indeed they may have to view it as ordinary income for tax purposes. Thus, their incomes increase by exactly the same amount as the increase in the interest rate. However, paying taxes on income not yet received may create a problem, one that should be dealt with before PLAMS are issued.

Of course, there are notification lags and each PLAM in the portfolio is adjusted only once a year (to make them practical from the borrower's view point); and on the liability side, the mix of long and short-term debt makes any one for one matching very unlikely in the short term. However, over time, a general profit margin hedge is provided with PLAMs, and over a longer time period, the differences between actual and expected inflation will be smaller, as compared to differences that arise in the short run. Thus, a long term hedge is more

certain.

There is a problem of cash flow during the startup period for PLAMS, when the interest accrued on the PLAM would only be 4 per. cent. This is only a transitional prob lem, but is one that may cause problems for weaker S&Ls.

Actual Versus Expected Inflation

The following comparisons involv ing the PLAM, the SFPM, the GPM, VRM, and the SAM focus only on the first two years of payments. These comparisons bring out some critical differences in the alternative mortgage instruments (AMIs).

It is assumed initially that the expected rate of inflation in the first year is 10 percent and the real rate of interest is 4 percent, which yields an initial SFPM rate of 14 percent and a PLAM rate of 4 percent, and a VRM rate of 13.5 percent.

Assume that the actual inflation rate for the first year is, alternatively, 5, 10, and 15 percent-less than, equal to, and greater than the expected rate of 10 percent To keep the examples manageable, the inflation rate for the second year is assumed to equal the rate observed for the first year.

Table 3 shows the contract interest rates in years 1 and 2 for SFPMs, VRMS, and PLAMs, all of which were lent at the beginning of the first year with no refinancings assumed. As expected, the SFPM and, accordingly, the GPM rates remain the

same, at 14 percent. The PLAM rate remains constant at 4 percent The initial VRM rate is 13.5 percent, but the second year rate depends on the inflation experienced in the first year, and on whether the contract rate is constrained. A constrained VRM allows only a 0.5 percent movement per year. Special notice should be given to the wide swings in the unconstrained VRM interest rate, which follow the assumed wide swings in inflationary expectations.

Table 4 provides terms for the SFPM. Of particular interest are the payment to income (PI) and the loan-to-value (L/V) ratios. It is assumed in all examples that income and home prices increase at the actual rate of inflation. With any increase in inflation, both the P/I and L/V ratios decline from their initial levels. assumed to be 25 and 80 percent, respectively. The faster the rate of inflation, the faster these ratios decline. While this may be of comfort to homeowners, the problems are actually twofold. First, when inflation fell from 10 to 5 percent, the borrower suffered a capital loss. because the current SFPM rate had fallen from 14 to 9 percent The

borrower in this case is likely to refinance, at considerable cost, which also results in a loss to the lender. On the other hand, when the inflation rate is greater than expected, the lender suffers an unrealized capital loss. Secondly, in all cases, the initial payments are higher than they would be if no inflation was expected, or equivalently, if the borrower had obtained a PLAM. (See table 5.)

Of course, the levels of the payments and outstanding balance in the second year depend on the actual rate of inflation, with the monthly

payments being dependent on the first year's actual inflation, and the outstanding balance at the end of the second year depends on the actual inflation over both years.

Table 6 presents the constrained VRM terms. The second year monthly payments depend on the then-current inflationary expectations. The movements in the rate are constrained to a minimal 0.5 percent.

Table 7 shows how the VRM would operate in the unconstrained form. The second-year monthly payments could vary considerably depending

on the change in the interest rate (as shown in table 3). Of particular importance here is that without maturity adjustments, the VRM payment-to-income ratio can increase above the initial, and presumably "safe" level. The PLAM avoids this problem because (1) the outstanding balance changes according to the actual inflation rate, a rate more likely to be in proportion to the change in income than that of the interest rate change, and (2) the monthly payment and price level change proportionately, whereas

RM payment changes are greater an the inflation rate. Table 8 presents GPM terms for -year graduation period of paynts increasing at an annual rate of percent and leveling off thereer. Of particular importance here hat the financing gap, which was minated by the PLAM, is illdressed by this instrument, the epest of the GPMs, even though GPM was designed to lower initial athly payments. Compared to SFPM payment of $592, the GPM rs a figure of $461, while the AM payment is only $239 initially. reason that the GPM is relatively fective is that its interest rate :include the inflation premium, ́eas the PLAM's does not.

Shared Appreciation Mortgage

hared appreciation mortgage is .which the lenders share in the l gain when the home is sold, a specified point in time in the -. Consequently, the lender can An interest rate lower than the

, but not as low as the PLAM. AM is similar to a PLAM in ere is some type of inflation built-in.

