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F o r m N o . 131 Office Correspondence Governor Bodes From J » M, DaigeiW / FEDERAL RESERVE Date JtfEy 9, Subject: Attached memorandum on real-estate __ loan amendments to the Banking let The attached memorandum follows the lines of our discussion of Friday evening: 1* It raises the question whether the safeguards provided for mortgage loans under the House and Senate measures are adaquate to the increased privileges which these measures would confer on the member banks with regard to mortgage loans* 2. It then discusses the reasons why these enlarged privileges are desirable and justifiable* 5* It then discusses the differences between the House and Senate measures and shows that they have nothing in common as far as new safeguards for mortgage lending are concerned* 4. It then proposes a solution of the legislative and tenHug problems which this situation presents* S* One aspect of this solution having to do with amortization, this subject is then discussed with regard to the amortisation requirements of various governmental and private agencies* 6* The other aspect of this solution having to do with regulation by the Federal Reserve Board, this subject is then discussed in the light of the shortcomings of the existing and proposed statutory provisions* Fo'inNo. 131 Office Correspondence To Governor Eeelaa From J» M» Bftlgqflfluffl FEDERAL RESERVE Date July B, 1SS5 SnKjWf- Lack of adequateflftfAgti»T»dflla pending amendments relating to r^ttl ftftt^tft 1 naryi ___ (Copies yo 16% lyatt, Dr. £taldeu*eiser, Kr« Thursten) The real estate loan provisions of the proposed g of 1935, both as enacted by the House of Representatives and as reported by the Senate Committee on Banking and Currency, may reasonably be said to look toward enlarging and encouraging mortgage investments on the part of member banks of the Federal Reserve System. For reasons that will be presently related, this would seem to be a logical, proper, and timely development in the successive changes that have been made over a number of years in our banking laws governing real estate loans • An examination of the specific amendments now pending, however, and a consideration of these amendments in the light of the knowledge gained by all types of mortgage-lending institutions from their experience during the depression years, suggests that this question may fairly and prudently be raised: Do the pending amendments look toward an improvement in mortgage practice—toward standards or safeguards commensurate with the larger volume of mortgage lending by banks that the amendments are calculated to bring about? The enlargement of the mortgage-lending privilege contemplated in both sets of the pending amendments is of a twofold character: (1) the total volume of real estate loans that a national bank may make would be increased, and (2) the total amount that it may loan on a given mortgage in relation to the appraised value of the property would be increased* In the first respect, the provisions of the measure enacted by the House and that reported to the Senate are alike* In the second respect, there is a difference between the House and the Senate provisions, but either would constitute an enlargement over the provisions of the existing law* Besides making a larger proportion of bank funds available for mortgage lending, both in the aggregate and In respect of the individual transaction, the House and the Senate measures each contain provisions that would make real estate mortgages eligible as collateral for advances by the Federal Reserve banks. Here, too, there is some difference between the House and the Senate provisions, but the effect of either would be to give to real estate mortgages, in common with other types of long-term assets held by member banks, an important status that they do not now possess* Such assets were formerly eligible for borrowing at the Reserve banks, though only under a temporary statute (March 1952Ifarch 1955) and only "in exceptional and exigent circumstances•• The - 2 - temporary aspect of the old statute and the restriction of the borrowing privilege to an emergency are dene away with in both forAS of the pending amendment* Considered together, then, the three sets of provisions enumerated above constitute the basis of a wider participation by basics in mortgage lending, with the assurance that sound assets thus acquired will not be denied access to the Reserve banks should ©ceasion arise for borrowing against then* There Is a variety of reasons why this broadening and strengthening of the base of mortgage lending by basks may be regarded as desirable and justifiable. In the first place, the member banks of the Federal Reserve System hold, In addition to their commercial deposits, some ten billion dollars of the savings accounts of the people In their communities* Where mutual savings banks are relatively numerous, as in the New York and New England areas, a large pert of the people1 s savings Is held by these institutions; but the extent to which the member banks are used elsewhere as the principal savings depositories In their communities Is indicated by the fact that in the country as a whole, exclusive of New York City, nearly half of all member-bank deposits are savings deposits* These are funds that should properly be invested largely for long-term purposes In the same manner as the funds of mutual savings banks, trust companies, building and loan associations, and insurance companies; and among such long-term purposes sound investments in real estate mortgages have always held a place of great Importance to the social and economic life of the country* In the second place, the present low level of real estate values and the progress of recovery in trade and employment combine both to create a demand for mortgage funds and to make mortgage Investments more than ordinarily attractive to Institutional lenders* It the same time there has been evidenced, for six consecutive months now, a sustained Increase of more than 100 per cent over the corresponding period of last year in the volume of residential construction In the country at large, and a consequent increase in the demand from this source for mortgage funds* Statutory measures that would lessen the existing restrictions on banks