to be passed on, they merely heighten the risk that the effects of any oil shocks will rapidly multiply and percolate all through the economy. Even in the absence of irretrievable losses, it is desirable to have less-thancomplete indexing-to have a system in which some prices can fall relative to the general price level. When everything is indexed, any inflationary jolt will inevitably spread through the entire economy. To the extent possible, we should limit our indexes to areas where their absence creates disruption; we should not be indexing in areas where it is easier to adapt to inflation. Unfortunately, we now tend to do the opposite. We have indexes precisely where alternatives are readily available; for example, we give cost-of-living adjustments to wage earners, even though wages tend to rise as rapidly as inflation without COLAS. And we generally lack indexes in areas where it is difficult to adapt, for example, we have not yet acted to adjust tax brackets so that they reflect the lower real value of nominal incomes under inflation. Astray in Britain We also have a lot to learn about how indexes should be constructed Taxes that reflect increased government services shouldn't be in an index designed to measure living costs Sales taxes earmarked for better local garbage collection shouldn't be in, for example. Nor should we include increases in taxes when the increase is offset by decreases elsewhere in the tax system. This might seem almost too obvious to mention, but Britain's recent experience with sales taxes shows that it's easy to go astray here. In Britain, as in the US., sales taxes are included in the main price indexes, and income taxes aren't. Recently, the British increased sales taxes in an effort to offset a reduction in income taxes. For most individuals, the net of the changes was fairly small-as it was supposed to be. Yet the changes drove up the consumer price index, and in the process set off inflationary wage and price adjustments One important question now facing US. inflation fighters is whether consumer price indexes should fully reflect the coming large increases in Social Security payroll taxes Ordinarily, all such increases are passed along in higher prices and flow right into the C.P. But the increases scheduled for next year (which will range up to $387 per worker) are in some measure associated with rising benefits for Social Security recipients; to the extent continued On a $100,000 mortgage, a five-point rise would increase monthly carrying charges by close to $400. that they are, the increases should be kept out of the C.P.I. So should the price increases that the oil industry will surely post next year, when its costs rise in the wake of the windfall-profits tax. Most of those price increases will be offset by transfer payments and subsidies for energy-related investment, paid out of the revenues from the new tax. It is now well understood that rapid rises in mortgage interest rates can distort the C.P.I.; however, there is perhaps less understanding of how to deal with the problems that inflation creates for home financing. The main problem is finding a way to finance mortgages when future home values and future interest rates are unknowable. Some of the familiar solutions to this problem turn out to create further problems. Variable-rate mortgages-which have been available for years in Canada and are now receiving a lot of attention in the US-afford some protection to the lender. By the same token, however, they create new risks for bor. rowers. On a $100,000 mortgage, a fivepoint rise would increase monthly carrying charges by close to $400. An eye on the principal Our own preferred solution is a quite different one. It is to index the principal, not the interest. When this is done, monthly payments would not generally be rising more rapidly than family incomes. If the inflation rate soars to 20%, say, there would be a 20% increase in the principal of the loan. There would also be a 20% increase in monthly payments: that is, the interest rate would be unchanged but would now be applied to the larger loan. In the typical case, the homeowner would find that the higher payments were offset by the increased value of the property-and by the homeowner's higher income. The charts on page 61 afford some sense of what's involved in the two kinds of indexing When the principal is indexed for the full amount of inflation, the lender shares the owner's capital gain-or, more precisely, he has a stream of larger payments coming in to reflect the increased principal of the loan. What the borrower has is some assurance that (a) mortgage money will be available even in periods of rising inflation and (b) a rise in rates will not leave him strapped The Oppenheimer plan Thus far, no major mortgage lenders have formally instituted arrangements to index the principal. However, the socalled equity-mortgage concept might be thought of as a step in the direction of such indexing. In this concept, the