America's Housing Challenge The Money Market

...Accordingly, a discounting practice has developed, under which the lending institutions advance less money than the face value of the mortgage but the borrower pays back the full value The difference equalizes the gap between the FHA maximum and the going market rate While the practice may seem somehow abhorrent, the FHA recognizes that the supply of mortgage money would otherwise shrink, and tolerates it, at the same time, the official FHA rate has soared from 4 5 to 8 5 per cent to attract a flow of money into mortgages A second major government effort to minimize mortgage rates involves the curious case of the public housing program As this emerged in the late '30s, local housing authorities were encouraged to enter into Annual Contributions Contracts with the Federal government that, in effect, guaranteed the repayment of mortgage money the localities borrowed to cover the development costs of projects to house families of low income In addition, interest paid by local housing authorities to the buyers of their bonds was made exempt from Federal and (within the state involved) state income taxes Naturally, investors are willing to purchase tax-exempt obligations that pay a lower rate of interest than they would insist upon receiving if the > [receipts were taxable This feature saves no money for the Federal government in the long run because the loss in income tax revenues probably exceeds the reduction in the annual contributions to the local housing authorities But the loss in taxes is less visible than the amount of the subsidy The latter requires affirmative Federal action, the former is noticed only by close students of government finance The notion, therefore, of using Federal income tax exemption on the interest received by the owners of local bonds has spread widely through the field of residential mortgage investment New York was the first state to take full advantage of this device In 1955 the Limited Profit Housing Company Law authorized the sale of state bonds to raise mortgage money for private housing whose occupants would be persons of limited income, and whose owners would be held to a 6 per cent annual profit on their equity investment The City of New York was given similar powers Since then approximately $3 billion in mortgage money has been put into so-called middle-income housing developments in the state, the debt-service reduction, averaging about 2 per cent, amounts to roughly $60 million per year The idea has proved to be contagious, and some 30 states now have established finance agencies to sell tax-exempt bonds for housing mortgages As might be expected, the tax exemption has its opponents in Washington The Nixon Administration at one point suggested that the Internal Revenue Code be amended to discourage use of the privilege for local bonds floated for housing mortgage purposes unconnected with the central activities of local government Many fiscal experts have recommended that tax-exempt municipal bonds for any purpose be terminated, and that part of the increase in the ensuing interest cost be made up by the Federal government through direct subsidization Congress remains divided on the issue Meanwhile, the tax-exemption device is no longer working as well as it used to In the first place, the total construction and operating cost of multifamily urban housing has risen so high that even a 2 per cent reduction in the mortgage rate leaves these buildings beyond the reach of a much broader spectrum of families than in the past Monthly rents in new developments financed by New York's Limited Profit Housing Company now average almost $100 per room, as against approximately $21 per room 15 years ago Family incomes have increased by a much smaller margin Secondly, the growth in local and state debt has been tremendous over the last two decades, although state governments have generally been able to increase their own tax rates sufficiently to keep themselves fiscally on a sound basis Still there must come a time when the pressure of the supply of tax-exempt bonds will depress the interest-rate differential to the point where it will be of little consequence m mortgage lending "Fanny Mae" Since the interest paid by the Federal government on its own obligations is not tax exempt, Congress had to devise a less indirect method for reducing mortgage interest in 1963, when it decided to support middle-income housing under private ownership The result was the 221 (d) 3 program, which insured mortgages carrying a 3 5 per cent interest rate, provided occupancy was limited to persons whose income fell within certain narrow ranges and the ownership was in the hands of a corporation controlled as to dividends and profits Of course, 3 5 per cent was far below the market rate even in 1963, and no bank would extend such a mortgage unless it could immediately dispose of it at face value—a procedure made possible through the Federal National Mortgage Association (FNMA) "Fanny Mae" was then a government corporation that bought up the mortgage at par and continued to accept the 3 5 per cent interest from the mortgagor while absorbing much higher interest charges on the money it borrowed to pay the mortgage originator Ultimately, FNMA made its mortgages directly This system did furnish relatively low-cost mortgages for special groups in the population Its problems were partly fiscal, partly connected with ownership, and partly the result of insufficient attention to the social package of services The program was finally stopped, after a rather typical Federal policy zigzag, because the holding of a mortgage that produced less interest than the government itself paid to borrow the money was construed to be a burden on the national debt limit As a result, Fanny Mae was divided into a private and a public function A new Government National Mortgage Association (GNMA), m effect, provided the subsidies needed to enable FNMA to carry the mortgages as a private institution, and the total charge to the national debt was reduced to the annual interest deficit instead of the very much larger face amount of the mortgages involved As housing costs rose still higher, Congress adopted a new interest subsidization plan, also limited to people with incomes too large for public projects but too small for the open market—FHA 235 for single-family housing and FHA 236 for multifamily housing Under these programs the government would pay to the mortgage lender each year the difference between the debt service needed to carry a 6 per cent mortgage, plus amortization, and 1 per cent of the capital cost, drastically reducing the amount of rent necessary to cover the actual mortgage payments Once again, the interest rate was artificially low, so the mortgages were owned by GNMA, FNMA or a state housing finance agency Today FHA 236 is on the verge of being abandoned by Congress, notwithstanding that it worked very well fiscally The objections stem from problems of tenure and its allegedly high cost Undeniably, it is an expensive program, combining an interest subsidy with special tax deductions for the owners, but it is not uniquely expensive or even more expensive than the so-called housing supplement program or the government leasing of units in buildings financed by private sources (Section 23) The Costly Truth The simple reality is that the provision of decent new housing for families who cannot fully afford it is an unavoidably expensive proposition, in terms of construction, financing and operating costs For those families who can afford some of the basic fiscal costs and all of the operatmg costs, the interest subsidies set forth in FHA 236 are perfectly sensible, and their