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THE BANKING REFORM ACT OF 1971 HEARINGS BEFORE THE COMMITTEE ON BANKING AND CURRENCY HOUSE OF REPRESENTATIVES NINETY-SECOND CONGRESS FIRST SESSION ON H.R. 5700 A BILL TO PROHIBIT CERTAIN CONFLICTS OF INTEREST AND ENCOURAGE COMPETITION IN THE BANKING INDUSTRY AND RELATED FIELDS TO PROVIDE FOR RESTRICTIONS AND DISCLOSURES WITH RESPECT TO CERTAIN LOANS, TO PROHIBIT BROKERED DEPOSITS IN BANKS AND OTHER FINANCIAL INSTITUTIONS, TO PROHIBIT THE USE OF GIVEAWAYS IN THE SOLICITATION OF DEPOSITS, TO PERMIT FULL DEPOSIT INSURANCE FOR GOVERNMENT DEPOSITORS, AND FOR OTHER PURPOSES H.R. 3287 A BILL TO PROHIBIT FEDERALLY INSURED BANKS FROM MAKING LOANS TO PROVIDE FOR THE PURCHASE OF BANK STOCK, AND FOR OTHER PURPOSES H.R. 7440 A BILL TO CLARIFY THE AUTHORITY OF THE FEDERAL HOME LOAN BANK BOARD TO REGULATE CONFLICTS OF INTEREST IN THE OPERATION OF INSURED SAVINGS AND LOAN ASSOCIATIONS. AND FOR OTHER PURPOSES PART 2 APRIL 28, 29, 30; MAY 3 AND 4, 1971, AND APPENDIX Printed for the use of the Committee on Banking and Currency THE BANKING REFORM ACT OF 1971 HEARINGS BEFORE THE COMMITTEE ON BANKING AND CURRENCY HOUSE OF REPRESENTATIVES NINETY-SECOND CONGRESS FIRST SESSION ON H.R. 5700 A BILL TO PROHIBIT CERTAIN CONFLICTS OF INTEREST AND ENCOURAGE COMPETITION IN THE BANKING INDUSTRY AND RELATED FIELDS TO PROVIDE FOR RESTRICTIONS AND DISCLOSURES WITH RESPECT TO CERTAIN LOANS, TO PROHIBIT BROKERED DEPOSITS IN BANKS AND OTHER FINANCIAL INSTITUTIONS, TO PROHIBIT THE USE OF GIVEAWAYS IN THE SOLICITATION OF DEPOSITS, TO PERMIT FULL DEPOSIT INSURANCE FOR GOVERNMENT DEPOSITORS, A N D FOR OTHER PURPOSES H.R. 3287 A BILL TO PROHIBIT FEDERALLY INSURED BANKS FROM MAKING LOANS TO PROVIDE FOR THE PURCHASE OF BANK STOCK, AND FOR OTHER PURPOSES H.R. 7440 A BILL TO CLARIFY THE AUTHORITY OF THE FEDERAL HOME LOAN BANK BOARD TO REGULATE CONFLICTS OF INTEREST IN THE OPERATION OF INSURED SAVINGS AND LOAN ASSOCIATIONS, AND FOR OTHER PURPOSES PART 2 APRIL 28, 29, 30; MAY 3 AND 4, 1971, AND APPENDIX Printed for the use of the Committee on Banking and Currency U.S. GOVERNMENT PRINTING OFFICE 60-299 WASHINGTON : 1971 COMMITTEE ON BANKING AND CURRENCY WRIGHT PATMAN, Texas, Chairman WILLIAM A. BARRETT, Pennsylvania WILLIAM B. WIDNALL, New Jersey LEONORK. (MRS. JOHNS.) SULLIVAN, FLORENCE P. DWYER, New Jersey Missouri ALBERT W. JOHNSON, Pennsylvania HENRY S. REUSS, Wisconsin J. WILLIAM STANTON, Ohio THOMAS L. ASHLEY, Ohio BENJAMIN B. BLACKBURN, Georgia WILLIAM S. MOORHEAD, Pennsylvania GARRY BROWN, Michigan ROBERT G. STEPHENS, JR., Georgia LAWRENCE G. WILLIAMS, Pennsylvania FERNAND J. ST GERMAIN, Rhode Island CHALMERS P. WYLIE, Ohio HENRY B. GONZALEZ, Texas MARGARET M. HECKLER, Massachusetts JOSEPH G. MINISH, New Jersey PHILIP M. CRANE, Illinois RICHARD T. HANNA, California JOHN H. ROUSSELOT, California TOM S. GETTYS, South Carolina STEWART B. McKINNEY, Connecticut FRANK ANNUNZIO, Illinois NORMAN F. LENT, New York THOMAS M. REES, California BILL ARCHER, Texas TOM BEVILL, Alabama BILL FRENZEL, Minnesota CHARLES H. GRIFFIN, Mississippi JAMES M. HANLEY, New York FRANK J. BRASCO, New York BILL CHAPPELL, JR., Florida EDWARD I. KOCH, New York WILLIAM R. COTTER, Connecticut PARREN J. MITCHELL, Maryland PAUL NELSON, Clerk and Staff Director CURTIS A. PRINS, Chief BENET D . GELLMAN, Investigator Counsel JOSEPH C. LEWIS, Professional Staff Member GARY TABAK, Counsel ORMAN S. FINK, Minority Staff Member (H) CONTENTS (The same table of contents appears in parts 1 and 2) Hearings held on— April 20, 1971 April 21, 1971 April 22, 1971 April 23, 1971 April 26, 1971 April 27, 1971 April 28, 1971 April 29, 1971 April 30, 1971 May 3, 1971 May 4, 1971 Text of— H.R. 5700 H.R. 3287 H.R. 7440. 1 113 173 227 267 387 453 569 657 741 837 1 9 14 STATEMENTS Bryan, John William, Granite State Bank, and the Bank of Arlington, Granite Falls, Wash Burns, Hon. Arthur F., Chairman, Board of Governors, Federal Reserve System Camp, Hon. William B., Comptroller of the Currency Carlson, Donald M., president, Independent Bankers Association of America; accompanied by Rod L. Parsch, chairman, Federal Legislative Committee Darnell, Prof. Jerome C., associate professor of business administration, University of Colorado Dooley, Prof. Peter C., University of Saskatchewan Farrar, Prof. Donald E., senior fellow, University of Pennsylvania Law School, Center for the Study of Financial Institutions Fey, John T., president, National Life Insurance Co., Montpelier, Vt., on behalf of the American Life Convention and the Life Insurance Association of America; accompanied by Bruce P. Hayden, vice president, Connecticut General Life Insurance Co., Hartford, Conn.; and Thomas F. Murray, senior vice president and chief investment officer, The Equitable Life Assurance Society of the United States Green, Sampson, chairman, Activists, Inc.; accompanied by Father John Martinez, cochairman, housing committee, Activists, Inc., Baltimore, Md Groos, Ernest, Jr., president, Groos National Bank, San Antonio, Tex Hamilton, John S., Jr., vice president and general counsel, American Mutual Insurance Alliance; accompanied by James P. Allen, Jr., vice president, Liberty Mutual Insurance Co Herbert, Edward, senior vice president, First National Bank, Montgomery, Ala., on behalf of Robert Morris Associates, National Association of Bank Loan and Credit Officers Herman, Prof. Edward S., Wharton School of Finance, University of Pennsylvania Hinrichs, Dr. Harley H., The Saver Incentives Premium Industry Committee; accompanied by John F. Daly, International Silver Co.; William M. Dalton, W. M. Dalton & Associates; Larry O. Edwards, Lincoln Rochester Trust Co.; and Neil Kanney, Grace China Co Hovde, Donald I., Madison, Wis., chairman, Realtor's Washington Committee, National Association of Real Estate Boards (Hi) 675 276 129 592 396 417 388 474 321 821 490 624 227 677 464 IV Jackson, Philip C., vice president, Mortgage Bankers Association of America; accompanied by Walter F. Terry III, vice president, James W. Rouse & Co., Columbia, Md Levine, Milton E., chairman of the board, Meyers Pollock Robbins, Inc., New York, N.Y McDonald, Angus, consultant to the Mid-West Electric Consumers Association McLaren, Hon. Richard W., Assistant Attorney General for Antitrust, Department of Justice; accompanied by Donald I. Baker, chief, Office of Policy Planning Martin, Hon. Preston, Chairman, Federal Home Loan Bank Board; accompanied by Arthur W. Leibold, Jr., General Counsel Meyer, John M., Jr., chairman of the board, Morgan Guaranty Trust Co. of New York Oberg, Dr. Harold S., vice president, Arthur Lipper Corp., New York, N.Y Renchard, William S., president, The New York Clearing House Association, and chairman of the board, Chemical Bank, New York, N.Y.; accompanied by Richard S. Simmons, counsel Rockefeller, David, chairman of the board, Chase Manhattan Bank; accompanied by Herbert T. Patterson, president, Chase Manhattan; and Ray C. Haberkern, counsel Scott, Tom B., Jr., chairman, Legislative Committee, United States Savings and Loan League; accompanied by Stephen Slipher, legislative director; and Arthur Edgeworth, Washington counsel Smith, Richard B., Commissioner, Securities and Exchange Commission; accompanied by Prof. Donald E. Farrar, University of Pennsylvania; and Philip A. Loomis, General Counsel, SEC Sommer, Clifford C., president, American Bankers Association; accompanied by Richard P. Brown, president, ABA Trust Division; and B. Finley Vinson, chairman, ABA Federal Legislative Committee Stastny, John A., president, National Association of Home Builders; accompanied by George C. Martin, vice president and treasurer, Louisville, Ky Swift, Harlan J., past president, National Association of Mutual Savings Banks, and chairman of the NAMSB Committee on Relations With Federal Supervisory Authorities; accompanied by Edward P. Clark, past president of NAMSB; and P. James Riordan, general counsel Vance, Prof. Stanley C., H. T. Miner professor of business administration, Graduate School of Management and Business, University of Oregon, Eugene, Oreg Ward, Alan S., Director, Bureau of Competition, Federal Trade Commission Wille, Hon. Frank, Chairman, Federal Deposit Insurance Corporation. _ ADDITIONAL INFORMATION SUBMITTED FOR THE 468 347 236 838 37 796 676 605 746 179 114 575 453 657 173 136 25 RECORD Annunzio, Hon. Frank, submission of letter and statement of Donald M. Graham, chairman of the board of directors, Continental Illinois National Bank and Trust Co., Chicago, 111., relating to H.R. 5700 and the committee staff report on sales of Penn Central stock (part V) Axelrod, Irving M., Big Bonus Stamp Co., Houston, Tex., letter dated April 21, 1971 Battle, William C., president, Premium Advertising Association of America, Inc., New York, N.Y., letter dated April 29, 1971 Begich, Hon. Nick, a Representative in Congress from the State of Alaska: Letters to Hon. Wright Patman: April 9, 1971 April 5, 1971, with attached letter from Eric E. Wohlforth, commissioner, Department of Revenue, State of Alaska, dated March 30, 1971 Berle, Rudolph, P., Berle & Berle, New York, N. Y., letter dated April 22, 1971, re H.R. 5700 with attachment on proposed amendment No. 5 prepared by the National Association of Mutual Savings Banks Bodine, William H., president, Savings Association League of New York State, Scarsdale, N.Y., letter dated April 13, 1971 Bright, Edgar, Jr., Standard Mortgage Corp., New Orleans, La., letter dated Mav 6. 1971 Pa&e 861 737 733 110 109 673 739 552 V Building Industry Association of California, Los Angeles, Calif., resolution adopted March 30, 1971, supporting H.R. 18676 introduced in the 91st Congress 566 Burns, Hon. Arthur F.: Response to questions of: Chairman Patman 286, 314, 316 r Hon. Parren J. Mitchell 304 Hon. Henry S. Reuss 293 Hon. William B. Widnall 964 Hon. Lawrence G. Williams 301 Camp, Hon. William B.: Prepared statement 130 Response to questions of Chairman Patman 169 Carlson, Donald M., prepared statement on H.R. 5700 597 Caton, Richard B., vice president and manager, loan administration, Stockton, Whatley, Davin& Co., Jacksonville, Fla., letter dated April 30, 1971 559 Cederberg, Hon. Elford A., a Representative in Congress from the State of Michigan: Statement on H.R. 3242 and H.R. 5700 363 Attached articles to statement: "Small Banks Go Under, and Authorities Assail Role of Money Brokers," from the Wall Street Journal 364; "Times Reporters Unearth the Story Behind the Story," with accompanying article, "Shadow Syndicate Seen Lurking in Background of Bank Failures," from the Bay City Times, June 28, 1970 368 Chase, Goodwin, president, Pacific National Bank of Washington, Tacoma, Wash., letter dated April 5, 1971 570 Clark, Edward P., president, Arlington Five Cents Savings Bank, Arlington, Mass., letter to Hon. Leonor K. Sullivan, dated May 5, 1971 699 Cooper, W. M., letter date May 5, 1971 552 Crow, Trammell, Dallas, Tex., letter dated April 20, 1971 563 Dalton, William M., president, W. M. Dalton& Associates, Inc., statement724 Daly, John F., International Silver Co., statement 723 Darnell, Prof. Jerome C.: Prepared statement 400 Response to questions of Hon. Stewart B. McKinnev 450 Deane, Disque D., New York, N.Y., letter dated May 1971 556 Dooley, Prof. Peter C.: Prepared statement with an attached study entitled, "The Interlocking Directorate" 421 Response to questions of: Hon. William A. Barrett 447 Hon. Stewart B. McKinney 449 Dwyer, William J., Jr., Mount Kisco, N.Y., letter dated May 3, 1971 563 Edwards, Larry O., vice president in charge of marketing, Lincoln Rochester Trust Co., Rochester, N.Y., statement 726 Fey, John T.: Prepared statement 480 Response to questions of: Hon. Margart M. Heckler 528 Hon. William B. Widnall 509 Gilliland, John A., first vice president, Stockton, Whatley, Davin & Co., Jacksonville, Fla., letter dated May 5, 1971 551 Graham, Donald M., chairman of the board of directors, Continental Illinois National Bank & Trust Co., Chicago, 111.: Letter to Hon. Frank Annunzio, dated May 4, 1971 861 Statement relating to H.R. 5700 and the committee staff report on sales of Penn Central stock (part V) 862 Green, Sampon: Letter from Hon. Preston Martin, Chairman, Federal Home Loan Bank Board, dated February 18, 1971 380 Submission of studies prepared by Activist, Inc., Baltimore, Md.: "A Conspiracy to Defraud and Exploit Homebuyers: The Story of Jefferson Federal Savings and Loan" 325 "Communities Under Siege'' 334 "Two Blocks on Mount Holly Street"-. 323 Greene, Raleigh, chairman, Committee on Legislation, National League of Insured Savings Associations, statement— 187 VI Oriebel, Richard H., president, Lehigh Valley Industries, Inc., New York, N.Y., letter dated May 5, 1971, with excerpts from statements of Hon. William B. Camp, Comptroller of the Currency; Hon. Preston Martin, Chairman, Federal Home Loan Bank Board; and Hon. Frank Wille, Chairman, Federal Deposit Insurance Corporation 734 Gross, Jenard M., chairman of the Legislative Committee, National Apartment Association, statement 502 Hallo well, Burton C., Tufts University, Medford, Mass., letter dated April 26, 1971 561 Hamel, John F., New York, N.Y., letter dated April 28, 1971, with attached commentary of sections 20 and 21 of H.R. 5700 354 Hamilton, John S., Jr.: Prepared statement 492 Response to questions of Hon. Margaret M. Heckler 527 Hayden, Bruce P., vice president, Connecticut General Life Insurance Co., response to question of Hon. Thomas L. Ashley 515 Henderson, S. T., executive vice president, Home Realty and Management Co., Charlotte, N.C., letter dated May 12, 1971 555 Henri, Joseph R., Commissioner, Department of Administration, State of Alaska, letter dated April 13, 1971 110 Herbert, Edward, prepared statement 625 Herman, Prof. Edward S.: Prepared statement 231 Summary of conflict of interest study on savings and loan associations entitled, "Conflict of Interest Reform" 254 Hinrichs, Dr. Harley H., prepared statement with attached partial list of firms in the premium industry 681 Hovde, Donald I.: Prepared statement 467 "The Future Largest Landlords in America," article from Fortune Magazine, July 1970. ___ 536 Hume, Kenneth C., president, Alaska State Bank, Anchorage, Alaska, letter dated May 11, 1971 110 Jackson, Philip C., letter with attachment to Hon. Thomas L. Ashley, dated April 30, 1971 544 Kaiser, Edgar F., chairman of the board, Kaiser Industries Corp., Oakland, 741 Calif., statement Kanney, Neil, president, Grace China Co., South Hackensack, N.J., statement 729 Kenney, Thomas J., Baltimore, Md., letter with attachments to Hon. Wright Patman, dated April 27,1971, replying to certain aspects of study submitted by Activists, Inc., of Baltimore, Md 342 Klein, Michael J., vice president, J. P. Cabot, Inc., New York, N.Y., statement 373 Kling, Herbert R., director, Central National Bank, Canajoharie, Fultonville, N.Y., letters dated: January 25, 1971___ 572 February 8, 1971 573 Levine, Milton E., prepared statement 352 Lipper, Arthur, III, president, Arthur Lipper Corp., letters dated May 17, 1971, to: Hon. Henry S. Reuss 704 Hon. John H. Rousselot 710 McDonald, Angus: Letter to Chairman Wright Patman, dated April 28,1971 266d List of power company executives who may have conflicts of interest in theirfinancialcorporate directorships. 244 Prepared statement 239 McLaren, Hon. Richard W., response to questions of Hon. William A. Barrett 847 Manges, Clinton, stockholder, Groos National Bank, San Antonio, Tex. with attachments: Statement on H.R. 5700 823 Letter from Lloyd M. Bentsen to Hon. Wm. B. Camp, Comptroller of the Currency, dated March 24,1971 827 Letter from Tim Timmins, Dallas, Tex., dated January 21,1971 827 VH Martin, Hon. Preston: Letter to Speaker Carl Albert dated April 17, 1971, with attached draft and section-by-section analysis of proposed bill: Housing Page Institutions Modernization Act of 1971 84 Prepared statements: Discussion of Housing Institutions Modernization Act of 1971 78 H.R. 5700 and H.R. 3287 40 Response to questions of: Chairman Wright Patman 51 Hon. Leonor K. Sullivan 62, 63, 64, 66 Martin, George C., additional statement submitted in response to questions of Hon. Margaret M. Heckler 526 Mayo, Robert P., president, Federal Reserve Bank of Chicago, letter dated April 12> 1971, expressing views on H.R. 5700 274 Melody, Lawrence J., vice president, Northland Mortgage Co., Minneapolis, Minn., letter dated May 11, 1971, with attached copy of letter to Hon. Bill Frenzel commenting on section 14 of H.R. 5700 553 Meyer, John M., Jr.: Appendix to statement: response to committee report, "The Penn Central Failure and the Role of Financial Institutions," Part V 802 Response to questions of: Chairman Wright Patman 805, 817 Hon. Stewart B. McKinney 814 Hon. William B. Widnall 807, 808 Miller, Stanley L., Port Chester, N.Y., letter dated April 23, 1971, with attached analysis and commentary of sections 19 and 21(a) of H.R. 5700— 358 Moody, Dan M., Jr., Houston, Tex., letter dated May 14, 1971 567 Myrick, Richard S., The Myrick Co., realtors, letter dated April 30, 1971.. 562 National Association of Home Builders, response to questions of Hon. Frank Annunzio 548 National Association of Small Business Investment Companies letter from Charles M. Noone, general counsel, dated May 3,1971___ 557 New York Clearing House Association, memorandum of comments on H.R. 5700 609 Oberg, Dr. Harold S., response to questions of Hon. William B. Widnall.. 695, 697 iPatman, Hon. Wright: Exchange of correspondence with Hon. Arthur F. Burns, Chairman, Federal Reserve Board 268-273 "Interlocking Directorships Between 10 Largest Life Insurance Companies and Competing Financial Institutions—1971" (table) 285 "Interlocks Among 10 Largest Commercial Banks and 10 Largest Life Insurance Companies—as of December 31, 1969" (table) 284 Letter from Robert P. Mayo, president, Federal Reserve Bank of Chicago, dated April 12, 1971 - . 274 Letters received from various small town banks concerning H.R. 5700: Chase, Goodwin, president, Pacific National Bank of Washington, Tacoma, Wash., dated April 5,1971 570 Kling, Herbert A., director, Central National Bank, Fultonsville, N.Y., dated: January 25, 1971 572 February 8, 1971 573 Shapiro, Ernest M., Lewiston, Maine, dated March 18, 1971 573 Watson, William R., Peoria, 111., dated April 17, 1971 574 "Mutual Savings Bank Investment Authority in Commercial Bank Stock" (table) 692 Response to statement submitted by Donald M., Graham, chairman, Continental Illinois National Bank and Trust Co., Chicago, 111 869 Survey of Interest Rate Calculations carried out by Federal Reserve Board at request of Chairman Patman, along with covering letter from Hon. J. L. Robertson, Vice Chairman, Board of Governors, Federal Reserve System, dated April 30, 1971 940 "Ten Largest Life Insurance Companies and 10 Largest Commercial Banks in United States—1970" (table) 283 Parsch, Rod L., chairman, Federal Legislative Committee, Independent Bankers Association of America, submission of statement on H.R. 3287. _ 600 Phalle, John de Saint, vice president, Paine, Webber, Jackson & Curtis, Inc., New York, N.Y., letter dated May 3,1971 563 vin Pittman, Steuart L., counsel for Committee of Foreign-Owned Banks, Washington, D.C., letter dated May 5, 1971, with attached enclosures consisting of (A) suggested amendment to section 14 of H.R. 5700 and Page (B) list of members 564 Proctor, Edward A., Jr., president, Proctor Homer Warren, Inc., Detroit, Mich., letter dated May 17, 1971 566 Renchard, William S., attachment to statement entitled, "Memorandum of Comments of the New York Clearing House Association on H.R. 5700". 609 Rockefeller, David: Appendix to statement entitled, "Information Concerning Sales of Penn Central Stock by the Chase Manhattan Bank During May and June of 1970" 752 Response to questions of: Chairman Wright Patman 759, 786, 787 Hon. Bill Chappell, Jr__ 775 Hon. James M. Hanley 775 Hon. Edward I. Koch___ 784 Hon. Robert G. Stephens, Jr___ 767 Hon. Leonor K. Sullivan 764 Hon. William B. Widnall 762 Rollings, R. C., president, Specialty Advertising Association International, Chicago, 111., letter dated April 28, 1971 732 Ruby, Howard F., general partner, R & B Development Co., Los Angeles, Calif., letter dated April 30, 1971 558 Ruffin, Peter B., Galbreath-Ruffin Corp., New York, N.Y., letter dated April 27, 1971 561 Schnitzer, Kenneth, chairman of the board, Greenway Plaza—Century Development Corp., letter dated May 13, 1971 566 Scott, Tom B., Jr.: Response to questions of: Hon. Henry B. Gonzalez 205 Hon. Leonor K. Sullivan 201 Supplemental statement with attached document entitled, "Officer's Questionnaire" 182 Shapiro, Ernest M., Lewiston, Maine, letter dated March 18, 1971 573 Smith, James B., mortgage vice president, Equitable of Iowa, Des Moines, Iowa, letter dated April 28, 1971 566 Smith, Melville H., president, D F S, Inc., Chadds Ford, Pa., letter dated May 6, 1971 733 Smith, Richard B., prepared statement. 118 Sommer, Clifford C.: Prepared statement 582 Response to questions of: Hon. Frank Annunzio 650 Hon. Henry B. Gonzalez 1 646 Hon. John H. Rousselot 644 Stallard, Carton S., chairman of the board, Jersey Mortgage Co., Elizabeth, N.J. letter dated May 17, 1971 567 Stastny, John A.: "A Special Report—Equitv Participation," report on survey conducted by NAHB in June 1969 523 Correspondence between Federal Home Loan Bank Board and William F. McKenna, general counsel, National League of Insured Savings Association regarding Board's position on S. & L. loans which include "equity participation" 462 Extract from NAHB Statement of Policy for 1971, adopted at annual convention, January 20, 1971, Houston, Tex 462 Prepared statement 457 Resolutions on "equity participation" adopted at NAHB board of directors meetings, 1969-70461 Response to questions of: Hon. Frank Annunzio 548 Hon. Margaret M. Heckler 523 Stern, Edgar B., Jr., president, Royal Street Corp., New Orleans, La., letter dated May 3, 1971 551 IX Sullivan, Hon. Leonor K.: Excerpt from House Conference Report 91-1781 Excerpts from the Congressional Record on H.R. 7440: April 7, 1971— December 2, 1970 Relevant excerpts of letter received from the Federal Home Loan Bank, dated December 11, 1970 Submission of table, "Baltimore—29 Savings and Loan Associations and Their Interlocks"-...-. Swalling, A. C., president, Matanuska Valley Bank, Anchorage, Alaska, letter dated May 10, 1971 Swift, Harlan, J.: Prepared statement Response to request of Hon. John H. Rousselot. Submission of table, "Savings Bank Activity in Premium Campaigns in 1970" Terry, Walter F., I l l : Letter to Chairman Wright Patman, dated May 5, 1971... __ Prepared statement Response to questions of Hon. William B. Widnall Tweedv, Harold L., president, First Federal Savings & Loan Association of Pittsburgh, letter to Hon. Thomas S. Gettys, dated April 30, 1971 Vance, Prof. Stanley C.: Prepared statement — Response to questions of Hon. Parren J. Mitchell Viertel, Joseph, Presidential Realty Corp., White Plains, N. Y., letter dated May 6, 1971 Venzke, E. W., Hennepin Federal Savings and Loan Association, Minneapolis, Minn., letter dated April 6, 1971 Ward, Alan S., prepared statement Watson, William R., Peoria, 111., letter dated April 17, 1971 Whatley, Brown L., chairman of the board, Stockton, Whatley, Davin & Co., Jacksonville, Fla., letter dated May 12, 1971 Wille, Hon. Frank: Letter to Chairman Patman dated April 12, 1971, expressing views on H.R. 3287 — Prepared statement Response to questions of: Chairman Patman Hon. Fernand J. St Germain. Williams, Hon. Lawrence G., submission of financial advertisement by Pennzoil United, Inc Wohlforth, Eric E., Commissioner, Department of Revenue, State of Alaska, Juneau, letter dated March 30, 1971 23 15 18 21 382 110 663 711 715 548 472 508 560 174 220 552 738 138 574 555 36 27 48 102 154 109 APPENDIX Adams, Gene D., president, The First National Bank, Seymour, Tex., letter to Hon. Graham Purcell, dated April 15,1971. Allen, R. S., president, Shoshone First National Bank, Cody, Wyo., letter to Hon. Teno Roncalio, dated April 1,1971 _ J.. Allen, Richard, president, Clear Lake Savings Association, Houston, Tex., letter dated May 6, 1971 Arthur, John M., Duquesne Light Co., Pittsburgh, Pa., letter dated April 15, 1971. Association of American Railroads, submission of statement Bennett, Hon. Charles E., a Representative in Congress from the State of Florida, submission of statement with attached copy of H.R. 583 Berle, Rudolf, P., Berle & Berle, New York, N.Y., letter with proposed amendments, dated April 26,1971 Binsfeld, Joseph J., senior vice president, attorney at law, Milwaukee Federal Savings & Loan Association, Milwaukee, Wis., letter dated April 19,1971Bisselle, Morgan F., secretary-general counsel, Utica Mutual Insurance Co., Utica, N.Y., letter to Hon. Alexander Pirnie, dated April 29,1971.. Brereton, Harmar, vice president and general counsel, Eastman Kodak Co., Rochester, N.Y., letter dated May 19, 1971 Burns, Franklin L., president, the D. C. Burns Realty & Trust Co., Denver, Colo., letter dated May 20,1971 933 875 913 917 881 871 926 911 915 960 963 X California Savings and Loan League, Pasadena, Calif., Franklin Hardinge, Jr., executive vice president, submission of statement Carlander, John, chairman of the board, the State Bank of Faribault, Faribault, Minn., letter to Hon. Albert H. Quie, dated May 12, 1971... Chapman, Alger B., Jr., president, Shearson, Hammill & Co., Inc. and Robert M. Gardiner, managing partner, Reynolds & Co. on behalf of the Legislative Council of Association of Stock Exchange Firms, New York, N.Y., and Investment Bankers Association of America, Washington, D.C., letter dated May 21,1971 Chisholm, John D., president, Olmsted County Bank & Trust Co., Rochester, Minn., statement Coffey, J. A., president, the First National Bank of Sanger, Sanger, Tex., letter to Hon. Graham Purcell, dated April 15,1971. Conference of State Bank Supervisors, submission of statement "Corporate Directors Under Fire," article by Ephraim P. Smith, Ph. D., University of Rhode Island and Louis R. Desfosses, Ph. D., University of Rhode Island, submitted by Hon. Fernand J. St Germain 1 Credit Union National Association, Inc., Washington, D.C., letter from Evert S. Thomas, Jr., acting managing director, dated May 6,1971 Crow, Trammell, Dallas, Tex., letter to Hon. Graham Purcell, dated April 14,1971 Davis, Charles Lee, president, Texarkana Federal Savings & Loan Association, Texarkana, Ark., letter dated April 21,1971 Davis, Hilton, general manager, legislative action, Chamber of Commerce of the United States, Washington, D.C., letter dated May 5,1971 Dixon, George H., president, First National Bank of Minneapolis, Minneapolis, Minn., letter to Hon. Bill Frenzel, dated April 27, 1971 Ellis, James H., Ellis, Holyoke & Co., Lincoln, Nebr., letter dated April 27, 1971 Elson, Gerald W., the Gerry Elson Agency, Inc., Brookfield, Mo., letter dated April 23, 1971 Faust, Joseph, president, First National Bank of New Braunfels, New Braunfels, Tex., letter dated April 22, 1971. Feagin, David A., president, The First State Bank, Colmesneil, Tex., letter dated April 16, 1971 Floreen, David A., Atlantic Mutual Insurance Co. and Centennial Insurance Co., New York, N.Y., letter dated, May 14, 1971 Getz, Bert A., Scottsdale, Ariz., letter dated April 6, 1971 Gilchrist, Charles W., Lee, Toomey & Kent, Washington, D.C., letter dated May 4, 1971 Glaze, Robert E., of Trammell Crow, Dallas, Tex., letter to Hon. Graham Purcell, dated April 15, 1971 Graham, Donald M., Continental Illinois National Bank & Trust Co., Chicago, 111., letter