IMPACT OF FINANCIAL REORGANIZATION ON HOUSING What does financial reorganization mean for housing? Unfortunately, no one can forecast the impact of financial reorganization on housing and mortgage markets with certainty. There are at least three. aspects of housing markets one might be concerned about: the long run size of the housing stock, cycles in homebuilding, and the distribution of the housing stock. Size of the Housing Stock Concern about the long run size of the housing stock usually translates into a concern about the impact financial reorganization will have on mortgage rates. The concern is not so much with what will happen to mortgage rates next year or the year after that, but rather with what will happen to the average of mortgage rates over a longer period of time. Will mortgage rates, and hence the cost of housing, be higher or lower? We simply do not know. There are several econometric simulations that attempt to ascertain the impact of financial reorganization on the mortgage rate and the stock of houses. These models are discussed below. By and large these simulation results suggest that financial reorganization will have little or no adverse impact on the size of the housing stock or the mortgage rate. There are, however, still questions, not only about the specific simulations and models, but also about the basic methodology that suggest one should not accept these findings uncritically. In particular, I would conclude that the simulations do not offer convincing evidence of a benign impact and that one should, instead, conclude that the impact of financial reorganization on the housing stock and on mortgage rates is still unknown. Housing Cycles With regard to the question of housing cycles, neither of the two simulations reviewed below looks at the question of cycles in homebuilding and what impact financial reorganization would have on them. One point should be made clear from the beginning. Given dramatic increases in interest rates, cycles in homebuilding are to a large extent inherent in the nature of houses. Houses are the epitome of long-lived, durable goods. The purchase of such goods is easily postponed temporarily when interest rates rise. If inflation continues to fluctuate and if monetary policy continues to bear a major burden for stabilization policy, then one would have to expect that we would continue to see periods of dramatic increases in interest rates and associated declines in homebuilding with or without financial reorganization. There is the further question of whether, with financial reorganization, these declines will be as severe as they have been in the past. There is a large body of work that suggests that at times of tight credit markets swings in the availability of mortgage credit have exacerbated the swings in homebuilding. A major element in this view is related to households reallocating their savings away from thrift institutions and toward the direct purchases of market securities at times when short-term interest rates rise. Thrift institutions in turn have fewer funds to lend as mortgages. At the same time, yields on mortgages do not look as attractive as the yields on alternative assets, as the increase in mortgage rates usually lags the increase in other interest rates. Institutions with portfolio flexibility slow down their accumulation of mortgages preferring instead to acquire other, higher yielding securities. How will financial reorganization affect this process? Under most plans for financial reorganization there are two potentially offsetting effects. Which effect will be stronger is unclear a priori. A major feature of most plans for financial reorganization is the elimination of ceilings on rates paid on savings deposits and an expansion of investment powers for thrift institutions. Thus, in periods when interest rates rise, thrifts will be able to raise their deposit rates and continue to compete for savings. Expanded investment powers work to shorten the effective maturity of assets held by thrifts. Thus their earnings will respond more quickly to an increase in interest rates, enabling them to pay higher deposit rates. To the extent that thrifts can maintain deposit inflows in periods of high interest rates, they may be able to soften the decline in mortgage lending. On the other hand, to the extent that they have portfolio flexibility, it may be at precisely these same times that other assets, offering more attractive yields than mortgages, induce thrifts, as well as other institutions, to make fewer mortgage loans. It should be clear that this shift out of mortgages is to some extent self limiting. The allocation of funds away from mortgages would be expected to result in higher mortgage rates and lower vields on the favored assets. Thus at some point the portfolio shifts do not continue to look so profitable. However, at what point the shift out of mortgages would stop is not at all clear. The magnitude, and, thus the net impact of these two effects, the competition for deposits and the subsequent portfolio allocation decisions, is difficult to measure. As a result there is a great uncertainty about the impact of financial reorganization or cyclical patterns of mortgage lending. Distribution of the Housing Stock The final area of concern has to do with the distribution of the housing stock, in particular the cost and availability of housing for low and moderate income families. I do