g lInd lun 'rt gtitg. llii t oiIl*1 .


over the life of the loan, rather it would vary in response to changes in
some reference rate agreed to when the loan was originated.20
The basic idea, common to all the proposals, is to make the earnings
from a mortgage portfolio more responsive to changes in short term
interest rates. If these earnings were more responsive to movements in
short term rates then thrift institutions could afford to pay deposit
rates that were competitive with short term market rates. In such a.
world it would be expected that institutions could do without deposit
rate controls and that when short term rates rose they would not
suffer massive deposit outflows. Thus mortgage lending would be
stabilized over a cycle in interest rates.
Several things should be pointed out. To the extent that long term
rates, like mortgage rates, are correct predictors of the sequence of
future short term rates, then VRM's tied to short rates would work
only to change the time sequence of interest and principal payments.
After a mortgage was paid back, the VRM or a traditional mortgage
would, in retrospect, look the same to both the borrower and the lender.
However, the V"RM does introduce strong elements of uncertainty.
Viewed before the fact, one simply does not know whether the un-
known sequence of rates on a VRM will in the end be equivalent to the
fixed rate on a traditional mortgage. Further, it may be of small con-
solation to some households that especially high mortgage payments
will, sometime in the future, be offset by especially low payments.
The VRM does make a real difference, beyond shifts in the payment
stream, when the sequence of short rates does not, in fact, turn out
to be equivalent to the initial long term rate. In these cases there is
currently an obvious asymmetry depending on whether future short
rates turn out to be lower or higher than implied in initial long term
rates. If short term rates turn out to be lower than expected, then a
VRMf borrower's payments will also be that much lower. With the
current mortgage instrument one would expect that, when expecta-
tions were adjusted to reflect the realizations of lower than initially
expected short term rates, long term rates, including the mortgage
rate, would decline. Assuming the decline to be of sufficient magni-
tuide, one would expect mortgage borrowers to refinance.
When the sequence of short rates turns out to be higher than initially
expected, then VRM's make a real difference of substantial impact.
It is at precisely these times that thrift institutions get into trouble
and the VRM is designed to help them out. The VRM helps them out
by requiring larger payments from borrowers. While these larger pay-
ments from borrowers would help lenders, they obviously are not so
good for borrowers and, not surprisingly, have been resisted for this
reason. With the current mortgage instrument, a borrower's payments
do not rise. To briefly summarize, when future short term rates are
lower than originally expected, a V-RM mandates lower payments
while market forces would be expected to lower payments with the
current mortgage instrument. If future short term rates are higher
20 Proposals for VRM's differ in terms of the reference rate proposed, the adjustment of
the payment stream when the reference rate changes-does the size of the payment changpp
or the maturity of the loan or both ?-limitation on the cumulative magnitude of possible
changes, the frequency of changes, and other safeguards and options that would be avail-
able to consumers. It should be mentioned that the reference rate need not be a single
interest rate but could be an average of several rates.


than originally expected, a VRM mandates higher payments while the
current nmiortgage instrument leaves payments unchanged.
Borrowers obviously lose under a VRM with unexpected increases
in short termn rates as compared with the alternative of a traditional
mortgage with a fixed interest rate and a fixed stream of payments.
However, under some circumstances, borrowers with traditional mort-
gages are big gainers. One could view VRM's as requiring borrowers
to share some of their current big gains. Specifically, if short term
interest rates rise umexpectedly because. of unexpected inflation, then
borrowers would be expected to have capital gains on their property
and higher normal incomes as a result of the inflation. With tradi-
tional mortgages the capital gainl accrues entirely to the borrower. The
VRMI would require the borrower to share part of the capital gain
with the enderr.
The sharing analogy can perhaps be carried too far. The VRM re-
quires payment to the lender when interest rates rise, that is when
thi- capital gain takes place. The borrower would probably not realize
tlHit capital gain for some time. The borrower is thus forced to finance
the early payment of part of the as yet uncertain capital gain to the
lender. There may also be significant distribution effects. Interest rates
respond to inflation in the economy as a whole, i.e., the average of price
increases over all sorts of goods in all sorts of places. It is possible
that houses in general, or particular houses in particular places, would
not experience capital gains that matched economy wide measures of
in flation.
There are other circumstances where, when making higher payments
under a VRM, borrowers would not simultaneously be receiving other
benefits that might finance these payments. If the unexpected in-
crease in short-term rates is in response to a change in real interest
rates, not changes in the rate of inflation, then borrowers would not be
expected to have capital gains with which to finance higher mortgage
What impacts might VRM's have on thrift institutions and housing?
As with tlhe general question of the impact of financial reorganization,
this (question can not be answered with certainty. The wide scale in-
troduction of VRMNI's could change borrower and lender behavior in
ways that would be exceedingly difficult to capture with existing
simulation models. Further, the variety of VRM proposals means that
even if we had the perfect simulation model, there might not be one
an;\ver to the question; the answer could well differ from proposal
to proposal. With these caveats in mind, mention might be made of
somlie silinulation work done bv Professor James Kearl. Kearl simulates
tlhe complete adoption of VRM's over the period 1962 through 1973
and finds that the introduction of VRM's, accompanied with the elimi-
nation of deposit rate ceilings, does three things: (1) the housing stock
is snialler, (2) profits of savings and loans, as measured by their re-
serves, are larger, and (3) the size of savings and loans, as measured
by their total deposits, is smaller.21
Kearl attributes these results to the implicit change in the role of
savings and loan associations. With earnings tied to short term rates,
21 K ir's simnulations Involve the extreme assumption that all mortgages are converted
to V\ 'HIi. In such situation there la a less pressing case for broader investment powers
for thrift InKtitutions. If VRM's formed only a small part of the mortgage portfolio of
thrift Institutions, there would still be a strong case for wider Investment powers.


savings and loan associations are no longer intermediating between
long and short term interest rates and hence no longer earning the
profits that come from taking that risk. These lower profits on average
mean lower deposit rates on average, a smaller industry, less mortgage
lending, a higher mortgage rate and hence a smaller housing stock. In
particular most of these effects appear to come in the last part of
Kearl's simulation. In particular, the variable rate on mortgages and,
with a lag, the deposit rate paid by savings and loans drops from mid
1969 through 1972. This lower deposit rate means fewer deposits, less
mortgage lending, etc.
The role of reserves at savings and loan associations in the model
used by Kearl is difficult to interpret. Kearl's particular results about
the growth in reserves needs to be interpreted with care. Within the
model transfers to reserves are, for the most part, measured as the
difference between mortgage interest income and deposit interest ex-
penses. There is no feedback from large reserve accumulations to
higher deposit rates, a feedback one would expect in the real world.
To the extent that savings and loan associations were able to use their
higher reserves to increase deposit rates, one would not expect as large
a reduction in either the size of savings and loan associations or the
size of the housing stock as implied by Kearl's simulations. In spite of
this limitation of the simulations, Kearl's results raise some funda-
mental questions as to whether VRM's could be expected, by them-
selves, to solve the problems of thrift institutions.
One can have serious doubts that the conversion of all mortgages to
VRM's would solve the problems of thrift institutions. One could also
oppose the conversion of all mortgages to VRM's on other grounds.
However, neither of these two positions need imply that one should
also be opposed to allowing the introduction of and experimentation
with VRM's. As implied in the discussion above, the VRM shifts the
risks involved in interest rate changes as between borrowers and lend-
ers. In a world where both types of loans existed, there could well be
borrowers and lenders who, at times, would find VIRM's mutually
beneficial. To prohibit the use of VRM's would, in these cases, relegate
both borrower and lender to less preferred options. The basic principle
here is that, with adequate safeguards and information, more choice
is better than less choice.

Some observers have suggested that the federal government should
offer interest rate insurance to mortgage lenders.22 Under such a pro-
gram, the federal government would guarantee to lenders that if
some reference interest rate, which might be a single interest rate
or an average of several rates, rose above its value when the mortgage
loan was made, then the federal government would pay to the lender
the increment in the reference interest rate times the outst;,din,:
principal of the mortgage. Thus if interest rates rose. lenders- with
this rate insurance would see their income keep paco with the rise in
interest rates instead of remaining unchanged. Note that mortgage
payments by homeowners would remain unchanged. The purpose of
this proposal is to solve the problem of the impacts of adverse move-
22 This proposal is discussed In more detail by James Pierce. .


mnients in the term structure of interest rates on thrift institutions.
In this regard the term structure insurance is very similar to the VRM,
however there is a big difference in who is paying.
What benefits would one expect in this world where the earnings
of mortgage lenders were protected against adverse movements in
the term structure? With the simultaneous abolition of deposit rate
ceilings, one would expect that the forces of competition would pass
these higher earnings on to depositors in the form of higher deposit
rates. These higher deposit rates would enable thrift institutions to
remain competitive with direct market securities. To the extent that
these higher deposit rates prevented massive disintermediation then
cycles in homebuilding would be moderated. It should be noted that
the proposal makes little sense without the abolition of deposit rate
What happens when interest rates, including mortgage rates, de-
cline? Exactly what would happen would depend upon the form of
term structure insurance. One version of this scheme would have
mortgage lenders swap the income from their mortgages for a flow
of income determined by the reference interest rate. Under this ver-
sion income to mortgage lenders would decline when interest rates
in general declined. Again homeowners payments would be unchanged
at a level determined by the original lending rate. In such a situation
one would expect that institutions would compete for making mort-
gage loans by offering automatic rolling over of mortgage loans when
interest, rates decline. That is the institutions would treat homeowners
as if they had paid off their existing high rate mortgage and had
taken cut a new mortgage that reflected current, lower interest rates.
With this sort. of response the government would cease to get the
original higher mortgage payments and would in essence be offering
insurance only against increases in interest rates. An alternative ver-
sion of the interest rate insurance proposal would recognize this
onesidledncss and simply offer insurance against an increase in in-
terest rates.
This term structure insurance solves the fundamental problem of
the impact of adverse shifts in the term structure of interest rates.
One could imagine offering such insurance only to institutions that
invested a substantial portion of their assets in mortgages. That
is the insurance could be offered only to thrift institutions. In this
case the proposal would achieve a change in substance without a
change in form. There would be no need to allow thrift institutions
broader asset or liability powers because the term structure insurance
would achieve the same result. Alternatively one could imagine allow-
ing broader powers to thrifts and offering the insurance to any and
all mortgage lenders.
. What would such a proposal do to mortgage rates and what would
it cost the governmentV The impact on mortgage rates and the cost to
government both appear to depend on how the term structure in-
surance would be implemented. In particular, would the insurance be
free? If not, how would a price be determined? If the insurance
were offered for free, I would expect new mortgage rates to look
very much like short-term interest rates. If institutions did not need
to worry about the risk of interest rates rising and if they could attract
large amounts of funds at rates that were competitive to other short


