of $2,333 million in mortgages to retire the Government stock. Pending this retirement of Government ownership, the certificates will not receive any earnings. To attach a price tag of 3 percent to the users of the facility and, simultaneously, to require, as does section A, that the price to be paid by the association for any mortgage purchased by it under this section should be established at or below the market price for that particular class of mortgage involved is, in effect, to discount all loans purchased at the very best 3 percent below the current market price for such mortgages.

To make this discount more palatable, the 3 percent requirement could be reduced. A drop to 2 percent, however, raises the dollar amount of mortgages to be purchased by $770 million. If the certificate purchase requirement were set

at only 1 percent of the loans sold to the facility, the corporation would have to buy $7 billion worth of mortgages at a price still 1 percent below, at best, the current market price. To expect investors to utilize a device of this kind under these circumstances is a forlorn hope. While the investor ultimately would recover his investment in that the certificate would be convertible into stock ownership when, if and as the Government investment is retired, this will certainly take a considerable length of time.

I personally would not place a value on the present worth of the future benefits which might accrue to an investor out of the conversion of these certificates to stockownership.

One of the real but almost totally ignored problems of creating a genuine secondary market facility is the constant insistence that such a facility purchase outright mortgages offered to it by its member institutions. A facility which operates on the purchase principle must confine its borrowings from the money markets entirely to the long-term market. It must depend solely on its own credit position. It must assume fully the risk of return of principal, of the servicing costs of the mortgages it buys and of the abrupt changes that can and have occurred in the long-term interest rate structure. In short, once you impose upon such a facility the obligation that it operate on a purchase basis, while at the same time it must obtain funds by borrowing in the capital markets, you create the credit dilemma which has haunted all of the debates on a secondary market facility.

The dilemma can be briefly stated. Seemingly everyone wants some kind of a central mortgage facility. On the other hand, everyone is equally insistent that the proposed facility not operate as a primary lender. Unfortunately, no concise definition of the term "primary lender" is offered. However, what is obviously intended is avoidance of construction of a one-way street whereby mortgages enter the portfolio of the facility and never again emerge into the normal, everyday secondary market except at costly losses to the facility. How can this be prevented? The answer is simple but harsh.

There is only one way such a facility can operate without being a primary lender. It must operate in response to the same pecuniary incentives that motivate the investment program of any other large lender. In essence, it must operate like a private bank, a private insurance company, or a private savings and loan association. It must maintain a margin between the cost of its money and the yields it obtains on the mortgages it purchases wide enough for it to be a genuine private institution. This fundamental operating principle does not mean that the facility must invest its funds in exactly the same way as private landers. It does mean it must maintain a proper margin between cost and income.

For a secondary facility not to operate as a primary lender, it must consummate its purchases on the same terms and conditions as those imposed by the vast network of banks and insurance companies which today constitute the private secondary market for mortgages. The postwar FNMA purchased loans of a type and at a price higher than the private market offered; hence, it became loaded with what the President termed "frozen investments." The reason it could purchase at terms and conditions other than those offered by the private market was because its operations were animated by motives other than the pecuniary incentives which dominated the investment decisions of the private secondary market. It raised its investible funds under the protection of the Treasury at rates below the rates private investors paid for their funds. A successful Government-sponsored mortgage facility must therefore be reasonably held to the same profit-andloss bookkeeping as is a large insurance company or any other purchaser of mortgages. This means there can be no subsidy, direct or indirect, by the Government to such a corporation. Such a subsidy can only operate to weaken, if not to completely destroy, the pecuniary motives which must dominate the facility's operations and, consequently, compel the facility to operate as a primary lender. 44750-54-pt. 1—19

Even with such private incentive, the facility could still get locked in through abrupt changes in the yield structure.

The critical point, however, is that secondary operations of the facility must be conducted without subsidy. Whether the proposed facility will in fact be subsidized or not depends entirely on the meaning of he separate accountability requirements of section 307 of the bill. Does the separate accountability apply to income and expenses as well as to assets and liabilty? What happens to any net income that may accrue to the corporation from performance of its special assistance functions and the mangement and liquidation of the existing FNMA portfolio? How are the expenses of operation to be allocated?

These are critical questions, for if the existing earning assets of FNMA are turned over to the new corporation and if the new corporation is charged that rate of interest the present FNMA is currently paying the Treasury, substantial net income will be made available to the corporation. Even if this net income is not allocable to reserve and surplus accounts, it could easily be dissipated by absorbing expenses which would otherwise not be possible.

The same can be said of net income arising from performance of the special assistance function. Here again a subsidized money cost is available through the Treasury. If this is directly or indirectly made available to the corporation in its secondary operations, we would again have an indirect but nonetheless substantial subsidy to the secondary operations. As a matter of fact, in view of the bookkeeping and accounting difficulties inherent in the consolidation into 1 corporation of 3 diverse functions, 2 of which are subsidized, a serious question can be raised as to the desirability of a single corporation.