dated March 30, 1971 Gullander, W. P., president, National Association of Manufacturers, New York, N.Y., letter dated May 7, 1971 Hagan, Hon. G. Elliott, a Representative in Congress from the State of Georgia, letter dated April 22, 1971, with attached letter from John B. Spiney, president, First Federal Savings & Loan Association of Swainsboro, Swainsboro, Ga Hall, W. G., Citizens State Bank, Dickinson, Tex., letter dated April 5, 1971, with attached list of Texas bank failures and schedules of the dollar losses Hodges, Joe H., president, Abilene National Bank, Abilene, Tex., letter to Hon. Graham Purcell, dated April 15, 1971 Holman, Bill, president, the First National Bank of Henrietta, Henrietta, Tex., letter to Hon. Graham Purcell, dated April 15, 1971 Horton, Charles C., chairman, legislative committee, Rhode Island League of Savings and Loan Associations, Providence, R.I., letter dated May 10, 1971 Jones, L. D., Jr., Seymour, Tex., letter to Hon. Graham Purcell, dated April 20, 1971 Josch, Martin, Jr., vice president, the Huntington State Bank, Huntington, Tex., letter to Hon. Graham Purcell, dated April 22, 1971 Kimberlin, Sam O., Jr., executive vice president, Texas Banking Association, Austin, Tex., letter to Hon. Graham Purcell, dated April 13, 1971— Lee, John F., executive vice president, New York Clearing House, New York, N.Y., letter dated May 24, 1971, with proposed amendment to section 19 of title 15 of the Banking Reform Act of 1971 88$ 954 962 887 934 876 890 909938 911 91& 901 931 916 901 90& 91fr 931 929" 93& 899 918: 898 903 937 932* 910 933 935 934 959' XI Leighton, Howard H., president, National Association of Insurance Agents, Inc., Washington, D.C., letter dated May 14, 1971 Levine, Milton E., chairman of the board, Meyers Pollock Robbins, Inc., New York, N.Y., letter dated March 15, 1971 Lewis, A. J., chairman of the board, Jefferson State Bank, San Antonio, Tex., letter to Hon. Henry B. Gonzalez, dated April 26, 1971 Lumsden, Arthur J., president, Greater Hartford Chamber of Commerce, Hartford, Conn., letter dated May 19, 1971, with policy statement re Banking Reform Act of 1971 McAuliffe, William J., Jr., American Land Title Association, Washington, D.C., letter dated May 3, 1971 Miracle, R. W., president, the Wyoming National Bank, Casper, Wyo., letter to Hon. Teno Roncalio, dated April 6, 1971 Nathan, Robert R., Robert R. Nathan Associates, Inc., Washington, D.C., letter dated March 29, 1971 National Association of Insurance Agents, Inc., Washington, D.C., letter from Howard H. Leighton, president, dated May 14, 1971 Needham, Oran F., chairman and chief executive officer, the Millers Mutual Fire Insurance Co. of Texas, Fort Worth, Tex., letter to Hon. Graham Purcell, dated April 16, 1971 Orth, Frederick J., Unigard Insurance Group, Seattle, Wash., letter dated April 22, 1971 ... Pittman, John H., president and cochairman, Commonwealth National Bank, Dallas, Tex., letter to Hon. Graham Purcell, dated April 20,1971_„ Price, Hon. Robert D., a Representative in Congress from the State of Texas, submission of statement Purcell, Hon. Graham, a Representative in Congress from the State of Texas, letter dated April 27, 1971, with attached letters Quie, Hon. Albert H., a Representative in Congress from the State of Minnesota, letter dated May 18, 1971 Ray, W. Wilson, president, First National Bank, Bridgeport, Tex., letter to Hon. Graham Purcell, dated April 16, 1971 Rhode Island League of Savings and Loan Associations, letter dated May 10,1971, from Charles C. Horton, chairman, legislative committee— Robertson, Hon. J. L., Vice Chairman, Board of Governors, Federal Reserve System, letter dated April 30, 1971, with attached final tabulations of responses to committee's survey of interest calculations banks use on loans Roncalio, Hon. Teno, a Representative in Congress from the State of Wyoming, statement. Attached letters to statement: Allen, R. S., president, Shoshone First National Bank, Cody, Wyo., dated April 1, 1971 Miracle, R. W., president, the Wyoming National Bank, Casper, Wyo., dated April 6, 1971 Steadman, Oliver W., Steadman & Steadman, Cody, Wyo., dated March 31, 1971 Rushlow, B. C., chairman of the board, the National Bank of Northern New York, Watertown, N.Y., letter dated March 25, 1971. St Germain, Hon. Fernand J., letter dated May 11, 1971, with attached paper entitled, "Corporate Directors Under Fire" Sawyer, William P., president, Massachusetts Federal Savings Council, Inc., statement re H.R. 5700. Shands, Ned, Jr., Peavy & Shands, Lufkin, Tex., letter to Members of Congress from the State of Texas, dated April 19, 1971 Shuman, Charles B., Sullivan, 111., letter dated March 26, 1971 Spivey, John B., president, First Federal Savings & Loan Association of Swainsboro, Swainsboro, Ga., letter dated April 14, 1971.. Stathis, Gus, Gus Stathis Construction Co., Inc., Oak Lawn, 111., letter dated May 13, 1971 Steadman, Oliver W., Steadman & Steadman, Cody, Wyo., letter to Hon. Teno Roncalio, dated March 31, 1971 Stewart, Maco, Stewart Information Services Corp., Princeton, N.J., letter dated April 30, 1971 Still, Willard J., president. Southwest National Bank, Wichita Falls, Tex., letter to Hon. Graham Purcell, dated April 26, 1971 Talley, Jerry L., president, Grayson County State Bank, Sherman, Tex.,' letter to Hon. Graham Purcell, dated April 20, 1971 The First National Bank of Atlanta, submission of comments on H.R. 5700. Pw 914 925 906 961 923 874 899 914 937 917 934 872 932 954 932 910 940 874 875 874 876 900 890 882 939 900 898 924 876 922 939 936 955 XII Thomas, Evert S., Jr., acting managing director, Credit Union National Association, Inc., Washington, D.C., letter dated May 6, 1971 Tippett, Robert A., Tippett Land & Mortgage Co., Kennewick, Wash., letter dated April 29, 1971 Vander Zee, Harlan D., president, Hereford State Bank, Hereford, Tex., letter to Hon. Graham Purcell, dated April 23, 1971 Waggoner, Dick, City National Bank, Wichita Falls, Tex., letter to Hon. Graham Purcell, dated April 19, 1971 Walden, Roland W., Midway National Bank of Grand Prairie, Grand Prairie, Tex., letter to Hon. Graham Purcell, dated April 16, 1971 Wetzel, Carroll, Dechert Price & Rhoads, Philadelphia, Pa., letter dated March 31, 1971 Wimmer, Ed, vice president, public relations director, National Federation of Independent Business, Covington, Ky., letter dated April 16, 1971__ 909 924 936 933 937 899 920 TABLES Baltimore—29 Savings and Loan Associations and Their Interlocks Interlocking Directorships Between 10 Largest Life Insurance Companies and Competing Financial Institutions—1971 Interlocks Among 10 Largest Commercial Banks and 10 Largest Life Insurance Companies—as of December 31, 1969 Mutual Savings Bank Investment Authority in Commercial Bank Stock. _ Savings Bank Activity in Premium Campaigns in 1970. Ten Largest Life Insurance Companies and 10 Largest Commercial Banks in United States—1970 382 285 284 692 715 283 CHART Daily Sales of Penn Central Common Stock by Three Banking Institutions During Period May 15, 1970 to June 19, 1970 (fold-in) facing page ORGANIZATIONS R E P R E S E N T E D AT Government: Comptroller of the Currency, U.S. Treasury Department of Justice Federal Deposit Insurance Corporation Federal Home Loan Bank Board Federal Reserve Board Federal Trade Commission Securities and Exchange Commission Private: Activists, Inc American Bankers Association American Life Convention American Mutual Insurance Alliance Arthur Lipper Corp Chase Manhattan Bank Independent Bankers Association of America James W. Rouse Co Life Insurance Association of America Morgan Guaranty Trust Co Mortgage Bankers Association of America Myers Pollock Robbins, Inc National Association of Home Builders National Association of Mutual Savings Banks National Association of Real Estate Boards New York Clearing House Association Robert Morris Associates. Saver Incentives Premium Industry Committee United States Savings and Loan League— 804 HEARINGS 129 838 25 37 276 136 114 __ 321 575 474 490 676 746 592 468 474 796 468 347 453 657 464 605 624 677 179 THE BANKING REFORM ACT OF 1971 WEDNESDAY, APRIL 28, 1971 HOUSE OF REPRESENTATIVES, COMMITTEE ON BANKING AND CURRENCY, Washington, D.C. The committee met, pursuant to recess, at 10:05 a.m. in room 2128, Rayburn House Office Building, Hon. Wright Patman (chairman) presiding. Present: Representatives Patman, Barrett, Sullivan, Ashley, St Germain, Gonzalez, Gettys, Annunzio, Griffin, Koch, Cotter, Widnall, Johnson, Blackburn, Brown, Williams, Heckler, Lent, and Archer. The CHAIRMAN. The committee will come to order. This morning the committee will take testimony from representatives from five trade associations, two representing businesses involved in construction and real estate, and three representing the insurance industry. The witnesses are John A. Stastny of the National Association of Home Builders; Donald I. Hovde, chairman, Realtors' Washington Committee, National Association of Real Estate Boards; Philip C. Jackson, vice president, Mortgage Bankers Association of America; John T. Fey, American Life Convention and Life Insurance Association of America; and John S. Hamilton, Jr., of the American Mutual Insurance Alliance. These witnesses were primarily scheduled at one time because of their particular interest in the issue of equity kickers or equity par* ticipation. In this way the committee is provided with an opportunity to hear all sides of the argument on this issue at the same time. We will hear from these gentlemen in the order I listed them. Please try to summarize your statements in 10 minutes so we will have time to ask questions of the witnesses. And usually most of the things in your statement are brought out anyway. But if the things you want brought out are not brought out, you have permission to extend your remarks when you look over your transcript to bring out any points that you want to in your own interest. The first witness is Mr. Stastny of the National Association of Home Builders. STATEMENT OF JOHN A. STASTNY, PRESIDENT, NATIONAL ASSOCIATION OF HOME BUILDERS; ACCOMPANIED BT GEORGE C. MARTIN, VICE PRESIDENT AND TREASURER, LOUISVILLE, KY. Mr. STASTNY. My name is John Stastny. I am a homebuilder from Chicago. And I am here in my capacity as president of the National Association of Home Builders of the United States. (453) 454 I have asked Mr. George Martin of Louisville, Ky., to accompany me. Mr. Martin is a vice president of our association, and has had a great deal of personal experience with lenders in this business of equity kickers and equity participation. The CHAIRMAN. We are glad to have him. Mr. STASTNY. We appreciate the opportunity to be before you and testify and we support the section of H.R. 5700 which we will address ourselves to. The bill is a broad and comprehensive effort to regulate certain activities offinancialinstitutions and certain relationships which their officer*, directors, and employees have with otherfinancialinstitutions, business, and customers of the institutions. We feel, though, that our competence and our personal experience make us most useful to this committee and to the Congress in the specific area that we will address ourselves to, and we will leave to others, who are more knowledgeable in the business, the task of dealing with other issues in the bill. The one section of H.R. 5700 with which we do have a great deal of familiarity and which we feel competent to testify on is section 14. And we feel that because of many actions taken by our board of directors—we have gone on record on four different occasions with resolutions which we have attached to the prepared statement we have submitted—we feel that, in line with the many expressions we have made publicly and incorporated in our policy statements which have also been submitted to you, we must come in and support vigorously the provisions of section 14 of H.R. 5700. We first became concerned with equity participation in 1969. Our first resolution was adopted at our board" meeting in October 1969 in San Diego, and then subsequently in the next several meetings. It was during the spring and summer of 1969, as money got tighter and tighter, that many lenders found the possibility, and exercised it, of squeezing that extra last drop of blooa through equity participation , from the people who were borrowing the money. The practice was growing rapidly, and our board felt that there was a serious necessity to register its feelings. Now, in the statement of policy which we adopted at our convention in Houston in January 1970 we again called on the Congress to investigate what we then called a rapacious practice. With your permission, sir, I would like to read one paragraph from that policy statement, because I think it describes our feeling, and I think it is constructive: We call on the Congress to investigate the rapacious practice—now standard in insurance company lending and spreading to other institutions (including pension funds)—of demanding a share of property income in addition to astronomical interest and fees. Whether or not it is a device to protect lenders against long-term inflation, the practice is thoroughly and intrinsically unsound. Unless checked, it will lead to widespread foreclosures at the first substantial economic downturn—with serious adverse consequences to developers, to lending institutions and those entrusting their savings to them, and, most important, to the general public. Now, our members are very concerned. And you might question why. There are many, many reasons. We feel that it is a disturbance to the historic and basic relationship between borrower and lender. The lender who is also a borrower in a transaction of this kind might 455 simply not tend to be as rigorous as he otherwise would be in assuring that the risks of a particular loan are reasonable. In too many cases we have seen a desire on the part of the lender to lend money on an unsound deal where he can get a piece of the action, as opposed to a solid transaction where no equity participation is obtainable. This can only result in ultimate serious trouble for such lenders. Where the lender, in addition to the normal payment of principal and interest, takes a substantial portion of the earnings of the project, the incentives to the project owner to maintain the project and to be concerned about its long-term stability and feasibility are severely lessened. In fact, we did a study a couple of years ago that showed that the developers building under equit}' participation simply had no intention of keeping their projects for as long a period as they would had there been no equity participation. Many lenders are thus liable to find themselves 5 to 10 years after making such a loan the owners of apartment projects which have had to be abandoned because the economic feasibility had been beaten out of them. One of the frequent arguments made by those favoring equity participation is that it permits the borrower to obtain a more favorable interest rate, and that this is especially important in times of tight money. We have not seen it work that way, sir. Our experience has been to the contrary. Interest rates charged in connection with mortgage loans in which there has been equity participation have usually been at the same levels as those charged without equity participation. And the only more favorable aspects of the financing have been somewhat longer terms, and in some cases occasionally higher loan to value ratios. A very serious side effect of equity participation in apartment financing is that the builder-owner of the project, in order to realize a return commensurate with that earned by investors in real estate projects without equity participation, has to set rents higher than those charged in competitive projects. These rents are frequently difficult to obtain, unless there is a severe shortage of rental apartments available. The net result can be an increase in housing cost to all of the people in a given community because of this kind of effect, because if he is able to raise those rents, the other guys are going to follow along with him. Perhaps one of the most serious indirect effects is this unwarranted increase in the cost of housing, an increase which in many cases drives people out of the market who in the past have been able to afford modest-priced housing without subsidy. Now, a potential real problem is the future of a project which carries a mortgage of 9 to 10 percent because it was initiated at the height of the money crunch and which carries the additional burden of an indirect charge being paid in the form of an equity kicker which is locked in for perhaps 10 or 15 years. The rents that will have to be charged if such a project were to stay financially alive generally have to be higher, certainly higher than the project which is put in today at 7 Yz percent, with no equity participation driving up the cost. Now, there are many, many approaches—and 1 am sure you are aware of all of them—to equity participation. We enumerate them in the testimony we submitted for the record. Some of them are more 456 complicated than others. Some of the simpler methods, and therefore the more common methods, have been described in the July 1970 issue of Fortune magazine. (See page 536.) And that issue "of the magazine—I recommend it to you, sir—also details some very esoteric approaches developed by some of the Nation's largest insurance companies. The article also points out why equity participation became such a factor in the multifamily mortgage market during 1969 and 1970. The lender had the upper hand because of the shortage of money, and they were not satisfied with the interest rates at the highest level in a hundred years, and they endeavored to grab as much as they could during the process. The CHAIRMAN. Would you pick out some of the examples in the Fortune magazine article and insert them in connection with your remarks so that it will be a part of the record? Mr. STASTNY. We shall, sir, if we are permitted to submit them in writing at a later time. The result of what is pointed out in this article is that the projects were not being built during a time of housing shortage because of the resistance by borrowers to giving lenders a piece of the project. Now, if a deal cannot work you cannot build it. And this certainly did contribute to the downtrend in housing production during a time of severe housing shortage. A review of housing startsfiguresduring that period will show that apartment starts were down considerably more than single family starts. Now, this committee should be aware of another proposal which we find shocking, with reference to equity participation. And that is that lenders should be allowed to develop methods of participating in the equity which is created for and by homeowners in single-family housing. We object strongly to his idea, and we oppose it greatly. One of the strongest incentives for the purchase of a home for most families is the opportunity that it provides to develop equity and thus a family estate. We see no reason why lenders should be given any opportunity to curtail the operation of the American system under which families since the beginning of our history have had an opportunity to become property owners. We hope the committee will agree with us. The most avid practititoners of equity have been the insurance companies. The banks and savings and loan associations have not been as active in this field as yet. . We are heartened by the recognition of the FDIC that it might well be advisable to ban the practice of equity participation. Mr. Frank Wille, who is Chairman of the Federal Deposit Insurance Corporation in his statement to this committee on April 20, pointed out the problem, and his recommendations, and tied it to action which was taken by the Congress on one-bank holding companies. We are concerned, though, by the position taken by Dr. Preston. Martin, Chairman of the Federal Home Loan Bank Board. I refer you to his statement to this committee on April 2Q. He suggested that .prohibition of this practice might be undesirable. That is quite disturbing. We do not Agree with him. We make reference in our testimony to letters that have been 457 written by the general counsel of the Federal Home Loan Bank Board and others with whom they have corresponded. I would like to point out that, in the April 25 letter to which we refer from Mr. Wilfand, stating that receiving a percentage of gross rents of a project did not constitute a form of equity participation, but that receiving a percentage of net rents would, we find it terribly disturbing to see that the Home Loan Bank Board is apparently endorsing what is probably the unsafest of the equity participation approaches. Where a percentage of gross rents must be paid regardless of whether enough rents are collected to meet debt service requirements, and operating costs, a project might well be forced into foreclosure as a result. On the other hand, where a percentage of net rents is paid, the extra pay out only occurs after all of the project obligations have first been met. I would like to touch briefly on the details of section 14 of H.R. 5700. A similar prohibition contained in H.R. 18676 of the 91st Congress was endorsed by our board of directors. However, that endorsement was conditioned on the prohibition being applied only to loans involving real property. It was the feeling of many of our directors that they were not qualified to pass upon the appropriateness of equity participation in other types of situations. So they limited their endorsement to that area with which they were most familiar. The prohibition in H.R. 5700 would be limited to insured banks and savings institutions, bank and savings and loan holding companies, as defined in Federal legislation, and their subsidiaries, and insured mutual savings banks and insurance companies. This would seem to exempt from the prohibition non-insured banks and savings and loans as well as mortgage bankers and other lenders in the business of making loans. These would have been covered by chapter 4 of H.R. 18676. We urge this committee to expand the prohibition in section 14 of H.R. 5700 to include all lenders. Some question arose in our board deliberations as to whether the prohibition contained in the bill barring a lender from accepting any equity participation in consideration of making any loan would bar a true joint venture, which might be initiated at the behest of a builder, and not imposed by a lender as a condition of the making of a loan. It was our feeling that such would not be prohibited. But we urge the committee to make the point clear either with statutory language or with adequate legislative history. In closing, I want to say how much I appreciate the opportunity to be here, and the fact that the committee is giving serious consideration to the provisions that we have mentioned. (Mr. Stastny's prepared statement with attachments follows:) P R E P A R E D STATEMENT OF JOHN A . STASTNY, PRESIDENT, N A T I O N A L ASSOCIATION OF H O M E B U I L D E R S Mr. C H A I R M A N : My name is John A. Stastny. I am a home builder from Chicago, Illinois and I appear before you today in my capacity as President of the National Association of Home Builders. With me today is Mr. George C. Martin who serves as NAHB's Vice President and Treasurer. Our members build about two-thirds of the homes and apartments constructed annually by professional builders. About two-thirds of those who build apartments do so with the intention of retaining ownership. • I appreciate this opportunity to appear before you and present the views of the home building industry on H.R. 5700, the Banking Reform Act of 1971. This bill 60-299—71—pt. 2 2 458 is a broad and comprehensive effort to regulate certain activities of financial institutions and certain relationships that their officers, directors or employees have with other financial institutions, businesses and customers of the institutions. These proposals are complex, many are of a technical nature, and they deal with areas upon which we do not really consider ourselves qualified to comment. We will, therefore, leave to others, more knowledgeable with the workings of the various financial institutions, the making of detailed comments on these provisions. There is, however, one section of H.R. 5700 with which we do have great familiarity and on which we do feel ourselves fully competent to testify. That is Section 14 which would prohibit certain lenders from accepting "any equity participation in consideration of the making of any loan." A similar provision contained in H.R. 18676 of the 91st Congress was endorsed by our 800-member Board of Directors at its meeting in Boston on September 21,1970. That resolution was the fourth resolution in a row adopted by our Board of Directors in opposition to the practice of lenders making equity participation a condition for the granting of a loan on an apartment project. These resolutions were adopted at our Board of Directors' meetings in October 1969, January 1970, and May 1970, as well as the September 1970 meeting. The practice was also condemned in the Statements of Policy adopted at our Annual Conventions in Houston in January 1970 and 1971. Copies of these resolutions and the pertinent extracts from our Statements of Policy are attached. The first resolution, adopted as our Board meeting in San Diego in October 1969, reflected the fact that this insidious practice had just begun to be a significant factor in the financing of apartments. It was during the spring and summer of 1969, as money got tighter and tighter, that many lenders found it possible to squeeze out the extra drop of blood that equity participation often represents. This practice had grown so rapidly that, by the time of our Board of Directors meeting in San Diego during the second week of October, there was great alarm among those who build multifamily dwellings. As stated in that resolution this practice "often encourage (s) unsound loans with high loan-to-value ratios . . . (and) . . . the economic feasibility of many apartment complexes is jeopardized bjr such practices." In that resolution we urged the Congress and Federal and state regulatory agencies to investigate and curb these practices. In the Statement of Policy adopted at our Convention in Houston in January 1970, we again called on the Congress to investigate this "rapacious practice." I believe that the paragraph of that Statement of Policy dealing with equity participation states as well as practically anything else the problems inherent in it. I would, therefore, like to read you that entire paragraph. We call on the Congress to investigate the rapacious practice—now standard in insurance company lending and spreading to other institutions (including pension funds)—of demanding a share of property income in addition to astronomical interest and fees. Whether or not it is a device to protect lenders against long-term inflation, the practice is thoroughly and intrinsically unsound. Unless checked, it will lead to widespread foreclosures at the first substantial economic downturn— with serious adverse* consequences to developers, to lending institutions and those entrusting their savings to them, and, most important, to the general public. Why is it that our members are so concerned about any widespread incidence of equity participation: There are many reasons. A prime reason is that it disturbs the historical relationship between lender and borrower. It is not the disturbance itself which is of such concern but the potential results from this disturbance. The lender who is also a borrower in the same transaction may tend to not be as rigorous as he would otherwise be in assuring that the risks of a particular loan are reasonable. In too many cases have we seen a desire on the part of a lender to lend money on an unsound deal where he can get a piece of the action, as opposed to a solid transaction where no equity participation is obtainable. This can only result in ultimate serious trouble for such lenders. Where the lender, in addition to normal payments of principal and interest, takes a substantial portion of the earnings of a project, the incentives to the project owner to maintain the project and to be concerned about its long term stability and welfare are severely lessened. In fact, a study conducted by us two years ago indicated that those developers building under an equity participation scheme were intending to hold the project for a much shorter period of time than those not giving any equity participation to the lender. Many lenders are thus liable to find themselves five to ten years later, the owners of apartment projects which have been abandoned by their owners, because they do not make economic sense any longer, and which are in need of repairs and past due maintenance attention. 