borrower gets a specified bargain rate on interest and agrees to give the lender a specified proportion of any capital gain. A plan now being offered to investors by Oppenheimer & Co. involves mortgages that will be sold at about one-third below market rates, but will provide lenders a chance to latch onto one-third of any capital gains on the houses. In the long run, indexed plans may be made applicable to plant and equipment, where the obstacles to financing arrangements in an inflationary era are essentially no different from those in housing. In general, an increase in formal indexing would help stimulate business investment, which has been discouraged by the front-loading of costs associated with high interest rates. Further indexing of the tax system, to avoid unlegislated increases in business taxes, could do much to spur savings, investment, and innovation. When inflation increases from zero to 10%, a corporation that had been earning 10% on its capital might need as much as 20% to give it an equivalent profit. Under present law, however, the corporation would then pay twice as much tax on earnings whose purchasing power had not increased. Such automatic tax increases have by now wiped out the benefits of the accelerated depreciation allowances and investment tax credits legislated in 1962. Indexing the right kind of indexingis essential to economic growth in periods when inflation is on everyone's mind. It is also essential to the campaign against inflation. he housing industry is in deep trouble The cause is said to be high interest tates That is musicading Whether mortKage rates are high or low depends on both taxes and future rates of inflation. More important, the basic problem is the continund us during inflation of mortgage instruments designed for stable prices The mtroduction of variable-rate and rollover motripes is step-but only a timnd step. the rat direction. Much More far-reaching change is required. High Mortgage Rates? Suppose you buy hous now and borrow at a 14 per cent rate on a 30-year Conventional mortgage Interest pandisdeductibl. in computing the Federal income tax. If you are in a 15 percent bracket, your net-interest cost would be 91 per cent, not 14 per cent If inflation over the next years 10percent, the remat ing principal of your mortgage will 10 per cent less in terms of purchasing power than in terms of dollars The greater part of the payments designated "interest" have really been a repayment of principal Your net-n'erest cos will have been negative. You will have been paid per cent per year to barrow Under those condiTrons 14 per cent is a low, not a high, rate of interest enacted (as it should be as part of a compre hensive inflation-proofing of the personal and corporate income tax) Consider now the second point This distortion can be avoided by offering a fully inflation-proof mortgage as an alternative to the conventional mortgage The basic idea is to calcu late the mortgage contract as if there were no inflation That calculation would determine the mitial monthly payment and its division between principal and interest Subsequent monthly payments would be Itmation averages 10 per cent during the term of the mortgage, the two contracts are financially equivalent over the period as a whole. The big difference, as the final entries in the table show, is in how fast the mortgage is amortized. After ten years, the remaining principal under the conventional contract is less than half as much as under under the inflation-proof contract. More than 60 per cent of the mortgage, corrected for inflation. has been paid off under the conventional contract: only a bit more than 20 per cent under the inflation-proof contract TWO SAMPLE 30-YEAR MORTGAGES Initial principal i Assumed intiation rale ! Monthly payment Initial The labeling principal L.. Texments as nierest payments bas twyfects (1) It confers a tax advan tage on the brower-the major reason why borrowers have not exerted pressure for correct labeling (2) It leads to higher red monthly payments than would oth cwb. Issary or put differently, to Last, all rates of the moripare, pric Phng out of the reach of many popive purchasers a major resou for the cure a housing slump If the 14 per cent were correctly labeled. 