not see that financial reorganization has any special implications for the distribution of the housing stock other than its impact on mortgage rates. To the extent that financial reorganization raises or lowers mortgage rates, there will be effects on the cost of housing for everyone, including low and moderate income families. To the extent that housing expenditures form an especially large fraction of expenditures for low and moderate income families, these families will be affected more than most families by a rise or fall in the mortgage rate. As regards the prospects of homeownership, to the extent that moderate income families are the marginal mortgage borrowers who get loans when interest rates are low and who do not get loans when rates rise, either because they choose not to buy at times of high rates or are simply rationed out of the market on non-price terms, then financial reorganization will have large impacts on them as it raises or lowers the average mortgage rate and through its impacts on cycles in mortgage lending. To briefly summarize, there are several aspects of housing markets that may well be affected by financial reorganization, but the specific impacts of financial reorganization are unclear. One can make plausi ble a case for different impacts. The appropriate response in this situation is not to oppose financial reorganization-the other gains from reorganization are too great-but rather to consider the design and implementation of alternative public policy measures that will work to complement the aims of financial reorganization and at the same time guard against untoward impacts on housing markets or specific income groups. The paper also includes a discussion of some possible policy responses: (1) do nothing more, (2) mandatory credit allocation, (3) mortgage income tax credit, (4) interest rate insurance, (5) an expanded role for the Federal Home Loan Mortgage Company, (6) variable rate mortgages. THE CASE FOR FINANCIAL REORGANIZATION The Congress has a long standing concern about the housing conditions of American citizens. This concern is hardly surprising and led in 1949 to a declaration of national housing policy: The Congress hereby declares that the general welfare and security of the Nation and the health and living standards of its people require housing production and related community development sufficient to remedy the serious housing shortage, the elimination of substandard and other inadequate housing through the clearance of slums and blighted areas, and the realization as soon as feasible of the goal of a decent home and a suitable living environment for every American family, thus contributing to the development and redevelopment of communities and to the advancement of the growth, wealth, and security of the Nation. Congressional concern with housing predates the 1949 declaration and is reflected in forms of direct aid-public housing programs established in the thirties and other forms of subsidized housing in the sixties as well as policies designed to influence the provisions of mortgage credit-FHA mortgage insurance, VA mortgage guarantees, the Federal Home Loan Bank System, and a host of other specialized mortgage market institutions. The close connection between housing decisions and mortgage financing is also not surprising. Buying a home is the largest financial decision most families make. For most families their ability to buy a home is strongly affected by their ability to secure mortgage financing. The importance of financing to individual homebuyers, as well as to the development of rental property, is the reason why concerns about housing enter into any discussion of changes in the structure of financial institutions. The development of financial institutions and their regulation, in particular the development of savings and loan associations and the Federal Home Loan Bank System, have reflected a concern on the part of the Congress to insure that an adequate supply of mortgage credit be available. In the last ten years there have been three dramatic declines in the amount of new homebuilding, 1966, 1969-1970, and 1974-1975. All of these declines have been associated with a decline in savings flows to thrift institutions and a consequent reduction in mortgage lending by these institutions. It is not surprising then that proposals to change the structure of thrift institutions, specifically to weaken their reliance on mortgage lending by broadening their investment opportunities, should give rise to a concern about the implications of such a change for housing markets. The general case for restructuring of financial institutions receives overwhelming support among academic economists. The professional training of academic economists teaches them that competition is good. In a search for higher profits, firms are led to adopt lower cost technology and the forces of competition pass these lower costs on to consumers in terms of lower prices. A major thrust of the proposals for restructuring financial markets, the Hunt Commission and the Financial Institutions Act, is to introduce more competition into financial markets primarily by eliminating interest rate ceilings on savings accounts, allowing thrift institutions to offer checking accounts of one form or another, and allowing thrift institutions wider investment powers. These proposals would find support among academic economists on general grounds