459 One of the frequent arguments made by those favoring equity participation is that it permits the borrower to obtain a more favorable interest rate and that this is especially important in times of tight money when interest rates are otherwise very high. Our experience has been to the contrary. Interest rates charged in connection with mortgage loans in which there was an equity participation involved have usually been the same as those charged without equity participation. The only more favorable aspects of the financing have been somewhat longer terms in some cases and occasionally higher loan-to-value ratios. A very serious side effect of equity participation in apartment financing is that the builder or other owner of the project, in order to realize a return commensurate with that earned by investors in real estate projects without equity participation, must set rents which are higher than those charged in competitive projects. These rents are frequently difficult to obtain unless there is an extremely tight vacancy situation in the community. Then they have the unsatisfactory side effect of tending to draw up rents in other projects, thereby increasing the cost of housing to all. Perhaps one of the most serious indirect effects is this unwarranted increase in the cost of housing, an increase which in many cases drives people out of the market who in the past have been able to afford modest, unsubsidized rental housing. A potential real problem is the future of a project carrying a mortgage at 9 % to 10% because it was initiated at the height of the money crunch and carrying the additional burden of an indirect interest charge being paid in the form of an equity participation locked in, as is common, for perhaps 10 to 15 years. The rents that will have to be charged in such a project for it to stay financially alive generally will be considerably higher than those needed in a project started today with 7 to 7%% mortgage money and no equity participation to drive up the carrying cost of the project. As the vacancy situation hopefully becomes better, we may see many of the projects financed with equity participation going under. You may be asking exactly what do we mean by equity participation. We mean many separate things, since there are almost as many schemes as there are lenders. However, there are about five basic approaches which I will briefly describe. Perhaps the most common is a flat percentage of the project's gross income. This is uncomplicated and thereby does not involve the lender in any management considerations. The percentage commonly varies from 1% to 3%. A variation on this approach is a participation in all gross income after a •certain break-even point. This approach at least leaves enough motley in the project to pay some of the basic expenses, a deficiency of the first approach. A third approach is to take a percentage of the net income of the project. This approach does not jeopardize the financial stability of the project to the same extent as the first two. A more complicated approach, which has several variations, is for the lender to buy all or part of a project, such as the land, for example, and lease it back to the developer. The lender then may become the ultimate owner of the project upon termination of the lease or the developer may have an option to buy back the property upon full payment of the mortgage. This scheme is also frequently combined with some percentage of gross or net receipts. A fifth means is for the lender to insist upon a substantial portion of any increase in rents over those calculated at the time the project is put together, regardless of whether increased operating costs necessitate such increased rents. The lender's objective is to get at the increased values stemming from inflation. These are the simpler methods and therefore the more common. An article in the July 1970 Fortune details some very esoteric approaches developed by some of the nation's largest insurance companies. This article also points out why equity participation became such a potent factor in the multifamily mortgage market during 1969 and 1970. The lenders had the upper hand because of the shortage of money. They weren't satisfied with interest rates at the highest levels in 100 years and endeavored to grab as much more as they could. One result of this greed pointed out in this article is that projects were not being built because of the resistance by borrowers to giving lenders a piece of the project. The deal just won't work, and for the builder the project becomes an impossibility. This certainly contributed to the downturn in housing production during 1969 and 1970. A review of housing starts figures over the last two years indicates that apartment starts declined considerably more, proportionately, than -did single family starts. The Committee should be aware of another proposal which we find shocking 460 with reference to equity participation, which is that lenders should be allowed to develop methods of participating in the equity which is created for and by home owners in single family housing. We object strongly to this idea, we oppose it completely. One of the strongest incentives to the purchase of a home, for most families, is the opportunity it provides to develop equity and thus a family estate. We see no reason why lenders should be given any opportunity to curtail the operation of the American system under which families since the beginning of our history have had an opportunity to become property owners. We hope this Committee agrees. The most avid practitioners of equity participation have been the insurance companies. Many, in fact, will only lend money on that basis. The pension funds have increasingly required it. Less active in this area have been the banks and the savings and loans. We were heartened by the recognition of the Federal Deposit Insurance Corporation that it may well be advisable to ban the practice of equity participation. In fact, Frank Wille, Chairman of the FDIC, in his statement to this Committee on April 20 points out one further problem with this practice—that the acceptance of equity participations by banks runs counter to the philosophy, underlying the determination of the Congress last year in its actions on bank holding companies, that banking and commerce should be separate. Of concern to us however was the position taken by Preston Martin, Chairman of the Home Loan Bank Board, in his statement to this Committee also on April 20. His statement that any prohibition of this practice would be undesirable is quite disturbing. This statement, taken in conjunction with a decision by the Board's General Counsel's office in April 1969 and the recent announcement by the Federal Home Loan Mortgage Corporation that it is willing to purchase participations in loans which included an equity participation, seems to indicate a feeling on the part of the Home Loan Bank Board that this practice is desirable.. The decision by the Board's General Counsel's office is set out in a letter dated April 25, 1969 from Max Wilfand, Acting General Counsel of the Board, to Mr. William F. McKenna, General Counsel of the National League of Insured Savings Associations. That letter distinguished a position taken by a previous General Counsel of the Board in a letter of January 15, 1969, to Mr. McKenna. In the January 15 letter, Mr. Alan Jay Moskov stated there was no authorization for a Federal savings and loan association to invest in the equity of a real estate project. The particular approach proposed was that, in addition to its earning interest on the loan, the association would receive a specified percentage or share of the income derived from the operation of the project. The April 25 letter from Mr. Wilfand stated that receiving a percentage of the gross rents of a project did not constitute a form of equity participation, but that receiving a percentage of the net rents would. It is disturbing to see the Home Loan Bank Board endorsing what is probably the unsafest of the equity participation approaches. Where a percentage of the gross rents must be paid regardless of whether enough rents are collected to meet debt service requirements and operating costs, a project may well be forced into foreclosure as a result. On the other hand, where a percentage of net rents is paid, the extra payout only occurs after all the project's obligations have first been met. A copy of this correspondence is attached. I would like now to touch briefly upon the details of Section 14 of H.R. 5700. As I stated before, a similar prohibition contained in H.R. 18676 of the 91st Congress was endorsed by our Board of Directors. However, that endorsement was conditioned upon the prohibition being applied only to loans securing real property. It was the feeling of many of the members of the Board of Directors that they were not qualified to pass upon the appropriateness of equity participation in other types of situations and, therefore, they limited their endorsement to that area with which they were most familiar. The prohibition in H.R. 5700 would be limited to insured banks and savings institutions, bank and savings and loan holding companies, as defined in Federal legislation, and their subsidiaries, uninsured mutual savings banks, and insurance companies. This would seem to exempt from the prohibition noninsured commercial banks and savings and loans, as well as mortgage bankers and other lenders in the business of making loans. These would have been covered by chapter 4 of H.R. 18676 and we urge the Committee to expand the prohibition in Section 14 of H.R. 5700 to include all lenders. Some question arose in our Board of Directors' deliberations as to whether the prohibition contained in the bill barring a lender from accepting "any equity 461 participation in consideration of the making of any loan" would bar true joint ventures initiated at the behest of a builder and not imposed by a lender as a condition to the making of a loan. It was our feeling that such would not be prohibited, but we urge the Committee to make the point clear, either with statutory language or with adequate legislative history. In closing, let me say that we are very pleased that this Committee is seriously considering this legislation on equity participation. It has been one of the most serious problems confronting our industry in its efforts to provide needed apartments over the past two years of tight money. We urge the Committee to approve Section 14 of H.R. 5700. Thank you. NAHB RESOLUTIONS M O R T G A G E F I N A N C E COMMITTEE, A P A R T M E N T CONSTRUCTION & M A N A G E M E N T C O M M I T T E E , San Diego, Calif., October IS, 1969. EQUITY PARTICIPATIONS Whereas the practice of requiring an equity participation, as a condition for •extending long term permanent financing, has grown to the exclusion of fixed yield mortgages, and Whereas such participations often encourage unsound loans with high loan-tovalue ratios, and Whereas the economic feasibility of many apartment complexes is jeopardized by such practices: Now, therefore, be it Resolved, That we once again condemn these practices in the strongest terms possible and that we urge the Congress and Federal and State regulatory agencies to investigate and curb such practices and that NAHB examine and develop as a priority a program aimed at curbing the abuses inherent in these practices; and be it further Resolved, That there be presented to this Board, at its next meeting, proposals which are aimed at this objective. MORTGAGE FINANCE COMMITTEE, MORTGAGE FINANCE COMMITTEE, NATIONAL LEGISLATIVE COMMITTEE, Houston, Tex., January 19, 1970. Be it resolved that legislation be sought to bar lender participation, in any form other than interest, in the proceeds of a pioject securing a loan made by a lender who operates across State lines or who pavs less than a fully effective Federal income tax rate. Washington, D.C., May 25, 1970. Whereas, current NAHB policy is that legislation be sought to bar lender participation, in any form other than interest, in the proceeds of a project securing a loan made by a lender who operates across state lines or who pays less than a fully effective Federal income tax rate, Now, therefore, be it resolved, that a fiduciary be precluded from using a majority interest in, or a wholly owned subsidiary, as a vehicle to circumvent the objective of this policy. Boston, Mass., September 81, 1970. PROHIBITION OF EQUITY PARTICIPATION Whereas, NAHB has consistently expressed its opposition to the practice of mortgage lenders requiring, in addition to interest ana fees, a share of the equity or comparable participation in the proceeds of a project in return for making a mortgage loan, and Whereas, Chairman Wright Patman (D-Texas) of the House Banking and Currency Committee in July introduced the Safe Banking Act of 1970 (H.R. 18676) which under Chapter 4 would subject to civil and criminal penalty any lender requiring equity participation in consideration of making any loan, 462 Now, therefore, be it resolved, that with respect to the financing cf projects NAHB express to the Congress its complete support for the provisions of Chapter 4 of H.R. 18676 providing that, " N o lender may accept any equity participation in consideration of the making of any loan.", providing that such restrictions are applied to loans securing real property only. E X T R A C T F R O M THE N A T I O N A L ASSOCIATION OF H O M E BUILDERS 1 STATEMENT OF POLICY FOR 1 9 7 1 APPROVED BY NAHB BOARD OF DIRECTORS, JANUARY 20, 1971, HOUSTON, T E X . The need for thorough investigation of residential lending is emphasized by: (a) almost complete abandonment of this area of activity by large segments of the private mortgage market; and (6) the rapacious practice—now standard in insurance company lending and rapidly spreading—of demanding compulsory equity participation (in addition to an insupportably high-cost first lien). This forfeiture by those entrusted with huge pools of the people's savings raises a real and unwelcome threat that the secondary markets provided by the Federal National Mortgage Association and by the Federal Home Loan Bank Board may, of necessity, develop into a huge mortgage company rather than a last resource. FEDERAL HOME LOAN BANK BOARD, Washington, D.C., July 8, 1970. M r . NORMAN J . FARQUHAR, Director, Mortgage Finance Department, National Association of Home Builders> National Housing Center, Washington, D.C. D E A R M R . F A R Q U H A R : This is in reply to your letter of June 2 5 , 1 9 7 0 , regarding our opinion of April 25, 1969 concerning the practice of Federal savings and loan associations receiving a percentage of the rent in addition to interest on a loan. That opinion still represents our thinking on this matter, and a copy of it is enclosed for your information. You will note that we have no legal objection to this practice provided that the association does not obtain an equity interest in the project. Sincerely yours, ARTHUR W . LEIBOLD, J r . , General Counsel. F E D E R A L H O M E LOAN Mr. WILLIAM F . MCKENNA, BANK BOARD, April 25, 1969 General Counsel, National League of Insured Savings Associations, Washington, D.C. D E A R M R . M C K E N N A : This is in reply to your letter of April 8 , 1 9 6 9 , inquiring as to whether a Federal savings and loan association may legally make a loan on> a multifamily housing project under the terms of which the association would receive a percentage of the rent in addition to the stated rate of interest. In our previous letter to you dated January 15, 1969 we indicated that a Federal savings and loan association was not authorized to invest in an equity interest in a real estate project, either in the form of stock ownership or a percentage of the rent. You now ask whether our position would be different if the association received, in addition to the stated rate of interest, a percentage of the gross rent rather than a percentage of the net rent. The argument is made that such arrangement does not place the lender in the position of an equity holder in the project because his right to receive a share of the gross income removes him from the risks carried by an equity owner. We agree that there is no prohibition in the Federal Regulations against an association receiving a percentage of the rent in addition to the interest as long as the association does not acquire an equity in the project. We would also agree, in general, that the right to receive a percentage of the gross rent in a project probably would not constitute an equity interest. It should also be noted that a transaction involving a percentage of rent may be subject to state usury laws. 463 I know you realize that we cannot render any definitive ruling in the foregoing, connection, in the absence of the facts in a particular case. Sincerely yours, (Signed) Max Wilfand MAX WILFAND, Acting General Counsel. FEDERAL H O M E LOAN B A N K BOARD, Washington, D.C., January 15, 1969. M r . WILLIAM F . M C K E N N A , General Counsel, National League of Insured Savings Associations, Washingtonr D.C. D E A R B I L L : This is in reply to your letter of Januay 9 , 1 9 6 9 , in which you request my opinion as to whether a Federal savings and loan association may engage in a transaction which you describe as follows: A loan would be made by a Federal association to a contractor for construction of an apartment house. The loan would carry the market rate of interest and would be repayable according to a schedule of periodic payments of principal and interest calculated to repay the loan completely by the maturity date. No disproportionately uneven (or balloon) payment of principal would be included in the repayment schedule. The portion of the investment arrangement that would distinguish it fvom the normal apartment house loan would be a provision that in addition to repayment of principal and of interest at a stated rate in the mortgage note, the association would also be entitled to receive a specified percentage or share of income derived from operation of the apartment project. To this, extent, the Federal association would be acquiring an equity interest in the project. The equity interest might be evidenced by ownership of stock in a corporation that owns the apartment project, or it might be evidenced by a provision in the mortgage documents entitling the lender to receive a share, of the income from the project. The transaction under consideration involves, in addition to a real estate loan,, an investment by a Federal association in an equity interest in the project. As you know, the authority of Federal associations to make loans and investments is contained in § 5(c) of the Home Owners' Loan Act of 1933, as amended, and in Part 545 of the Rules and Regulations for the Federal Savings and Loan System. While a Federal association is certainly authorized to make loans secured by a first lien upon real estate, there is no authorization for it to invest in the equity of a real estate project. Of course, it may be argued that the Federal association would not be investing in the equity of a real estate project but only in the loan, with the equity being an additional benefit. This argument, however, ignores the fact that the equity aspect is part of the inducement for the association to enter into the transaction, and, therefore, the association would, in fact, be investing in both the loan and the equity features of the transaction. It may also be argued that the only concern of the statutory and regulatory provisions on loans and investments is to assure the safety of loans and investments,, and that the loan feature of the proposed transaction, by itself, provides such assurance. In view of the fact, however, that the association would probably not make the loan without the added inducement of the equity interest, some doubt is cast on the safety of the loan. This is because an association might be willing to make a high risk loan if the profit potential were high enough. By the same token, the borrower would probably not be compelled to offer an equity interest in addition to the market rate of interest if the risk were not high. For the foregoing reasons, therefore, it is my opinion that a Federal association is not authorized to engage in the type of transaction you have described. Sincerely yours, ALAN JAY Moscov, General Counsel. The CHAIRMAN. Thank you very much. Your statement is very interesting. And it includes the points, of course, that we are hearing testimony on, right now. And we appreciate your testimony. Mr. Hovde, chairman of the Realtors' Washington Committee of the National Association of Real Estate Boards is our next witness. 464 STATEMENT OF DONALD I. HOVDE, MADISON, WIS., CHAIRMAN, REALTORS' WASHINGTON COMMITTEE, NATIONAL ASSOCIATION OF REAL ESTATE BOARDS Mr. HOVDE. Mr. Chairman, I am Donald Hovde, a realtor in Madison, Wis., and president of Hovde Realty. I am appearing here today as chairman of the Realtors' Washington Committee of the National Association of Real Estate Boards. I have a prepared statement to read, and the balance of it is to be incorporated in the record. And after I read this prepared text I wish to make a summary of my remarks. The CHAIRMAN. Each of the witnesses may insert whatever he desires if it is pertinent to this inquiry. Mr. HOVDE. Thank you, Mr. Chairman. Mr. Chairman and members of the committee, I appreciate this opportunity to testify on behalf of the National Association of Real Estate Boards, in regard to certain aspects of H.R. 5700 which directly affects the real estate industry. EQUITY PARTICIPATION We will first address ourselves to section 14 of H.R. 5700 which would prohibit equity participation, as a condition for making a loan, by insured and regulated financial institutions in addition to insurance companies. We support the enactment of this provision. Our national convention in November 1970 and by the way also November of 1969— adopted a policy statement on this issue as follows: We deplore the trend whereby mortgage lenders are demanding equity positions as a condition to making mortgage loans. We feel this policy jeopardizes historically sound lending practices. Equity participations, or equity kickers as they are known in the trade, represent a fairly recent innovation in real estate financing. New managerial concepts inspired by an unfortunate reconciliation or surrender to increasing inflation and consequent erosion in mortgage )ortfolio values, have generated the equity kicker as a compensating actor. While the logic behind this innovation may appear persuasive, the consequences in terms of lender morality and risk, coupled with entrepreneurial discouraging in real estate development, pose serious problems to which the Congress must appropriately address itself. The 91st Congress in its deliberations on bank holding companies sought to draw a line between the lenders of money and the users of money. We believe that it is vital to our financial institutions to insist that this line not be blurred by permitting these institutions to be influenced in their lending decisions by the degree of the equity kicker which they exact from the developer seekingfinancingfor a housing or commercial project. Not only is there the danger of unsound lending practices, influenced by a sizable kicker from a marginal project, but the temptation of preferential treatment for the developer, acceding to the kicker, injects an element of trade restraint which discourages entrepreneurial activity in the real estate business. The introduction of the equity participation as a condition for making a mortgage loan introduces a new factor which puts an undue 5 465 strain on the fiduciary responsibility of financial institutions. They should not be permitted to dilute the criteria applicable to their investments because of the kicker surrendered by a developer who might otherwise not qualify for financing under sound lending practices. Financial institutions should not be permitted to forsake normal business risks for those of a more speculative nature because of the equity kicker. We recommend that the definition of institutions covered by the ban against equity participations be extended to cover all financial institutions, including pension funds, mortgage bankers, real estate mortgage investment trusts, and other financial institutions engaged in the business of making or placing mortgage loans. We strongly recommend approval of section 14 of H.R. 5700. Those comments with respect to interlocking relationships have been submitted and are on record. And rather than read them I would rather take this time allotted to me to speak some more on the equity participations. In 1965 we saw the insurance companies—and 1 speak of the insurance companies because in the equity participation or kickers we have found that it has been these institutions that have perhaps practiced this or required it far more, in larger dollars and degrees than the other two, and also the banks, in fact those other two type institutions have not really gotten into it in any magnitude whatsoever. In early 1966 the insurance companies decided for some reason to get out of single family home loans primarily, which they have been doing for many, many years. And it was in the spring of 1966 that we in the housing industry of single family homes first saw evidence of tight money. This can be attributed perhaps to many factors. However, when you take one of the large suppliers of funds out of the market, one of the three large suppliers, the S. & L.'s the commercial banks and the insurance companies, and take the insurance companies who charged their mortgage portfolios from single family residences into multi-family and commercial loans, we experienced in our industry the first evidence of tight money. Then after they got into the multifamily and commercial loans in a much bigger way, it then became a practice for what we are talking about here today, the equity participation. They saw a way through this route, they said to increase their yield, to help offset inflation, and to get a better run on their mortgage portfolios. However, as a result of this several things have taken place. You have through Congress and through the various States established certain laws for the protection of the public interest. One of them was State usury laws. The equity participation, Mr. Chairman, I submit to you has made a mockery out of State usury laws, because they can establish an interest rate that would comply with a State usury law and through equity participations totally circumvent that. And we have found that this has made a mockery of State usury laws. You have established a limit on loan ratios; namely, 75 in most cases. Nevertheless we see through equity participations that concept goes out the window. Ninety to one hundred percent loans are made in order to get a piece of the action by the lender. 