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X-9260 CUBfJiJMTIAL Vot f o r publication MEMORANDA ON Pfiopogsp REGULATION OF REAI^-ESTATE LOANS (With Particular Reference to Lack of Adaquate Safeguards i n 8ection 207 of H. R. 7617 as Reported t o Senate) J u l y 12, 1055 X-9260 CONFIDENTIAL Not f o r publication MEMORANDUM ON PROPOSED REGULATIONS OF REAL-ESTATE LOANS (With Particular Reference to Lack of Adaquate Safeguards i n Section 207 of H* R. 7617 as Reported to Senate) 1 THE NATURE 0? ™tf«rfTOi The real-estate loan provisions of the proposed Banking Act of 1955* both as enacted by the House of Representatives and as reported by the Senate Committee on Banking and Currency, may reasonably beiaid to look toward enlarging and encouraging mortgage investments on the part of member banks of the Federal Reserve System, For reasons that w i l l be related presently, t h i s would seem to be a l o g i c a l , proper, and timely development i n the successive changes that have been made over a number of years i n the laws governing real-estate loans by banks* An examination of the specific amendments now pendingf however, and a consideration of these amendments i n the l i g h t of the knowledge gained by a l l types of mortgage-lending institutions from their experience during the depression years, suggests that the following question may f a i r l y and prudently be raised: i Do the pending amendments look toward an improvement i n mortgage practice—toward standards or safeguards commensurate X-9260 ~ - 2 with the larger volume of mortgage lending by banks that tbp ss amendments are calculated to bring about? The enlargement of the mortgage-lending privilege contemplated i n both sets of the pending amendments i s of a twofold character: (1) the t o t a l volume of real-estate loans that a national bank may make would be increased, and (2) the t o t a l amount that i t may loan on a given mortgage i n r e l a t i o n to the appraised value of the property would be increased. In the f i r s t respect, the provisions of the measure enacted by the House and that reported to the Senate are a l i k e . In the second respect, there i s 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 i n the aggregate and i n respect of the individual transaction, the House and the Senate measures each contain provisions that would make real-estate mortgages e l i g i b l e as c o l l a t e r a l for advances by the Federal Reserve banks. Here, too, there i s some difference between the House and the Senate provisions, but the effect of either would be to give to real-estate mortgages, i n 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 e l i g i b l e for borrowing at the Reserve banks, though only under a temporary statute (expired March 3, 1955) and only " i n exceptional and X-9260 - 3~ exigent circumstances." The borrowing privilege i s made permanent law i n both forms of the pending amendment, and the r e s t r i c t i o n of such borrowing through an emergency i s done away with. Considered together, then, the three sets of provisions enumerated above constitute the basis of a wider participation by banks i n mortgage lending, with the assurance that sound assets thus acquired w i l l not be denied access t o the Reserve banks should occasion arise f o r borrowing against them. II IMPORTANCE QF ttffi W f i G S P LENDING rowps There i s a variety of reasons why t h i s broadening and strengthening of the base ef mortgage lending under the Federal Reserve Act may be regarded as desirable and j u s t i f i a b l e . In the f i r s t place, the member banks of the Federal Reserve System hold, i n addition to their commercial deposits, some ten b i l l i o n dollars of the savings accounts of the people i n their communities. Where mutual savings banks are r e l a t i v e l y numerous, as i n the New York and New England areas, a large part of the people 1 s savings i s held by these i n s t i t u t i o n s ; but the extent to which the member banks are used elsewhere as the p r i n c i p a l savings depositories i n their communities i s indicated by the f a c t that i n the country as a whole, exclusive of New York City, nearly half of a l l member-bank deposits other than inter-bank deposits are savings deposits. These are funds X-9260 - 4 ~ that should properly be invested largely for long-term purposes i n the ease aonner as the funds of mutual savings banks, trust companies, building and loan associations, and insurance companies; and among such long-term purposes sound investments i n real-estate mortgages have always held a place of great importance to the economic l i f e of the country. In the second place, the present low l e v e l of real-estate values and the progress of recovery i n trade end employment combine both to create a demand for mortgage funds and to make mortgage investments more