It would be a much cleaner, clearer operation if the secondary market operations were the sole concern of one corporation, and the subsidized operations of the proposed facility were handled by a second corporation.

One further special comment needs to be made about the operation of the special assistance function where the facility will operate in effect as a primary lender to encourage the use of certain types of mortgage plans.

Some types of incentive should be placed on lenders using the facility to absorb mortgages of the types designated so that the facility does not become a dumping ground. Subsidized insurance schemes assure builders of a ready and pressing market for houses financed under these specialized mortgage devices. Every effort should be made to require builders and lenders to assume a proportion of the risk involved in the long-term performance of such loans. It might be that a 3 percent or 4 percent deposit should be required to accompany the submission of the loans to the facility. Such a deposit could be returnable after the expiration of a period of time depending on the performance of the particular mortgage submitted. This requirement would make the original lender a partial guarantor of the soundness of its own underwriting processes and hence would partially inhibit improper use of the facility.

My final comment on the housing bill relates to title 6 and, more particularly, to section 603 wherein the Home Owners Loan Act of 1933 was amended. The amendments proposed by section 603 are the result of a long, tedious process of discussion and compromise between the interests of the administration, of certain Members of Congress, and of the savings and loan business. In these discussions, Congressman Gordon McDonough has played an important and valuable role, and the savings and loan industry and the Government owes Congressman McDonough much commendation for his patient work.

Section 603 is an excellent example of how reconciliation of the various interests of the business and of the Nation can be effected. Here the broad powers granted to the Home Loan Bank Board are spelled out in statutory form and at the same time the supervisory effectiveness of the Board is tremendously increased. The provisions of 603 give the Board for the first time a law of misdemeanor and a method of enforcing it. For too long the Home Loan Bank Board has been confronted with the awesome choice of either using a conservator to enforce its actions or of doing nothing. By the provisions of this section, the Board is, in effect, given the power to issue cease-and-desist orders after compliance with the necessary requirements of proper administrative proceedings and, in addition, is given resort to the judicial processes for the enforcement of such orders. This fills a tremendous void in the previous processes of the Board. On the other hand, however, by writing into the statute inhibitions on the use of this power and by spelling out the grounds on which conservators may be appointed, guaranties are given to the industry against arbitrary use of this enhanced power.

Mr. WELLMAN. Mr. Chairman and members of the committee, my name is Charles Wellman. I am executive vice president of the Glendale Federal Savings & Loan Association, a Federal savings and loan association with assets in excess of $90 million, and an association which is engaged in making all types of loans.

My comments to the committee today are confined principally to those sections of title I of the bill, making changes in the old title II, section 203, to the provisions of title III of the bill respecting the reorganization of the Federal National Mortgage Association, and the provisions of title VI on the Federal Home Loan Bank System.

Title I of the proposed bill makes many substantial changes in the old title II, section 203 1- to 4-family housing units. As Mr. T. B. King of the Veterans' Administration, testified before this committee, the effect of these changes, as to loan amounts, amortization terms, use of FHA for refinancing, and the extension of maximum term and amount to existing housing, will have the effect of placing nonveterans in virtually the same position on housing credit as has been reserved previously to veterans.

In short, the bill will extend and liberalize considerably the credit terms previously available only to veterans, and there seems to be no disagreement among all of the various groups concerned with this bill as to that effect.

Of course, from that solid point of agreement, you branch off into various types of disagreements, which range all the way from how FHA should be organized, down to questions of whether or not the bill actually is a step toward or a step away from the private enterprise concept.

However, I feel that the basic issue, the key to the reconcilement of these various differences of opinion, lies in the contingent liability of the Government on the FHA plan.

Under the mutual mortgage insurance scheme, the Government is a backstop. If the insurance fund is inadequate to cover any losses that might be insured, the Government is to make up those losses. At the present time, under title II, section 203, I believe the insurance reserve is approximately 1.6 percent of the outstanding insured portfolio.

The CHAIRMAN. And what is that?

Mr. WELLMAN. About $151 million, as I recall it, on a portfolio in excess of $9.5 billion.

I am limiting this only to section 203, the one- to four-family housing plan.

The CHAIRMAN. And that,. you say, is about 1.6 percent?

Mr. WELLMAN. That is right.

The CHAIRMAN. What is the reserve to the total outstanding of all FHA?

Mr. WELLMAN. I don't believe if you except the insurance fund to the property improvement loans, which is a separate type, that would change the figure materially. I would guess it is about 1.4 to 1.8 on the total insured program, title I, section 8, title II, and all the other various titles.

The CHAIRMAN. You think that reserve is large enough?
Mr. WELLMAN. No, sir, I do not.

And I think that the FHA, at the request of the President's Advisory Committee on Housing, prepared a study of the adequacy of the insurance reserve. That study is contained in appendix 7 of the FHA and BA subcommittee report. And it showed that on the basis of certain assumptions, which you naturally have to make if you are going to calculate the adequacy of reserves, on the basis of those assumptions the fund is short approximately $70 to $100 million, and that the effective reserve needed would be in the neighborhood of 22 percent of the total outstanding portfolio.