466 While the insurance companies went for the equity participation because of higher yield to onset inflation, I submit to you gentlemen and ladies that it in itself was highly inflationary, for through the <eguity participations rents had to be raised and projected at much higher levels than normally would be the situation. It is rather ironic that the very thing that caused or created the higher interest rates came back to plague many insurance companies, and therefore policyholders. Policyholders, recognizing the exceedingly high interest rates, would go back and borrow on the face value of their loans to the point that the policy loan or loans to policyholders became of such a magnitude that it caused deep concern to the insurance companies. And had rates not gone to the exceedingly high rate that they did, it is questionable whether this outflow of policy loans would have in fact taken place. I submit to you that the single family home mortgage loan has now, because of this practice, become such a low point on the totem pole that they no longer are attractive to insurance companies. We fear that if this practice is to continue by other financial institutions, the single family home loan because it has a fixed interest rate and may not be attractive comparatively speaking, is going to be the real sufferer in this entire practice. We have found that standard loans, normally 75-percent loans, may not even be accepted. And I submit to you also the article appearing in Fortune magazine of July 1970 (see p. 536). I will quote from that: One company was so devoted to the idea of acquiring equity that if the developer came forward with his own equity money and said, lend me 75 percent of the value of the building, I can put up the rest, the insurance company would reject it. So in fact would many other companies. In the fifties scrupulous lenders worried that developers had too little of their own equity in the project. Today the developers are not allowed to put any in. We regard the equity participation as a highly; speculative position for these lenders to be in. They are dealing primarily with the marginal developer who has little to lose. The normal economic criteria of credit analysis and appraisal analysis we have seen minimized and diminshed in relationship to profit items by the lender seeking the equity kicker, and the long-term investor, the developer that has the capital, cannot get the normal type of loan that has been historic in the past. I salute you, Mr. Chairman, for the introduction of this bill, particularly section 14. We have in our industry for these past 3% years or 3 years wondered how such a practice could continue at such a magnitude, and with soimany biases, and obvious economic unsoundness. We have wondered that it could continue as long as it has. I appreciate this opportunity to appear before you today and salute you for what takes great courage, to introduce this type of prohibition, because of the magnitude and the concentration of wealth that exists for those companies that are practicing this very unsound mortgage lending. Thank you. (The prepared statement of Mr. Hovde follows:) 467 P R E P A R E D STATEMENT OP D O N A L D I . H O V D E , M A D I S O N , W I S . , C H A I R M A N R E A L TORS' WASHINGTON C O M M I T T E E , N A T I O N A L ASSOCIATION OP R E A L E S T A T E B O A R D S Mr. Chairman and members of the Committee, I appreciate this opportunity to testify on behalf of the National Association of Real Estate Boards, in regard to certain aspects of H.R. 5700 which directly affects the real estate industry. EQUITY PARTICIPATIONS We will first address ourselves to section 14 of H.R. 5700 which would prohibit equity participation, as a condition for making a loan, by insured and regulated financial institutions in addition to insurance companies. We support the enactment of this provision. Our national convention in November, 1970, adopted a policy statement on this issue as follows: We deplore the trend whereby mortgage lenders are demanding equity positions as a condition to making mortgage loans. We feel this policy jeopardizes historically sound lending practices. Substantial use of equity participations, or equity kickers as they are known in the trade, represent a fairly recent innovation in real estate financing. New managerial concepts inspired by an unfortunate reconciliation or surrender to increasing inflation and consequent erosion in mortgage portfolio values, have generated the equity kicker as a compensating factor. While the logic behind this innovation may appear persuasive, the consequences in terms of lender morality and risk, coupled with entrepreneurial discouragement in real estate development, pose serious problems to which the Congress must appropriately address itself. The Sist Congress in its deliberations on bank holding companies sought to •draw a line between the lenders of money and the users of money. We believe that it is vital to our financial institutions to insist that this line not be blurred by permitting these institutions to be influenced in their lending decisions by the degree of the equity kicker which they exact from the developer seeking financing for a housing or commercial project. Not only is there the danger of unsound lending practices, influenced by a sizeable kicker from a marginal project, but the temptation of preferential treatment for the developer, acceding to the kicker, injects an element of trade restraint which discourages entrepreneurial activity in the real estate business. The introduction of the equity participation as a condition for making a mortgage loan introduces a new factor which puts an undue strain on the fiduciary responsibility of financial institutions. They should not be permitted to dilute the criteria applicable to their investments because of the kicker surrendered by a developer who might otherwise not qualify for financing under sound lending practices. Financial institutions should not be permitted to forsake normal business risks for those of a more speculative nature because of the equity kicker. We recommend that the definition of institutions covered by the ban against •equity participations be extended to cover all financial institutions, including pension funds, mortgage bankers, real estate mortgage investment trusts, and other financial institutions engaged in the business of making or placing mortgage loans. We strongly recommend approval of section 14 of H.R. 5700. INTERLOCKING RELATIONSHIPS We will now address ourselves to prohibitions against directors, officers, or employees of insured institutions who are appraisers or who directly or indirectly control a company "which provides services in connection with the closing of real estate transactions." The latter quotation is so broad that we must assume that it includes real estate brokers and counselors who in the regular course of their business provide services in connection with the closing of real estate transactions. The bill is so sweeping in its prohibition that an appraiser could not serve on the board of directors of a savings and loan association or an insured bank in Washington, D.C., even if he did no appraising for such institution, if his son were a broker or an appraiser in California. We seriously doubt that the drafters of the bill intended such a sweeping and grossly unreasonable prohibition, yet that would be the result of the bill as we conclude from the meaning of the language employed. We now shift to another prohibition in the bill which presents a more debatable issue. The bill would prohibit a director, trustee, officer or employee of an insured institution from, at the same time, occupying a comparable position in an appraisal company or a company providing services in connection with the closing 468 of real estate transactions if the institution has a "substantial and continual business relationship with such company." In everyday language this means that an appraiser or broker could not be a director, officer, etc., of a savings and loan association or a bank if he at the same time did business with the institution. While we conceded that such a relationship could give rise to a conflict in interest situation, we believe that the regulatory agencies have ample authority to require disclosure of such relationship and to prevent any abuse which might arise. The broad prohibition contemplated by the bill would deny to savings and loan associations the expertise which appraisers and brokers could bring to bear on the problems facing these institutions in investment decisions. The Federal Home Loan Bank Board, for example, requires annual disclosure of any business relationship between an association and any officer, director, or employee, and also any commission, fee, or other benefit. Other regulatory agencies should have comparable disclosure requirements, and, if necessary, their cease-and-desist and removal power should be extended, as the Chairman of the Federal Deposit Insurance Company recommended on April 20, to this Committee. We recommend, therefore the deletion of these prohibitions as they apply to appraisers and brokers serving as directors of financial institutions covered by the bill. I want to emphasize that in making this recommendation we sincerely believe that appropriate regulatory measures by the agencies concerned would minimize the chances of abuses such as those found by the Ad Hoc Subcommittee on Home Financing Practices and Procedures in the District of Columbia. The CHAIRMAN. Thank you very much, sir. Now, Philip C. Jackson. You have a prepared statement. You may proceed in your own way, sir. STATEMENT 0E PHILIP C. JACKSON, VICE PRESIDENT, MORTGAGE BANKERS ASSOCIATION OF AMERICA; ACCOMPANIED BY WALTER P. TERRY III, VICE PRESIDENT, JAMES W. ROTTSE & CO., COLUMBIA, MD. Mr. JACKSON. Because our statement is relatively brief, I believe I can present it in short order. Mr. Chairman, my name is Philip C. Jackson. I am vice president of the Jackson Co., a mortgage banking firm in Birmingham, Ala., and vice president of the Mortgage Bankers Association of America. With me this morning is Mr. Walter F. Terry III, vice president of James W. Rouse & Co. in Columbia, Md., with whom I would like to share a portion of my time. It is our belief that Mr. Terry and his company have a unique position as both borrowers and lenders from which they can enlighten the committee. The CHAIRMAN. YOU may share part of your time with him. Mr. JACKSON. Thank you, sir. We appreciate this opportunity to appear before your committee to express our views on H.R. 5700, the "Banking Reform Act of 1971." To understand our interest in this legislation, it might be well for me to explain whom our association represents and what our members do. The Mortgage Bankers Association of America (MBA), now in its 57th year, consists of more than 2,000 members, the largest proportion of which are mortgage banking companies that engage directly in the origination, financing, selling, and servicing of real estate mortgage loans for such institutional investors as life insurance companies, 469 commercial banks, mutual savings banks, savings and loan associations, fire and casualty insurance companies, investment funds, and pension funds. Our interest in H.R. 5700 is directed principally to those sections of the legislation which deal with the restrictions it would place on interlocking directorates and the prohibition on the use of equity participation financing. Because the greater portion of my remarks will be addressed to section 14 which deals with equity participations, I shall direct my initial comments to that matter. The mortgage banker's involvement in the use of equity participations stems from the fact that he usually stands between the developer and the investor and manages the details of financing the project which the developer seeks to build and the investor wishes to finance. In this capacity, the mortgage banker has a responsibility to both parties to the transaction and it is therefore, to his advantage to see that the interests of both parties are protected. For this reason, the mortgage banker finds it of great importance that the developer as well as the investor find this arrangement to be mutually beneficial. The equity participation is a creature of inflation and also of situations where the lender's return may be long deferred. In times of inflation those who require large sources of capital are deterred not only by the strong competition for available financing, which is reflected in the form of high interest rates which they have to pay, but also by the desire of individuals, fiduciaries and other investors to place funds where they can obtain an inflation hedge. It is mainly during such periods that other means than a mortgage loan must be found by which money can be made available to those who wish to build large projects such as office buildings, apartment complexes, hotels, motels, shopping centers, and even whole cities. There is no typical equity participation arrangment since the form taken is tailored to the particular project and developer in question. Mr. Stastny, I believe, outlined several different potential arrangements. Some of the various approaches are: 1. A means by which the cash flow is shared and the lender receives a specified share of the project income after payment of expenses and amortization; 2. An arrangement under which the lender purchases the land, leases it back for afixedrent plus some percentage of gross income, and then also makes a first leasehold mortgage to the developer; 3. A stipulation giving the lender a percentage of all rent increases over the first year's projected rent. The equity participation form benefits both the lender and the developer. It provides the investor with a hedge against inflation and gives the borrower added advantages of: 1. Borrowing at a lowerfixed-interestrate than would otherwise be the case, thus reducing the required interest expense of a project and thereby making it feasible in a highly competitive market; 2. Paying little or nothing beyond the limited fixed charges if the property yields no profit; and 3. Expanding the scope of his activity since his limited equity funds are supplemented by the equity contributions of the lender. Section 14(b) of H.R. 5700 prescribes that "No lender may accept any equity participation in consideration of the making of any loan." 470 What would be the effect of this prohibition? 1. The interest cost of financing apartments and commercial properties, the monthly carrying costs, and therefore the rents required for constructing these buildings will increase substantially. When confronted with substantial and continuing prospects that the funds loaned will be repaid in cheaper dollars, lenders will seek investments where this risk can be offset. Inflation is the culprit, while the equity participation and high interest rates are the whipping boys. In a continuing inflationary economy, long-term fixed-rate securities become relatively unattractive to savers or lenders. Their only choice is to seek hedges against inflation—hedges that make savings worthwhile, i.e., (a) an interest rate that provides for a competitive real rate of return after allowing for inflation or, (6) a means for participating in the inflating value of the asset created. 2. Indications are that lenders probably would continue to make mortgage loans to finance construction of apartments and other commercial properties, but only in greatly reduced volume. As late as the spring of 1970, a survey conducted by the McElvainReynolds Co., an active mortgage banker located in Chicago, revealed that two-thirds of the Nation's largest life insurance companies were willing to make large mortgage commitments on income properties at a simple interest rate—if the developer had substantial cash equity. 3. The volume of lending and construction of apartments and commercial properties would decline substantially. If the institutional investor is restricted to a creditor position, he must be assured that the borrower has an equity position sufficient to> secure the loan and to protect the savers he represents. Developers of apartment buildings, office buildings and shopping centers are typically short on available capital funds and unable on their own account to supply large amounts of equity investment. That is why they have actively sought and preferred to borrow as much of the property's appraised value as the lender is willing to supply and to trade a larger percentage of financing in return for a participation by the lender in the equity. The point is that developers of commercial properties do not have, or do not care to employ, the equity capital necessary to develop large apartment and commercial properties on the scale they have in recent years without this type of assistance. A reasonable analogy, created and approved by the Congress, is the Small Business Investment Corporations which extend credit and at the same time invest in the common stock of their borrowers. This is substantially the same type of equity participation which this legislation would prohibit. 4. Dollars of credit driven from financing of apartment and commercial properties by the prohibition against equity participations will not be transferred into the home mortgage market. For reasons already cited, many lenders, particularly those who were willing and able to make equity participation loans, shifted away from the home mortgage market in the early sixties, well in advance of the expanded use of equity participation. They made the move originally because other lenders were flooding the stagnant home mortgage market with ample funds whereas the growing apartment and commercial markets were short of funds. 4711 After mid-decade, the shift continued because fixed interest rates on single-family home mortgages did not protect investors from inflation, especially when they were called on to provide loans as high as 97 percent of value, and because more attractive investment opportunities, which would better protect their savers' funds, were available elsewhere. Under these circumstances, it would be wishful thinking to expect the prohibition of equity participations to result in a larger flow of credit into home mortgages. If inflation subsides, the use of participations will subside. Nevertheless, they will not disappear altogether since many developers will still want to trade a share in an ownership position in order to obtain the higher leverage and larger financing they cannot command with the limited capital they are able or willing to invest. The prohibition of equity participations by lenders can do nothing except reduce the volume of needed construction. It can promise no offsetting increase in the flow of funds into the home mortgage market. In summation, we urge that Congress not enact this prohibition against equity participations since its effect will, in our view, be counterproductive. In the final analysis, it would place the borrower in potentially a less advantageous position. INTERLOCKING DIRECTORATES The sections of the "Banking Reform Act of 1971" that deal with interlocking directorates are not of direct concern to the Mortgage Bankers Association of America. Some officers of our member firms undoubtedly serve as directors of financial institutions and title companies. In many cases, they participated in the formation of these institutions and without their assistance their communities would not now be served by the bank, savings and loan association, or title company they helped form. In all cases, they bring to the directorships a knowledge of local real estate conditions and national credit conditions that is of value to the institution's management. Our concern about this legislation is more broadly based. Never before have thefinancialinstitutions of this Nation been in greater need of expert and experienced directors on their boards. As the economy becomes complicated by advanced technology and by governmental intervention, wise and experienced leadership is necessary to their survival. At the same time, the age group of our population that represents experience and technical know-howT is in short supply and declining. Legislation that reduces the use of this pool of experienced men to a one-for-one relationship would use these men inefficiently and force many institutions to accept the cost of relying on less experienced directors. Financial institutions located in small towns and communities, where experienced men are most scarce, will be most affected by this legislation. If there is a management scarcity in this country today, this legislation will undoubtedly magnify that scarcity many times. In many of the Nation's smaller communities an independent banking facility would not be economically feasible without this use of talent on a part-time basis. Our fear is that this legislation could well create a situation wherein only large branching institutions will be able tosurvive this prohibition. 472 Surely a less repressive way can be devised to avoid conflicts of interest. Furthermore, legislation will not change the moral fiber of any individual. The appropriate solution to this problem is to enforce present laws by vigorously seeking out and prosecuting those who violate their fiduciary responsibilities as members of boards of directors. The remedy would seem to be to vest adequate authority in the Federal supervisory agencies that currently regulate the industries affected by this legislation and to provide adequate funds to investigate and enforce the present law. Thank you for providing us the opportunity to express our views on this measure. I would like to surrender the rest of my time to Mr. Terry, Mr. Chairman. Mr. TERRY. Walter Terry with the James Rouse Co. I have submitted a prepared statement. The CHAIRMAN. It will be included in the record, sir. Go ahead and give us your comments. Mr. T E R R Y . I will try to quickly summarize our concern as a real estate developer. We are continually frustrated by the inability of the real estate industry in general to attract sufficient capital to carry out the various tasks of the industry. We as a developer, for example, in Columbia simply could not have carried on what we have carried on in Columbia if we did not have the right to give to a lender the participation that would enable us to do things sometimes with higher, but I think prudent risks. We are a large real estate developer, but a very small company. And to do things at the pace we do them we need every right to give a lender an equity participation. We have not found any lenders to be lowering their investment standards. We are receiving, I feel, legitimate 75 percent financing on our projects. Financing beyond that point is through an equity participation. And for that equity participation a lender, I think, is very well deserving of an extra item of interest. We have not had to slowdown in the last few years because of tight money. The reason we have not is because we have been able to give lenders a participation. We are still a very profitable real estate developer. We simply as a company could not live with short-term financing. And I think lenders are motivated by inflation. If they are motivated by inflation, I think the natural result of section 14 would be life insurance companies and banks seeking shorter term investments, requiring us to refinance periodically. That could break us. We are a very small company, with very large real estate debt. Thank you, Mr. Chairman. (The prepared statement of Mr. Terry follows:) P R E P A R E D S T A T E M E N T OF W A L T E R F . T E R R Y I I I , V I C E THE R O U S E C o . , C O L U M B I A , M D . PRESIDENT, I appreciate the opportunity to express my views to the Committee concerning H.R. 5700. My remarks are limited to Section 14 of the Bill, since that is the only area on which we feel competent to comment. We are opposed to Section 14. It. is probably worth a moment to explain the make-up of The Rouse Company so you might better appreciate our reasons for opposing Section 14. The Rouse Company is a real estate developer and mortgage banker. The company pioneered 473 the concept of enclosed, air-conditioned, heated mall shopping centers; and is today one of the largest developers of shopping centers in the country. Columbia, a new town between Baltimore and Washington, is a major project of the company. The company is currently developing apartments, office buildings, motor inns, and shopping centers. Through its wholly-owned subsidiar}-, James W. Rouse & Company, Incorporated, the company is the tenth largest mortgage banking firm in the county, servicing over $900 million in mortgage loans for 70 institutional investors. Because of the developer/mortgage banker make-up of the compan3r, we feel we are in a unique position to clearly see both sides of the issue. My personal responsibility within the mortgage company is that of negotiating financing for The Rouse Company. During the past two years, the company has borrowed over $100 million in long-term financing for its various projects. The last two years have certainly represented the tightest money market we have ever seen as a company. Virtually all of the $100 million carried some form of equity participation. There are many legal restrictions that affect the lending of money secured by real estate. One of these restrictions is that most first-mortgage lenders are prevented from making a loan in excess of 75% of the value of the property. Because of ever-increasing building costs and higher capitalization rates applied to income streams, the resulting equity requirement needed above a 75% loan is today more than most developers can stand. Financing above 75% of value can be obtained through second-mortgage financing or equitj^ financing. Both methods are more expensive than a typical 75% first-mortgage loan; however, the greater risk justifies the greater reward. If equity financing methods had not been available to us in the last two years, many of our projects would not have gotten off the ground because of our capital limitations, large as they are compared to most developers. We don't represent to you that we are happy to pay the higher cost of equity participation or higher interest rates; however, we do suggest that it is a very necessary option we must keep open to ourselves. If project financing in total does not permit us to achieve a satisfactory economic result, we simply would not move forward. Therefore, we do not feel we need to be protected by Section 14. If Section 14 is included in H.R. 5700, it appears to me that the result would be disastrous to real estate financing. The reasons: 1. If participation is not available to lenders, an immediate increase in the fixed interest rate would occur. This fact greatly increases the difficulty in carrying a project in the early stages. Participation in future income permits a lender to accept a somewhat lower-than-market return in fixed interest rate. This fact allows a developer to keep rents on apartments, stores, or offices at a competitive rate. Participations are usually on an "if, as, and when earned" basis. Clearly, this is to the developers' advantage. 