term rates, then lending these funds out as mortgages would be profit-
able until the mortgage rate dropped to something just above their
deposit rate plus an allowance for the costs of making and servicing
the loan. Thus, with free insurance and assuming some fairly auto-
matic rolling over of mortgages when interest rates declined, the in-
terest rate insurance makes the mortgage a short term instrument as
far as financial institutions are concerned while it still looks like a
long term instrument for households.
The costs to the government of this sort of scheme could be quite
substantial. With the automatic rolling over, all mortgage rates would
decline when rates in general declined, but when rates in general rose,
mortgage rates for old borrowers would not rise. They would stay at
their recent low point. New loans would be made at higher rates, but
again whenever mortgage rates declined they would bring down with
them all loans made at higher rates and carry them down as far as the
reference rate dropped. Thus whenever interest rates in general, in-
cluding the reference rate rose, the federal government would be liable
for at least the differential between current rates and their recent low
times the whole stock of outstanding mortgages2 3 While such an
arrangement would solve the problem of financial instability it also
represents a huge subsidy to anyone with a mortgage. It seems quite
clear that this sort of subsidy is entirely unjustified.
If the insurance were not free, but instead carried a price, what sort
of price might one expect financial institutions to be willing to pay?
What implications would that have for mortgage rates and for the
cost to the federal government? The expectations theory of the term
structure suggests that, in principle, the differential between long and
short term interest rates would be a good measure of what institutions
minoht pay for this interest rate insurance.
If the expectations theory-that long rates are good predictors of
future short rates-is correct, there is, in fact. less need for this sort of
insurance. One does not need insurance against all future increases in
short rates. In particular one does not need insurance against expected
future increases. Term structure differentials could be expected to take
care of these increases. However, to the extent that thrift institutions
are risk adverse, interest rate insurance would be attractive to them
even if long rates were good predictors of future short-term interest
rates. There is a much stronger case for insurance against unexpected
increases in short-term rates which, by definition, are not accounted
for by regular term structure differentials. It was argued above that
one might view much of the change since 1966 as having been unex-
pected, primarily the result of government action and inaction. In this
case, some form of interest rate insurance seems appropriate.
The above discussion suggests that thrift institutions might pay
something based on the term structure differential for interest rate in-
surance. If these institutions are risk averse they might even be willing
to pay something more. On the other hand, if these institutions felt
that the federal government would still bail them out if they got into
massive problems they might only be willing to pay something less.
If the term structure is a good predictor of future interest, rates and
if this differential does reflect what thrifts would pay for rate insur-
231 say at least because some mortgages might have even lower rates from a lower
earlier trough. These mortgages would entail even larger payments.


dance, then, barring large. unexpected shifts in the level of interest rates,
over the long run this insurance would involve only minimal outlays.
There would be times when more is taken in than paid out and other
times when the reverse occurred, but over the long run things would
even out. A couple of other features should be noted. This insurance
would presumably be offered on a voluntary basis to financial institu-
tions. That is the government would stand ready to undertake such
insurance when an individual institution wanted it and paid for it. If
a particular institution held very strong views about future interest
rates that were different from market evaluations as summarized in
the term structure differential, then it need not buy insurance. In par-
ticular if a particular institution felt rates would rise more sharply
than implied by the market determined term structure, then the insur-
ance would appear to be a good deal. If the institution felt rates would
not rise as rapidly, the insurance would appear to be a bad deal, the
premium would be too high, and it need not purchase it. As mentioned
above there have been times, especially recently when the term struc-
ture differential has been negative. On the expectations view, this nega-
tive differential reflects expectations that short rates are temporarily
high and will decline. In these cases one would expect that the demand
for rate insurance would not be very strong.
What implications does term structure insurance have for housing
and mortgage markets? This is a difficult question to answer. The pro-
posal has some similarities to variable rate mortgages and thus the
results of the Kearl simulations may be applicable. Savings and loan
associations give up their term structure intermediation, one might
expect that they would have slightly lower returns on average, hence
lower deposit rates, less deposits, less mortgage lending, higher mort-
gage. rates and a slightly lower housing stock on average. However, tlhe
insurance proposal is not exactly the same as a variable rate mortgage,
in particular there are different impacts on borrowers and different
impacts as between increases and decreases in interest rates. Thus the
Kearl results may be only suggestive of some possible effects. Clearly
the proposal needs further study and thought in order to sort out all
its likely impacts.

This final proposal is directed only at the problem of credit ration-
ing. Many observers who have been concerned about the severity of
recent declines in housing activity feel that the severity of the decline
is due in some degree to credit rationing. When market interest rates
rise, savings inflows decline, mortgage lending declines and mort-
gage rates rise to ration some potential borrowers out of the market.
Credit rationing suggests that additional borrowers are rationed out
of mortgage market by other means. On this view the mortgage rate
d(loes not rise fast enough to eq(iiate0 demand with a substantially re-
duced supply. Some l)orrowers want mortgages and are willing to pay
for them at existing mortgagee rates. The lenders simply do not have
the finids anid either refuse to len<1 a'lnd/or i:mke other ternis so one(rois
as to discourage these borrowers. This lack of lending in turn results in
not only less residential construction but frustration as people may
liave difficulty moving among existing units.
.An expanded role for the Federal Home Loan Mortgage Corpora-
tion (FIILMC) could eliminate the problem of credit rationing l)y


assuring a supply of mortgage credit at appropriate interest rates. It
should be noted carefully that nothing is guaranteed about the mort-
gage rate. The only guarantee is that if someone were willing and able
to pay the going mortgage rate he will be able to get a loan.
Undoubtedly many people have proposed similar ideas in the past.
I do not mean to slight anyone by omission. I associate the idea with a
paper written by Warren Smith in 1970. Smith's proposal would have
the FHLMC make a market in conventional mortgages by always
being willing to lend mortgage money at a rate equal to its borrowing
plis administration costs.24 In particular, if the demand for mortgages
increases, FHLMC would be expected to raise more money in order to
make loans. If raising this money raised their borrowing costs, then
it should raise its mortgage rate. As Smith says, "Under such a system,
potential mortgage borrowers should always be able to obtain accom-
modation, provided they were willing to pay the prevailing interest
rate." Note again that what is being assured is that mortgage money
will be available, nothing is being guaranteed about the mortgage rate.
How would FIHLMC buy mortgages? Smith suggests that FHLMC
establish a schedule of prices that reflect its costs and then that
FItLMC should be willing to buy all the mortgages offered to it at
those prices.25 Mortgage lending institutions would always have the
option of originating a mortgage loan that could be sold immediately
to FHLMC, retaining appropriate origination and servicing fees.
Thus an institution could make mortgage loans even if it did not
have any funds of its own to lend out provided there were borrowers
who were willing to pay the going mortgage rate.
What implications does this proposal have for cycles in homebuild-
ing? To the extent that there continue to be cycles in interest rates and
to the extent that these cycles in interest rates result in movements
along the demand curve for houses and mortgages, there will still be
cycles in homebuilding, but under the Smith proposal these cycles
would not be aggravated by credit rationing.
Smith's proposal would presumably work very much like GNMA
insured mortgage securities. That is FHLMC securities would essen-
tially be a repackaging of the underlying mortgages. If this repack-
aging makes mortgages more attractive to traditionally non-mortgage
oriented lenders, it could provide a strong and continuous link be-
tween mortgage markets and general capital markets, and essentially
eliminate credit rationing as a factor in housing and mortgage
Credit rationing has effects that need not show up in cycles in
homebuilding. People simply get angry and frustrated when they
want something, are willing to pay the price and are simply denied
access to it. Transfers in existing housing units can be delayed, often
with frustration, significant non-pecuniary costs and sometimes with
24 The particular institution involved is not an essential feature of the proposal. Thp
siuhb.piupnt discussion aoiunips use of the FHLMC primarily because Smith (lid. ThIerp
is, one important as)ect in which the particular institution is important. Thli.s aspect
nlso suggests why FNMA should not be expected to serve the same .function. Smith
would have the FHLMC stand ready to buy as lone as the yields it could earn "bear a
stable and cons ltent relationship to the current borrowing costs." (p. 97) FHLMC would
thus work much the way an economist would expect a textbook competitive market to
work. One should not expect FNMA to operate in a similar manner. While it is public
sponsored, it has stockholders who are interested in maximizing profits, not in social
25 A schedule of prices would be necessary because mortgages differ by maturity, loan-
to-value ratios, and original interest rate.


significant pecuniary costs. Smith's proposal, by eliminating credit
rationing, would eliminate these costs and frustrations.
What would it cost the government? If the FHLMC prices its pur-
chases to reflect its real costs there should be no direct costs to the
government. There could be an indirect cost of unknown magnitude
if holders of FHLMC securities perceived these securities as essen-
tially very close substitutes for government securities. In this case,
more FHLMC securities would be equivalent to more government
securities in general and would be expected to raise the rate on both
types of securities.
Symmetry would suggest that the FHLMC should be willing not
only to buy mortgages at stated prices, but also to sell mortgages at
tho'.e same prices. In terms of eliminating the problem of credit
rat ioning, it is more important that the FHLMC buy in times of tight
money. It is at lose times that most observers feel credit rationing
is an important phenomena. When interest rates are declining, the
mortgage market seems to work pretty well and the need for correc-
tive action is substantially reduced.
Let me say a few words regarding my personal evaluation of these
six proposals. I react negatively to the proposals for mandatory credit
allocation and the mortgage income tax credit as presented in the Fi-
nancial Institutions Act. With respect to the variable rate mortgage
proposal, my understanding of the political realities of the situation
says it is not a viable option. My understanding of the economics of the
proposal says there is good reason to doubt if it could be the panacea
for all the ills of housing and mortgage markets. However I would
still argue that one need not be opposed to allowing the introduction
of and experimentation with variable rate mortgages. There could well
be borrowers and lenders who, at times, would find variable rate mort-
ages mutually beneficial. To prohibit the use of these instruments
would, in these cases. relegate both borrower and lender to less pre-
ferred options. The basic principle is that, with adequate safeguards
and information, more choice is better than less choice.
There are some strands of the do nothing more proposal that are
quite appealing to me as an economist. However implicit in the whole
argument is a basic faith that minimizing government regulation and
constrailits will enable the free play of market forces to allocate cred(lit
to housing in the most socially desirable way. One may simply l)e skep-
tical of that argument. Past problems with the mortgage market may
lnot 1)c, entirely tl1 result of :voi'ltbible errors in government policy,
but isteai If ilie latter is tie, then freer markets nivy not necessarily solve
Iall tlie problems of mort'gafre markets amild appropriatee govermueient
po,! i(y factions may be need(led.
'i1ii leaves the l:st two proposals, insurance against interest rate
ijncre:.('s and tle expan(led role for the FIILMC. I think that the in-
surnnce proposal has some interesting aspects lbut I would like to hear
mor0e discw-sion of tlie proposal l)efore committing myself. Currently
I would stronjv support a carefully conceived program for expand-
ing the role of tlhe FIILM[C.


The discussion below is a more detailed examination of papers by
Ray Fair-Dwight Jaffee and Patrie Hendershott.1 Both of these
papers attempt to evaluate the impact of financial reorganization by
simulations of large econometric models. These models, estimated by
sophisticated statistical techniques, are attempts to explain actual
behavior. By hypothesizing how financial reorganization would change
behavior, the authors make appropriate changes in their equations and
resimulate their models. The comparison of the simulations with and
without these changes is used as an indication of the impact of financial
Although the authors consider different sorts of changes and sim-
ulate them in different ways, both papers come to similar conclusions:
financial reorganization will have little if any adverse impact on
housing and mortgage markets. In fact there are a number of simula-
tions in both papers which show a substantial decline in the mortgage
rate as a result of financial reorganization. If these conclusions could
be accepted with a high degree of certainty, they would only strengthen
what is already a strong case for financial reorganization.
However, a detailed look at some of these simulations, along with
the general sorts of considerations discussed in the basic paper, lead me
to a more skeptical position. Because of the limitations of these pa r-
ticular models and simulations, and most likely of any model and its
simulations, I would reject the authors' conclusions as unproved and
assert instead that we simply do not know what the impact of financial
reorganization will be on housing and mortgage markets. The ap-
propriate response in this case is not to oppose financial reorganization
because we are not sure of its impacts on housing and noritgage
markets, but rather it is to consider supplementary policies that would
guard against any undesirable impacts.