abandonment on fiscal grounds is unconscionable Thousands of units of acceptable housing have been built under this program, its shortcomings lie in management and inattention to the social package under the severe constraints of local land use patterns To relieve families who would not ordinarily find themselves among the housing deprived but who now discover themselves priced out of the market by the unprecedented interest rates of the 1972-74 period, the government has supported a secondary mortgage market by lending GNMA billions of dollars to buy up mortgages made by banks and other institutions at or below ceiling interest rates In fact, the current rate ceiling is unrealistically low, if banks want to sell their mortgages on the public market, they would be forced to unload them at a discount By enabling GNMA to purchase these mortgages at a stipulated price above the real market level, the government has, for all practical purposes, been trying to maintain a differential between the effective mortgage rate in housing and the prevailing interest rates on similar types of long-term borrowing throughout the economy Thus, through agencies like GNMA and the Federal Home Loan Bank Board (which provides liquid capital for its member savings and loan associations), as well as semi-private-semipublic agencies like the new FNMA, the Federal government has taken an ever larger role m mobilizing the capital resources needed for housing construction Typically, it has operated behind a facade of existing institutions, probably with ample justification, for there would be tremendous resistance to replacing them with a set of new enterprises Nevertheless, some of the responsibilities of the existing mstitutions are disappearing into the vast Federal maw that stands ready to buy up their mortgages and act as the true intermediary between the saving public and the housmg builder The challenge at this stage of the nation's economic development is finding a way to mobilize our housing resources on a sufficiently broad scale without so increasing the demands for capital as to cause or contribute to an even more serious and disruptive inflation-cum-unem-ployment than we already have Such a mobilization requires economic planning sensitive enough to distinguish between varying degrees of need, particularly in periods of high interest rates, yet simple enough to operate effectively It must stimulate the development of the housing industry, but also give adequate attention to tenure and the utility and social packages It must be workable and effective on the local level, without at the same time compromising fatally the social objectives of a racially harmonious America Perhaps the challenge is unlikely ever to be fully met Still, there are some practical suggestions to be made...

...THE MONEY MARKET Drilling for oil is a high-risk enterprise because those holes in the ground are of little value if they fail to hit target Except for the most bizarre creations of eccentric imaginations, housing is in a somewhat different category because a dwelling that is suitable for any one family will usually be suitable for others This, plus the fact that houses are in universal demand and reasonably secure from being dragged away or misappropriated, makes the provision of housing generally less speculative than digging oil wells Since oil wildcatting is considered an inappropriate gamble for widows, orphans and savings banks, it must be financed by wealthy speculators with other substantial assets But permanent housing debt, secured largely by the putative market value of the structure itself, is regarded as a proper investment for the institutions that manage the funds of widows, orphans and other citizens who have to be satisfied with lower rewards in return for greater safety The expectation (often in the form of a written commitment) that a investing institution will put up long-term mortgage money for housing makes possible the extension of short-term building loans These, coupled with a relatively small entrepreneurial commitment (in some government-assisted programs no risk capital is involved at all), finance the actual construction While the initial borrowing is of relatively short duration, the interest on it nevertheless contributes Significantly to the development cost of the building The interest rate on the permanent financing is, of course, a larger factor in the ultimate cost of housing Nearly as important are the terms of repayment, or "amortization," of the mortgage debt and its ratio to the development cost In the case of owner-occupied single-family housing (which under FHA regulations, as we noted, may have as many as tour families in residence), a high ratio reduces the size of the down payment required and thereby enlarges the number of eligible buyers As a rule, too, stretching out the terms of a mortgage lowers the monthly repayments, though it adds to the total amount of interest paid in the end For the consumer, the mortgage interest rate is by far the major manageable in housing cost On a $30,000 unit, the difference between a mortgage at 7 5 per cent and one at 9 5 per cent works out to approximately $50 a month, whether rental or owner-occupied That implies a very different clientele tor the finished housing, which affects the potential mortgageability of the house, which effects the availability of construction money, which affects the overall mobilization of resources for housing Consequently, a nation that wants to achieve growth m housing has to create an atmosphere favorable to mortgages by encouraging lower interest rates, high debt ratios and long terms of repayment Most Western countries have found themselves involved in precisely this process, even at times when housing policy needs—low interest rates, for instance—interfered with other economic goals, like controlling inflation In the United States, however, despite concerted efforts at all levels of government, the trend of general interest rates over the past 25 years has been almost unrelentingly upward In fairness, though, the government has succeeded m keeping mortgage interest rates lower than they would otherwise be To understand how this has been accomplished, it is first necessary to review the major sources of housing mortgage money and the various economic forces that influence the level of interest rates The vast majority of permanent residential mortgages in America are made by four types of institutions commercial banks, savings and loan associations, life insurance companies, and (in 18 states) mutual savings banks All of these institutions accept money from the public and invest it in interest-bearing obligations To attract deposits, they may offer interest income, long-term benefits (like life insurance), or services such as checking accounts Their customers have the right to withdraw their money at will, albeit sometimes subject to the payment of a penalty charge As suppliers of mortgages, they all benefit from forms of treatment and powers under the law that differ from those extended to other types of financial institutions Mutual savings banks, life insurance companies, and savings and loan associations are regarded as trustees of their depositors' money, so that only a portion of their actual earnings are considered to be income for tax purposes The commercial banks are treated for the most part like other corporations under the income tax law, but they enjoy the enviable power of creating money on which they charge interest When a customer takes out a loan, the amount lent is simply credited to his account, thus increasing the bank's total deposits—on paper—and giving it more money with which to make more loans In practice...