than ordinarily attractive to i n s t i t u t i o n a l lenders* At the same time there has been evidenced, f o r six consecutive months now, a sustained increase of more than 100 per cent over the corresponding period of l a s t year i n the volume of residential construction i n the country at large, and a consequent i n crease i n the demand from t h i s soiree for mortgage funds* Statutory measures that would lessen the existing r e s t r i c t i o n s on banks i n the making of mortgage loans should therefore have an important influence i a easing the mortgage market and i n furthering recovery and employment i n the longdormant construction industry* For another thing, the banks have at the present time a hug* volume of i d l e funds that can i n part at least be made more largely a v a i l able f o r mortgage lending* Furthermore, the banks are the largest and most widespread group of leading agencies that have such a huge surplus of funds* A greater use of these funds i n the f i e l d of mortgage investment would d i r e c t l y benefit the communities served by the banks, would further relax the pressure for Federal appropriations f o r mortgage lending, and would X-9260 - S enable the banks to acquire sound earning-assets to meet the interest requirements on their savings deposits. The need of finding a remunerative and secure outlet for savings deposits i s for many banks a serious problem, the p r a c t i c a l solution of which, to begin with, would seem to l i e i n the growing demand now being manifested for construction loans and mortgage loans. This r e c i t a l of factors that point the p r a c t i c a l purposes to be served by a larger volume of mortgage lending by banks might be carried farther, but enough has been related to show that the pending amendments are on s o l i d ground insofar as they would (a) authorize national banks to increase t h e i r t o t a l real-estate loans r e l a t i v e l y to either their time and savings deposits or their c a p i t a l and surplus, and (b) authorize the Reserve banks to make advances to member banks against such loans, thus precluding a repetition of the experiences i n which banks generally found their mortgage portfolios frozen during a period of abnormal withdrawals, III COMPARISON OF HOPSE AND SENATE PROPOSALS I t i s where the amendments have to do with mortgage loans i n dividually rather than i n the aggregate that opportunity i s to be found for strengthening the amendments i n the interest of sound lending. That the r e s t r i c t i o n s i n the existing law were i n s u f f i c i e n t to prevent many unsound practices and abuses and large losses i s now too w e l l known t o require X-9260 - 6~ comment. That there i s r e a l need of improvement i n mortgage-lending p o l i c y and practice i s not only generally recognized, but widely urged on the part of bankers themselves. Yet neither the measure enacted by the House nor the alternative proposals reported to the Senate f u l l y meet the need and the opportunity for Congress t o establish, i n the Banking Act of 19S5, better standards of mortgage lending and adequate safeguards for the mortgage investments to be acquired henceforth by member banks. As a p r a c t i c a l matter, i t i s exceedingly d i f f i c u l t to prescribe by statute regulations that would be practicable and s u f f i c i e n t at a l l times, i n a l l places, and under a l l conditions of the real-estate and mortgage markets, to govern banks i n the making of loans on (a) improved farm land, (b) improved business property, and (c) improved residential property. Recognizing t h i s f a c t , the House measure l i m i t s such loans t o 60 per cent of the appraised value of the r e a l estate and then authorizes the Federal Reserve Board to prescribe from time to time regulations governing loans within that l i m i t and requiring banks to conform to sound practices i n making real-estate loans. The l i m i t a t i o n of loans to 60 per cent of appraised value of the r e a l estate and the authority of the Board to prescribe other regulations and to require sound practices are made applicable, however, only t o national banks. The corresponding provision as reported to the Senate retains the time l i m i t of f i v e years and the loan l i m i t of 50 per cent of appraised value of the r e a l estate provided i n the existing law, but creates X-9260 - 7 ~ an exception authorising loans up to ten years i n amounts not exceeding 60 per cent of appraised value of the r e a l estate i f installment payments are required that would reduce the loan t o at least one-half i t s face aaoimt i n ten years* These several r e s t r i c t i o n s are likewise made applicable only to national banks, and no authority i s given to the Federal Reserve Board to prescribe additional regulations or to require