Ray Fair and Dwight Jaffee have run simulations of financial reor-
ganization with the Federal Reserve-MIT-Penn (FMP) econometric
model.2 The FMP model is a very large econometric model with special
attention given to the mortgage market. The Fair-Jaffee simulations
are primarily concerned with impacts of financial reorganization on
housing and mortgage markets. The Fair-Jaffee simulations are im-
'I am indebted to Ray Fair, Dwight Jaffee and Patric Hendershott for valuable com-
ments on an earlier draft of my comments.
2 See Fair and Jaffee. "Ain Empirical Study of the Hunt Commission Report Proposals for
the Mortgage and Housing Markets." in Policies for a More Comipetitire Financiail R .-fem.
Boston Federal Reserve Bank Conference Series No. 8, 1972 and Jaffee, "The Extended
Lending, Borrowing and Service Function Proposals of the Hunt Commisinm Rhport,"
Journal of Money, Credit and Banking, November 1972, pp. 990-1000.

portant because they represent some of the first efforts to quantify the
impacts of financial reorganization.
Their work was published in 1972 and tries to evaluate the sorts
of clainges proposed by the initial Hunt Commission Report. In partic-
ular they simulated the FMP model, with and without changes, from
1960 to 1970. They then used the differences between simulations as a
measure of what might have happened had the indicated changes been
made in 1960. This attempt to replay the past under new rules is
meant to be suggestive of the future impact of a changes in the rules.
The major simulations they report attempt to measure the impacts of
(1) removing regulation Q ceilings, (2) granting new service func-
tion-checking accounts and consumer loans-to thrift institutions,
and (3) granting wider investment powers to thrift institutions.
The Fair-Jaffee results are partial simulations of the FMP model.
The complete FMP model was not simulated. Three sectors, currency,
labor and employment were held exogenous. Holding these three sec-
tors exogenous would appear to preclude the possibility of any feed-
back effects through changes in income as a result of any changes in
residential construction. Holding employment and labor productivity
('constant would appear to hold real GNP constant. Thus, in thlie Fair-
Jaffee simulations, any expansionary impacts on residential construc-
tion could not have multiplier impacts on tlhe level of income. As a
result any decline in interest rates is likely to be overstated as increases
in in.olme would be expected to moderate any decline in interest rates.
Fair-Jaffee are interested in what they call long run impacts. As a
result they report simulation results at three separate points in time.
1 year, 5 years and 10 years after the indicated change. They do not
report the time paths of relevant variables following the implementa-
tion of financial reorganization. Thus one is not able to see what if
any impact their simulated changes would have had on the cyclical
response of housing and mortgage markets. At best the Fair-Jaffee
simulations will show what would have happened to the stock of
houses over a long period of time.
The general conclusion reached by Fair-Jaffee is that the sorts of
changes they consider would have little serious impacts on housing and
mortgage imiarkets. After ten years their simulations show only slight
differences between thle housing stocks with or without financial re-
organization. I however, there are several questions about specific simu-
latioiis and one important feature of the model that minliht lead one
to be less sure that these changes would have only minor impacts.
Fair-Jaffee simtilated expanded service functions by artificially add-
ing to tlhe yield spread betwveenll deposit rates at thrift institutions and
coiiimercial banks. In the FMP model inflows of funds to specific de-
p)ository institutions depend in part on thle rates they pay on deposits
vis-a-vis delposit rates at other institutions. Fair-Jaffee simply add so
n.mynv ba-is points to that diffevrential in a way that favors thrift insti-
illtiht s. lxpalindled service fiunctions-c-lecking accounts and consumer
lendin iower-wouild allow thrifts to offer "one-stop"" banking. Fair-
Ja ffte's simulations assume that tlhe advantages of "one-stop" banking
cab lhe ejplated to ain interest rate d(lifferelitial.
They silmunlate two such differentials, one of 25 basis points and
anothler of 50 basis points. Both of these simulations have rather sub-
staitial impacts on deposit flows. In tlhe case of the 25 basis point


simulations, deposits at thrift institutions rise by over 13 percent after
ten years. The 50 basis point simulation shows an increase in deposits
roughly twice as big. Since in the FMP model thrift institutions
basically turn deposits into mortgages, the amount of mortgage lend-
ing rises substantially and the mortgage rate falls.3
One may be skeptical of the magnitude of the deposit shift. The
magnitude of the shift in funds simply seems too large. In the simulla-
tions a substantial part of these funds come from commercial banks.
One simply would not expect that commercial banks would allow a
transfer of funds of this magnitude to occur without responding. One
would expect them to compete for these deposits, either moire aggres-
sively than before or in ways that the FMP model cannot adequately
measure. Either response means that the Fair-Jaffee simulations over-
state the magnitude of the deposit switches.
Fair-Jaffee attempt to simulate the effects of wider portfolio powers
by adjusting tlhe equations for mortgage acquisitions by mutual sav-
ings banks and savings and loan associations. These adjustments are
accomplished by reducing the value of all coefficients in the relevant
equations by al)propriate amounts. 10 percent in one simulation and
30 percent in the other. This procedure has the effect of reducing
average mortgage holdings by roughly the indicated percentages.
But it also has the effect of making the portfolio allocation decision
of both savings and loan associations and mutual savings banks less
sensitive to changes in relative rates of return.4 In fact one might well
expect that wider investment powers would make investment decision
more, rather than less. sensitive to relative rates of return on alter-
native assets. One would especially expect this sort of result for sav-
ings and loan associations. This increased rate sensitivity could have
important impacts on the magnitude of mortgage lending, especially
during periods of high demands for credit when interest rate differ-
entials have typically moved against mortgages. Neither the Fair-
Jaffee simulations nor the presentation of their results enable one to
reach a judgment on this question.
Fair-Jaffee assume that wider investment powers will increase the
earnings on thrift institutions and that these higher earnings will be
passed on to savers in terms of higher deposit rates. Additional simu-
lations are presented to suggest that these marginally higher deposit
rates will give rise to substantially higher deposit inflows. (The mag-
nitude of the responses is similar to the simulation results for ex-
panded service functions.) Again one might simply be skeptical of
the magnitude of the response.
Beyond these specific questions, there is a basic feature of the FMP
model that appears to be responsible for the general direction of the
Fair-Jaffee results. This feature is the very high interest sensitivity of

3 Actually the increase in mortgages exceeds the increase in deposits. In both simulation--
mortgages increase by about $1.08 for every $1.00 increase in deposits. Siwulatiin. pre-
sented in Jaffee (972a. p. 205) suggest that mutual saving-s banks will eventually in-
crease their holdings of mortgages dollar for dollar with an increase in deposits. This
result is most likely the result of experience in the late fifties and early sixtie- when thp
increase in mortgage holdings divided by the increase in deposits at mutual savinz- banks
waN greater than unity. This period is a substantial part of the estimation period for the
FMP model. Behavior since 1965 has been quite different. Over the period 1O95-l1973 the
increase in mortgage holdings was only 65 percent of the increase in deposits.
4 In particular the parti;il derivatives of asset demand functions with respect to a 4--liane
in interest rates are reduced. As Dwight Jaffee has pointed out to me the .Iaticiripx are
unchanged. However the argument developed hire -zingPsft. that for saviinz- and1 loan
associations one might expect that wider inve-tmenr powers would inr:p!a-, not decrease,
both the partial derivative and the elasticity.


the demand for mortgages. As reported in Jaffee (1972a) : "A 10-basis-
point increase in the mortgage rate . causes the mortgage-demand-
house ratio to decline by over 7 percent." (Page 164.) Fair-Jaffee
report a housing stock of $564.3 billion at the beginning of 1965. A
10 basis point reduction in the mortgage rate then would have in-
creased the demand for mortgages by over $40 billion. Expressed as
an elasticity, these numbers imply that the elasticity of the demand for
mortgages with respect to a change in the mortgage rate is 9.5. That
is a 1 percent change in the mortgage rate results in a 9.5 percent
change in the demand for mortgages. Conversely, with an unchanged
housing stock, a 9.5 percent change in the stock of mortgages would
be associated with only a 1 percent change in the mortgage rate, about
9 basis points at current rates.
What all this means is that, in the Fair-Jaffee simulations, rather
large changes in the quantity of mortgages will be associated with
only very small changes in the mortgage rate. These small changes in
the mortgage rate, in turn, imply only small changes in the equilibrium
stock of houses. Thus in the FMP model the stock of houses is rela-
tively insensitive to the sorts of changes simulated by Fair-Jaffee.
This insensitivity is built into the model from the beginning through
the high mortgage rate elasticity of the demand for mortgages.
There are several reasons to be skeptical of the mortgage demand
elasticity in the FMP model and hence some reason to be suspicious of
their result of minimal impact on housing. In particular, there are
some peculiar features in the estimated mortgage demand equation
and the resulting estimate of the mortgage rate elasticity seems too
The mortgage demand equation as estimated attempts to explain
the demand for mortgage debt arising from both the existing stock of
homes as well as the flow of new homes constructed. This concern with
both elements of the demand for mortgages is a good thing but the
particular implementation of this concern has some implausible re-
sutilts. The equilibrium mortgage-debt/house ratio for existing homes
is constrained to equal the mortgage-debt/house ratio for new con-
struction. The latter ratio has been a bit above .7 for the last fifteen
years. While we do not have directly data on the equilibrium mort-
gage-debt/house ratio for existing homes, the actual ratio of the stock
of inortrare debt to the stock of houses is simply nowhere near that
]high. Meltzer suggests a ratio of .375 for 1970, substantially below .7.
'The data Fair-Jaffee present in their table 1 suggests a rIatio of 44
percent, still substantially below .7.
The mortgage demand equation in the FMP model has another re-
lated peculiar result. As mentioned before the equation assumes that
the equilibrium mortgage-debt/house ratio for the existing stock of
liiumes is equal to the ratio for new construction. Further this ratio is
estimated to depend on both the mortgage rate and the corporate bond
rate. For the period 1966 through 1974 the implied mortgage-debt/
house ratio averages .85. It is over 1.0 for 8 quarters, a result that is not
(1lly implausible, but also impossible if traditional collateral require-
mients are to be met. In contrast, Federal Home Loan Bank Board data
show that tlhe loan-to-value ratio for new homes with conventional
mortgage financing averaged .74 over the same l)period.

From a mortgage-debt/house rate of .85, 20 basis point reduction
in the mortgage rate would be sufficient to send the implied ratio over
1.0. The simulations reported in Jaffee, 1972b, show a reduction in the
inortgage rate of 39 to 47 basis points. In fact Jaffee himself warns
"bnot to extrapolate the results of this equation to the range of interest
rate spreads at which the collateral requirement, in the aggregate, be-
comes binding on households." (Jaffee, 1972a, p. 164.)
What all this is meant to suggest is that the mortgage demand equa-
tion in the FMP model has several peculiar features: the equality of
debt/equity ratios on new and existing homes, a very large mortgage
rate elasticity, and implausible implications for much of the period
since 1966 as well the period of simulated change. In light of these
problems and in view of the crucial role of the equation in the simula-
tions, one might well be skeptical of Fair-Jaffee's major conclusion of
little or no adverse impact on housing and mortgage markets.