In the making of mortgage loans should therefore have an Important influence in easing the mortgage market and in furthering recovery and employment in the long-dormant construction Industry* , For another thing, the banks hare at the present tine a huge volume of Idle funds that can In part at least be made sore largely available for mortgage lending* Furthermore, the banks are numerically the largest group of lending agencies that hare such a huge surplus of funds and they are located in communities tbrotyhout the country % A greater use of these funds in the field of mortgage investment would further relax the pressure for Federal appropriations for mortgage lending, would directly benefit the communities serred by the banks, and would enable the banks to acquire sound eerning-aseets to meet the interest requirements on their savings deposits* The need of finding a remunerative and secure outlet for savings deposits la for many banks a serious, problem, the practical solution of which, to begin with, would seem to H e In the growing demand now being manifested for construction loans and mortgage loans • This recital of factors that point the practical purposes to be served ty a larger volume of mortgage lending by banks might be carried feirther, but enough has been related to show that the pending amendments are on solid ground Insofar as they would (a) authorise national banks to Increase their total real-estate loans relatively to either their time and savings deposits or their capital and surplus, and (b) authorise the Reserve banks to make advances to member banks against such loans, thus precluding a repetition of the experience In which banks generally found their mortgage portfolios frozen during a period of abnormal withdrawals* It is where the amendments have to do with mortgage leans individually rather than in the aggregate that opportunity is to be found for strengthening the amendments in the Interest of seuod lending• That the restrictions in the existing law were insufficient to prevent many unsound practices and abuses and large losses is now too well known to require comment* That there is real need of improvement In mortgage-lending policy and practice Is not only generally recognized, but widely urged on the part of bankers themselves• let neither the measure enacted ty the House nor the alternative proposals reported to the Senate fully aeet the need and the opportunity for Congress to establish, in the Banking Act of 1955, better standards of mortgage lending and adequate safeguards for the mortgage investments to be acquired henceforth by member banks • As a practical matter, it is exceedingly difficult to prescribe by statute regulations that would be practicable and sufficient at all times, In all places, and twier all conditions of real-estate and mortgage markets, to govern banks In the making of loans on (a) improved farm land, (b) improved business property, and (c) improved - 4 residential property* Recognizing this fact, the House measure limits such loans to 60 per cent of the appraised value of the real estate and then authorises the Federal Reserve Board to prescribe trm time to time regulations governing loans within that limit and requiring basks to conform to sound practices in making real-estate loans. The limitation of loans to 60 per cent of appraised value of the real estate and the authority ef the Board to prescribe other regulations aid to require sound practices are made applicable, however, only'to national banks* The corresponding provision as reported to the Senate retains the time limit of five years and the loan limit of 50 per cent of appraised value of the real estate provided in the existing law, but creates mi exception authorising loans up to ten years in amounts not exceeding 60 per cent of appraised value of the real estate if installment pay* ments are required that would reduce the loan to at least one-half its face amount In ten years* These several restrictions are likewise made applicable only to national banks, and no authority is given to the Federal Reserve Board to prescribe additional regulations or to require sound practices. The Senate proposals also retain the provision of the existing law with regard to the geographical limits within which a national bank may make real-estate leans, together with the existing requirement that such loans shall be made or acquired only in their entirety* The House measure leaves both these matters to regulation by the Federal Reserve Board* Both sets of amendments 'exempt renewals or extensions of loans heretofore made, and loans insured under the provisions of Title II of the National Housing Act, from the limitation to 60 per cent of appraised value of the real estate; and the latter class of loans is similarly exempt from the time limits of five and ten years, respectively, provided in the Senate proposals* Loans insured under the provisions of Title II of the National Housing Act are not exempt, however, from the geographical limitations retained in the Senate proposals* The House measure would leave this matter subject to the regulatory authority given to the Federal Reserve Board* As far as establishing new safeguards for mortgage lending is concerned, therefore, it will be aeon that the two sets of amendments have nothing in common. The House measure looks toward such safeguards and vests the responsibility for prescribing them In the Federal Reserve Board; the bill reported to the Senate would leave the existing law unchanged with the single exception of the new provision relating to loans amortized by one-half or more within ten years—a requirement that experience would indicate to be beyond the ability of most mortgage borrowers to meet, and hence of very limited practical application* _ 5 ~ A wholly workable solution of the legislative and bankIng problems which this situation presents—a solution, moreover, that would meet the interests of both the public and the banks and conform to the objectives of Congress as evidenced In various existing laws and In the two sets of pending amendments here discussed—would seen to be afforded if modifications having the following purposes in view were made in the proposals now before the Senate and then included In the measure as finally enacted by the Senate and the House* 