2. Since most long-term lenders are greatly motivated by inflation, the inability to receive a participation would greatly reduce the amount of money available for long-term real estate debt, forcing short-termfinancing.Short-term debt to finance real estate development is totally unacceptable since periodic refinancing could bankrupt a developer. If a developer accepts a five-year loan on a property, he runs the unsatisfactory risk of refinancing when economic or real estate conditions may well be to his disadvantage. 3. Real estate development involves many high risks. A developer may not want to take those risks by himself and hence seeks a financing partner, as we did in Columbia. We feel it is absolutely necessary in the conduct of our business to be able to share high-risk situations with a financial partner. Real estate development has always had difficulty in attracting capital because of its non-liquid character. As we look ahead at real estate challenges and opportunities in the years to come we are very excited. Responding to those challenges and opportunities would be frustrating for us as a company and as an industry if we are unable to attract capital in enormous amounts. To attract capital we must have the right to join forces with financial institutions in the most economic and creative ways possible, including equity participations. The CHAIRMAN. Thank you, sir. If you desire to extend your remarks and bring in any additional points you may do so. Mr. John T. Fey, president of the National Life Insurance Co., on behalf of the American Life Convention and the Life Insurance Association of America. 60-299—71—pt. 2 — a 474 STATEMENT OP JOHN T. PEY, PRESIDENT, NATIONAL LIFE INSURANCE CO., MONTPELIER, VT., ON BEHALP OP THE AMERICAN LIFE CONVENTION AND THE LIFE INSURANCE ASSOCIATION OF AMERICA; ACCOMPANIED BY BRUCE P. HAYDEN, VICE PRESIDENT, CONNECTICUT. GENERAL LIPE INSURANCE CO., HARTFORD, CONN.; AND THOMAS P. MURRAY, SENIOR VICE PRESIDENT AND CHIEF INVESTMENT OFFICER, THE EQUITABLE LIFE ASSURANCE SOCIETY OF THE UNITED STATES Mr. FEY. Mr. Chairman and members of the committee, I am John T. Fey, president of the National Life Insurance Co., Montpelier, Vt. With me this morning are Mr. Bruce P. Hayden, the vice president in charge of mortgages and real estate at the Connecticut General Life Insurance Co. of Hartford, Conn., and Mr. Thomas F. Murray, senior vice president of the Equitable Assurance Society of the United States, of New York City. Mr. Murray is the chief investment officer of that institution. Together we represent the American Life Convention and the Life Insurance Association of America, two associations with a membership of 360 companies and representing approximately 91 percent of all of the life insurance in force. As the other speakers, we have submitted our written statements. I would like to briefly summarize some of the major points which we consider to be of importance in considering the memorandum. First of all, the opposition which we are presenting this morning includes not only section 14, the equity participation, but also the sections dealing with the interlocking directorates. Since the other speakers have addressed themselves to the equity participation this morning, I shall take that section first. So far we have heard a great deal about the so-called equity participation, which may be a misnomer, because often it does not represent an equity position in the usual sense. It is actually an income participation based upon gross incomes expected to be realized or projected in the future. When we refer to this we would prefer to refer to that type of credit transaction as an income participation. Our concern extends beyond this to other types of equity participations or credit transactions that could be covered by the broad and sweeping language of section 14, which says that no lender may accept an equity participation as a condition to making loans. In the broad sense this could include convertible bonds, particularly those convertible bonds which are private placements. It could cover bonds, notes, and debentures with warrants. It could cover a sale and leaseback transaction. It could cover a joint venture in real estate. And of course as we have heard this morning, it does cover the so-called income participation. I would like to make three observations on these types of credit transactions. First of all, in the case of the income participation, this is not an extra which has been given. There is a reduction in interest in consideration of the additional income participation. Second, I think it should be emphasized that all of these credit transactions, with the exception of the income participation, are of longstanding usage in the business community. They have been tested during the last century. 475 And finally, I should like to emphasize the fact that all of these are used in commercial transactions; none of them has been applied to the case of a private single dwelling home. Now, I would like to cover some of these various types of transactions. Convertible bonds are a very important part of the financial operation of the American economy. A large number of convertible bonds are privately placed in order to save the expense of a public issue, and many of the private placements are with pension funds, insurance companies, and other trust funds. In the period from 1967 to 1969, over $12 billion in financing of of corporations was raised by the use of convertible bonds, about 20 percent of the total capital raised on bonds during that period. The second area, bonds or notes or debentures with warrants, again does not present any opportunity for control, because, like convertible bonds, initially they are a debt position. While convertible bonds provide for a subsequent transfer to an equity position, the bonds, notes or debentures with warrants attached also provide for a second infusion of capital into the business enterprise at the time that the warrant is exercised. So not only is the borrower receiving the benefit of the initial loan, but also the corporation is receiving the benefit of an additional capital contribution in the form of an equity position at a later date if the leader chooses to exercise his warrants. Now, those types of transactions are used largely by the smaller and the medium sized business enterprise, although not restricted to them entirely. As many of the members of this committee may recall, American Telephone and Telegraph during the past year issued debentures to the extent of $1.6 billion with warrants attached. These credit transactions are indeed an important part of ourfinancialworld. The sale and leaseback likewise is a recognized and well-established method of financing of long standing. The advantage of the sale and leaseback to the landowner is that it gives him the maximum capital in the initial stages of his enterprise. In the sale and leaseback a loan is generally made for the construction of the building. The land is conveyed to the lender in consideration of the payment of a sum of money. So in addition to the financing of the construction, there also is the purchase of the land which adds to the capital stability of the borrower. In this case similarly there is no control by the borrower. The lease is a straight leaseback for a period of years, depending upon the business factors that are within the consideration of the borrower. The borrower is in complete control of his property. The fourth type of transaction which would be outlawed by the broad sweeping language of section 14 would include joint ventures. The Columbia project which has been mentioned this morning, and which one of our witnesses, Mr. Hayden, has been very instrumental in organizing, represents a joint venture in the true sense today. A joint venture is nothing more than a partnership to provide for putting together a real estate operation. In the typical case a developer comes to a lender with an option on land, with a plan, and without the capital necessary to develop the property. They decide on the basis of commercial negotiation to establish a partnership, and to HniM an ontp.rr>ri<%A that will provide 476 ^either housing, shopping center facilities, or office facilities—in the «case of Columbia, a city by 1980 of over 100,000. We all know that we 'could well use several hundred new cities of this type in our country today. Finally, I wish to discuss the income participation which we have heard mentioned here this morning. There are many forms it can take, but typically it takes the form of a lower rate of interest at the going-in period, with a provision for sharing in the gross or net rentals in the event that they exceed the projections. This, of course, is designed to offset the impact of inflation. Now, the percentage that is provided for generally runs anywhere from 2 to 20 percent, depending on whether the base is gross or net revenue. When this is worked out it really, over the lifetime of the loan, amounts to an additional one-half to 1 percent return on the investment. So the actual gross amount that is provided is a very deceptive factor. What it really does amount to is a reduction in the present rate of interest collected, and an increase in the later rate of interest, if inflation results in increasing the gross income of the project. It does not require that this income participation be added to the rents. It does not require that the developer or the owner or the manager of the operation increase rents. It merely provides that if the rents are increased, then the lender shares in the windfall that the developer has received in borrowing money at a lower interest rate than would probably be the result in a different type of market without this vehicle. I emphasize the fact that all of these except the income participation have for many years been all important to the operation of our financial system in the United States. In terms of the businesses involved, all businesses need both equity and debt capital. And one of the characteristics of the real estate industry is that it is grossly undercapitalized. The fact is that through these credit transactions we can provide the needed credit at the lowest possible interest rate. They are used in a competitive situation. They are used with business and commercial borrowers. And they all represent an arm's length transaction between these parties. The comment has been made that we went out of the housing market the individual housing market because of the ability to get income participations. The fact is that most of our companies began to move out of the individual housing market in the 1950's. This was partly a function of changing levels of interest. And it was also partly a recognition of the fact that the servicing function of thousands of individual housing mortgages was very difficult for a company that was remotely situated. In our own company we had over 68,000 mortgages that averaged $11,000 apiece. We had 144 mortgage managers throughout the United States that serviced these mortgage loans. The servicing costs were very high. We felt that as a matter of real service to the borrower it was a much healthier situation for the individual to borrow from his local lending institution, the savings and loan or the banking institution where he had a total credit relationship and where they had their local appraisal and where they could look out for the interests of the individuals. We felt that we could produce the most significant contribution to the needs of our country through 477 providing multiple housing units and through providing commercial money for the development of our economy. And so many of our companies as a matter of practice have already gone out of the individual housing market. I mentioned that the Life Insurance Industry began to move out of the single-family homefinancefieldin the early 1950's which, of course,, was long before equity participations became a matter of common practice. A number of our companies have reported that their move out of this field was only semi-voluntary. As one institution put it, "We didn't withdraw from the field of single-family home financing— we were chased out. Beginning in 1953, we found instance after instance around the country wherein local financial institutions competing with us for residential mortgages could beat us six ways: local institutions were allowed by law to make a larger loan, for a longer term; they would make it at a lower rate of interest and grant the borrower considerably faster service and the cost to the borrower of getting the loan was materially less than we had to charge. We came to the conclusion that in anything like a normal market, the out of town life insurance company was at a marked disadvantage in competing for this single-family loan business—in fact, we couldn't compete. As a result, we abandoned to the localfinancinginstitutions, a field in which they could serve the public better than we could, in order to concentrate 011 the larger commercial loan field where, in most instances, we could serve better than they could." We also found in 1966, with the rapid rise in inflation, and the rapid rise in interest rates, that our liquidity needs were much greater than we had anticipated, largely because polic3Tholders were borrowing on their policies at a 5 percent rate. This resulted in a very heavy cash flow out of our companies. We found that we needed a new degree of liquidity. We also found that we were being buffeted a bit by inflation, because the effect of inflation has been to raise the level of interest rates. The fixed income mortgages and bonds which we had bought that were providing for an interest rate of two and a half to three and a half percent could only be sold at a loss. We could not liquidate our bonds, and we could not sell our mortgages. In order to provide this liquidity it was necessary to look to other investment vehicles. We did find that we could sell our common stock at a gain. And this was one of the factors that directed our own company into looking at equity positions and providing for some method of protecting our policyholders against the excessive impact of inflation. The CHAIRMAN. Mr. Fey, so that we can get through in a reasonable time and allow the members an opportunity to interrogate you gentlemen, I suggest that you shorten your statement. We will have one other witness, Mr. Hamilton for about 10 minutes. But if there is anything lacking in your testimony, we want you to put it in, because we want you to present your case from your viewpoint the very best way possible. Mr. FEY. May I complete this part of the equity participation, and later cover the interlocking directorate. I would like to say just a few words about that. The C H A I R M A N . G O right ahead, sir. Mr. FEY. I think of most importance is the fact that the effect of 478 eliminating the right to use these types of credit transactions would be, No. 1, that it would disrupt the flow of capital into housing and shopping centers and offices, and it would be contrary to the best interest as expressed by Congress in the Housing Act of 1968 and the Housing and Urban Redevelopment Act of 1970. Second, it will divert many of these borrowers to the real estate investment syndicates. It will operate to the disadvantage primarily of the small investor. Third, it will have an adverse impact on our security markets. And fourth, it will result in a higher interest rate on ourfixedincome investments. And now, if I may, I would just like to say a few words about the interlocking directorates, because this is a very important factor to our industry. It is really like a second subject. It has not been covered here this morning, and I would like to have an opportunity to cover it if I may, Mr. Chairman. The C H A I R M A N . Y O U may do so, of course you are taking the time away from someone else. But go ahead. Mr. FEY. If I could just have about 5 minutes I think I could cover it. The CHAIRMAN. IS there objection? The Chair hears none. You may proceed for 5 minutes. Mr. FEY. There has been reference to the fact that income participation will result in taking a greater risk than normal, that perhaps we are taking steps that are not in the interest of the security of our portfolios. I would like to say here and now that the life insurance industry is one of the most heavily regulated industries in the United States. If you do business in several States, the life insurance companies investment program is subject to the examination of each one of those States. We are periodically examined by the insurance examiners from all of the States in this country, or by their representatives. They do look at each one of our investments in terms of the type of security which we have received in return for the investment. Also—and this gets to the point of the interlocking directorates—the financial practices and policies of our companies are reviewed by our directors. One of the most important functions of a director of a life insurance company is to safeguard the interest of the policyholders and to review thefinancialoperation of our investment departments, and to formulate a policy that will provide security, and a reasonable rate of return to the investor, and also the desired or necessary liquidity to carry out the interest or the payments that are being made under the life insurance contracts and the annuity contracts. There are six sections under the interlocking directorates provisions of H.R. 5700 which are of concern to the life insurance business. I will skip over the ones that deal with the blanket prohibition. All I can say about them is that they would destroy and upset the total operation of our boards of directors. All of our boards of directors depend upon the wide counsel and views of individuals with a financial background and, thus, who may happen to be directors on a bank board. In our own company, out of eight directors who are members of bank boards—there are 14 directors in total—there is only one who is a bank officer. He is an officer of a savings bank. 479 This independent overview and backup is very important. We depend upon the competency of our management. But we also depend upon the safeguarding of our decisions and the overview of our fiduciary relationship that is exercised by these outside directors. We oppose section 7, which prohibits an interlock where a financial institution manages a pension plan or a welfare fund. We have had some difficulty in finding the reasoning for this, because in the vast majority of our cases pension funds and profitsharing plans are pooled in our reserves or in our separate accounts. And in order for there to be any collusion or management in favor of the second company it would be necessary to have these accounts segregated, in fact they are not segregated. But even aside from that, if there are some abuses, there certainly is no need for this flat prohibition to have interlocking directors. We have State examiners who examine these transactions each time that they examine the company. And certainly we have the Federal fiduciary standards approach. I understand H.R. 1269, the Dent bill, is now before the Committee on Education and Labor. If the committee should desire to review the fiduciary standards in this respect, this would certainly seem to be a more direct approach to handling a few abuses that may appear in this area. But certainly in the case of a life insurance company there is little or no opportunity for abuse, because of all of the other safeguards that are provided in the case of the management of the pension funds. In the case of 5-percent ownership of a corporation, interlocks are also prohibited under section 8 of the bill. I would like to suggest to the committee a very important point. This provision would rule out our legitimate subsidiaries. Many of our life insurance companies have subsidiary and holding companies under State laws just as the banks have holding company situations under the act of 1956. And so I ask at least the same exemption as the bill grants to banks for their holding companies. But quite aside from that, there certainly can be no control danger because, number one, in most of our States there is a limit on the percentage of our assets that may be invested in any one company other than a subsidiary. In our own case in Vermont and in New York, which we comply with, it is 1 percent of out total assets. We may not under those same laws hold more than 5 percent of the outstanding stock of any company. So we already have the necessary safeguards as far as the States are concerned. Finally, with respect to the prohibitions where a continuing financial relationship exists as provided in section 9, we feel that this would be very unfair in the case of lines of credit. A line of credit is a very standard transaction, it is usually based on the prime rate. Insurance companies, incidentally, are not normally borrowers. They borrow occasionally on a line of credit to smooth out their cash flow. The fact is that a line of credit is subject to continuing scrutiny. There is very little likelihood of one single director being able to influence this in the first place, but in the second place, it certainly is subject to objective review as to whether it is fair or not. So at the very least we ask that this be stricken out. And finally, since many of us are broker-dealers dealing in variable annuities, which is part of our pension trust business, we would say 480 that any reference to broker-dealer, or any reference to services performed in appraising or closing a loan, should not result in the insurance companies being included in this prohibition on interlocking directors. I know I have talked too long, Mr. Chairman. But I do appreciate your courtesy. The CHAIRMAN. Thank you very much. (The prepared statement of Mr. Fey follows:) P R E P A R E D STATEMENT OF JOHN T . F E Y , PRESIDENT, N A T I O N A L L I F E I N S U R A N C E C o . , ON B E H A L F OF THE AMERICAN L I F E CONVENTION AND THE L I F E I N S U R A N C E ASSOCIATION OF AMERICA Mr. Chairman, my name is John T. Fey, and I am President of the National Life Insurance Company, located in Montpelier, Vermont. I am accompanied by Bruce P. Hayden, Vice President of the Connecticut General Life Insurance Company, located in Hartford, Connecticut, and Thomas F. Murray, Senior Vice President and Chief Investment Office of the Equitable Life Assurance Society of the United States, located in New York. We are appearing on behalf of the American Life Convention and the Life Insurance Association of America. These two associations have an aggregate membership of 360 United States and Canadian companies, accounting for about 91 percent of the total life insurance in force in the United States. We appreciate this opportunity to comment on H,R. 5700. My statement will be directed to two aspects of this bill which would have a serious adverse impact on life insurance companies: (1) those provisions relating to prohibited directors, and (2) the provision prohibiting equity participations in connection with loans. PROVISIONS RELATING TO PROHIBITED DIRECTORS H.R. 5700 contains a variety of provisions imposing restrictions on the composition of an insurance company's board of directors and on the ability of a director, officer or employee of an insurance company to serve on the board of directors of other corporations. These provisions, if enacted, would require wide-sweeping changes in boards of directors—to the detriment of the insurance companies and their policyholders—through a series of broad prohibitions which in our opinion go far beyond any demonstrable need. I would now like to address myself to specific provisions of H.R. 5700. I. General prohibition againet interlocking directors amongfinancialinstitutions (sections 2, 3f and 4 of the bill).—These provisions would flatly prohibit any individual who is a director, trustee, officer or employee of a commercial bank, a mutual savings bank or a savings and loan association from serving on the board of directors of any other financial institution—which is defined for this purpose to include insurance companies. This prohibition would apply not only where the individual involved is an officer or employee of the bank or sayings and loan association, but also where he is engaged in some completely unrelated field and merely serves on the board of directors of the bank. Enactment of these provisions would have serious and unreasonable implications for the life insurance business. Since one of the most important functions of a life insurance company is the investment of the funds underlying its commitments to policyholders, it is essential that the company and its policyholders have, through its board of directors, the counsel and judgment of men of broad experience in the field of business and finance. Moreover, in order to obtain this board experience and overview, it is necessary for a company to reach beyond its own management in selecting its directors. The question then is simply one of where an insurance company can find individuals outside jf its own employees with the prerequisite financial and business background. A logical—if not the most logical—source is persons with a broad banking background. They understand the meaning of maintenance of reserves and liquidity. They have experience with the problems of financial standing, credit worthiness, and credit risks in lending activities. They have knowledge of real estate values. They are accustomed to assuming and exercising fiduciary responsibilities in accordance with the same high standards of probity and integrity that are called for in reaching overall policy decisions concerning the investment of reserve funds in behalf of millions of life insurance policyholders. 