Patric Hendershott, along with several collaborators, has developed
a large econometric model of financial flows based on flows of funds
data. Hendershott has simulated his model to represent the proposed
VIA changes.5 Hendershott's simulations are only partial simulations
not full simulations of his model. The simulations appear to include
only the financial sector, flows of funds and interest rates. Levels of
production and income are held constant. Even within the financial
sector certain things, such as deposit rates, are also held constant.6
Hendershott's simulations suggest that there would be a substantial
stimulative effect on residential construction. Such a development
would be expected to have multiplier effects on income with associ-
ated feedback effects on interest rates and financial flows that to some
extent would undercut the original stimulate effects on residential con-
struction. Hendershott's simulations do not have these multiplier and
feedback effects and are thus not a complete evaluation of the FIA
The simulations are incomplete in another important way. Some of
HIendershott's simulations show substantial decline in the mortgage
rate. One would usually expect that deposit rates at thrifts would also
decline in the face of a large decline in the yield on mortgages. If
deposit rates declined, then deposit inflows would also decline and the
final decline in the mortgage rate would be smaller. Unfortunately
Ilendershott's model does not allow for this effect as all deposit rates
are exogenous.
Feedbacks from the real sector and from endogenous deposit rates
would moderate any decline in mortgage rates. It seems unlikely that
5 See P. Hendershott. "The Impact of the Financial Institutions Act of 1975," in
Housing Goals and Mortgage Credit: 1975-80, Hearings before the Subcommittee on
Housing and Urban Affairs of the Committee on Banking. Housing and Urban Affairs.
United States Senate, 94th Congress, 1st session, September 22, 23 and 25, 1975. See also
unpublished appendix. A revised version of this paper, with comments by Cassidy and
Swan, is forthcoming in a volume from the Department of Housing and Urban Develop-
6 The exact simulation model is never presented. There are references to versions of the
molel in other papers but one is never sure exactly what equations are in or out of the
simulations. A related point is that one does not know what the form of the simulation
equations i-. This latter point turns out to have some relevance. See Cassidy's discussion
of Hendershott's modification of the estimated equations.


they would, by themselves, result in an increase in mortgage rates.
However, failure to account for these feedbacks means that the Hen-
dershott simulations paint much too optimistic a picture.
Hendershott's simulations are only partial simulations in another
important respect. The model is simulated in flow terms only and ig-
nores entirely the initial stock adjustments as institutions initially
react to expanded powers under the proposed FIA changes. Hender-
shott acknowledges that the initial stock adjustments will be much
larger than the flow adjustment. However the impact of these initial
stock adjustments is simply ignored. Hendershott's simulations give
one no idea what sorts of impacts these initial adjustments might
Simulation results in the papers are reported in a rather peculiar
way. Instead of the time paths of responses, Hendershott reports a
single number, the median response over the last two years of his five
year simulation period. One simply has no idea what is happl)ening
over time. Are the differences from the control simulation-and hence
the impact of the FIA proposals-getting biroger over time? Smaller
over time? Are they oscillating in some peculiar fashion? One simply
does not know.
Another limitation of the use of medians is that one has no idea
of how the FIA proposals would affect the cyclical responses of house-
holds and thrift institutions. Would they tend to aggravate or mod-
erate cyclical tendencies? There appears to be an a priori presumption
that the expanded asset and liability powers should moderate cyclical
effect, but Hendershott presents no simulation results that bear on this
question. Again one simply does not know.
In the Hendershott model, portfolio allocation decisions by mutual
savings banks appear to be substantially more sensitive to interest
rate differentials than the decisions of savings and loan associations.8
Hel(lershott adjusts the interest., rate coefficients to reflect the impact
of tihe mortgage investment tax credit. For both institutions tihe
result, of the tax credit is to reduce the interest sensitivity of their
portfolio decisions. However the more basic question is whether the
FIA proposals, specifically the expanded investment powers, will
maki, savings and loans more like mutual savings banks? In
partiicular, will their portfolio allocation decisions now show inter-
est rate sensitivity like that of mutual savings banks? If the answer to
this question is yes, then there is much more uncertainty about the
long run and cyclical impacts of new investment powers. The Hender-
sllott siimulantions, like others, extrapolates old behavioral relation-
slips whenll the, proposed changes may imply fundamentally different
relat ionshlip)s.
7 iH iid, rI.Itrh it argii,- that t lie stock nd.iu tinents must evvi'nlt'illy have lin 111mpa11t of tli.
samIO -Ilin at his flow imi,,.-ts. i-n, in thi rs e there Is still thle question of timlni,- whi1li doe, not address. Further the relation between I[endershott's stock and flow
vtiiifilori,. is unr1V:ir. On this point see Cassldy.
T'lhere I. some cn'iifsision niiii t which Inrstitution Is minore rate senstive. Aecordlin Ino
ed, 1iin te', pre.-ie'1l by liIndershott anrid Villani rate chining induces mutual .ivnlls hanks
to reillat. i only the flow of new funds wihi savilnvs and lioan associations re'allcwat,
n part of their ,toklhioli. ncs as well as the flow of new funds. This asymmetricnl treatmnnl
,41ri., ;i % it pectilnlar and is at variance with a large part of current work on Iportfolio
thliery. I 'unoriif Il his- 1 i m,Yi ,i rie. l trentim-nt nid loedi ki n nly at the estimated rtwflidents
fir iit restr i ntt. s-iisit1 11 ily shows thiit tho ipefl(liclpnt for mnUtiial savings banks is over 201)
times s I lirge as th,. l (enffli. nit for snvlngs and loan :lss.(falatlni-.


SHendershott.'s basic methodology is to shift his estimated asset de-
mand functions to reflect the impact of expanded investment powers
and the changes in the determination of tax liabilities. These equation
shifts also reflect expanded liability powers for thrift institutions. The
precise nature of these shifts is to a large extent arbitrary and ad hoc.
To what extent will savings and loan associations make use of ex-
panded powers to hold consumer credit and corporate debt instrument?
If they hold more of these new assets, what type of assets will be
reduced? Mortgages? Government securities? We simply do not know
the answers to these questions. It is to Hendershott's credit that he
tries various assumptions, however one could still question some of
Hendershott's alternatives and wonder whether his assumed shifts
are not a bit too optimistic.
There are two major areas where I have questions about the re-
allocations Hendershott uses: One, the size of demand deposit shifts;
and two, the use of new investment powers.
Hendershott assumes that thrift institutions will end up holding 15
to 35 percent of household demand deposits. Using figures for the end
of 1973 this would amount to 7.7 to 16.2 percent of total deposits of
thrift institutions.9 Evidence from states where thrift institutions
now have the power to issue demand deposits shows substantially
smaller holdings of demand deposits. Anderson and Eisenmenger
report data for mutual savings banks that can issue demand deposits
in four states. In 1970, demand deposits as a percent of total deposits
ranged from 1.5 to 6.4 percent. Additional evidence comes from the
development of NOW accounts in Massachusetts and New Hampshire.
At the end of 1973, 18 months after their introduction. NOW account
deposits represented only 1 percent of deposits at mutual savings banks
offering NOW accounts. "However, 55 percent. of these accounts were
opened by transferring funds from another account which the de-
positor held with the same institution. Thus, even the 1 percent figure
overstates the gain in savings banks deposits created by NOW ac-
counts." (K. Gibson, p. 22.)
It is possible that expanding portfolio powers, in particular the
ability to make consumer loans, might work in a way that makes de-
mand deposits at thrift institutions more attractive then they are at
the institutions surveyed above. While a possibility, the magnitude of
this synergistic effect is difficult to measure. Even allowing for some
such effect, the evidence surveyed above suggests that Hendershott's
least favorable demand deposit, shift (15 percent) may well be too
There is the further question about how these new funds will be
invested. Hendershott says that "the thrifts will [be expected to]
invest the funds [demand deposits] in a manner more similar to com-
mercial banks (70 percent in short term assets. 30 percent in longs and
mortgages) than the normal pattern of thrifts (5 percent in shorts
and 95 in longs and mortgages)." (Hendershott, 1975, p. 3:)0.) He
then goes on to assume that only 10 to 30 percent of new cherkinog
accounts will be invested in short term assets.
9 According to Federal Reserve flow of fund, dati. hon-zehr,ldq. personal trusts ndl
nonprofit organizations held demand deposits and currency of $170.2 billion at tho 'n'1 nf
1973. Assume that $150 billion of that is demand deposits. (The resulting $20 billion in
currency translates into $93 for every man. woman and child.) Total deposits at thr'ift
institutions at the end of 1973 were $323.6 billion.
62-748-76-bk. I-- 6


What difference does it make to the simulation results whether thrift
institutions capture a large or small fraction of household demand
deposits and whether they invest a large or small fraction in short
term assets? The precise answer to this question would require new
simultations. However an approximate answer is suggested by the
The difference in the mortgage rate between Hendershott's large
demand deposit share simulation (35 percent of the market with 10
percent in shorts) and his small demand deposit share simulation
(15 percent of the market with 30 percent in shorts) is 15 basis points.
That is. the mortgage rate is 15 basis points higher in the simulation
where thrifts capture the smaller fraction of household demand de-
posits and invest less of those funds in mortgages. Hendershott claims
that the 35 percent of market with 10 percent in shorts implies that
18 percent of present demand deposits would flow into home mort-
gages. The 15 percent of market with 30 percent in shorts implies that
) percent of present demand deposits would flow into home mortgages.
Thus every 1 percent of demand deposits into mortgages appears to
lower the mortgage rate by 1.25 basis points.
The evidence from mutual savings banks and Hendershott's own
discussion suggest that his less favorable assumptions, 15 percent of
market with 30 percent in shorts, may be too optimistic. One might
assume instead that thrifts will capture only 10 percent of household
demand deposits and will invest 70 percent of these funds in short term
assetss. The 10 and 70 percent figures imply that only about 1.75 percent
of existing demand deposits would flow into home mortgages. Using
the interpolation developed above, the even smaller market share and
larger holdings of shorts suggests that the mortgage rate would be
about 5 basis points higher than in Hendershott's unfavorable simula-
lation and 20 basis points higher than in Hendershott's favorable
Trhe other major area of uncertainty has to do with the portfolio
sliifts induced by the new investment powers proposed by the FIA.
No one knows for sure to what extent these new powers will be used.
Ilendershott presents two alternatives but again one might still won-
der how sensitive the results are to alternative portfolio shifts.
Some additional work that Hendershott performed for the Senate
TBanking, Housing and Urban Affairs Committee suggests that the
results are indeed quite sensitive to alternative assumptions about. port-
folio slifts. The simulations for the committee have two major differ-
cics. One, the committee has thrifts exploiting their new powers
sli iht ly more, and two, in order to exploit these new lending powers,
the committee has thrifts making a much more substantial shift away
from mortgages.
What happens to the mortgage rate under these two alternatives?
ITendcrslhot.t's assumptions lead to a reduction in the mortgage rate
of 5 basis points while the committees assumptions lead to an increase
in the mortgage rate of 45 basis points. One does not have to choose
between these two simulations. One just has to note that to rule out
any possible increase in the mortgage rate one would have to argue
Iliat. Hendershott's simulation is the worst possible case. However
taking a weighted average of the two results suggests that there are a
wide, range of plausible. outcomes-only slightly more pessimistic than
Tlond(lerslott but considerably less pessimistic than the committee-
tllIat woulId result in hlighler mortgage rates.