sound practices. The Senate proposals also r e t a i n the provision ef the existing law with regard to the geographical l i m i t s within which a national bank may make real-estate leans, together with the existing requirement that such leans s h a l l be made or acquired only i n their e n t i r e l y . The House measure leaves both these matters te 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 T i t l e I I of the National Housing Act, from the l i m i t a t i o n to 60 per cent of appraised value of the r e a l estate; and the l a t t e r class of loans i s s i m i l a r l y exempt from the time l i m i t s of f i v e and ten years, respectively, provided i n the Senate proposals, Loans insured under the provisions of t i t l e I I of the National Housing Act are not exempt, however, from the geographical limitations retained i n the Senate proposals. The House measure would leave t h i s matter subject to the regulatory authority given te the Federal Reserve Board, X-9260 - 8 ~ Ad far as establishing new safeguards f o r mortgage lending i s concerned, therefore, i t w i l l be seen that the two sets of amendments have nothing i n common. The House measure looks toward such safeguards and vests the r e s p o n s i b i l i t y for prescribing them i n the Federal Reserve Board; the b i l l reported to the Senate would leave the existing law unchanged with the single exception of the new provision relating to loans amortized hy one-half or more within ten years—a requirement that experience would indicate to be beyond the a b i l i t y of most mortgage borrowers t o meet, and hence of very limited p r a c t i c a l application. IV KT,ppWTS Op A PRACTICAL S O ^ O N A wholly workable solution of the l e g i s l a t i v e and banking problems which t h i s 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 i n various existing laws and i n the two sets of pending amendments here discussed—would seem to be afforded i f modifications having the following purposes i n view were made l a the proposals now the beforeASenate and then included i n the measure as f i n a l l y enacted ty the Senate and the House: 1. To r e t a i n the limitations of f i v e years and 50 per ceat of appraised value of the r e a l estate, and to establish an exception authorising ten years and 60 per cent of appraised value X-9260 - 9 ~ of the r e a l estate i n the case of amortized loans, but t o pro-* vide that the l a t t e r class of loans are to be amortized at a r a t ? that would r ^ l r $ t h ? i ^ 2. t fo twgnfry yyayp. To authorize the Federal Reserve Board, subject the limitations prescribed by Congress for real-estate loans by national banks, t o prescribe additional regulations governing real-estate loans by member banks, but with the exception that such regulations would apply t o State member-banks only insofar as the regulations did not c o n f l i c t with express provisions of e x i s t ing State laws. V t p p p c y TCWRP mw iff A M Q B i m t o y The reason for suggesting the f i r s t of these proposed modifications has already been indicated. I t i s to make possible a much wider use of the amortized mortgage i n hanklhg practice than would be possible i f the proposal now before the Senate i s adhered t o . The a d v i s a b i l i t y of encouraging and fostering the use of the amortized mortgage, i n the interest of both borrower and lender, i s now universally recognized; and there i s a marked tendency ajrong lending agencies generally to adopt the policy of either requiring amortization of a l l mortgage loans or to give preference and more l i b e r a l terms to mortgages that c a l l for periodic payments. X-9260 - 10 ~ The three-year or five-year mortgage, hitherto customary even among lenders not bound by a statutory l i m i t a t i o n i n respect of maturity, has come more and more to be recognized as a l e g a l f i c t i o n — a contract usually impossible of performance and one that tends to perpetuate debt Instead of providing for i t s actual payment. Moreover, i n p r a c t i c a l operation i t has subjected borrowers to onerous and unwarranted "renewal" charges, i t has caused lending agencies to take imprudent r i s k s , and i t has put both borrower and lender under severe pressure i n periods of l o c a l or general econQmic stress. Congress has i t s e l f taken cognizance of the essential long-term nature of a real-estate loan and has given the chief impetus and d i r e c t i o n to the present general movement toward the adoption of amortization as sound practice. In doing t h i s , i t has also indicated the period that i t regards as necessary for the amortization of mortgage loans made by private lending agencies. For example, the maturity limitations authorized for f u l l y amortized loans i n the case of Federal Savings and Loan Associations i s 20 years. The corresponding