In a world of free choice, both SAMs and PLAMs should be available to borrowers and lenders alike. However, there are notable differences between the two. First, the Bank Board's proposed SAM has only one adjustment which may produce rather large changes in monthly payments. Second, the outstanding indebtedness of the SAM when due is computed as the remaining outstanding balance on the SAM plus a specified share of the capital appreciation of the home. This calculation could differ substantially from a PLAM. The return realized by a SAM lender depends heavily on the loan-to-value ratio and the sharing percentage in the SAM contract. On the other hand, the return to the PLAM lender is calculated more easily. Third, the SAM requires an appraisal of the home whereas the PLAM does not. Fourth, it is very important as to what region of the country and in what section of a city that a SAM is originated because the expected return to the lender differs according to the actual rate of the home's appreciation. The PLAM, conversely, is adjusted according to a national index. While the risk of default varies according to the property's location,

this factor is far less important to PLAMS than to SAMS. This distinction between the SAM and the PLAM implies that it would be much easier for lenders to set the initial contact interest rate for the PLAM than for the SAM.

The Risk to Consumers

The final issue of concern is the affordability of PLAMS. During periods of inflation, real incomes may fall, on average, thus the nominal payment burden could increase relative to nominal income. However, several factors mitigate against this becoming a serious factor. First, the change in PLAM payments this year depends upon the actual inflation of last year. Therefore, the chances are greater that a household's income will catch up shortly after the time when higher payments were first assessed. Second, as mentioned above, contractual agreements can be made for payment increases at a fraction of the inflation rate. Third, maturity adjustments could be applied when there appears to be a problem of financial strain. Finally, the concern over whether individual households will encounter

undue financial stress, as opposed to the average household, has been addressed in a study sponsored by the Federal Home Loan Bank Board. GPM burdens were simulated based on the growth of nominal incomes of each household in a sample of 3,000 households for a nine-year period through 1976. The study found that as compared to the SFPM, there was some increase in financial strain, but the more serious cases constituted an insignificant portion of the households studied. These indicate that, with care in structuring the PLAM to fit individual household needs and conditions, the payment burden for individual households should be tolerable in most cases. One could argue that actual GPM payment increases approximated the rate of inflation for the latter years of the simulation, so the payment increases were comparable to those of a PLAM.

Therefore, while there is a need for concern over the financial strain associated with a PLAM, the problem should not be serious and there are a number of ways in which to mitigate perceived and actual prob

lems.

Summa.y

Figure 3 shows the monthly payments for the first two years for the PLAM versus the SFPM, VRM (both constrained and unconstrained), and the GPM. Notice that the level of the initial PLAM payments are very low relative to the others, and that the second-year payments of the PLAM are still very modest, even with a 15 percent inflation rate during the first year. The unconstrained VRM payments reach nearly $800 in the second year with 15 percent inflation,

and even when inflation falls to 5 percent, the VRM payments are still well above the PLAM payments.

The borrower is, of course, giving up part of one of the commonly cited inflation hedges, homeownership. That is why a PLAM is not for everyone. It should appeal most to those frozen out of current homeownership opportunities by the rigidity of the current menu of home mortgage instruments in the face of high interest rates caused by high inflation rates. Perhaps now is the time to seriously consider the use of PLAMs.J

of Alternative Mortgage Instruments," Journal of the American Real Estate and Urban Economics Association, Winter, pp. 411-33, also published in Kaplan (1975), Vol. II. 6. Holland, Daniel M., 1975, "Tax and Regulatory Problens Posed by Alternative Nonstandard Mortgages," in Modigliani and Lessard (1975), pp. 271-88.

7. Kaplan, Donald M., Director, 1977, Alternative Mortgage Instruments Research Study, Federal Home Loan Bank Board.

8. Lessard, Donald and Modig hani, Franco, 1975, "Inflation and the Housing Market: Problems and Potential Solutions," in Modiglamı and Lessard (1975), pp. 13-45.

9. McKenzie, Joseph A., 1980a, "Shared-Appreciation Mortgages,' Federal Home Loan Bank Board Journal, November, pp. 11-15. 10. -1980, Simulation Analysis of Rollover Mortgage Portfolios," Research Working Paper No. 98, Office of Policy and Economic Research, Federal Home Loan Bank Board.

11. Modigliani, Franco and Lessard, Donald, 1975, New Mortgage Designs for Stable Housing in un Inflationary Environment, Federal Reserve Bank of Boston Conference Series No. 14.

12. Poole, William, 1972, "Housing Finance Under Inflationary Conditions," in Ways to Moderate Fluctuations in Housing Construction, Board of Governors of the Federal Reserve System, pp. 355-76. 13. Smith, James D., 1979, "Measuring Economic Strain under Alternative Mortgage Instruments," Invited Research Working Paper No. 27, Office of Economic Research, Federal Home Loan Bank Board, September.