previously it had been shared by the lender. These are questions that should be closely examined. However, I am not sure that these factors pose as serious a problem as the current situation in which only limited mortgage money is being provided and housing is not being constructed, financed or purchased. The advocates for this proposal are an interesting and colorful group and would provide excellent hearing witnesses. These include economists Milton Friedman of the University of Chicago and Herman Kahn of the Hudson Institute, a variety of bankers, brokers and developers who have experimented with the real dollar concept and one individual who has helped set up real dollar mortgage programs in Isreal and throughout Latin America--areas with inflation rates so high that only this concept proved workable. I would be happy to provide you and the Subcommittee staff with additional information regarding this proposal, as well as assist in preparations for any hearings you may choose to convene on this topic or on the broader question of mortgage finance. Let me again commend you for your leadership in initiating these hearings and offer my full cooperation and support. Sincerely, Stan Lundine Member of Congress (From the Journal of the Home Loan Bank Board, January 1981) Price-Level Adjusted Mortgages Versus Other Mortgage Instruments by Henry J. Cassidy, Director, PLAMS-Price Level Adjusted Mortgages are mortgage instruments having an outstanding balance which is periodically adjusted by a percentage change in a selected price index, such as the Consumers Price Index. PLAMS have been in use since the early 1970s, in particular in other countries, such as Brazil and Israel, while only a few individuals in the United States have ever used a PLAM. Perhaps now is the time to consider seriously the use of the PLAM in this country. In the past, as recent as 1977, Price, Level Adjusted Mortgages (PLAMs) were considered politically unfeasible. However, with the recent advent of a host of new variable rate, graduated payment, and renegotiable rate mortgages, it appears as though the time has arrived for the introduction of PLAMs. This article presents an indepth description of PLAMs, their major advantages, as well as disadvantages to both borrowers and lenders. Comparisons between other mortgages, such as the standard fixed rate mortgage (SFPM), the Variable Rate Mortgage (VRM) which includes the Renegotiable Rate Mortgage (RRM), and the Graduated Payment Mortgage (GPM). The newly introduced Shared Appreciation Mortgage (SAM) is also presented as a type of PLAM The major feature of PLAMs is that they are affected by the actual course of inflation; whereas the expected course of inflation affects the SFPMs, VRMS, and the GPMs. (See figure 1.) All fixed-rate mortgages, such as SFPMs and GPMs, have a contract rate that contains an "inflation premium "In order to lend out one dollar today for repayment one year later, the lender must charge for the expected deflation of that dollar, as well as for the service of lending the money. These charges are incorporated into what is called the "nominal" interest rate. The nominal rate equals the "real" rate that rate charged if no inflation was expected-plus the "inflation premium." In the following examples, it is assumed that a 14 percent SFPM rate is the sum of the real rate (4 percent) plus the expected rate of inflation (10 percent).' Thus, the amount paid back at the end of one year for this SFPM is $1.14. The interest rate for the PLAM does not need to include the inflation premium because at year's end, the original dollar is paid back, plus the 4 percent interest, and the actual percentage rate of inflation, which may or may not have equalled the rate of inflation originally expected. If the rate of inflation turns out to be The 10 percent expected rate of inflation actually may be a weighted average of diffe en rates of ination expe ird in differen future years but it is assured here that a constant rate of inflation expected 10 percent, then the same amount is paid back-$.04 for interest, plus $.10 for the inflation, or price level adjustment-plus the original dollar. However, if the actual inflation is greater or less than expected, the PLAM payment will also be greater or less than the SFPM payment. If the principal does not have to be paid back at the end of the first year, the advantage of the PLAM over the SFPM is clear: the first year interest charges to the borrower are $.04 for the PLAM and $.14 for the SFPM. The following year, the outstanding balance for the PLAM is increased, upon which the four percent interest charge is levied, so the interest payments would increase with the PLAM. SFPM and the PLAM For a $50,000, 30-year mortgage, the monthly payments for the SFPM are $592 for 30 years, while the PLAM payments start out at $239 and increase with the assumed rate of inflation of 10 percent per year. (See table 2 and figure 2.) However, if inflation was to cease in the ninth year, then the PLAM's payments Figure 1.-Schematic of the Effects of Expected and Actual Inflation on Alternative Mortgage Instruments able 2.