of competition leading to increased efficiency. Beyond the general case for more competition, events of the last ten years strongly suggest that the traditional forms of organization may run serious risks in what appears to be a new environment for financial markets. These changes in the environment reflect the complex interaction of high and variable rates of inflation, a more vigorous role for monetary policy and the development of new technologies for handling money. There is good reason to believe that this new environment calls for a reorganization of financial institutions, especially thrift institutions. High and variable rates of inflation and the more vigorous use of monetary policy in the last ten years have had dramatic impacts on interest rates. These factors have had an especially dramatic impact on the normal relation between short term and long term interest rates. The technical term for the relationship between short- and long-term interest rates is the term structure of interest rates. The discussion below is organized as follows: first the impact of the term structure, particularly changes in the term structure, on thrift institutions is examined. Then the relationship between the term structure of interest rates, on the one hand, and inflation and monetary policy, on the other, is discussed. THRIFT INSTITUTIONS AND THE TERM STRUCTURE OF INTEREST RATES As mentioned above the development and regulation of thrift institutions has reflected a concern to provide adequate sources of mortgage financing. By tradition savings and loan associations have been specialists in mortgage lending. These tendencies to specialize in mortgage lending have been strengthened by regulation and tax advantages, so that currently the assets of savings and loan associations are almost exclusively mortgages. At the end of 1974, savings and loan associations held almost $250 billion of mortgages, over 84 percent of their total assets.1 Holdings of savings and loan associations were over 44 percent of total residential mortgages outstanding at the end of 1974. From 1970 to 1974 savings and loan associations placed almost 83 percent of the increase in their assets in mortgages and accounted for over 51 percent of the net increase in residential mortgages. Considering mutual savings banks as well as savings and loan associations shows 1 These numbers understate to some degree the attachment of savings and loan associations to the mortgage market. Savings and loan associations hold mortgages indirectly by holding GNMA-guaranteed, mortgage backed securities and FHLMC participation certificates. These holdings are not reflected in the figures above. that at the end of 1974 the two thrift institutions held 56.6 percent of the residential mortgage debt outstanding. The two thrifts provided 58.3 percent of the net increase in residential mortgage debt from 1970 to 1974. For a long time the provision of long term mortgage credit by thrift institutions worked smoothly but recent developments, especially since 1965, have exposed some fundamental weaknesses. Thrift institutions have basically borrowed short-savings deposits that are for all practical purposes withdrawable on demand-and lent long-home mortgages with initial contract maturities of 25 to 30 years and effective maturities of perhaps 10 to 15 years. This sort of business was profitable and not very risky as long as (1) short term rates in general were lower than long term rates and (2) rates on short term assets that competed for household funds were not significantly above rates paid by thrift institutions. Since late 1965 the relationship between short and long term interest rates has changed dramatically. Table 1 illustrates the behavior of the spread between long term and short term rates since 1950. From 1950 to 1964 long term rates were consistently above short term rates. In 1966 and 1969 the traditional positions of short and long term interest rates was reversed as short term rates exceeded long term rates. TABLE 1.-SELECTED ASPECTS OF DIFFERENTIAL BETWEEN YIELDS ON LONG- AND SHORT-TERM SECURITIES Yield on corporate bonds (Moody's Aaa) minus yield on 4-6 month, prime commercial paper. b Yield on taxable government bonds minus yield on 3-month treasury bills. • Standard deviation=(1/52(S1-S)2)1/2 where S; yield spread for particular year S=5 year average of S1. Source: 1975 Economic Report of the President, Table C-58. The period 1970-1974 may appear to have reestablished traditional yield differentials. However looking at the differentials on a year by year basis one sees tremendous variation in the yield spreads. In 1970 yield spreads were low by historical standards. 1971 and 1972 yield spreads were among the highest of the period. Finally in 1973 and 1974 yield spreads registered their largest negative differentials of the period. This tremendous roller coaster variation in yield spreads is seen in the standard deviations of the yield spreads that are also presented in Table 1. For the period 1970-1974 the variation. in yield spreads, as measured by the standard deviations, is two to three times as large as any of the earlier periods. The yield spread is of tremendous importance to thrift institutions because they are borrowing short and lending long. When short term market interest rates rise above rates paid on deposits, households find that market securities offer more attractive yields than savings ac |