l i m i t a t i o n i n the case of loans insured by * the Federal Housing Administration i s also 20 years. In the case of loans by the Federal Land Banks i t i s 40 years. Among the several groups of mortgage-lending i n s t i t u t i o n s , the building and loan associations constitute the only class with which amortization has hitherto been standard practice. The length of time prescribed for complete amortization of their loans varies, depending on State laws or on l o c a l custom i n the absence of statutory l i m i t a t i o n . X-9260 - 11 ~ In general, the period of amortization runs from ten to f i f t e e n years, with a recent tendency toward twenty years. The usual l i m i t a t i o n on the amount of such a loan i s 66 2/5 per cent of appraised value of the r e a l estate* Federal Savings and Loan Associations, however, are authorized to make loans up to 75 per cent of appraised value of the r e a l estate, and the period of amortization authorized by Congress for loans by these associations i s from a minimum of f i v e years to a maximum of 20 years, depending on the nature of the loan. 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 i n newspapers i n various parts of the country. These advertisements would indicate that insurance- company loans on r e a l estate are available up to 20 years, with provision for p a r t i a l or complete amortization depending on the length of the loan. I t would appear that, even i n the absence of statutory provisions that authorize or c a l l for amortization ever a period of 20 years^practice i s more er less general among insurance companies of requiring seme annual curtailment. The requirements i n t h i s respect are for payments that would f u l l y r e t i r e the leans i n periods ranging variously from 20 years te 50 years. The practice among mutual savings banks, incorporated savings banks, trust companies, and commercial banks i n respect of amortization requirements also varies widely. Many i n s t i t u t i o n s among these groups have no such requirements; many others do have. There i s apparently no guiding p r i n c i p l e that i s accepted among them with regard to amortization, X-9260 - 12 but In general the tendency seems to be t o have mortgage loans more or less regularly curtailed. The Committee on State Legislation of the American Bankers Association, i n i t s report of February 1, 1935, on "Legislative Trends i n Banking,19 pointed out that the time l i m i t a t i o n of f i v e years or ten years on mortgage loans, as provided by law i n various States, 19 is c r i t i c i s e d on the ground that i t results i n straight mortgage loans rather than amortized ones, although experience teaches that the heavier losses occur on straight mortgages." The Committee made no s p e c i f i c recommendation with regard to a time l i m i t a t i o n on amortized loans, but cited the period of f i f t e e n years authorized i n Pennsylvania as meeting the problem. The Special Committee. of the American Bankers Association on the Proposed Banking Act of 1955, i n i t s report of March 22, 1955, expressed i t s e l f as favoring loans up to 60 per cent of appraised value of the property, with a time l i m i t of f i v e years on unamortized loans; but the Committee omitted to make any s p e c i f i c recommendation with regard to a time l i m i t for amortized loans. The Federal Advisory Council, i n i t s statement of A p r i l 10, 1955, suggested that loans up to 60 per cent of appraised value of the r e a l estate be authorized up to 12 years, i f provision were made for reduction "by payments of not less than 5 per centum per annum on p r i n c i p a l i n add i t i o n to current i n t e r e s t . " X-9260 - 15 In the case of loans up to 60 per cent of appraised value of the r e a l estate, a time l i m i t a t i o n that would seem practicable from the standpoint of the a b i l i t y of the borrower to r e t i r e the loan i n f u l l by periodic payments would be one predicated on the 20 years provided by Congress f o r loans made by Federal Savings and Loan Associations and for loans insured by the Federal Housing Administration. Where loans up to t h i s l i m i t are amortized by annual or more frequent periodic payments of interest and p r i n c i p a l combined, approximately 35 per cent of the p r i n c i p a l i s paid i n ten years. The proposed requirement that 50 per cent of the p r i n c i p a l be r e paid i n ten years i n the case of mortgage loans by national banks, would i n volve considerably larger periodic payments—payments at a rate that would r e t i r e the entire p r i n c i p a l i n approximately 15 years rather than 20 years. The alternative method, amortizing by annual or more frequent payments of principal with interest added, would likewise involve, especially i n the earlier years of the