-Payments and Outstanding Balances for a PLAM and an SFPM riginal Loan is $50,000, Term to Maturity is 30 years, and Actual Inflation Rate is 10 Percent per Year) would no longer increase, thus remaining at the approximate level of SFPM payments. In figure 2, the PLAM monthly payments come up to the SFPM payments in about the ninth year. The SFPM payment stream is known with certainty, except for prepayment, while the PLAM payment stream is uncertain, based on the actual course of inflation over the life of the mortgage. On the other hand, the payment stream in real dollars is uncertain with the SFPM, but certain with the PLAM. The difference between the initial payments, $592 versus $239, or $353, is called the "financing gap" caused by inflation. (See figure 2.) The purpose of the PLAM is to provide a constant payment stream in inflationadjusted, or real dollars. As shown in table 2 and the top panel of figure 2, the real PLAM payments remain constant at $239 per month, while the SFPM payments decline over time in real terms. Thus, according to rule-of-thumb underwriting standards relating initial income to initial payments, the SFPM borrower must have a much higher income to obtain the same loan as would a PLAM borrower, in this instance, almost 21⁄2 times as much income. Also, the borrower can qualify for a more expensive house with a PLAM than with an SFPM. The implications for first-time homebuyers are especially important. Since they do not have the inflation hedge of a previously owned home to make a higher downpayment, the PLAM is the best (unsub sidized and fully amortizing) mortgage instrument to overcome this qualification hurdle. Should a potential homebuyer be concerned with the rising outstanding balance and monthly payments that accompany a PLAM in an inflationary environment? No, because the payments and principal increase only as fast as the rate of inflation. In real terms, the PLAM amortization schedule looks exactly like that of the SFPM in nominal terms. (See figure 2.) However, if the house hold income or the house price do not keep pace with actual inflation, then some danger of economic strain is likely. If it appears that either household income or the house price will not keep pace with inflation, then perhaps the PLAM should not be used, or possibly a fixed fraction of the percentage change in the price level should be used to adjust the outstanding balance. For example, the outstanding balance may be adjusted by 50 percent of the percentage change in the selected price index. This scaled-down PLAM would carry a higher interest rate than the 100 percent PLAM. This higher rate would be determined in the marketplace. Regulations on the PLAM should permit freedom of choice by borrowers and lenders concerning the fraction of the price increase that is to be applied to the outstanding PLAM balance. Advantages and Disadvantages The major advantage of the PLAM for borrowers is that it eliminates the financing gap of the SFPM caused by expectations concerning inflation. In an inflationary environment, the critical initial payments are considerably lower than those of the SFPM. The PLAM also minimizes the uncertainty over inflation. If inflation is expected to be 10 percent and the borrower takes out a 14 percent SFPM, and the inflation rate falls to 5 percent, then the SFPM rate would fall to 9 percent. The borrower can refinance, but usually at great cost, including ordinary closing costs and possibly a prepayment penalty. Accordingly, because the SFPM is costly to refinance, the borrower would pay a price for the uncertainty over inflation. The PLAM removes this factor. Its contract interest rate is the real rate, 4 percent in the aforementioned example, regardless of the inflationary expectations. Borrowers would not have to refinance, even if the actual or the expected rate of inflation had changed. Lenders also lose with the SFPM if the inflation rate drops far enough because the fees and penalties would not compensate for the income lost from refinancing a 14 percent SFPM with a 9 percent SFPM. Also, over the course of an interest rate cycle, borrowers can "ratchet down" to generally lower rates, which biases the SFPM portfolio yield downward. The PLAM protects lenders from the uncertainty over inflation that is inherent with the SFPM. As mentioned earlier, there may be financial difficulties for borrowers and lenders with PLAMs if individual incomes or home prices do not keep pace with inflation. This is the major disadvantage of the PLAM. However, PLAMs that share only in a fraction of the inflation rate mitigate this disadvantage. Another PLAM advantage for lenders is that it serves as a hedge against inflation as it allows lenders to maintain their profit margins, in a way quite similar to VRMs. Only Over time, or secularly, are VRMs able to provide the type of balance sheet hedging so desired by home mortgage lenders. PLAMS provide as good a balance sheet and income statement hedge as do the current VRMS and RRMs because expectations for inflation are based primarily on recent actual rates of inflation. The commonly used, and perhaps naive forecast of next year's inflation rate is the inflation rate observed over the past year. Under this type of scenario, the PLAMs provide complete income hedging over the course of the year, as follows: as interest rates increase due to an increase in the expected rate of inflation, a capital gain accrues to PLAM lenders because the increase in the interest rate was assumed to be accompanied by an increase in the actual rate of inflation over the past year, thus giving rise to the expectations of a higher level of inflation and hence the higher interest rates. Lenders may view the capital gain from adjusting outstanding balances of PLAMs as ordinary income, and |