Further both of these simulations incorporate the 15 percent of
household demand deposits with 30 percent in shorts assumption. One
might instead assume that thrifts will capture only 10 percent of the
market for household demand deposits and invest 70 percent of these
funds in short term assets. The discussion above suggests that these
alternatives would mean a mortgage rate that was another 5 basis
points higher. .
Our basic point is not that the mortgage rate will be 5 basis points
higher or lower, but rather that there is a wide range of uncertainty.
Further, the uncertainty is not how far the mortgage rate will fall, but
rather whether it may not increase.
Increases in housing prices have become of increasing concern.
Public policy has been committed to seeing that all individuals be as-
sured of a decent home and a suitable living environment. To further
this goal a number of public policy measures have been designed to
promote homeownership. There is a growing fear that increases in
the price of housing may make these goals impossible to achieve.
Before committing public policy and public resources it is important
to look carefully at the relevant numbers.
Tables 1 to 13 present data on income, general prices, housing prices
and mortgage payments since 1960. It is important to look at data from
a variety of sources because the way different series are constructed
may make them more or less appropriate for particular uses. Series
that appear to measure the same thing may show quite different results.
Sometimes these differences can be understood by taking account of
the conceptual differences in the series.
All the series on income in Tables 1 and 2 show a continuing in-
crease in income since 1960. The Census series on median family in-
come and the GNP series on per capital disposable income tell roughly
the same story over the period 1965-1970 although there are some
differences in the two sub periods. Average per capital disposable in-
come is the broadest measure of income and for many purposes is the
most appropriate measure of income. It shows substantial increases
in both nominal and real income (nominal income adjusted for the
change in prices) over any broad period of time.1 Only in 1974 did real
per capital disposable income fail to increase. Data on median family
income shows a pattern similar to that of average per capital income,
except that the increase in the nominal level of income fails to match
the increase in prices in three years, 1970, 1971, and 1974.
Data on average spendable earnings tells a substantially different
story-little or no growth in real income over the whole period 1965
to 1974. As detailed below this series is subject to several serious
shortcomings that limit its usefulness as a broad based measure of
'Percentage increases in real income are approximately the difference between the
percentage increase in nominal income and the percentage increase in prices.


purchasing power. However tlhe figures do suggest that there may be
a substantial group of people who have not shared in the increase in
real income suggested by the figures on both disposable income and
median family income.
Census data on median family income is a measure of income before
taxes. The other two series attempt to measure spending power after
taxes. Figures on disposable income average all sources of income for
all people and is thus the most appropriate, broad based measure of
spending power. The series on spendable earnings attempts to measure
wa-e and salary income of production and nonsupervisory workers on
private, nonagricultuLiral payrolls. As a result it ignores certain iim-
poritant sources of income. Further, the way in which the series is
co st rueted introduces certain biases.
The series is derived from payroll data and in essence averages the
earnings of full and part time workers. The increasing proportion of
part time workers in the basic data means that the series understates
earnings for full time workers. Further, the series excludes three im-
portant. categories of family income: fringe benefits, income earned by
other family members and all other sources of income.
To summarize, the data on median family income and average per
capital income show substantial increases in both nominal and real
income. However the series on spendable earnings suggests that there
may b)e a group of people who have not shared to the same extent in
the general increase in real income.

When looking at house prices one needs to carefully distinguish be-
tween selling prices of houses and house price deflators. One also needs
to distinguish between the housing units themselves and land. Indexes
of house selling prices measure what is happening to selling prices of
houises-structures and land-that are actually sold. As a result they
capture not only any inflation in house prices but also any changes in
the characteristics of houses sold such as a change in size or quality
of the structure and/or the land. House price deflators on the other
land attempt to measure only the, pure inflation by correcting for
changes in the (quality of houses. There are separate deflators for struc-
tures and land as well as ones that include both. Data on house prices
and deflators are shown in Tables 5 to 8.
Tlie ('ensuis Bureau index attempts to measure the pure inflation
in land and striuctire prices. It uses regression analysis to control for
changes in tlhe characteristics of homes. However the index does not
correct. for changes in lot size. Tie Censius Bureau index uses total
paymitents for landl as a measure of thie inflation in land prices and thius
uin(derstates tlhe increase in land prices as lot size lhas decreased.
Tlie GNP residential construction deflator is based on the Census index. 'lie residential construction deflator is a measure of
iintlation in :t r4ucturie prices only. "'le residential construction deflator
i-, oh btaitiled by adjust ing the Census Bureaui in(lex to exclude all etf'ects
of land prices. As a rTesult it is a good measure of the inflation of con-
strh ilion costs Nit a poorer measure of what is happening to house
lpries beci-a -e houses are usually sold with land.


The Boeckh index is also a measure of inflation in construction costs.
However there is a major shortcoming in the Boeckh index. As a result,
the Boeckh index overstates the inflation in building costs and shows
considerably more increase than the residential construction deflator.
The Boeckh index is in essence an average of wages and the cost of
materials. It makes no allowance for increases in labor productivity
and/or material substitution. As a result the Boeckh index overstates
the. inflation in housing costs by about 11/- percent per year over the
period 1965-1974 and 1 percent over the period 1970-1974.
FHA collects data on the price of land of FHA insured property.
This data is subject to several weaknesses but strongly suggests that
there have been substantial increases in land prices.
VWhat do these different deflators show has happened to construction
costs? The available deflators confirm that there has been a substantial
increase in construction costs. Over the period 1965-1970 construction
costs of structures as measured by the GNP residential construction de-
flator rose in line with overall prices as measured by either the overall
GNP deflator or the consumer price index. All of these indexes robe
about 23 percent. The rise was substantially less than the increase in
average per capital disposable income over the same period. Income
was more than keeping pace with prices in general and construction
costs in particular.
The Census Bureau index, which includes land prices, shows a
slightly larger increase over the same period. When one considers the
limitations of the way the Census Bureau index treats land prices,
there is a suggestion that the Census Bureau index might understate-
the pure inflation in house prices including land.
Since 1970, construction costs have risen substantially more than
prices in general. A comparison of the residential construction de-
flator with the overall GNP deflator and the CPI suggests that over
the period 1970-74 construction costs rose by one third more than
the average of other prices. Structures were becoming relatively more
The Census Bureau index, which includes land prices, shows a
slightly smaller increase over the period 1970-1974. This result seems
especially surprising in view of the FHA data on land prices and is
most likely the result of the way the Census Bureau index treats land.
Allowing for an increase in land prices at even faster rates than struc-
ture prices suggests that house prices including land showed a pure
inflation substantially greater than prices on average. Not only was the
inflation in houses prices faster than that of prices in general over the
period 1970-1974, but it exceeded the increase in income. Over the
period 1970-1974, construction costs, as measured by the residential
construction deflator, rose by about as much as average per capital
disposable income. The FHA data on land prices shows an even larger
increase. Combining the data on construction costs and land prices
suggests that the increase in house prices-structures and land-ex-
ceeded the increase in income.
There are several series on sales prices of homes. They are shown in
Tables 7 and 8. It should be remembered that these series on selling


prices measure not only any pure inflation but also include changes in
the characteristics of units and/or lots. The Federal Home Loan
Bank Board (FHLBB) and the Census collect information on the
sales price of conventionally financed new single family homes. Both
series tell a similar in terms of rates of increase although some details
differ. (The levels of the two series differ for a technical reason: the
Census figure is a median, the FHLBB series is a mean which is higher
because of the inclusion of some very expensive homes.)
The Census figure is probably the more appropriate figure to use
as a measure of the cost of an average house. Being the median price
means that one half of all houses sold had a sales price less than or
equal to the median price while the other half had sales prices greater
than or equal to it. Over the period 1965-1970, both series show an
increase in the sales price of new homes in excess of the pure inflation
as measured by the house price deflators, suggesting that people were
buying bigger and/better houses. The period 1965-1970 was also a
period of strong gains in real income and a period when the inflation
in construction costs was similar to general inflation.
Over the period 1970-1974 increases in sales prices of new homes
did not match the increase in construction costs, suggesting that people
were buying smaller homes and/or homes of reduced quality. In con-
trast to the earlier period, 1970-1974 was a period of smaller gains in
real income and a period when the inflation in construction costs sub-
stantially exceeded the general rate of inflation.
The Census Bureau also collects data on sales prices of new units with
FHA and VA financing. These data show a slightly different picture.
Over the whole period 1965-1974, both series show larger increases
than for conventional financed homes. Further the pattern of increases
in the two subperiods also differs from the pattern for conventional
financed units. The figures for the separate period are more v'aried
than those for conventionally financed houses and reflect among other
things the impact of the 235 program as well as the timing of changes
in FHA and VA regulations as to maximum house prices and interest
Both the FHLBB and the National Association of Real Estate
Boards collect data on prices of existing homes. Tables 7 and 8 present
the FHLBB data on sales prices of existing homes. Over the periods
1965-1970 and 1970-1974 the FHLBB data for existing homes shows
virtually the same increases as the FHLBB data for new homes. The
year to year movements differ but the longer period increases are quite
similar. It should be noted that the data collected by the National
Association of Real Estate Boards shows a slightly higher rate of
The similar response of prices of new and existing homes should
not be too surprising. One would expect that when two goods are
close substitutes their prices should show similar movements. If their
relative prices move far from normal relations one type of housing
represents an especially good buy when compared to the other. In
such a situation an economist would expect that individuals would
switch their buying plans and reestablish the traditional differentials.
The increase in prices of existing houses points up another aspect
of the recent inflation in house prices and that is the large capital
gains that most current home owners have experienced. In addition

most homeowners are highly levered with mortgage financing and have
thus experienced substantial rates of return on the equity investment
in their homes.
Monthly mortgage payments are determined by the interaction
of mortgage terms-interest rate, maturity, loan-to-value ratio-
and house prices. If mortgage terms remained unchanged monthly
mortgage payments would rise in step with house prices. Over the
period 1965-1974 mortgage terms have not remained unchanged. Data
from the FHLBB survey of conventional mortgage lending allows one
to detail the change in mortgage terms. The average maturity of con-
ventional mortgages for new homes has increased, which by itself
would tend to reduce monthly mortgage payments. The average loan-
to-value ratio has also increased which by itself would tend to increase
monthly mortgage payments. However, dwarfing both these figures
has been the increase in interest rates that has resulted in a substantial
increase in monthly mortgage payments. The combination of the in-
crease in house prices and the change in mortgage terms has resulted in
an increase in mortgage payments of 105 to 120 percent from 1965 to
1975. Tables 9 to 11 detail these changes.
Over the period 1965-1974 the increase in mortgage payments is
substantially in excess of the increase in average incomes. Using
Census data, the ratio of mortgage payments to income has risen over
the period by almost 20 percent. But this ratio needs to be inter-
preted with care. Imagine a family in 1965 with the median family
income of $6,957 buying a median priced new home with conventional
financing at a price of $22,700. This family would have mortgage
payments in 1965 of $1,265 equal to 18.2 percent of its before tax
income. Imagine another family in 1974 with the 1974 median family
income of $10,836, buying a 1974 median price new home with conven-
tional financing for $38,000. This family would have mortgage pay-
ments in 1974 of $2,793, equal to 21.8 percent of its before tax income.
The second family thus has initial mortgage payments that take up
3.6 percent more of its before tax income than was the case for the first
family (3.6 is 20 percent of 18.2).
However when one considers the case of the first family in 1974,
nine years after it purchased its home. one gets a decidedly different
picture. If the income of this family kept pace with median family
income, the ratio of mortgage payments to before tax income would
have dropped dramatically. In fact it would have dropped to 9.9
percent. This is because the traditional mortgage contract fixes pay-
ments in nominal terms over the life of the mortgage. The yearly
mortgage payments remain at $1,265. On the other hand the family's
nominal income would be expected to grow, reflecting both inflation
and trend increases in productivity. As a result the ratio of mortgage
payments to income would fall. The family that bought a home in 1965
is now sing a smaller fraction of its income to meet mortrare pay-
ments. Further, the family that bought a home in 1974 can expect
a similar decline in the fraction of its income that must be used to meet
mortgage payments.
Mortgage payments are an important cash outlay for homeowners
but they are not a complete measure of the costs of homeowning. In


particular one would want to account for additional expenditures
for property taxes, insurance, and maintenance and repair. Detailed
(lata from the CPI series on the cost of hlomeownership show that
these three categories of expenses have all increased less than average
income. As seen in Tables 12 and 13, over the period 1965-1974 the in-
flation in maintenance and repair expenditures was 88 percent, almost
as much as the increase in average income, while taxes increased by
65 ) per1 1't and insurance premiums by 38 percent.
An economist would want to make four further adjustments to
arri\-e at what. he would call the cost of housing. In particular he
v.-outild want to eliminate the principal portion of the mortgage pay-
ment-that ic a form of saving. Secondly, he would want to allow
for thle opportunity cost of the homeowner's equity. If a family rented,
it would invest its current equity and earn a return on that money.
Thirdly, he. would want to make some allowance for thlie capital gains
on houses which works to reduce the cost of housingg. Fourthly, lihe
would want to take account. of special income tax preferences for
hliomeowners that also work to reduce the cost of housing.