1* To retain the limitations of five years and 50 per cent of appraised value of the real estate, and to establish an exception authorizing ten years and 60 per cent of appraised value of the real estate In the case of amortised loans, but to provide that the latter class of loans are to be amortized at a rate that would retire them In full In twenty years* £• To authorize the Federal Reserve Board, subject to the limitations prescribed ty Congress for real-estate loans by national banks, to prescribe additional regulations governing real-estate loans by member banks, but with the exception that such regulations would apply to State member-banks only Insofar as the regulations did not conflict with express provisions of existing State laws* The reason for suggesting the first of these proposed modifications has already been indicated* It Is to make possible a much wider use of the amortized mortgage In banking practice than would be possible If the proposal now before the Senate is adhered to* The advisability of encouraging and fostering the use of the amortized mortgage, in the Interest of both,borrower and lender, is now universally recognized, and there is a marked tendency among lending agencies generally to adopt the policy of either requiring amortization of all mortgage loans or to give preference and more liberal terms to mortgages that call for periodic payments* - 6 The three-year or five-year mortgage, hitherto customary even among lenders not bound by such a statutory limitation, has come more and mare to be recognized as a legal fiction—a contract usually impossible of performance—and one that tends to perpetuate debt instead of providing for its actual payment• Moreover, in practical operation it has subjected borrowers to onerous and unwarranted "renewal" charges, it has caused lending agencies to take imprudent risks, and it has put both trader severe pressure in periods of local or general economic stress* Is a matter of fact, Congress has itself, in the powers conferred on various governmental agencies, taken cognizance of the essential long-term nature of a real-estate loan and given the chief impetus and direction to the present general movement toward the adoption of amortization as standard practice* The Federal Land Banks, for example, make most of their loans for thirty years or more; the Land Bank Commissioner, who may lend on second mortgages as well as first mortgages and whose loans are usually made to redeem farms sold under foreclosure or to refund existing obligations, makes most of his loans for thirteen years* Amortisation is required on all loans by both the Federal Land Banks and the Land Bank Commissioner, the rate of amortisation depending on the length of the loan* Amortization is also required on all loans made by the Home Ownersf Loan Corporation, the period for amortization running up to fifteen years* The RFC Mortgage Company lends up to ten years and aims at amortization of half of the loan within that period, but makes provision for varying this requirement according to the circumstances of a particular transaction* The National Housing Act, adopted by Congress a year ago, expressly requires complete amortization of all mortgages insured by the Federal Housing Administrator and authorizes the insurance of such mortgages up to twenty years* By regulation the Federal Housing Administrator has prescribed that all home mortgages insured under the provisions of Title II of the National Housing Act must be amortized monthly. The Housing Division of the Public Works Administration has until recently required complete amortization by semi-annual payments extending over a period of twenty-five to thirty years* It is understood that the amortization period is now to be extended up to sixty years with amortization required for the cost of the building but not for the cost of the land* - 7 ~ Among private lending institutions, the building and loan associations constitute the only class with which amortisation has hitherto been standard practice* The length of time prescribed for complete amortisation varies, depending on State laws or on local custom in the absence of statutory limitation* In general, the period of amortisation runs from ten to fifteen years* The usual limitation on the amount of such a lean is 66 2/5 per cent of appraised value of the real estate* Federal savings and loan associations* however, are authorized to make leans up to 75 per cent of appraised value of the real estate* and the period of amortization authorized by Congress for loans by these associations is from a minimum of five years to a maximum of twenty years* Evidence of the extent to which insurance companies are turning to the long-term amortized mortgage loan has been afforded for some months past by advertisements published by such companies in newspapers in various parts of the country* These advertisements would imiicate that insurance-company loans on real estate are available up to 60 per cent of appraised value of the property for periods ranging from ten years to twenty years* with provision for partial or complete amortization, depending on the length of the loan* A large number of insurance companies* it would appear* are also requiring annual amortization at a rate that would fully retire loans variously in twenty years to fifty years* The practice among mutual savings banks* incorporated savings banks* trust companies* and commercial banks varies widely in respect of amortization requirements • Many institutions of these groups hare no such requirements; many others do hare* There is apparently no guiding principle that is accepted among them with regard to amortization* but in general the tendency seems to be to have mortgage loans more or less regularly curtailed* The Committee on State Legislation of the American Bankers Association, in its report of February 1, 1955, on "Legislative Trends in Banking**1 pointidout that the time limitation of five years or ten years on mortgage loans* as provided by law in various States* U s criticised on the ground that it results in straight mortgage loans rather than amortized ones* although experience teaches that the heavier losses occur on straight mortgages." The Committee made no specific recommendation with regard to a time limitation on amortized loans* but