10percent would be treated as a repayment of remata o interest, and would be mother deductibl to the brewer nor tabit the lender The effective interest at would be 4 per cent That is the only part he would be deductibl. to the hor Fatal taxable to the lender Conventional contract $50.000 00 Inflation-proof contract $50.000.00 14 10% 4 10 4% 592 44 592 44 592 44 592 44 238 71 262 58 619 15 3.786.6H 49.883 43 45.348.57 47,640 75 18.367.57 54.031 40 102 171 74 adjusted for actual inflation by multiplying the mutual monthly payment by the ratio of a selected price index at the time the payment is made to the mitial price index The same escalation would be applied to the part of cach paymen, regarded as interest and the part regarded a principal The table compares a $50,000, 30-year inflation proofcontra.with...conventional contract of the same matial amount and niaturity The difference in the initia monthly payment is striking $230 versus $502 1inflation continued at a steads 10 per cent, the payments under the inflation proof contract would remam less than under the conventional contract for about ten years They would then become Luger even tually more than six times as large the power of infiition and compound interest If inflation averages more than 10 per cent during the term of the mortgage, the conventional contract benefits the borrower, hurts the lender. If inflation averages Jews than 10 per cent. the conven tional contract hurts the borrower. benefits the lender in ef fect. the conventional contract requires both lender and borrower te gamble on inflation. The inflation-proof contract eliminates the gamble True. dollar payments are uncertain under the inflationproof contract, but so are dollar incomes If inflation is high, the dollar payments will rise rapidly. but so will dollar incomes Inflation is low, dollar payments will rise slowly, but so will dollar inconies The Obstacles: In order for financial institutions to be able to offer mflation-proof mortgages they would have to be able to raise funds on a similar hasis That is desirable in any event, to provide an inflation-proof asset to the many smal savers who have been taken to the Jeaners by inflation, during these past several decades Such a contract would clearly make a major difference to the housing market Fiolistacles to its introduction are almost entnch governmental-in the form of tax Provisions and regulations imposed on finam al mistitutions. These obstacles can be removed by government. A crash program tod se would simultaneously bring housing within the reach of many more families. promote employment and foster savingsall while being wholly consistent with a long term policy of ending inflation 95-197 0-82--21 (From The Salt Lake Tribune, September 1981) State Pension Fund By John Serfustini Tribune Staff Writer Take $20 million in state retirement money, add a dash of "magic" and presto! you've got something that looks like 10.5 percent financing for 200 to 300 homes in Utah. That's what the Utah State Retirement Systems Board has in mind. Now before you start thinking this archconservative institution is playing around with sacred money, you ought to know about magic. "Magic" is the way you pronounce MGIC, which is the acronym for Mortgage Guarantee Insurance Corp. It's a private enterprise version of the Federal Housing Administration and it it does just what its name implies insures mortgages guaranteeing payment to the lenders. MGIC will insure the loans. Then MGIC's parent, MGIC Investment Corp., will issue insured pass-through certificate to the Retirement System. Those certificates will show that the system has an undivided ownership of the pool. Since the ownership is insured, Mr. Gillette said, "it's an investment and a safe one at that." That means the board isn't neglecting its fiduciary and trustee responsibilities. But what about return on investment? Isn't there a responsibility to keep retirement funds ahead of inflation, something that 10.5 percent interest won't do? Six-Month Average As it turns out, that low figure is just something to base monthly payments. on so people can qualify. The interest a borrower will actually pay is the six-month average of the Consumer Price Index plus 4.75 percent. Payments will be adjusted every six months, but as Retirement Systems investment officer Reed Gunderson put it, that averaging of the CPI should smooth out the index's monthly peaks and valleys and payments shouldn't bounce around too much. The plan keeps the retirement money a constant 4 percent ahead of the inflation rate. (The other 3/4 percent goes for servicing of the loans.) In between those six-month adjustments, any difference between the 10.5 percent nominal rate and the CPIpegged actual rate will be added to or subtracted from the unpaid balance of the mortgages. Key to New Home By adjusting the principal to suit the interest, it's possible to get a prospective homebuyer to qualify for a mortgage at the 10.5 percent figure. It may be a key to unlock the door to a new home for a person whose income isn't high enough to qualify for a 17 percent mortgage. That's because the income require ments to get a 10.5 percent loan are about one-third less than they are for a 17 percent one. For someone looking for a home in the $40,000 to $150,000 range, that difference is critical. Since MGIC is insuring the loans, though, it'll have the say on what the income and other criteria will be. Mr. Gillette said the pilot program is a "something for everyone" package. The Retirement System gets a secure investment at competitive rates, MGIC gets its insurance premiums on the mortgages, homeowners get their foot in the door by qualifying at low interest rates. How about the