Median Per capital Weekly
Family Disposable Spendable
Year Income Income Earnings

1960-----------------------------------------------....................................................... $5,620 $1,937 $72.96
1961------------------------------------------------....................................................... 5,737 1,984 74.48
1962 ...--------------------------------------------------.................................................... 5,956 2,065 76.9 9
1963.......----------------------------------------------- 6,249 2,138 /8. b6
1964.......................-----------------------------------------------.... 6,569 2,283 82.57
1965 -----------------------------------------------...................................................... 6,957 2,436 86.30
1966............................-----------------------------------------------............. 7,500 2,604 88.66
1967----------------------------------------------------....................................................... 7,933 2,749 90.86
1968 ....-.....................-...-....-....... --------.. 8,632 2,945 95.28
1969 .................----------------------------...--..... -- --------------- 9, 433 3,130 99.99
1970 .................................................-----------------------------------------------..... 9,867 3,376 104.61
1971 -----------------------------------------------..................................................... 10,285 3,605 112.21
1972........................................... .........-----------------------------------------------.. 11,116 3,843 120.79
1973 ....................................................---------------------------------------------- 12,051 4,296 127.41
1974-----------------------------------------------....................................................... 12,836 4,623 134.37

Source; col. 1: "Current Population Reports, Consumer Income," Series P-60, numbers 49, 93, 98.
col. 2 "Economic Report of the President, 1975," table C-18.
col. 3 "Business Statistics, 1973," p. 85; "Survey of Current Business," June 1975, p. S-16,


Median Per capital Weekly
Family Disposable Spendable
Year Income Income Earnings

1960................................................-..... 3.7 1.7 1.5
1961 .. .... ..---------------------------------........... ...- ----------2.1 2.4 2.1
1962 .......-----------------------------------------------.............................................. 3.8 4.1 3.4
1963 .. ...........................----------------------------..-------------------.. 4.9 3.5 2.0
1964.................................................... -------------------------------------5.1 6.8 5.1
1965 ........................-------------------------------------------------.............. 5.9 6.7 4.5
1966 ...............-------------------------................. 7.8 6.9 2.7
1967 .........-......... ........-----------------------.. 5.8 5.6 2.5
1968 ... -.....---. ............................... ---------- -----8.8 7.1 4.9
1969 ................................................... ------------------------9.3 6.3 4.9
1970 ...........------- ...................------------------------------------------.. ....... 4.6 7.9 4.6
1971.-----------------------------------.................................................... 4.2 6.8 7.3
1972 ...-.........------------... ------------........--------------............. ... 8.1 6.6 7.6
1973 ... ..... .------------- 8.4 11.8 5.5
1974 .- ... ----------...-----------------...... ...... -..-..... -... 6.5 7.7 5.5
1965 1970 ................................................ -----------------------41.8 38.6 21.2
1970 1974.................................................. -------------------------------------------30.1 36.9 28.4
1965 1974.................................................. -------------------------------------------84.5 89.8 55.7

Source: see Table 1



GNP Implicit Consumer
Price Deflator Price Index
Year (1967=100) (1967=100>

1960....----------.. ---. -.. -......--------------------------------------------- 87.8 88.7
1961 .. .. ....... ...-- -.. ..-......--- ....--...... .... ...--- -- --- -- - 89.0 89.6
1962..........................----------------------------------------------................. -------------- 90.0 90. 6
1963--------------...................... .................-.-..--.---. -- - -- --- 91.1 91.7
1964 .....-------------------------------------------------------------- 92.6 92.9
1965.---...-------- ------------------------------------------------ 94.3 94.5
1966.... -.------------------------------------................ -------- ------------------ 96.9 97.2
1967..........----------------........----....------------------..--..----..--..---..--------- 100.0 100.0
1968.............---------------------------------................------.--..-------------------- 104.0 104.2
1969......................................-----------------------------------------------------------.- 109.0 109.8
1970...-.......----------------------------------------------.--------------- 115.0 116.3
1971...... ------------------------------------------------------------- 120.2 121.3
1972.............................................-------------------------------------------------.------------ 124.3 125.3
1973-----. -----.-...-..--. --------------------- ----------------------. 131.2 133.1
1974 .-------. -------------.------------------------ ------------ 144.7 147.7

Source: col 1: "Economic Report of the President," 1975, Table C-3 (converted to 1967 base).
col 2: "Economic Report of the President," 1975, Table C-44.


GNP Imolicit Consumer
Year Price Deflator Price Index

1960-........------------------------------------------------------------ 1.6 1.6
1961 ----.--. ------- ------.....----------------..------...... ----------.......--- 1.3 1.0
1962 ........................... .... .. .. .. ... ....... .... .. ...... ... ....... .. 1. 1 1. 1
1963 --------- ------- --------------------------------------------------. 1.3 1.2
1964 ------------------------------------------------------------------- 1.6 1.3
1965 -.......---------.--..--- ------------------------------------------ 1.8 1.7
1966.-.---------- ----------------------------------------------------- -- 2.8 2.9
1967 --.--------------------- --------------------------------- 3.2 2.9
1968 ------------------------------------------------------------------- 4.0 4.2
1969 ------------------------------------------------------------------- 4.8 5.4
1970 ------------------------------------------------------------------- 5.5 5.9
1971- -----.-------- ---------------------------------------------------- 4.5 4.3
1972 -. ---------------------------------------.----- ------------------ 3.4 3.3
1973......---- ---------------------------------------- ------------------ 5.6 6.2
1974--------------------------------------------------------------- .......................................................................... 10.2 11.0
1957-1970-.. --------------------------------------------------------.. ...22.0 23.1
1970-1974 ..-- ------------------------------------------------------- --.. 25.8 27.0
1965-1974..------------ ------------------------------------------------- 53.4 56.3

Sources: see Table 3.


Bureau of The
GNP Census New
Residential One Family
Structures Houses Boeckh Index FHA Land Prices
Deflator (Including Lot) ResiJe-.ces (./Aedjian price
Year (1967=100) (1967=100) (1967=100) per square foot)

1960.------------------------------------ 84.9 na 81.8 na
1961-..----------------------------------- 85.3 na 82.0 na
1962---------- --------------------------86.7 na 83.4 na
1963---------------------- -- ------------ 88.5 90.2 85.2 na
1964 ....................................... 91.2 91.1 87.6 $.36
1965--.---------------------------------- 92.8 93.2 90.4 .36
1966-.....------------------------------------............. 95.4 96.6 94.3 .36
1967................................... ...-- 100.0 100.0 100.0 .38
1968 ------------------------------------ 105.4 105.1 102.3 .42
1969 ....................................... 111.9 113.6 116.2 .45
1970------------------------------------ 113.9 117.4 122.4 .57
1971 ------------------------------------ 119.7 123.2 132.8 .65
1972 ------------------------------------ 127.9 131.0 145.8 .75
1973.------------------------------------ 141.3 144.8 159.2 .85
1974-..---------------------------------- 155.6 158.1 172.0 .85

Source: col. 1: "Economic Report of the President," 1975, Table C-3.
col. 2: "Construction Review," April 1975, Table E 4.
col. 3: Business Statistics, 1973, p. 55; "Survey of Current Business," June 1974, p. S-10.
col. 4: "HUD Yearbook," various years; FHA, data is for the first three quarters of each year.
Na: not available.



Bureau of The
GNP Residential Census New One
Structures Family Houses Boeckh Index FHA Land
Year Deflator (Including Lot) Residences Prices

1960....................................... ------------------------------------- 1.4 na 1.6 na
1961 --------------------------------------...................................... 5 na .2 na
1962-..-------------------- ---------------- 1.6 na 1.7 na
1963.---------..........----. ---...-.-..---------.....- 2.1 na 2.2 na
1964....................................... ------------------------------------- 3.1 1.0 2.8 na
1965-----------.. -----....... --......-------------------........ 1.7 2.3 3.2 na
1966....................................... ------------------------------------- 2.8 3.6 4.3 0
1967.--------------------............- ---------------- 4.9 3.5 6.0 5.5
1968--------------------------------- 5.4 5.1 7.3 10.5
1969.... ------------------------------------- 6.2 8.1 8.8 7.1
1970....................................... ------------------------------------- 1.8 3.3 5.3 26.7
1971....................................... ------------------------------------- 5.1 4.9 8.5 14.0
1972 -------------------------------------............................... 6.8 6.3 9.8 15.4
1973....................................... ------------------------------------ 11.1 10.5 9.2 13.3
1974....................................... ------------------------------------- 10.1 9.2 8.0 0
1965-1970-..........-----------------......--.....-------------- 22.8 26.0 35.4 58.3
1970-1974.................................. --------------------------------- 36.6 34.7 40.5 49.1
1960-1974.................................. --------------------------------- 67.7 69.6 90.2 136.1

Source: see Table 5.
Na: not available.


FHLBB Survey Average Price Bureau of the Census Median Price of New
of Home with Conventional One Family Homes Sold
Conventional FHA VA
Year New Existing financing financing financing

1963...----------------------------..... $22,500 $17,800 $20,400 $15,500 $15,700
1964--------------.....................--------------- 23,700 18,900 21,300 15,600 16,200
1965-----------------------------................................. 25,100 21,600 22,700 16,500 17,900
1966 ---------------..............-.---.---------- 26,600 22,200 24,400 17,500 18,000
1967............. ..------- -- 28,000 24,100 26,600 17,800 18,700
1968-....---------------------------- 30,700 25,600 28,500 19, 200 19,800
1969 ----...---.--................-------------------- 34,100 28,300 30,400 19,300 21,800
1970......................-----------------------------........ 35,500 30,000 30,800 19,200 23,700
1971---------------................---..----------- 36,300 31,700 31,900 19,800 25,300
1972-----------------------------................................. 37,300 33,400 31,600 20,500 25,100
1973 -----------------------................................. 37,100 31,200 35,100 22,100 27,200
1974...............-----------------------------............... 40,100 34,700 38,000 29,800 31,300

Source: cols 1 and 2: "Federal Home Loan Bank Board Journal," various issues; Federal Reserve Bulletin, February
cols 3, 4, and 5: "Construction Reports, New One-Family Homes Sold and For Sale," Series C25, various


FHLBB Survey Average Price Bureau of the Census Median Price of New
of Home with Conventional One-Family Homes Sold
Conventional FHA VA
Year New Existing financing financing financing

1964.................... ........... 5.3 6.2 4.4 0.6 3.2
1965 .... ............... ...-...... 5.1 14.3 6.6 5.8 10.5
1966 ................................. 6.0 2.8 7.5 6.1 0.6
1967 ................................. 5.3 8.6 9.0 1.7 3.9
1968 .................. ....-....... 9.6 6.2 7.1 7.9 5.9
1969 ................................. 11.1 10.5 6.7 0.5 10.1
1970 ...............................- 4.1 6.0 1.3 -0.5 8.7
1971 ................................. 2.3 5.7 3.6 3.1 6.8
1972 ................................. 2.8 5.4 .9 3.5 0.8
1973 ................................. .5 6.6 11. 1 7.8 8.4
1974............................. -------------------------------.. 8.1 11.2 8.3 34.8 15.1
1965-1970............... ............---- 41.4 38.9 35.7 16.3 32.4
1970-1974 ........................... 13.0 15.7 23.0 55.2 32.1
1965-1974........................... 59.8 60.6 67.4 80.6 74.9

Source. see Table 7.