481 The Chairman of the Federal Reserve Board, Dr. Arthur Burns, has clearlyspelled out the advantages individuals with banking experience bring to a board of directors. In his letter to Chairman Patmao, dated December 16, 1970, he recognized that interlocking relationships may in some instances impair competition between firms in the same line of business. However, he concluded that such relationships should be prohibited only where there is a real risk of abuse and that a case had not been made for flatly prohibiting interlocks between banks and nondepository institutions. In this regard, he stated: On the other hand, economic benefits flow from a high standard of performance by corporate boards of directors. This entails a free interchange of advice, ideas, and experiences among directors of varied backgrounds. Bankers often often have experience and expertise that qualify them to render valuable service in this role. Interlocking directorates, in other words, are not inherently wrong. They may be good for the corporations involved and the public they serve. The problem is to define those situations where the risk of abuse outweighs the expectation of benefit. Thus, we believe that the skills, experience, and knowledge of individuals with banking experience are necessary to complement the skills of other directors— common examples of which include university presidents, businessmen, economists, and lawyers—so as to produce a well-rounded board of directors who are able to offer the insurance company and its policyholders the breadth and depth of leadership which are required for the successful operation of the company. It is believed that the inclusion of such individuals on an insurance company's board of directors could in particular instances result in undesirable practices, the proper solution is not to enact sweeping legislation outlawing the use of bankers in general, but rather, as Dr. Burns indicates, to define the particular situations where there is a real risk of abuse and deal with them on that basis. This, however, is not the approach taken by H.R. 5700. Instead, this bill would flatly prohibit an individual who is a director, trustee, officer or employee of a bank from serving on the board of directors of any instance company. The prohibition would apply without any necessity for the showing of wrongdoing and, for that matter, without regard even to any potential for wrongdoing. This would be truly a novel and undesirable step. We know of no existing antitrust law which so broadly proscribes a relationship between corporations or individuals. Actually, in the usual situation covered by the bill, there is not even a potential for abuse since the mere fact that an individual is one of a number of directors— typically, a rather large number—Df an insurance company will by no means give him control over the actions of that company. Without this control, he cannot effect any of the anticompetitive arrangements or agreements at which the bill is apparently aimed. As already indicated, the breadth of the prohibition is unlimited. It would, for example, prohibit outstanding industrialists, educators, or others of prominence from serving on an insurance company's board of directors merely because they also happen to have been selected as a director by a bank. Moreover, the prohibition would apply where the bank and insurance company are clearly not even serving the same geographical area, as, for example, where an insurance company located on the Eastern seaboard has a director who is also a director of a bank located on the West Coast. These examples clearly illustrate the arbitrary nature of the proposed prohibition. In conclusion, we strongly believe that the present ability of life insurance companies to draw on the financial expertise of men familiar with the banking business through having such men on their boards of directors is of substantial value to the companies, their shareholders, and their policyholders. This widely accepted business practice should not be proscribed unless abuse can be proven and existing remedies are demonstrably inadequate. Neither condition has been met. Moreover, we believe that the same principles should apply with respect to interrelationships between insurance companies and savings and loan associations and mutual savings banks. Thus, we strongly urge that H.R. 5700 be amended by deleting the words "any insurance company" now found in sections 2, 3 and 4. 2. Prohibition against interlocking directors wherefinancialinstitution "manages" a pension of welfare plan for the other corporation {section 7 of the bill).—This provision would prohibit an individual who is a director, trustee, officer or employee of a financial institution (defined to include an insurance company) from serving on the board of directors of any corporation for which such institution "manages" an employee welfare or pension benefit plan. It is not clear from the bill or background statements what is meant by the 482 term "manages". However, it appears that the prohibition is directed at the possibility that, through an interlocking relationship, the corporate employer and the financial institution may use the funds in the welfare or pension plan for the benefit of the corporation rather than invest them for the benefit of the employee beneficiaries. For this possibility even to exist, it is necessary that the funds for the particular plan be kept segregated. This, of course, is not the case with the usual type of insured plan where the funds are commingled with other assets of the insurance company so that no particular asset can be traced to any specific plan. Thus, at a minimum, section 7 should be amended to make clear that it does not prohibit an interlocking relationship between an insurance company and another corporation merely because the second corporation has a welfare or pension benefit plan which is wholly or partly funded through insurance contracts under which the premiums are commingled and invested along with other assets of the insurance company. However, we would not stop at this point but further urge that the prohibition be completely deleted as it relates to insurance companies. As is the case with the other provisions of H.R. 5700 relating to interlocks, section 7 would flatly prohibit interlocking relationships which otherwise may serve a valid business purpose solely because it is thought that they could in particular instances lead to possible wrongdoing. In fact, even this possibility is extremely remote in the case of insurance companies because of the strict fiduciary standards to which they are held by the state authorities. If any action is considered necessary in this area, it should be along the lines of imposing federal fiduciary standards where appropriate as would be done under legislation which is presently before the House Committee on Education and Labor. Under his approach, specific practices can be prohibited and effective remedies can be made available when abuses actually, occur. This is clearly a more effective and equitable way to approach the problem than is the sweeping and tangential approach taken in section 7 of H.R. 5700. 3. Prohibition against interlocking directors where there is more than 5 percent stock ownership {section 8 of the bill).—Under this provision, a director, trustee, officer or employee of a financial institution (defined to include an insurance company) would be prohibited from serving as an officer or director of any other corporation which the financial institution owns, and has power to vote, more than 5 percent of the stock. As currently drafted, this provision would not apply to prohibit interlocking relationships between companies within a bank or savings and loan holding company group. We assume that the Committee would be willing to provide a similar exemption for insurance holding company groups or insurance companies and their subsidiaries, which are permitted and regulated by state law. We would be happy to submit language to accomplish this purpose. However, turning to the prohibition as a whole, we have extreme difficulty in understanding the basic purpose of the provision especially in view of the existing laws in this area. Apparently there is some feeling that an insurance company can gain control of another corporation through a combination of stock ownership and an interlocking director relationship where such control would not occur if only one or the other existed. Additionally, one must also assume that this control—if, indeed, it exists—is inherently bad. We believe the basic premise is wrong. As I have already indicated, the fact that a corporation has one of its directors or even an officer or employee on the board of directors of another corporation certainly does not automatically give it control over the other corporation. The interlocking director will be only "one of a number of directors—frequently a large number. In this capacity, he certainly cannot direct the affairs of the other corporation. In fact, under the apparent theory of the bill, each of 5 or 10, or even as many as 19, different companies, each in an entirely unrelated line of business, could be assumed to have control of a single corporation. Such an assumption is clearly illogical. The premise underlying H.R. 5700 is also inconsistent with the pattern of state regulation of life insurance companies. One of the prime responsibilities of state regulation is to insure that insurance companies invest their funds in a manner which will provide maximum safety and return for their policyholders and not for some other purpose such as gaining control over a wide variety of businesses. To enforce this standard, the states provide two types of limitations: first, most of the states restrict the percentage of an insurance company's assets which may be invested in any one corporation, and, second, many of the states restrict the percentage of any one corporation's stock which may be owned by an insurance 483 company. These limitations do not vary depending on the presence of an interlocking director situation. The states have had a long and successful history of regulation in the insurance company area and the fact that they do not consider an interlocking director relationship to be of importance in appljring their investment standards would seem particularly significant. It is true that there are cases where an insurance company may wish to acquire control of another corporation either as a subsidiary or as a part of a holding company system. In these situations, there is comprehensive state regulation designed to protect the interests of policyholders and to assure that all transactions between the insurance company and its subsidiaries are fair and reasonable. In summary, it seems clear, as a practical matter, that the basic premise of section 8 is wrong to the degree that it assumes that the addition of an interlocking director relationship to a stock interest will automatically give a company control over the other corporation. Even if there are isolated cases where such control might evolve, the prohibition of section 8 would extend far beyond them. It would strike down all situations in order to reach the rare case. This is not sound legislative policy. It appears that another purported abuse at which the prohibition in section 8 is aimed is the possibility that the interlocking director will take advantage of his position to obtain insider information which will then be used by his company in making its investment decisions relating to the stock it holds in the other corporation. The federal securities laws provide clear and adequate remedies in the case of a director who misuses his position in this manner. There are three general antifraud provisions operative in this area—section 17(a) of the Securities Act of 1933, Rule lOb-o promulgated under section 10(b) of the Securities Exchange Act of 1934, and section 15(c)(1) of the Exchange Act—which provide the basis for administrative, civil or criminal action against directors who take advantage of inside information for their own benefit or for the benefit of their companies.1 4. Prohibition against interlocking directors where continuingfinancialrelationship exists (section 9).—Under this provision, a corporation would be prohibited from including on its board of directors an individual who is a director, trustee, officer or employee of a commercial bank, a mutual savings bank, or a savings and loan association if such corporation has a "substantial and continuing relationship" with that bank or savings and loan association with respect to the making of "loans, discounts, or extensions of credit". While insurance companies do not generally borrow money—but, in fact, are in the business of lending money—there are situations where an insurance company finds it necessary to utilize a line of credit with a bank in order to even out its cash flow. These lines of credit arrangements generally permit the insurance company to borrow up to a specified amount at any time with the interest rate geared to the prime rate prevailing at the time a particular loan is made. The loan is generally paid off in a matter of weeks or months—six months is the longest period we know of in the case of insurance companies. It would appear that the literal language of section 9 of H.R. 5700 might encompass an insurance company which has such a line of credit. As is the case with the general prohibition of interlocking directors between banks and insurance companies contained in earlier sections of the bill, we believe this prohibition is unwarranted and would unduly restrict insurance companies in obtaining qualified directors from the financial community. I have, in a preceding section of my statement, outlined the reasons why it is highly desirable that an insurance company have available to it the financial advice of indiviudals with a banking background. Apparently, the sponsors of H.R. 5700 feel that an interlocking relationship with a bank might lead to conflicts of interest and a lack of arm's length dealing with respect to the business relationships between the bank and the insurance company. We do not believe that any such potential exists in reality, especially in the context of the typical line of credit arrangements between banks and insurance companies. First, such a line of credit is a standard transaction with comparatively little that could be manipulated, even if there were a disposition to do so. The interest rate generally fluctuates in relation to the prime rate, the terms of the loans are short, and the details of the arrangement are standard. Moreover, even i These provisions are discussed extensively by Professor Louis Loss in his book on Securities Regulation (see, in particular, second edition [and supplement], Vol. 3, Chapter 9). 484 if there were a potential for abuse, the mere fact that an officer or director of one of the corporations is on the board of directors of the other will not provide an opportunity for that individual to effect the abuse. As I have already indicated, such an individual will be only one of a large number of directors with the result that he will by no means have control over the actions of the corporation. For these reasons, we strongly urge that section 9 of H.R. 5700 be amended to delete insurance companies from its prohibitions or, at a minimum, to make clear that a line of credit is not the type of relationship which will trigger these prohibitions. 5. Insurance companies registered as broker-dealers.—Most of the provisions on interlocking directors which I have discussed (sections 2, 3, 4, 7 and 8) apply separately to "any broker or dealer registered under the Securities Exchanges Act of 1934". There are situations where a life insurance company, although it is engaged only in the insurance business, is required to register as a broker-dealer and, thus, would technically be classified both as an insurance company and as a broker-dealer under the existing language of H.R. 5700. This will occur when the company sells variable annuity contracts which are, in essence, contracts providing for payments which will vary to reflect the investment results of assets held in a separate account. These contracts have been held by the Securities and Exchange Commission to constitute securities with the result that the company is required to register as a broker-dealer in order to sell them. Nevertheless, these variable annuity contracts represent a natural extension of the business of life insurance companies. They are, for purposes of state law, insurance contracts and are regulated as such. Thus, the fact that the insurance company is required to register as a broker-dealer in order to sell them should not affect the treatment such company is afforded under H.R. 5700. In other words, if, as we have urged, life insurance companies are excluded from the prohibitions of H.R. 5700, it should be made clear that the exclusion applies even though the company is registered as a broker-dealer. Also, of course, the exclusion should apply in the same manner to a subsidiary engaged solely in the distribution of the insurance company's variable contracts. More specifically, if any references to broker-dealers are retained in the bill, the descriptive language should be amended to read: "any broker or dealer (other than an insurance company, or a subsidiary thereof engaged solely in the distribution of variable contracts issued by the parent compan30 registered under the Securities Exchange Act of 1934". Along similar lines, any exclusions provided for insurance companies should not be nullified merely because a company participates in the closing of real estate loans made by it or by a real estate investment trust established by it. Unless amended, this might be the result under sections 2, 3, and 4 of the bill which prohibit interlocking relationships between a bank or savings and loan association and a company which provides service in connection with the closing of real estate transactions. Clearly the fact that an insurance company participates in the closing of its own loans (or loans made by its real estate investment trust) should have no bearing on whether it may have an interlocking relationship with a bank. Thus, these provisions of sections 2, 3, and 4 should be amended to exclude insurance companies. This completes my comments on the provisions of H.R. 5700 relating to interlocking relationships. In short, these sweeping prohibitions would cause a wholesale disruption of the boards of directors of a large number of life insurance companies. And this would be done not on the basis of proof that the individual directors have done anything wrong or are likely to do something wrong, but solely on the basis of conjecture that they might do something wrong. In our opinion, this is an unsound approach. PROVISION PROHIBITING EQUITY PARTICIPATIONS Section 14 of the bill would prohibit commercial banks, savings banks, savings and loan associations or insurance companies from accepting "any equity participation in consideration of the making of any loan". Equity participation is defined in the bill as an ownership interest in any property or enterprise, or a right to payment which is proportionate to or contingent upon net or gross income from any property or enterprise, including a share in the earnings of the borrower, or warrants to purchase the stock of the borrower, or shadow warrants based on changes in the market price of the borrower's stock. These broad prohibitions would rule out a wide range of established techniques 485 for raising capital in the corporate bond market and in the mortgage market for apartment houses, shopping centers, office buildings, and other commercial, structures. We are opposed to this legislation on the grounds that it would (1) seriously disrupt essential flows of private capital in traditional and desirable channels; (2) hamper business financing, especially for new ventures and expanding firms; and (3) adversely affect the development of real estate projects, including multifamily housing, by constricting the availability of funds. Motivations toward equity markets There are many reasons why the investing public has been attracted to equity markets over the past 20 years. It has been widely recognized that the increase of population, the rise in productivity, and the expansion of the gross national product is accompanied by similar growth over the long term in the dollar earnings of business enterprise. In a dynamic economy, investors quite naturally seek to share in that growth through the direct purchase of common stock. An added stimulus toward equities has come from prolonged high rates of inflation, particularly over the past three or four years. In an inflationary environment, investors are impelled toward those outlets with a prospective growth in dollar return, such as common stock, convertible bonds, or real estate. Conversely, investments with a fixed-interest return and repajTable in fixed-dollar amounts, such as non-convertible bonds and straight mortgage loans, tend to lose much of their attraction. At a 5 percent annual inflation rate, price levels would more than double in 15 years; the real value of a fixed-dollar bond or mortgage loan would be cut in half over that period. In contrast, equity investments hold out the potential of keeping pace with general price trends as business earnings and land values rise in dollar terms along with the economy One response to the inflation factor has been a sharp rise in interest rates on borrowed money. Borrowers are willing to pay the higher rates to beat tomorrow's higher prices, while investors require higher rates to offset the loss of real value from inflation. Another response has been to shift increasingly toward various forms of equity with a dollar growth potential, including common stock, convertible bonds, bonds with warrants, real estate, and mortgage loans with variable income provisions beyond the traditional fixed interest rate. These responses reflect far more than the portfolio practices of institutional investors; they originate in a shift in financial preferences by the public at large. For example, we in the life insurance business have responded to changing public preferences over the past several years with the development and marketing of variable annuities and mutual funds that provide a return based largely on the performance of equity investments. We are now in the process of developing variable life insurance which will also enable beneficiaries to share in the growth of investment dollars through insurance coverage that can rise above a fixeddollar minimum. As a result of the greater emphasis on equities, both in our insurance products and our investment portfolios, the net purchases of common stock by life insurance companies have risen substantially during the past decade. In the years 1968-70, for example, net purchases of common stock by life companies averaged $1.7 billion per year, compared with about $200 million per year during the period 1961-63. In addition, many of the corporate bond holdings of life insurance companies are convertible into common stock or carry warrants to purchase stock, reflecting more active purchase of such bonds in the past few years. We believe this is a sound financial practice in the best interests of our policyholders and stockholders, responsive not only to the effects of inflation on operating expenses in our companies but also to the desire to share in the long-term growth and expansion of our economj\ Funds invested by life insurance companies primarily represent the accumulated savings of millions of small policyholders and annuitants. It is our responsibility, in the interests of these families, to invest these savings at the most attractive return available, consistent with safety of the invested funds. Investment return is a key factor in the net cost of life insurance for these families. Inflation poses a threat to the financial position of our policyholders and our search for inflation hedges in investment operations is to their benefit. Investment earnings also have a direct impact on pension plans which we administer for millions of business employees. One rule of thumb is that a percentage point increase in investment return will produce a 5 to 6 percent increase in benefits or reduction in pension costs. It should be clear that the lonjrterm return on investments is of great concern to all types of investing institutions 486 EFFECTS OF H.R. 5 7 0 0 ON T H E SECURITIES MARKETS In the corporate bond market, the purchase of convertible bonds would appear to be ruled out by section 14 of the proposed legislation. For a business corporation, the sale of common stock and the issuance of bonds are two major forms of raising needed long-term capital. Convertible bonds represent a hybrid securitv combining elements of both debt and equity financing in a single instrument. The typical procedure is to issue long-term bonds with a provision for conversion of a prescribed number of bonds into a specified number of common shares of the borrowing corporation after a certain date, perhaps 3 or 5 years later. Because of the conversion feature, the coupon rate or interest cost on the bond issue is usually substantially below the rate for a straight bond issue, thus reducing the debt service charges to the borrowing corporation. The attraction for the lender lies in the potential of sharing in the earnings growth of the corporation at some later date, after the borrowed funds have generated additional earnings which lift the price of the common stock to higher levels. The use of convertible bonds is particularly helpful to a business which is expanding rapidly but lacks an adequate earnings record to support the current sale of common stock at economical prices. This technique also provides a method for the borrower to increase his equity capital base when later conversion takes place, thereby maintaining a balance between debt and equity in his financial structure. Convertible bonds have been* a standard technique in bond market financing throughout the twentieth century. In the 1967-69 period, almost $12 billion of convertible bonds were sold, representing about 20 percent of all corporate bond offerings during those three years. To prohibit this form of financing would limit the ability of business corporations to borrow at lower interest costs and to provide for the orderly enlargement of their equity capital base as their business expands over future years. The use of stock purchase warrants attached to bonds is generally similar to convertible bonds and also dates back more than fifty years. However, the arrangement takes a somewhat different form. A warrant represents the right to purchase for cash at some future date a certain number of common shares of the borrowing corporation. When warrants are attached to bonds, the investor does not turn in his bonds but instead can exercise the right to acquire common stock at a price fixed in advance, assuming that the appreciation in market price makes this attractive. From the investor's point of view, the debt capital he has provided makes possible a new venture or expanded operations which will generate higher earnings and hopefully a rising stock market price some years hence. From the borrower's standpoint, the sale of bonds with warrants provides long term debt capital which is much less expensive to him than financing a new venture through the immediate sale of common stock to the investing public. As his business grows and earnings rise, the exercise of warrants brings a new infusion of cash through the issuance of stock which enlarges his equity base and also his further capacity to borrow. This technique is especially useful to a small- or medium-sized business firm which may be in a poor position to raise equity capital but can plan to sell common stock to the warrant holders after the original infusion of debt capital has enlarged its operations and its earnings base. Stock purchase warrants have also been used by larger corporations, as in the case of AT&T when it sold $1.6 billion of percent debentures to the investing public one year ago, with warrants to purchase AT&T stock at $52 per share. For a business corporation, both debt and equity financing are necessary to a balanced financial structure. From the standpoint of investors such as life insurance companies, purchase of both corporate stock and corporate bonds has long been accepted as a legal and judicious form of investment. Thus, it is difficult to understand why a stone wall should be built between debt and equity financing and thus impair the ability of expanding business firms to obtain new capital in a time-tested fashion. EQUITY PARTICIPATIONS IN REAL ESTATE AND MORTGAGE LENDING A fairly recent development in mortgage and real estate financing has been the emergence of financial arrangements which provide additional income to the investor, either by participation in real estate project revenues or by capital appreciation from direct equity positions acquired by the investor. Such techniques have been utilized in the financing of income-producing properties such as office buildings, apartment houses, shopping centers, hotels, and commercial developments. The desire to hedge against inflation, through investments which 487 can yield a growing dollar return, has been a primary incentive in the development of financial techniques often referred to as "equity participations." Because of the complexities of the real estate market, and the wide variety of income properties being developed, there have been a great many variations in the techniques used to provide additional income or potential capital gains for investors engaged in real estate financing. However, the following are the major forms that would seem to be affected by section 14 of the proposed legislation: 1. Mortgage loans which provide that the lender may receive "contingent interest" in addition to the fixed interest rate, depending on the revenues generated by the project being financed. 