cited the period of fifteen years authorized in Pennsylvania as meeting the problem* The Special Committee of the American Bankers Association on the Proposed Banking Act of 1955* in its report of March 22* 1955* - 8 expressed itself as favoring loans up to 60 per cent of appraised value of the property, with a time limit of five years on unamortized loans; but the Committee omitted to make any specific recommendation with regard to a time limit for amortized loans • The Federal Advisory Council, in its statement of April 10, 1955, suggested that loans up to 60 per cent of appraised value of the real estate be authorised up to twelve years, if provision were isade for reduction «hy payments m£ not less than 5 per centum per annum on principal in addition to current interest." In the case of loans up to 60 per cent of appraised value of the real estate, a time limitation that would seem practicable from the standpoint of the ability of the borrower to retire the loan in full by periodic payments would be one predicated on the twenty years provided ty Congress for loans made by Federal savings ana loan associations and for loans insured lay the Federal Housing Administration, there loans up to this limit are amortised by annual or more frequent periodic payments of interest and principal combined, approximately 55 per cent of the principal is paid in ten years* The proposed requirement that 50 per cent of the principal be repaid in ten years would involve considerably larger periodic payments—payments at a rate that would retire the entire principal in approximately fifteen years rather than twenty years* The alternative method, amortizing by annual or more frequent payments of principal with interest added, would likewise involve, especially in the earlier years of the loan, larger payments than mortgage borrowers can ordinarily meet* The reason for suggesting that the Federal Reserve Board be given authority to prescribe regulations to supplement the statutory provisions governing real-estate loans is that this is the logical and practical means of raising the standards of mortgage-lending among member banks of the Federal Reserve System in the interest of sound banking* Up to this time the principal safeguards that legislation has sought to establish for a mortgage loan have been the time limit of five years and the loan limit of 50 per cent of appraised value of the real estate* Both these have proved illusory in the test of practical experience and both have proved easily susceptible of abuse* Most stress is usually placed on the loan limit as a factor of safety. Putting that limit, however, at 50 per cent of appraised value of the real estate is scarcely more dependable as a safeguard than putting the time limit at five years* The latter does not make - 9 the loan collectible in five years, nor does it assure whatever curtailment the bank may then insist on* Having learned these facts to their cost, more and more institutions have cose to insist that real-estate loans must be progressively paid off by some dearly defined program of amortization* In like manner they have come to recognize that the loan limit is not the allimportant factor that it was formerly thought to be* The loan limit is in reality based on a highly variable factor—namely, "the appraised value of the real estate•• Two appraisers, each honest according to his lights and each perfect according to his ability, may put substantially different values on the same piece of property* A bank on one corner may offer a loan of a certain amount on a piece of property* a bank on the opposite corner a much higher amount* and each be going to what it regards as the loan limit prescribed by law* The property that appraises at one figure under one set of conditions* appraises at a higher or lower figure when the economic conditions are altered* The Florida boom is the most recent conspicuous example of one extreme; the nation-wide experience of the depression abundantly illustrates the other extreme. In late years the 50 per cent loan has more often than not become the 60 or 80 or 100 per cent loan* sometimes within a matter of months* Nor is this factor of variability in appraisals the only reason for not placing too great a reliance on the loan limit* A 60 or 70 or 80 per cent loan on a given property may involve much less risk over a period of five years or ten years than a 40 or 50 per cent loan on the same type of property in another neighborhood or another community* The same divergence in risk is to be found among different types of property, and particularly so among different types of business property* In fact* for a number of types of business property appraised value is an extremely unreliable guide in making a real estate loan* For another thing* the degree of risk would appear to vary according to the size of the loan* even when the ratio of the loan to appraised value may be the same* The larger the loan in dollars, the greater the difficulty of finding a btgrer in the event of default* and the greater the risk* A prudent policy* therefore, would seem to suggest that the Federal Reserve Board be given authority to regulate real-estate loans by member banks in the same manner as it is given authority - 10 - to prescribe the coactltlons under which advances on such loans may be made by the Federal Reserve banks• It would seat desirable, that is to say, to surround these loans with adequate safeguards at the time they are made rather than to give the Board authority only to determine the conditions under which they will be available for borrowing at the Reserve banks after they are made. While it is true that the Board, no more than Congress, can as a practical matter prescribe real-estate loaa regulations in exhaustive detail, It can establish standards that should bring about a greater xmitormity and a greater degree of safety In the lending practices of member banks, lhat is of equal importance, It would be in a position at all times to revise these regulations to meet changing conditions in the real-estate and mortgage markets, to restrain speculative excesses and abuses, and to take account of economic conditions generally that might have a bearing on realestate values and on mortgage investments*
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