Conventional Financing
Based on Based on FHA Financing
Year FHLBB data Census data (Section 203)

1963 ..------------------------------------------------ $106.59 $96.64 $92.45
1964 -------- ------------------------------------------ 111.13 99.87 94.19
1965 -------------------------------------------------- 116.58 105.43 97.46
1966 -- --------------------------------------------------- 127.51 116.96 105.16
1967 -------------------------------------------------- 136.59 129.77 117.14
1968 .....--------------------------------------.....--...---------- 156.74 145.51 124.85
1969 ... ------------------------------------------------- 184.84 164.79 144.57
1970 ......-----------------------------......--------------------- 200.83 174.24 174.41
1971 ......-----------------------------------..... --------------- 198.10 174.08 174.40
1972 ----------------------..... ..... ------.....--..-------------------- 205.12 173.77 169.96
1973. --- --------------------------------------------------- 213.65 202.13 169.40
1974...-----------------------------......................................---..-----..--..----------- 245.61 232.74 200.26

Note: cot 1 & col 2: Principal and interest payments calculated from FHLBB survey data on characteristics of conven-
tional mortgage loans. Column 1 uses FHLBB data on average price of new homes. Column 2 uses Census data on median
price. Col 3: FHA data, based on average price.
Source: col 1: "Federal Home Loan Bank Board Journal", various issues
col 2: "Construction Reports, New One-Family Homes Sold and For Sale," series C25, various issues
col 3: "HUD Yearbook," various issues


Conventional Financing
Based on Based on FHA Financing
Year FHLBB data Census data (Section 203)

1964....... ---------------------------------------------------- 4.3 3.3 1.9
1965 -------------------------------------------------------- 4.9 5.6 3.5
1966 ........................................ ....---------------------------------------------------- 9.4 10.9 7.9
1967..----------------------.------------------------------ 7.1 10.9 11.4
1968 ----------------.- ---------------------------------- 14.8 12.1 6.6
1969-..-------------------------..--.. ......-------------... -----------..... 17.9 13.2 15.8
1970............................................................. 8.6 5.7 20.6
1971 --------------------.--.......... --------------------------... -- -1.1 -.1 -0.0
1972..--------------------------........--------------------------...... 3.5 -.2 -2.5
1973-...- ---------------------------------------------------...... 4.2 16.3 -0.3
1974 ............................................................. 15.0 15.1 18.2
1965-1970...................................................... -----------------------------------------------72.3 65.3 79.0
1970-1974-------------------------------------------...................................................... ---27.3 33.6 14.8
1965-1974........................................................ -----------------------------------------------110.7 120.8 105.5

Source: See Table 9.


1965 1974

Purchase Price-- ---.---------------....---------------------------....................... $25,100 $40,100
Loan to value ratio ---------------------------------------------------------- 739 .753
Maturity (years) .-------------------------------------------------------......................... 25 26.8
Interest rate (percent)........................................................... --------------------------------------------------5.74 8.71
Monthly mortgage payment ------------------ ---.------.----------------... $116.58 $245.61
change from
Payment 1965
Monthly mortgage payment if:
1965 mortgage terms, 1974 purchase price-...............-------------------------------- $186.25 59.8
1965 purchase price, 1974 mortgage terms---------.............. ------------------------ 153.74 31.9
1965 purchase price, L/V, interest rate, 1974 maturity-..--------------.. --------- 113.95 -2.3
1965 purchase price, maturity, interest rate, 1974 L/V............................ -------------------------119.58 2.5
1965 purchase price, maturity, L/V, 1974 interest rate---------.---------------- 151.99 30.4
1974 purchase price and mortgage terms.. --------------------------------- 245.61 110.7

Note: calculated from data from FHLBB survey of conventional mortgage lending.



Index of
Cost of Mortgage
Home- Rate Property Maintenance
Year ownership (1967-100) Taxes Insurance and Repair

1960 -
1961 ...-..--- ......----------.

1965- --- ------- -----
1966 .................................
1968 --------------.-...... -.....
1969 ---.........--- .....---..-.....
19690.... .. ...... ............ ... ......
19 70 -- - -- - - - - - - - - - - - - -
1971 -...0..........................
1972........ ---......-............
1974 .................--- --- .---

90 .8
14F. 7




140 7

Source: all cols.: "BLS Handbook of Labor Statistics, 1973, Monthly Labor Review," January and March 1975.
Na: not ava able.


Index of
Cost of
Home- Mortgage Property Maintenance
Year ownership Rate Taxes Insurance and Repair

1960.................................------------------------------- 2.3 4.6 na -0.3 1.7
1961................................. ------------------------------- 0.7 -2.6 na 0.4 1.5
1962..... ------------------------------- 1.1 -1.8 na 0.6 0.7
1963 .... ---------------......................... 1.3 -0.2 na 3.0 1.4
1964 ................................. 2.0 -0.7 na 5.1 2.1
1965.............................------------------------------- 2.1 0.3 4.1 6.8 2.0
196) ............................... 3.9 6.2 3.2 5.3 4.3
1967................ .........------------------------------- 3.8 4.9 5.9 5.7 5.0
196F .... ...........------------------------------- 5.7 6.7 5.6 4.7 6.1
1969............. -------------------------------... ...... 9.7 12.5 6.0 4.4 8.4
1970 .............------------------------------- 10.8 10.1 8.1 3.8 7.8
1971-------------------------------................................. 4.0 -8.9 8.3 5.7 7.8
1972 ...................... ........ 4.8 -2.4 11.1 2.8 5.2
1973 ... .... ... ----------------------------- 4.7 4.9 4.5 1.0 7.3
1974 .......... ...------------------------------- 11.2 13.8 -0.7 -0.2 13.6
1965 1970 -...... .....---------- 38.6 47.3 32.2 26.3 35.8
1970 1974 .......................... 27.0 6.1 25.0 9.5 38.4
1965-1974............................ --------------------------- 76.1 56.3 65.2 38.3 88.0

Source See Table 11.
Na: not available.



"Who can afford a new house?" h as become a popular question in
1975. (Caria Hills, Secretary of I 1' ), \;s rel)ported by the Associalted
Pres as ;isay ilig tlIat iI 1975 only 31 percent. of Americans could afford
at new m(ed(ian priced holile. A st idy for Thie (Joint Ecoim ic ('oinmit-
i'ee (JEC) reports tliat it 'required an annual illcollie of at least
S,.,.,30 to afford -a le(,w iled(ian priced liiome, in 1974, as contrasted with
;L IIediian family i ol('()iue of $12,40.1 Thlese sets of figurlles have led some
ol serves to b ( quite pessimiist.ic about tlhe future o)f homeownersship.

I .A i tllu i d cil i rlliIiif of tils s.ntimIy is attach(h d.


I want to stress two major points. One, the question "who can
afford a new house '", is incapable of being answered in any meaning-
ful sense, and, two, the answers that have been offered present a
false and extremely misleading impression of precision. These points
are important because of the possibility that the answers that have
been offered could lead to one of two unfortunate responses, either
the enactment of hasty and ill conceived policies to meet what is
perceived as a national disaster or, perhaps worse, a sense of impo-
tence and Tesignation in the face of such a large problem with a
consequent failure to attempt to solve any part of the problem.
A lot of studies, including the JEC study, take data on average
or median home prices, interest rates, etc., and, using rules-of-thumb,
derive how much income is necessary to be able to afford this house.
This median or average house and the associated income then become
implicit standards for public policy. The use of the median priced
home as a standard neglects the fact that half of new homes sold had
even lower sales prices. The use of the average price means even more
homes had a lower price. For example, in 1973, the Census Bureau
reported that the median sales price of new one family homes sold
was $32,500. For the same year the Federal Home Loan Bank Board
reported an average sales price for new homes of $37,100. A linear
interpolation of the census figures suggests that over 64 percent of
new homes sold had sales prices of less than $37,100.
I do not mean to imply that all new homes, regardless of sales
prices, provide decent housing. Undoubtedly some, especially at very
low prices, do not. All I mean to suggest is that it is not at all
clear that a concern for providing decent housing for all families
means that each family should be entitled to the average or median
of all new construction.
This question about what provides decent housing is at the heart
of why it is so difficult to answer the question "Who can afford to
buy a new house?" Every time anyone tries to answer this question
their use of a particular house price implicitly introduces their own
value judgment as to what is a reasonable and proper house. I do
not know how one can avoid this problem. I would suggest that this
problem should be faced openly and the inherent ambiguity acknowl-
edged from the beginning. I would also suggest that most reasonable
people, if asked to decide what provides decent housing, would decide
on a house that is significantly less expensive than the average or
median of all new constructions.
It is perhaps instructive to redo some of the mechanical computa-
tions of earlier studies using data for houses sold with FHA insurance
under Section 203. This exercise is not offered in defense of the average
of FHA construction as the right and proper standard for decent
housing, but rather to demonstrate the variation in answers from
adopting different standards and a personal belief that an explicit
public policy commitment to decent homes for everyone would prob-
ably end up closer to the average of FHA-insured homes than all new
The results of this exercise are shown in Table 1. The basic data
comes from FHA figures on average total monthly housing expenses
which includes mortgage payments, taxes, insurance, utilities, and
maintenance and repair. In line with earlier studies these monthly


figures are then multiplied by 48 to determine "required income." This
procedure is thus consistent with the rule of thumb of 25 percent of
income for housing. Finally these figures are compared to measures
of income distribution.
Let me offer an interpretation of these numbers realizing that the
same numbers can mean different things to different people. One. thing
that impresses me is that stability of these numbers. Over the entire
period since 1950 roughly 40 to 50 percent of families could have
"afforded" an average new FHA house. Further there is no conclusive
indication that the situation is getting substantially worse. The drop
in 1974 in the percent of families with incomes above the 25 percent
standard is nothing to cheer about. But at the present time, it is diffi-
cult to determine whether this represents the start of a new trend or is
the result of the increase in unemployment during 1974. Earlier years
of recession have shown similarly low percentages.
These figures do not mean that 50 to 60 percent of families are un-
able to buy decent homes. For one thing many existing homes, offering
decent housing, sell for less than the median price of a new FHA
house. In recent, years prospective housing expenses for existing houses
with FHA insurance have averaged 90 percent of expenses for new
homes. Further, the use of income figures for all families is likely to
be misleading. Both family income and family housing needs show
definite lifecycle patterns. Median family income rises with the age of
the head of household to about age 55 and then declines slightly. Many
young and old families, before and after years of child raising, choose
not to own their own home but prefer to rent. The effect of differing
housing needs and rising incomes can be illustrated using data from
1973 and 1974. If one looks only at families headed by an individual
aged 35 to 55, the percentage of families which could afford an aver-
age new FHA house in 19t3 rises from 49.7 percent to 62.7 percent.
For 1974 the proportion rises from 43.7 to 57.2 percent.
These figures are not meant to understate the problem many families
have in affording decent housing. They are meant to illustrate some
of the problems and pitfalls associated with trying to measure who
can afford a new house. Because of the ambiguity surrounding any
social standard of what provides decent, housing, there is a natural
ambiguity surrounding any related income figures. Further, using in-
come data for all families results in an implied group that cannot
afford decent housing which includes many families who do not want
to own a house-very young and very old families. The use of a new
house as the implied standard for public policy ignores the whole stock
of existing homes that provides housing for most of the population.
The maintenance and upgrading of the existing stock is a viable option
and should be part of any national housing program. There is the
danger that this option could be ignored with the continual emphasis
on new housing.