Of course, as I have said, it is difficult to calculate reserve requirements, and one of the weaknesses of the FHA study itself is that the reserve is calculated on the existing risks in the existing portfolio. The study was made on the assumption of the portfolio as of June 30, 1953. And, of course, calculating reserves is a product not only of what risks you have already assumed, it is a product of what you are going to take on, as well as the rate at which you make new loans. In other words, if you had a $100 million portfolio and let it run off and not add any loans to it, your reserve requirement would decrease. On the other hand, if you were to double your portfolio within a year, you would have the effect of substantially increasing your risk of loss. Now, what is the effect of these various proposed liberalizations in the title II? If you take the assumptions that the FHA made in its study of risk of loss, you would find that a brandnew loan made today, if it had a loss of the magnitude assumed by the FHA study, at the end of 3 years it would have a gross loss--that is the loss before you deducted the amount of the insurance premiums paid-in the amount of $379. On a $12,000 valued house, the maximum loan today would be $9,600. But when you raise substantially the amount of the loan, and extend the term, you materially affect that risk. For instance, under the proposed bill, the maximum amount of this loan, on this same property of $12,000, would be $10,600, a little over a 10 percent increase.

The effect of that increase in the loan amount is to raise the amount of risk 4734 percent, because it is the top amount of the loan that is involved in the risk. If, at the same time, you extended the term from, say, 20 years to 25 years, you would raise that amount of risk 60 percent.

So, the maximum amount of loan you make, and the term for which you make that loan, on any piece of property-regardless of what kind of property it is-frequently affects the amount of risk that you assume. And that is what the effect of these extensions, if they are put into operation, would be. It would be a material increase in the risk on an insurance fund that is already admittedly inadequate.

Now, of course, the problem is, what can be done about it. I personally do not feel that the choice is either abandoning the concept of insurance, or going on and accepting, with no changes, this material increase in the contingent liability of the Government.

For example, the President's Advisory Committee recommended that an independent objective study be made of the inherent risks in the portfolio. And I would respectfully submit and suggest to this committee that any legislation respecting housing should instruct the Housing and Home Finance Agency to cary on such a study so that the Congress and the administration would be in a position of knowing, at least on the basis of certain assumptions, the extent of its risk.

The second suggestion for dealing with this problem is a rather ancient method, and it is the method of changing the premium rate. If you are going to have a relatively weak company and you want to borrow money, you pay a rather high interest rate. If you are classified as a single A corporation, you can borrow at one rate; if you are a triple A corporation, you can borrow money at another rate. We seem to have gotten into the position with the FHA that a half of 1 percent of mortgage insurance premium is the most and the least that is going to be charged. There is no variation whatsoever in the premium rate charged by FHA, irrespective of the type of risk that is underwritten by the FHA, and there is certainly no magic in a half of 1 percent. If you are going to increase the risk 40 or 50 percent by increasing these amounts and extending the term the Commissioner of the FHA should vary the insurance premium.

If you increase the risk 50 percent, that would mean an increase in the premium rate from one-half of 1 percent to three-quarters of 1 percent.

If an individual comes into the Glendale Federal and he wants a conventional loan at a third of the appraised value of the property, we certainly are going to give him a loan at the lower interest rate than if he wants the maximum loan that we permit. And there is no reason, if the mutual-insurane fund is really going to be an insurance fund founded upon the elementary principles of actuary practice, why, to the extent of the liberalization of this bill, the premium rate should still remain the same, regardless of the class of risk that is taken on.

Now, the same problem applies with the FHA, where you have the FHA insuring the lender against any kind of risk, practically. You get a situation where the lender no longer performs his classic function of deciding who among these applicants is a good borrower. One of our biggest problems is the fact that lenders are tending more and more to throw onto the insurance fund or onto the FMA the problem of doing all the underwriting. Is this a man a good borrower? Is this a good property? Is this the kind of a house we want to make a loan on? How much of a loan should we make? And the result of that is that the prejudices and opinions-and you can't escape prejudices and opinions in the mortgage-lending business become fixed, because the FHA becomes the sole arbiter of these matters.

I personally would like to see us, at least on certain classes of property, get ourselves in a position where we don't have a straight 100-percent insurance. The 100-percent insurance was a necessity in 1934. We could hardly get anyone to make a loan on anything in 1934. That is not the problem in 1954.

Now, I agree on sections such as 221 or 220, the problem of 100-percent insurance may be important. But when you have a run of the mill average type of single-family residence in a good neighborhood, with a sound borrower, is there any reason why the Government should assume the full risk? The Government doesn't assume the full risk on a property improvement title I loan. They insure a portion of the portfolio, so you can charge against that portion your losses up to a certain percentage. The effect is that the Government in title I is not determining the desirability of