lenders? Well, they stand to get their cut in the servicing fees, and they'll also get a hefty loan origination fee somewhere around 3.5 to 4 percent compared to the standard 2 percent. Pretty Good Metaphor But come on, now. Something for everybody is the same principle that applies to throwing a goldfish into a tank of starving pirhanas, and that's a pretty good metaphor for throwing a mere $20 million to Utah's housine, (From Pensions & Investment Age, September 28, 1981) CPI-tied mortgages spawned By Clare Minick SALT LAKE CITY-The $1 billion Utah State Retirement System has embarked upon a unique instate mortgage program pegged to the Consumer Price Index (CPI). with the germ of the idea coming from the Mormon Church The initial $20 million commit. ment, which could build to $150 million if the program is a success. will funnel money into the local economy and also assist the fund according to Reed Gunderson, investment officer It is also one of the first known mortgage programs in this country tied to the CPI. although the Mormon Church had a similar program for its pension fund, but on a smaller scale according to Mr. Gunderson. However the CPI-return idea has a precedent overseas since British government has sold two debt issues which were pegged to the Retail Price Index, the UK equivalent of the CPI. pius a premium The pass-through mortgage certificates will have a base rate of 104% The Utah program is based on the following formula the base rate 10% plus 4% plus CPI adjustments over 4% Adjustments will be made every six months The net return would be less since Utah will pay % in servicing fees to the mortgage originators and MGIC. which is guaranteeing One ingenious aspect of the idea a constant interest rate This aspect of the pass-through certificates could benefit the Utah System since it would have increasing amounts to reinvest over ume at higher interest rates Asked how the lund arrived at the 475% figure the gross premium over the CPI. Mr Gunderson said the Utah staff analyzed 10 year numbers on Fannie Maes, and FHAs and their relation to the CP! They also looked at double-A electric utility bonds relative to the CPI Mortgages historically have averaged about 2% to 3% over the CPI. so "We decided to get 45 net over the CPI Historically it looked like we were on solid ground" The program stemmed from a need to diversify the portfolio. according to Mr Gunderson. The svstem looked at conventional morgages but found at 17% rates there were not a lot available" Mr Gunderson recounted a meeting in Salt Lake City of "concerned people" which included representatives of the Mormon At that time the system consid- Various people credited Alan Blodgett director of investments for the Mormon Church and urea surer of Deseret Mutual Benefit Association which handles benefit programs for the church with the idea The concept is apparently prevalent in South America Blodgett couldn't be reached 1: comment since he was traveling Asked whether his instate pr gram resulted from pressures to vest instate M: Gunderson said. was not tied to social investing pressures But he added tha mavbe in the future we will be pressured So we did this now Otherwise we might be forced to d something less prudent" Though many public funds have begun instate mortgage programs some at market rates others nr: few are willing to ascr.be the pr grams to pressures from special interest groups But another public fund representative explained that instate mortgage programs may be the easiest way to sausty certain pressure groups and sull obtain market or close to market rates of return for the fund An anomols in the bond market now a large differential between infiation as measured by the CPI and bond rates suggests that over the short haul Utah will not be ok taining market rates of return For example according to the quotes in The Wall Street Journal for September 18 Ginnie Mae 10% yielded 15.87% and the 11% vielded 16 03 Since these are higher quality thar. the privately-insured. singlerated Utah certificates they would yield slightly less The CPI figure was 10 73% for the 12 months ending Julv But Mr Gunderson believes tha: over the long term Utah "will get higher than market returns We feel they'll be better than Ginnie Maes over time He based his opinion on the historical studies of mortgage rates and the CPI Mark Korell executive vp of MGIC Markeung Corp described the new pass-throughs as a "potentially exciting breakthrough They may attract institutional capital t the mortgage market" He credited the peopie of Utah" including the Mormon Church with the idea Echoing Mr Gunderson's views he said he was no aware of a great deal of pressure" to begin the instate program "It will provide a fair and competitive yieid as well as provide affordable mortgages. The genius of the plan is that it accomplishes both objectives" he said The mortgages will be available in amounts ranging from $40 000 10 $150.000 with as little at 10% down The maximum term is 25 years |