Average Percent of
Monthly families with
Prospective Median income greater
Average Housing Required Family than required
Year Sales Prices Expense Income* Income income

1950....----------------------------- na $75.86 $3,641 $3,319 40.9
1955 ..---------..--------.----------- $12,113 98.02 4,705 4,421 44.8
1960 -..----------..------.------------ 14,662 130.82 6,253 5,620 42.4
1961 ..----------------------------- 14,894 134.12 6,438 5,737 42.4
1962 ----------------------------- 15,169 133.48 6,407 5,956 45.1
1963 ..--------..--------------------- 15,878 138.31 6,639 6,249 46.1
1964 ----------------.------------- 16,216 142.13 6,822 6,569 47.5
1965.---.....------------..-------------- 16,815 147.54 7,082 6,957 48.7
1966 ----------------------------- 17,605 159.74 7,668 7,5CO 48.5
1967..--------...........------...---------------.. 18,611 174.80 8, 390 7,933 46.3
1968. ----------------------------- 19,568 185.93 8,927 8,632 47.8
1969---------------------------- 20,563 208.87 10,026 9,433 45.8
1970.-.---------------------------- 23,056 245.92 11,804 9,867 39.4
1971 ----------------------------- 23,835 249.28 11,965 10,285 41.0
1972..-----------.------------------ 24,788 256.30 12,302 11,116 44.0
1973...----------. ------------------ 24,672 254.45 12,214 12,051 49.7
1974..----------------------------- 26,864 295.06 14,163 12,836 43.7

Sources: col. I, 2: "HUD Statistical Yearbook," various years; FHA.
col. 3: col. 2 X 48.
col. 4: "Current Population Reports, Consumer Income", Series P-60, numbers 49, 93, 98.
col. 5: Linear interpolation of distributions in the col. 4 sources.
Na: not available.


This paper by The Congressional Research Service (CRS) presents
two sorts of estimates: (1) The number of new homes available for
middle income families and (2) The cost of owning a new home. There
are serious shortcomings in both these estimates which will be dis-
cussed separately.


This part of the study attempts to estimate the number of homes
available for middle income families. It should be made clear from the
beginning that the CRS study fails to achieve this objective. A major
source of data used in the CRS study is from the sales of new and
existing housing units. Thus this part of the study is really a measure
of sales by purchase price not availability. Once it is collected, the
data on sales is contrasted to the stock of families. The result is a very
low fraction. It can only measure the fraction of middle income fami-
lies that bought a house. As a measure of availability it can only be
called spurious and misleading. All families have some type of hous-
ing. In this sense the ratio of available housing to families is 1.0,
by definition. To repeat, the ratios on page CRS-17 are only estimates

2 "Availability of Homes for Middle Income Families," Prepared by The Congressional
Research Service for The Joint Economic Committee, April 28, 1975.


of sales by sales price as a proportion of all families, they are not esti-
mates of a(i calblibty.
Even as an estimate of sales by sales price, the study suffers from a
number of shortcomings. The number of subsidized starts is elimi-
nated frum the number of new homes sold. Why these units are sub-
tracted is not clear. They do provide housing for the subsidized
families. Further, it appears that the number of subsidized families is
not subsequently subtracted from the number of families needing
The d(hita on the distribution of new homes by sales price is suspect
as it appears to contain several errors. One such error is illustrated by
referenciv to tbe studss slubtraction of subsidized units. On page
CRS-5, the sti(lyv estimates "than only 6,400 Section 235 units were sold
for more than $21.000." However data from Tables 245 and 175 of the
1973 HU'D Yearbook shows over 15,000 Section 235 units with a total
acqui-tion cost of over $21,000. The table at the bottom of the page
CRS-4 implies that there were no non-subsidized units sold in 1973
with a sales price under $20,000. However data from Tables 208 and
175 of the 1973 HUD Yearbook shows that almost 5,000 units with
FHITA insurance under Section 203 had a sales price of under $20,000.
FHA insurance under Section 203 is not a subsidy program. Further
the study ignores mobile homes entirely. Table 354 of the 1973 HUD
Yearbook reports that 566,920 mobile home units were shipped in 1973.
Retail sales in 1973 were estimated at $4.4 billion. These two figures
imply an average price of $7.912. (This figure is not to be taken as a
precise measure of average price. The data on total sales is only an
estimate and the data on units is a measure of shipments not sales.)
While not a precise estimate of average price, the $8,000 figure
is surely in the ball park and suggests that a substantial number of
mobile homes were available with a sales price of under $20,000.
The figures on new homes sold are combined with an estimate of
sales of existing homes to derive an estimate of total sales. How-
ever, the estimate of the number of existing homes sold makes little
sense. Data on the distribution of sales of existing homes by sales
price comes from the National Association of Realtors but there re-
mains the question of what base does one apply these percentages to.
The CRS study uses an estimate of net new units built (total housing
starts minus an estimate of the number of removals.) This is neither
an estimate of total sales of existing homes nor is it a good proxy
for total sales. The use of the number of net new units as a proxy
for total sales makes little sense.
A better, but still indirect, indication of the volume of existing
home sales can be derived from the HUD survey of mortgage lending.
HUD surveys mortgage lenders and asks them whether loans were
made on new or existing homes. Of the mortgage lenders surveyed for
the year 1973. the HUD survey shows loan originations for existing
1-_ family non-farm homes of 1.446.8 billion or 1.9 times the volume of
loan originations for new 1-4 family units. If this ratio of mortgage
financing is representative of the ratio of units sold, it suggests that
perhaps 2.150.8 million existing homes were sold in 1973. This num-
ber is 1.9 times the number of single family starts in 1973.
This number of 2.1 million sales is only an estimate and not a
precise measure. It is subject to several sorts of errors of unknown


magnitude. It is relatively easy to think of some types of errors that
make the number too large and others that make it too small. Whether
these errors just cancel out or can not be determined, but the estimate
of total sales of existing single family units of around 2 million units
is surely closer to the mark than the CRS study's estimate.
Using the data on the distribution of sales by sales price and the
estimate of 2.1 million sales in total suggests that 408,000 existing
homes sold in 1973 had a sales price of less than $20,000 (19 percent of
2,150,800 units). This figure of over 400,000 is in sharp contrast with
the 124,800 homes in the CRS study.
The second major part of the CRS study presents estimates of the
cost of owning a new home. The table on page CRS-19 summarizes
this effort. The numbers on this page purport to correspond to the
costs of and associated required income for a median priced home for
various years. This exercise is analogous to the estimates presented
above for new FHA insured houses. However there are several serious
weaknesses that result in a substantial overi:timate of costs and
required income.
While not a technical error, there is the question of what sort of a
house families should be able to afford. The CIS study answers that
question by using figures for the average of all homes built. It should
be reemphasized that there is no scientific answer to the quest ion, "How
big a house should families be able to afford?" The numbers presented
above, while recognizing that there is no precise answer to the ques-
tion, illustrated an answer that used the average of new FHA insured
homes as a standard. The CRS choice of the more expensive average
of all homes sold naturally raises the required income. The CRS study
uses a house price of $41,300 for 1974. (There is a timing problem asso-
ciated with this number that is discussed below.) By contrast the
Census Bureau reports an average price of a new FHA insured house
in 1974 at $29,800. The increase in sales price of over 35 percent would,
by itself, raise the associated required income by roughly 35 percent.
The CRS study purports to report data for a median price house.
That is a home priced such that 50 percent of homes had higher prices
and 50 percent had lower prices. But in fact the study uses data from
a Federal Home Loan Bank Board (FI-LBB) survey that reports
the average price of homes sold with conventional financing. The use
of the average rather than the median raises the selling price and im-
parts an upward bias to the results as a few very expensive homes
make the average exceed the median. Further, the use of homes sold
with conventional financing also results in a figure higher than one
that includes homes sold with FHA and VA financing.
It is easy to illustrate the impact of these points. For 1974 the
FHLBB reports an average price of new homes with conventional
financing at $40,100. The Census reports a median price for new homes
with conventional financing of $38,000, over $2,000 less. The Census
also reports median prices for new homes with FHA and VA financ-
ing of $29,800 and $31,300. The overall median price, regardless of
type of financing, as reported by the Census is $35,900. Clearly the
choice of average, rather than median, and the use of only conven-
62-748-76-bk. I-7


tionally financed homes has a substantial effect on the sales price.
The CRS study next assumes that their typical home is bought
with a 10 percent downpayment. In 1974, homes with low down-
payments tended to be homes with FHA or VA financing, homes that
are excluded from the CRS average. In fact the average downpayment
for the average FHLBB house was not 10 percent, but rather was
24.2 percent. The change in downpayment by itself means monthly
mortgage payments that. are 18 percent higher.
The interest rate data in the CRS study has two problems. First
of all. it is an inappropriate rate and, second of all, the choice of time
periods results in a misleadingly large increase for 1974 as compared
with 1973. Dealing with the second issue first, the data for 1973 and
earlier years is the average of rates over the year while the data for
1974 is for only one monthly. November. (This is the same timing prob-
lem mentioned above in connection with purchase price and it has a
similar effect.) Mortgage rates rose continuously throughout 1974, so
data for November represent a much higher figure than the average
for the year. However consistency with the earlier figures suggests
usinrr an average over the whole year rather than one month.
Dealing with the first is.-iie, in computing the monthly payment
the CRS study uses the FHLBB series on effective mortgage rates,
rather tlm.n the series on tlihe contract rate of interest. The difference
between the two series is that the series on effective rates is the result
of adjustments to the contract rate by the FHLBB to reflect the impact
of fees and cli;g es associated with making the loan. The effective rate
this exceeds the contract rate. The problem with using the effective
rate to determine monthly mortgage payments is that these payments
are determined by the colitract rate. not the effective rate. The fees and
charges are all paid when the loan is originated. They are costs of
liuying the house but are more like tlhe downpayment than they are
the nionthily payment. With the procedure used in the CRS study the
use of the effective mortgage rate, rather than the contract rate, results
in lhigrlier monthlyy mortgage payments and thus a higher required
All of these technical errors suggest that the CRS study substan-
tially overestimates the required income to buy a house. The extent of
this ovecrestiiiation can be illustrated. Tlhe CRS study concludes that
it takes an annual income of $23,330 to buy a house in 1974. Data on
mortgage (r characteristics for the year 1974-contract rate, principal,
nmaturity-the average price for the year 1974 and estimated other
expenses, derived from the CRS study, suggests a required income of
$20,178. almost 14 percent less than the CRS figure. Using the rule
of 25 percent of income for housing this income would support an
average priced new home bought in 1974 with conventional financing.
If one substitutes tlie Census figure for a median priced new home, but
still assitumes tlie use of (conventional financing the required income
drops to $19,121, or 18 percent below tihe CRS figure. Using FIIA data
for hotes insured under Section 203 during the first nine months of
1974 suggests a required income of $14,163, almost 40 percent below
the ('IS figure.