2. Land purchase and leaseback by an investor who also provides a mortgage loan against the security of the building. 3. Joint ventures between developer-borrowers and mortgage lenders who provide substantial equity capital in a real estate project in addition to longterm mortgage financing. Within each of these categories, there has been much diversity of details in the agreements between borrowers and lenders, depending on the requirements of each party and the characteristics of particular projects. Each of these broad approaches will be described in turn, emphasizing the positions of borrowers and lenders in the transaction. 1. CONTINGENT INTEREST ON MORTGAGE LOANS In a contingent interest arrangement, the lender looks to a return on his investment in two distinct forms: (1) a fixed interest rate on the amount borrowed and (2) additional or contingent income based on the earnings performance of the project being financed. As set forth in the loan agreement, contingent interest may be calculated as a percentage of gross rental income from the project, or a percentage (usually smaller) of net income after expenses and taxes. In some instances, the borrower is not required to pay contingent interest until revenues from the property rise above a predetermined dollar base related to the projected rate of occupancy and the expected scale of rent payments. Moreover, the contingent interest payment is not the entire amount above the agreed base, but only a predetermined percentage of any overage, usually 10 or 15 percent. As an example, take the case of a $1 million loan to finance a proposed threestory office building in a newly developed area. The developer, working out his plans with the lender, might project his gross rents, at $5.75 a square foot, to $285,000 a year. The loan agreement might provide that 15 percent of any rents collected over this $285,000 base would be paid to the lender each year as contingent interest, beyond the fixed interest rate on the mortgage, but in no event to exceed maximum legal limits. If the office building enjoys unusual success, or if inflation raises the whole rental structure to produce higher gross income, the lender receives a 15 percent share of that overage as added compensation for the fact that his funds made the project possible. It is important to recognize that in such a case contingent interest does not place a burden on the property or the developer until such time as justified by the higher revenues from the project. From the borrower's standpoint, contingent interest is more desirable than a higher fixed interest rate. When interest rates on bonds and mortgages moved sharply upward in 1968, 1969, and early 1970, many planned real estate projects became infeasible at the going market rates because of heavier debt service resulting from higher fixed rates. In this situation, many lenders and developers turned to contingent interest arrangements in which the fixed rate was held to a level that would allow the borrower's debt service costs to be covered by projected revenues. For their part, lenders could receive a competitive rate of return from the combination of a fixed rate of interest plus contingent interest payments tied to the growth of project revenues. Thus, both the developer and the lender could overcome inflationary pressures and financial stringency in an economically productive endeavor. The widening use of contingent interest features on mortgage loans has been closely associated with continued inflation and the rise in market interest rates during the 1968-70 period. With investible funds in short supply, lenders have given preference to those projects offering the most favorable terms and the highest long-term yield consistent with adequate safety of the principal invested. Contingent interest has become one of the many terms of negotiation in longterm financing, along with such items as loan maturity, loan-value ratio, repayment provisions, and contract interest rates. In the main, the developments being 488 financed are of substantial size, ranging upward from one million to several millions of dollars, and often involving major business corporations or large development firms. Borrowers and lenders in these negotiations are sophisticated professionals who are acquainted with money market matters and financial contracts, with access to a wide number of lenders. Contingent interest techniques have been applied to income-producing business properties but not, of course, to single-family mortgages for individual homeowners. Over the years, inflationary forces appear likely to bring rising rental scales on business and apartment properties, in addition to the pressures from a growing population and expanding business. The project owners are in a position to obtain an inflation hedge from tenants, through tax and expense escalation clauses, or renegotiation of short-term leases. It would be inequitable to deny an inflation hedge to the lender while permitting the owner-borrower to pass inflated costs on to his tenants and still repay the lender with depreciated dollars. It is important to recognize that contingent interest features on income-property mortgages do not involve ownership or control by the lending institution, since it has no voice in the management of the property, nor does it receive common stock or voting rights in the development corporation. Thus, it is inaccurate to describe this arrangement as an "equity" participation, since the lender does not obtain an equity position in the property, either during or after the life of the loan. In fact, the lender's claim to income participation comes to an end whenever the loan is paid off. The lender merely has a contingent right to additional income beyond the fixed interest rate, which may improve the overall return by perhaps % percent or 1 percent above the contract rate over the 10- to 15-year life of the loan, if the project achieves a success beyond normal expectations. It is interesting to consider what would have happened in the real estate field if the provisions of section 14 had been in effect during the past three years. Within a life insurance company, the mortgage loan department must compete against the bond department and the common stock department in the allocation of available investment funds, depending on the relative attraction of the expected rate of return. If real estate financing had been confined to straight mortgage loans without contingent interest or variable income features, investment funds would have flowed into other outlets which can offer an inflation hedge. More funds would have been channeled toward common stock or direct ownership of real estate, to the detriment of developers seeking funds for construction of apartment dwellings, shopping centers, and other commercial properties. In actual practice, the emergence of participation features which retain the competitive edge of mortgage loans against other investment has helped to sustain the flow of credit available to real estate developers. More housing has been built and more commercial facilities provided during these tight-credit years than would have been possible under traditional financing techniques. 2. LAND PURCHASE AND LEASEBACK A second type of financing that would appear to be ruled out by section 14 is the making of a mortgage loan on an income-producing building with the simultaneous purchase of the underlying land. In this transaction, the borrower receives mortgage financing for perhaps 75 percent of the value of the building and also obtains cash from the sale of the land to the lender. The borrower is thus able to recapture nearly all of his out-of-pocket costs and minimize the amount of his own capital tied up in the property. Although the investor is the nominal owner of the underlying land, he leases it to the developer on a long-term basis and has no control over the management of the building. The purchase-leaseback financing technique has been a long-established practice in the financing of real property. Recent modifications in purchase-leaseback arrangements have permitted the investor to obtain a variable income hedge against inflation in a number of ways, based on his ownership of the land. For example, periodic adjustment or renegotiation of the ground lease allows the investor to increase his income as property values rise over the years. Or an escalation clause in the ground lease can be tied to the gross or net rentals from the building, to provide a rising income as dollar rentals advance over time. Also, when the mortgage loan is paid off, the land can be resold to the borrower or a third party at its higher current value, thereby producing a capital gain for the investor. These recent innovations have meant that the investor may obtain variable income and possible capital gains on his equity position, rather than limiting his investment return to a fixed interest rate and an inflexible ground lease over a 20 to 30 year period of financing. 489 The advantages of purchase-leaseback financing for the developer-borrower are many. In addition to conserving his limited capital, the borrower retains control and management of the property whether it is used for rental space or occupied by the borrower's own company. Prohibition of these arrangements by section 14 would be clearly detrimental to the interests of developers and borrowers who obtain man}' financial advantages from this method of financing. 3. JOINT VENTURES IN REAL ESTATE Under a joint venture arrangement between a developer-builder and an institutional investor, the latter provides an equal or substantial share of the equity capital needed for a new real estate venture, in addition to providing mortgage financing. An outstanding example of this kind of arrangement is found in the case of Columbia, Maryland, in which a joint venture was formed between the Rouse Company of Baltimore and the Connecticut General Life Insurance Company to develop a new town with a planned population of 100,000 by the year 1980. Subsequently, the Chase Manhattan Bank and Teachers Insurance and Annuity Association became part of the financial structure. Other instances of joint ventures have involved large land tracts or industrial park complexes or housing-shopping-commercial developments in various parts of the country. Because of the many years of development that are required, and the millions of dollars of capital expended before any return can be expected, the joint venture participation with an institutional lender is frequently an essential ingredient in large-scale real estate development. Projects such as Columbia, Maryland, started more than six years ago, could never have been contemplated on the basis of equity capital from a single development corporation. Moreover, no responsible lender could have undertaken the risks involved on a fiat-rate mortgage basis. Even in smaller ventures, outside equity eapital is sought by developers to supplement their own limited funds or to permit a greater number of projects. Experienced mortgage lenders are obvious and natural partners in such enterprises because of their acquaintance with development techniques, the technical assistance they can provide, and the ability to supply "seed money" without rewards for several years. National policy has been directed toward the construction of new towns, the redevelopment of urban areas, and the expansion of community facilities through recent legislation that often was initiated by the House Banking and Currency Committee. Establishment of national housing goals bv the Congress in the Housing Act of 1968 has highlighted the need for 26 million new housing units within a decade. Operation Breakthrough represents an effort to mobilize the skills of private industry to produce mass housing with lower cost construction techniques. All of this new housing will also require an accompanying development of shopping facilities, industrial parks, and commercial structures that are necessary to an expanding population. Title VII of the Housing and Urban Development Act of 1970 specifically describes one of the purposes of the new communities provision as "encouraging the orderly development of well-planned, diversified, and economically sound new communities, including major additions to existing communities, and to do so in a manner which will rely to the maximum extent on private enterprise . . . . " We believe that the joint-venture real estate activities of life insurance companies and other investors are aimed toward identical goals and, indeed, are crucial to their accomplishment. If section 14 were to rule out joint ventures where equity capital and loan capital are combined, it is difficult to visualize how the enormous need for real estate development can be met over the next 10 to 20 years, unless both seed money and long-term capital are provided directly from government funds. If lending institutions are prevented from providing equity capital to supplement the resources of real estate developers, these developers will be forced to think small, plan small, and build small. In the light of the nation's housing and real estate needs, such prohibition would clearly work against the national interest. CONCENTRATION OP ECONOMIC POWER Concern has been expressed in some circles that the recent trend toward socalled "equity participations" in real estate financing could lead to a situation in which real estate throughout the United States would be dominated or controlled by life -insurance companies and other institutional lenders. For example, an article in the July 1970 issue of Fortune was entitled "The Future Largest Land60-299—71—pt. 2 1 490 lords in America" and pointed with alarm at the growing involvement of lenders in real estate activities. We do not believe that there is a sound basis for these fears. As pointed out above, many forms of so-called "equity participation" do not actually involve ownership or control by the lender. Moreover, the state investment laws which govern the operations of life insurance companies'would obviate any future trend toward domination of real estate markets or ownership and control of business enterprise. These laws typically fix upper limits on the percentages of total assets which may be held in various investment forms. Further, most state laws limit the percent of an insurer's assets which may be invested in the stock of any one corporation and many states also restrict the percentage of outstanding common stock of any one corporation that may be held. As one illustration, New York State imposes a one percent limit on the first basis and a five percent limit on the second. Special provisions are often made, of course, for the holdings of stock of a subsidiary or of other insurers and a variety of rules are applied to the formation or operation of holding companies which involve insurance companies. In addition, there frequently are limits on the percent of a life insurance company's total assets which may be held in the form of common stock. State investment laws also limit the percent of an insurer's assets that may be held in investment real estate. These percentage ceilings range from 5 percent in some states to 10 percent in many others and were imposed in the interest of a diversification of assets. In actual practice, present real estate holdings account for 3 percent of total assets of U.S. life insurance companies, of which about onequarter is used for company accupancy and the remainder was purchased for investment or acquired through foreclosure. Nevertheless, it is worth considering what the outer limits might be for life insurance assets in real estate markets. In 1968, according to a recent study by the National Bureau of Economic Research undertaken for the SEC Institutional Investor Study, the total value of private non-farm land was $419 billion and the value of private buildings (residential and non-residential) was $1,040 billion. (These figures do not distinguish between rental properties and owner-occupied homes or buildings.) Against this total of $1,459 billion, actual real estate holdings of life insurance companies were $5.6 billion, or less than of one percent of total real estate value. Even if life company holdings rose to the 10 percent limit permitted by some states, only 1.3 percent of total real estate would ke owned or controlled by life insurance companies. It should be further recognized that life insurance lenders have not demonstrated a widespread interest in owning, managing, and controlling rental properties as a primary form of investment. Such operations would require different skills than are present in most companies. Diversification of investments, together with the continuing attraction of other market outlets, are important factors which militate against any supposition that life company domination of real estate markets could be a future possibility. We are grateful to the Committee for this opportunity to present our views in opposition to a proposal which could have serious adverse consequences upon the flows of private capital being used to finance the expansion of growing business firms and the greatly needed development of real estate over the decade ahead. The CHAIRMAN. We will hear from Mr. Hamilton. Mr. Hamilton, if you will take about 10 minutes we will have more time to ask questions. We tried to divide it up evenly, but this last gentleman had more than 10 minutes by unanimous consent. STATEMENT OF JOHN S. HAMILTON, JR., VICE PRESIDENT AND GENERAL COUNSEL, AMERICAN MUTUAL INSURANCE ALLIANCE; ACCOMPANIED BY JAMES P. ALLEN, JR., VICE PRESIDENT, LIBERTY MUTUAL LIFE INSURANCE CO. Mr. HAMILTON. I am John S . Hamilton, Jr., vice president and general counsel of the American Mutual Insurance Alliance of Chicago. I am accompanied by James P. Allen, Jr., who is vice president and general counsel of Liberty Mutual Insurance Co. Mr. Allen is from Boston. 491 We appreciate very much the opportunity to present the views of our 101 mutual property and casualty companies on H.R. 5700. We submit our statement and ask that the full statement be placed in the record, please. The CHAIRMAN. Yes, it will be inserted in the record, Mr. Hamilton. Mr. HAMILTON. By no means do all the provisions of this bill affect our member companies. As I will indicate in just a moment, we have no position on section 14 with respect to equity participation. And I think I can explain the reason. Those which do affect our companies would have an extremely adverse effect on the ability of these companies to survive and to grow, and on their ability to serve their policyholders. As a basis for this I would like to take a moment to distinguish between mutual and stock insurance companies, and between life insurors and property/casualty insurance companies. A mutual insurance company has no stock and no stockholders. It is owned by its policyholders, each of whom has an indivisible ownership. There is no way to transfer that ownership. The directors of the company must be policyholders or representatives of corporate policyholders, they have an interest in the company as to its insurance service. Mutuals like many other corporations, have had difficulty in attracting the more competent directors because of the problems that certain directors have run into in recent years. Mutual companies, our member companies, need directors that are competent and experienced in the financial field. They cannot offer these persons a chance to buy into the company and make a profit out of the investment that they will help guide and direct. You cannot buy into a mutual company. You can only buy insurance from it. Now, as to the difference between mutual property casualty companies and other insurors, we do not consider that cur companies have any competitive aspect with banks or other banking institutions, or even the life insurance companies in the areas primarily under consideration here. We have made a survey of our member companies and their ratios of mortgage and collateral loan investment. In 1969 it was three-tenths of 1 percent of their total assets. This has been going down over the last 20 years. It never was very large. The ratio of real estate to total assets was 2.3 percent in 1969. This has been going down. In addition, the real estate is used primarily in the insurance companies* insurance business. Part of the reason for this, perhaps the major reason, is that a property and casualty insurance company, like a life insuror, needs stability and income in its investments, but it has a much greater need for liquidity of investments because of the more unpredictable fluctuations of losses. I will pass over the prohibitions of section 7 with respect to employee welfare and benefit plans. Our statement covers this. I believe that our friends in the life insurance business cover it, and Dr. Fey has referred to it. I would like to come to the serious handicap that would be presented to our member companies by the prohibition of section 8 against having a director who is connected with the mutual insurance company on the board of any corporation of which the mutual company owns 492 more than 5 percent of the stock. This would be a severe handicap on growth and on the maximum use of assets of our member companies. The trend in insurance in the past few years has been toward diversification through the use of holding companies and direct subsidiaries. The New York Insurance Department appointed a blue ribbon committee, including a prominent CPA, lawyers, regulators, and law educators, which in 1968 recommended the removal of certain restraints on investment, and the creation of new forms of regulation. Shortly thereafter the National Association of Insurance Commissioners developed a model holding company act which has been adopted by a great many States. It regulates the acquisitions, intercompany transactions, requires registration and reporting, and provides for other iegulation, and provides for examination. All of this is in addition to existing State regulation with respect to conflict of interest situations and restraints on competition. As I have indicated, a mutual company has no stock. It cannot become a part of a holding compan}' by feeing bought by a holding company. The only way our members can participate is by owning a holding company, organizing a holding company, or buying a direct subsidiary themselves. If the subsidiary is organized or acquired by the mutual for this purpose—that is, to provide greater total financial services to its policy holders—obviously a majority of the stock, quite frequently all of it, is owned by the parent mutual insurance company. In such a situation it seems to us totally unfair to prohibit designation of personnel from the parent mutuarfrom serving on the board of directors or as officers of the subsidiary^ It is unfair to the personnel in limiting their opportunities to gain business experience and business knowledge, it is unfair to the mutual in its competition with other insurors for growth and service, and it is unfair to the subsidiary which is trying to compete as best it can with other entities in its field of operations. We have tried to make a survey of the situation in which our member companies are today, and we have found no situation in which an officer, director or employee of one of our members is on the board of or an officer of another company where the 5 percent stock ownership exists, except in the case where the other company is a subsidiary of the mutual. I will come to a conclusion quickly. I will point out that all of the investments in business operations by insurance companies are subject to strict regulation by State insurance departments under the principles that were established most recently in the McCarran-Ferguson Act, Public Law 15. There is in this bill in a number of places an exemption of bank holding companies and savings and loan holding companies. We urge that you give favorable consideration to including in the bill an exemption of mutual property and casualty insurance companies and their subsidiaries along the lines of the bant holding company exemption. Thank you, sir. (The prepared statement of Mr. Hamilton follows:) P R E P A R E D STATEMENT OF JOHN S . H A M I L T O N , J R . , V I C E P R E S I D E N T AND G E N E R A L C O U N S E L , AMERICAN M U T U A L INSURANCE A L L I A N C E My name is John S. Hamilton, Jr., vice president and general counsel of the American Mutual Insurance Alliance, Chicago, Illinois. The American Mutual 49.3 Insurance Alliance is a voluntary association of 110 mutual property and casualty insurance companies which write a substantial portion of all fire and casualty insurance written by mutual insurance companies in the United States, and whose total annual premium volume for all lines of insurance is approximately 3.3 billion dollars. I am here today to comment upon the effect that certain provisions of H.R. 5700 would have upon the operations of mutual property and casualty insurance companies, generally, and also upon the operations of our member companies, specifically. In order to understand the drastic and unique effect that certain provisions of H.R. 5700 would have upon the operation of mutual property and casualty insurance companies, it is necessary to point out the differences between the corporate structure of a mutual property and casualty insurance company and that of a stock property and casualty insurance company. It is also necessary to distinguish between life and property/casualty insurance companies, both as to the type of risk covered and the general investment policy followed by such companies, and also to distinguish between property and casualty insurance companies' investment policies and those of other financial institutions such as banks. MUTUAL INSURER HAS NO STOCKHOLDERS A mutual insurer is defined as an insurance corporation without capital stock, owned by its policyholders collectively, who have the right to vote in the election of its directors. The ownership of a mutual insurance company, residing as it does with its policy holder members, cannot be exchanged in the open market place. A stock insurance company, on the other hand, has capital stock which is owned by its stockholders, who may or may not be policyholders of the company. The stock of a stock insurance company may be freely purchased or sold in the market place, and ownership may reside in a group of persons which to a large extent are different from that group which