...Risks The special income tax treatment accorded the principal mortgage institutions has some effect in keeping down the interest rates they would otherwise have to charge their customers But this is merely the simplest and most taken-for-granted form of government activity on behalf of moderate mortgage rates Incidentally, while mortgage rates have been rising, the tax liabilities of some institutions (notably the life insurance companies) have increased, and so has the rigor of Federal efforts to make savings bank depositors report their interest earnings Here, too, the populist motive of forcing the banking institutions to pay their "fair share" of the national tax burden has contributed in some small measure to the antipopulost objective of keeping interest rates high The first major government move to bring about moderate interest rates was the establishment of the Fedeial Housing Administration Originally a Depression measure, the FHA subsequently became a long-term enterprise, though it is now diminishing in importance Simply a government corporation that insures mortgage lenders against loss in return for a premium, the FHA has operated over the years at a profit The combination of its premium income, the interest earned on the investment of that income and the proceeds of the sales of the residential properties it acquired when insured mortgages went into default has substantially exceeded its payments to banks to make good their losses This profitability has drawn private competitors into the field, until now the FHA is insuring mostly high-risk mortgages that private insurers (who charge lower premiums and cover only a part of the risk) eschew Besides protecting qualified mortgage lenders and influencing the quality of construction through what it calls its "property standards," the FHA stipulates a maximum rate of interest that it will permit on an insured mortgage Since interest represents a compensation for calculated risk as well as for the use of money, the safety offered by FHA insurance probably had a moderating effect on mortgage rates up to the end of World War II With the rapid growth of capital demand m the postwar boom, the safety offered by FHA insurance no longer compensated mortgage institutions for the loss that was implied in the gap between the FHA ceiling and the rate available on the uninsured market...

...Federal and state laws reinforce the bank's natural prudence to restrict the use of this power When the demand for loans becomes very heavy and interest rates rise, commercial banks find less money lying about m their customers' non-interest-bearing checking accounts, forcing them to borrow?and pay interest on—funds to support their existing and new loans within the Federally prescribed reserve limits Under the same circumstances, depositors in the other types of mortgage institutions also become restive, withdrawing money to buy bonds and other obligations that pay higher interest rates but do not ordinarily go into residential mortgages This process, which has been given the elaborate name of "disintermediation," forces the mortgage institutions to pay higher interest rates on their depositors' savings or, in the case of life insurance companies, to seek higher-yielding investments to cover larger dividends on their policies Keeping interest rates low for residential mortgages involves separate kinds of activities that sometimes conflict with each other On the one hand, the institutions that customarily extend mortgages require some sort of insulation from the rest of the money market, so their depositors will not be tempted beyond their powers of resistance to disintermediate Obviously, a large money supply helps This is a favorite theme of American populism, given its most vivid expression by William Jennings Bryan's "You shall not crucify mankind upon a cross of gold " But some leakage of money from institutions in which interest rates are held down by regulation to forms of investment that are free from such control is inevitable A few states compel mutual savings banks to invest a certain percentage of their assets witinm the state, in the expectation that this will keep mortgage money at home and thus produce lower mortgage rates Yet such laws can do nothing to prevent the depositors in the state from withdrawing their money and putting it in less-regulated investments or out-of-state banks that pay higher interest rates In short, state or Federal attempts to clamp a lid on mortgage interest rates at times of high credit demand mainly serve to reduce the supply of mortgage money, which pushes interest rates up in any case Thus the populist policy wrongly timed may well lead to an antipopulist eventuality Rates vs...