loan, larger payments than mortgage borrowers can ordinarily meet. VI D P T O E MET BY m m s m w m The reason for suggesting that the Federal Reserve Board be given authority to prescribe regulations t o supplement the statutory provisions governing real-estate loans i s that t h i s i s the l o g i c a l and p r a c t i c a l means of r a i s i n g the standards of mortgage lending among member banks of the X-9260 - 14 ~ Federal Reserve System i n the interest of sound banking. Up to t h i s time the p r i n c i p a l safeguards that l e g i s l a t i o n has sought to establish for a mortgage loan have been the time l i m i t of f i v e years and the loan l i m i t of 50 per cent of appraised value of the r e a l estate. Both these have proved i l l u s o r y i n the test of p r a c t i c a l experience and both have proved easily susceptible of abuse. Host stress i s usually placed on the loan l i m i t as a factor of safety. Putting that l i m i t , however, at 50 per cent of appraised value of the r e a l estate i s scareely more dependable as a safeguard than putting the time l i m i t at f i v e years. The l a t t e r does not make the loan c o l l e c t i b l e i n f i v e years, nor does i t assure whatever curtailment the bank may then i n s i s t on. Having learned these facts to their cost, more and more i n s t i t u - tions have come to i n s i s t that real-estate loans must be paid o f f by some c l e a r l y defined program of amortization. In l i k e manner they have come to recognize that the loan l i m i t i s not the all-important fact that i t was formerly thought to be. The loan l i m i t i s i n r e a l i t y based on a highly variable f a c t o r — namely, "the appraised value of the r e a l estate.11 Two appraisers, each honest according to his l i g h t s and each perfect according to his a b i l i t y , 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 i t regards as the loan l i m i t prescribed by law. X-9260 - IS Furthermore, the property that appraises at one figure under one set of conditions, appraises at a higher or lower figure when economic conditions are altered. The Florida boom i s the most recent conspicuous example of one extreme; the nation-wide experience of the depression abundantly i l l u s t r a t e s 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 i s t h i s factor of v a r i a b i l i t y i n appraisals the only rea* son for not placing too great a reliance on the loan l i m i t . A 60 or 70 or 80 per cent loan on a given property may involve much less r i s k over a period of f i v e years or ten years than a 40 or 50 per cent loan on the same type of property i n another neighborhood or another community. The same divergence i n r i s k i s to be found among different types of property, and p a r t i c u l a r l y so among different types of business property. In f a c t , for a number of types of business property appraised value i s an extremely unreliable guide i n making a r e a l estate loan. For another thing, the degree of r i s k would appear to vary according to the size of the loan, even when the r a t i o of the loan to appraised value may be the same. The larger the loan i n d o l l a r s , the greater the d i f f i c u l t y of finding a buyer i n the event of default, the greater the r i s k . A prudent p o l i c y , therefore, would seem to suggest that the Federal Reserve Board be given authority to regulate real-estate loans by member banks i n the same manner as i t i s given authority to prescribe the conditions under which advances on such loans may be made by the X-9260 - 16 - Federal Reserve banks. I t would appear desirable, that i s to say, to surround these loans with adaquate safeguards at the time they are made rather than to give the Board authority only to determine the conditions under which they w i l l be available for borrowing at the Reserve banks after they are made. While i t i s true that the Board, no more than Congress, can as a p r a c t i c a l matter prescribe real-estate loan regulations i n exhaustive d e t a i l , i t can establish certain minimum standards i n appraisal practice and other governing factors that should bring about a greater uniformity and a greater degree of safety i n the lending methods of member banks. What i s of equal importance, i t would be i n a position at a l l times to revise these regulations to meet changing conditions i n the real-estate and mortgage markets, to r e s t r a i n speculative excesses and abuses, and to take account of economic conditions generally that might have a bearing on real-estate values and on mortgage investments. In conclusion i t may be observed that no reason has been suggested why regulation i n t h i s manner by the Federal Reserve Board would not be i n the public i n t e r e s t .
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