comprises its policyholders. In contrast, the mutual policyholder's interest as an owner is not transferable, and cannot be liquidated except upon dissolution of the company. The directors of a mutual insurance company must be policyholder members of that company, or must be officers or representatives of such a policyholder member. The directors of a stock insurance company need not necessarily be policyholders of the company. INVESTMENT POLICIES Property and casualty insurers also must be distinguished from life insurers, both as to the type of risk covered and as to the type of investment policies engaged in by each. A property and casualty insurer provides insurance against certain catastrophic events which may or may not occur during the life of the policy. While it is possible over a period of years to predict with reasonable accuracy the volume of such catastrophic events which will occur, it is extremely difficult to predict what that volume will be in any given year. Unlike the property and casualty insurer, the life insurer provides insurance for an event which is certain to occur, the death of the policyholder. However, the life insurer, through the use of mortality tables, is able to predict with startling accuracy the number of deaths among its policyholders and thus the approximate volume of payments which it will make during any given year. Unlike the property and casualty insurer whose volume of losses for catastrophic events may fluctuate widelj', the life insurer is reasonably certain that its payments will be made on a more or less stable basis from year to year. This difference in the experience of property and casualty companies as opposed to life insurers with respect to volume of losses in any given year points out a basic reason for the difference in investment policies of the two types of insurers. The property and casualty insurer has a need for liquidity in its investment program. Property and casualty insurance rates are regulated by state insurance departments and such companies have a special need for maximizing income derived from the investment program, in order to provide for a growing insurance market on a stable basis. The life insurer with its more stable volume of annual payments does not need such liquidity in its investment program and is attracted to longer term, less liquid, investments. This difference is pointed out in the publication "Non-Bank Financial Insti- m tutions" published by the Federal Reserve Bank of Richmond, June 1965, on page 11, in which it is stated as follows: There are important distinctions, however, arising from the basic differences between the two types of companies. For example, life insurance companies must pay most policies in full since all policyholders eventually die, whereas only a fraction of fire and casualty policies ever results in losses. Consequently, life companies accumulate relatively larger asset holdings in relation to the volume of their business, since the average policyholder must pay in enough premiums, together with the income the company earns on these funds, to pay, eventually, the proceeds of the policy. In addition, the pattern of deaths among policyholders is much more predictable than the volume of fire and casualty losses. The net result is that life companies can appropriately invest in longer term, less liquid, investment than can fire and casualty companies. Even among property and casualty insurance companies, there are some differences in the nature of their investment policies due to the type of insurance written by the company and to some extent their corporate structure. The publication of the Federal Reserve Bank of Richmond, cited above, succinctly points this out as follows: There are many differences among fire and casualty companies, however, Those that do primarily a casualty business typically invest in somewhat more liquid securities than fire companies since the extent of casualty losses cannot be predicted as precisely as the volume of property losses. Mutuals also usually hold more liquid investments than stock companies since they ordinarily have less policyholder surplus in relation to assets than to the stock companies. Thus, it can be seen that mutual property and casualty insurance companies have unique requirements as respects their investment programs, as opposed to those of life insurance companies and even those of stock property and casualty insurance companies Clearly then, if the investment needs of a mutual property and casualty insurance company are different from other types of companies within the insurance industry, they are vastly different from the other types of financial institutions which would be subject to the requirements of H.R. 5700. For example, mutual property and casualty insurance companies cannot be thought of in any manner as being in competition with banking institutions insofar as their investment programs are concerned, One of the primary functions of the investment program of most banking institutions is the making of mortgage and collateral loans and investments in real estate. However, these types of loans represent an extremely small percentage of investment programs of mutual property and casualty insurance companies. This point is clearly illustrated by the figures taken from the summary of classified assets of member companies of the American Mutual Insurance Alliance for the year 1969 and the trend over the past 20 years. In 1969, the percentage of total assets of such companies represented bv mortgage and collateral loans was 0.3%, down from 0.4% in 1959 and 0.7% in 1949. In 1969 the percentage of total assets represented by real estate investments of our member companies was 2.3%, whereas in 1959 it was 3.1% and in 1949 it was 2.4%. A very large part of the real estate investment is in the office buildings occupied by the insurers in carrying on their business. In contrast to this was the percentage of total assests of member companies represented by investments in all types of bonds and in stocks. In 1969 this was 86.2%, up from 84.9 % in 1959 and 82.5% in 1949 %. These figures clearly show that the type of investments which will fit the needs and requirements of mutual property and casualty insurance companies are totally different from those which comprise the bulk of investments of other financial institutions which would be subject to the requirements of H.R. 5700. The difference between property and casualty insurance companies, whose investment goals are liquidity and income as well as stability, and other types of financial institutions such as those specified in H.R. 5700, which are primarily lending institutions, was recognized in a report of the Subcommittee on Domestic Finance of the Committee on Banking and Currency entitled 4'Comparative Regulations of Financial Institutions" issued on November 22, 1963. In the introduction. to chapter 6, entitled Property and Casualty Insurance Companies, the following statements are made: Property and casualty insurance companies are financial intermediaries that obtain the bulk of their funds from businesses and households; they 495 invest their funds mainly in the bonds and stocks of governments and corporations. The flow of funds into these intermediaries arises from the specialized service that they offer—providing monetary protection against losses arising from fire, other accidents and misfortunes, and legal liability associated with injury to persons. From the policyholders' point of view, the service rendered cannot be thought of as including a liquid or even near liquid asset. Consequently, the influence of fire and casualty companies in money and capital markets is mainly to be found in the amounts of funds obtained and the investment policies pursued. Property and casualty companies command only a moderate amount of funds. They consequently represent a relatively limited influence. Property and casualty companies are principally investment institutions in contrast to lending institutions. The flow of funds out of property and casualty companies is regulated by state law. The purposes of regulations are, presumably, the achievement of a high degree of liquidity and the maintenance of solvency. However, within existing limits, the investment policies of stock companies and of mutual companies as well, are in all probability motivated by the desire for income and growth. State insurance supervisory authorities exercise close supervision over investment policies of property/casualty companies (as well as life insurers). Statutes, regulations and procedures cover types of investments, liquidity, diversification and valuation of invested assets. The foregoing explanation of the type of business engaged in by property and casualty insurance companies, and particularly mutual property and casualty insurance companies, and their investment needs and requirements, is made to demonstrate the many important differences between such companies and the financial institutions which are to be subject to the requirements of H.R. 5700. We express no views as to the desirability or need for the requirements of H.R. 5700 with respect to those other financial institutions. This is for the Congress to determine. However, we do wish to point out that property and casualty insurance companies, and particularly mutual property and causalty insurance companies, are not the type of business institutions which should be considered in connection with the category of financial institutions which H.R. 5700 intends to regulate. The nature of the property and casualty insurance business and the investment requirements to engage in this business make it imperative that it not be swept under the provisions of legislation establishing requirements for an entirely different type of business institution. Furthermore, the requirements of H.R. 5700, if applied to property and casualty insurance companies, and in particular if applied to mutual property and casualty insurance companies, would seriously restrict the fulfillment of their business requirements, and in the long run operate to the detriment of the insurancebuying public. NEED FOR COMPETENT DIRECTORS Several provisions of H.R. 5700 would establish some far reaching restrictions on the relationships between banks, savings and loan institutions, mutual savings banks and other "financial institutions," among which is included "any insurance company." Section 2 of the bill would prohibit any person who is a director, trustee, officer or employee of a bank insured under the Federal Deposit Insurance Act from being at the same time a director, trustee, officer, or employee of certain specified "financial institutions," among which is "any insurance company." Section 3 of the bill would add a similar prohibition with respect to any director, trustee, officer or employee of a savings and loan institution from acting in a similar capacity in certain specified "financial institutions" including "any insurance company." Again, in section 4 a similar prohibition is contained with respect to a director, trustee, officer or employee of a mutual savings bank from acting in the capacity of a director, trustee, officer or employee of other "financial institutions" including "any insurance company." The effect of these provisions, insofar as mutual property/casualty insurance companies are concerned is to prohibit a director, trustee, officer or employee of any of the listed banking institutions from serving in the capacity of a director of any of our member companies. In addition, a similar prohibition would be exercised with respect to a director, officer or employee of an insurance company serving on the board of any one of the specified financial institutions. 496 We feel that this prohibition, at least insofar as mutual property and casualty insurance companies are concerned, is an unreasonable restriction upon their right to seek out the most competent and experienced individuals available in the various areas of the business community encompassed by an insurance company's operations. Under today's conditions, it is difficult at best for any corporation to secure the kind of competent experience among its directors that is necessary for a successful business operation. Recent court decisions have made it abundantly clear that directors and officers of corporations will be held strictly accountable for their actions undertaken in that capacity. This is true not only if the activities of the directors or officers were the result of intentional wrongdoing, but also if they were the result of an uninformed or a negligently formed decision. Consequently, individuals who have the necessary business knowledge to be of assistance in guiding the operations of a corporation have become extremely reluctant to serve as directors of these corporations in view of the potential liability which might be placed upon them as a result of their activities as a member of the board of directors of a particular corporation. This difficulty in securing competent individuals to serve as directors is being experienced by all corporations at the present time. However, it is especially true with respect to mutual property and casualty insurance companies. Corporations which have stock which is bought and sold in the market place have some incentive to offer to individuals to encourage them to participate as a member of the company's board of directors. The individual may purchase shares of stock of the corporation and earn a financial reward through the increase in value of that stock as the result of the successful operation of the company. No such incentive is available to the directors of mutual property and casualty insurance companies. As indicated above, the corporate structure of a mutual property and casualty insurance company is such that it offers no opportunity for its directors to participate in the ownership of the company other than ownership rights inherent in his position as a policyholder of the company. The opportunity to earn a major financial reward for his endeavors is not available to the director of a mutual property and casualty insurance company as a compensatory factor for his efforts as a director and for assuming the risk of potential liability for the consequences of his service as a director. Thus, the prohibition contained in sections 2, 3 and 4 of H.R. 5700 would drastically curtail an already restricted pool of competent manpower from which a mutual property and casualty insurance company can hope to attract its directors. Furthermore, it would curtail manpower in an area of judgment which is sorely needed by mutual property and casualty insurance companies, that is, those individuals who have special competency, knowledge and acquaintance with developments in the financial area. As pointed out above, a mutual property and casualty insurance company is an investing institution rather than a lending institution and because of the great fluctuation in fire and casualty losses, it is a necessity that such a company maintain liquidity in its investments. Furthermore, because of this fluctuation, it is vital to the successful operation of a mutual property and casualty insurance company that its investment portfolio is managed so as to maximize income for any given year. Thus, it is absolutely essential for a mutual property and casualty insurance company to have the competence available at its board level to establish the policies which will insure the maximum success of its investment program. It is true that larger mutual property and casualty insurance companies have investment departments which are charged with the day-to-day administration of the investment portfolio of the company. It is also true that there are a large number of smaller mutual property and casualty insurance companies which do not have available to them the extensive facilities of a large scale investment department. However, even in the case of the larger companies which do have investment departments, they are primarily concerned with the day-to-day administration of the investment portfolio based on the policy and direction formulated at the board level. It is essential to them that they have available to them at the board level individuals with the necessary skill and competency in the financial community to establish the guidelines under which they operate. For smaller mutual companies without an extensive investment department, the availability of proficiency at the board level is vital to their continued successful business operation. Furthermore, the prohibitions contained in these sections of H.R. 5700 not only 497 would deprive the mutual property and casualty insurance company of the talent which is essential to its continued successful operation, but it would do so without any resulting public benefit since a decline in the success of the company's operations could only operate to the detriment of its policyholders and to the insurancebuying public in general. STATE REGULATION Finally, the restrictions that would be imposed by H.R. 5700 insofar as mutual property and casualty companies are concerned would operate to place additional burdens upon companies which are already regulated by perhaps the most comprehensive set of regulations to which any part of the business community is presently subjected. Insurance companies are subject to the insurance laws and to regulation by the insurance department of each of the fifty states. Companies are regulated not only in the state in which they are domiciled, but also in each of the states in which they do business. Many state insurance codes have specific provisions within the insurance code dealing specifically with conflict of interest situations among directors of an insurance company. In other states, such provisions are contained in the general business corporation provisions to which insurance companies are also subjected. In addition, the broad regulatory authority conferred upon the insurance commissioners in the Various states is more than sufficient to authorize appropriate action to remedy conflict of interest situations with respect to insurance company directors. The National Association of Insurance Commissioners has also seen the need for close regulation by the states of possible conflict of interest situations among directors of insurance companies. The uniform Annual Statement Blank (Fire and Casualty) promulgated by the NAIC contains in the General Interrogatories section, question 12b which includes a series of questions designed to elicit information which would indicate whether a conflict of interest situation exists among the members of the board of directors of the particular company, and whether the company has established procedures for disclosure of conflicts and their control. Furthermore, the NAIC has promulgated its model Insurance Holding Company Act which contains strict disclosure provisions relative to possible conflicts of interest among insurance company directors and directors of insurance holding companies. Finally, the courts of the several states have been especially alert to the possibility of conflict of interest situations arising among directors of corporations and holding companies, and particularly insurance companies. Transactions between corporations having directors or officers in common have been subjected to close judicial scrutiny to determine the absence or presence of fraud or unfairness. Thus, the prohibitions contained in H.R. 5700 which would preclude property and casualty insurance companies from having individuals serve upon their boards of directors who have the necessary financial mastery vital to the successful operation of their business is not only unreasonable, but it is unnecessary due to the close scrutiny to which the operations of insurance companies are subjected by the insurance departments and courts in the several states. MANAGING EMPLOYEE BENEFITS Section 7 of H.R. 5700 would prohibit a person who is a director, trustee, officer or employee of a financial institution, the definition of which includes any insurance company, from at the same time serving on the board of directors of any corporation with respect to which the financial institution manages an employee welfare or pension benefit plan. It has become increasingly more common over the past several years for a property and casualty insurance company, including mutual property and casualty insurance companies, to have subsidiary life insurance companies in order to provide their policyholders with a broad range of insurance services. Usually the life insurer subsidiary is wholly or majority owned by the parent mutual, and usually this life subsidiary is a stock company. This trend toward providing policyholders with a broad range of financial and insurance services will be discussed in greater detail in the comments with reference to section 8 of H.R. 5700. 498 In a typical situation in which a mutual property and casualty insurance company organizes a subsidiary life insurance company, a number of the members of the board of the parent property and casualty insurance company may also serve as members of the board of the subsidiary life insurance company. Since the life insurance company's services were designed to be integrated with the services offered by the parent property and casualty insurance company so as to present a broad range of insurance services to the insurance-buying public, it is not unreasonable that the boards of the two companies should have common directors. In a number of the cases in which a subsidiary life insurance company exists, it manages on behalf of the parent property and casualty company the employee welfare or benefit pension plans of that parent company. The prohibition contained in section 7 of H.R. 5700 would preclude the subsidiary life insurance company from managing the employee welfare or pension benefit plan of its parent property and casualty insurance company or would necessitate a board of directors of the subsidiary life insurnace company which is totally different from the board of directors of the parent property and casualty company. It would seem that either result would be unreasonbale in the situation outlined. Certainly it is reasonable to give a parent property and casualty insurance company the opportunity of placing the management of its employee welfare plans or pension benefit plans in a subsidiary life insurance company if it chooses to do so. However, this section would require that placement and management of such welfare or pension plans be in an entirely different company, or that the companies forego having common directors. Either situation would operate to hinder the integration of the insurance services provided by the two companies. We feel that this provision should be modified so as to permit the management of employee welfare or pension benefit plans by a life insurance subsidiary of a property and casualty insurance company even though the boards of directors may have some members in common. DIRECTORS OP SUBSIDIARIES Section 8 of H.R. 5700 would create far reaching prohibitions applicable in some respects to all corporations, but would place severe limitations upon the growth potential of mutual property and casualty insurance companies in particular. This section would prohibit a director, trustee, officer or employee of a "financial institution" from serving as a director or officer of any other corporation with respect to which the financial institution holds the power to vote, more than 5 % of any class of stock. The definition of financial institution in this section also includes "any insurance company." This provision would place severe obstacles in the path of any mutual property and casualty insurance company that wished, through growth and diversification, to supply its policyholders with a total package of insurance and ancillary services through the establishment of subsidiary companies, although stock property and casualty insurance companies would be able to bypass the restrictive effects of this section through the utilization of the holding company procedure as will be pointed out later. However, this section would stifle, in the case of a mutual property and casualty insurance company, any possibility of providing a broader range of service to its policyholders through diversification. The need for diversification within the insurance industry, and particularly within the property and casualty insurance industry, was recognized several years ago by industry and regulatory officials alike. INSURANCE HOLDING COMPANIES In 1967, the New York Insurance Department, concerned over a trend among non-insurance holding companies to acquire insurance company subsidiaries, established a Special Committee on Insurance Holding Companies to evaluate the reasons for this trend and to determine the best way of reconciling the public interest, the protection of policyholders and the reasonable expectations of company management in the holding company field. The New York Special Committee in its report in February 1968, concluded that there is a definite public need for a broad range of insurance and related services and that the growth of the industry, which would enable it to provide these broad services, was being stifled by unduly restrictive investment laws. The utilization of a non-insurance holding company device was considered a method 499 whereby the unreasonable restrictions of state insurance investment laws could be avoided. The Committee recognized that some of the restraints incorporated into insurance practice and insurance law were no longer essential and added unnecessarily to pressures to organize non-insurance holding companies. The Committee recommended that such investment restraints be relaxed to enable insurance enterprises directly and affirmatively to deal with the economic realities that they faced. It further recommended that life and property/casualty insurance companies be given greater latitude in the formation and acquisition of subsidiaries, both as to insurance subsidiaries and to non-insurance subsidiaries which are ancillary to the insurance enterprise. This liberalization permitting more diverse insurance company activity would, of course, be, at all times, subject to the scrutiny and appropriate regulation of the state department of insurance. In 1969, the National Association of Insurance Commissioners took formal cognizance of the need for insurance companies to diversify by adopting the NAIC Model Holding Company bill. The NAIC, in adopting this model bill, recognized that, as a minimum, insurance companies should be allowed to organize or acquire one or more subsidiaries engaged in businesses ancillary to the insurance enterprise. Among the ancillary activities specifically authorized for insurance company subsidiaries in this model bill are the following: Acting as an insurance broker or as an insurance agent, Management of an investment company, Rendering investment advice to governments, government agencies, corporations, or other organizations or groups, Rendering services related to the operation of an insurance company including actuarial, loss prevention, safety engineering, data processing, accounting, claims, appraisal and collection services. Ownership or management of any assets which the insurer itself could own or manage, Financing of insurance premiums, agents and other forms of consumer financing, and finally, Any other business or activity determined by the insurance commissioner to be reasonably ancillary to an insurance business. The NAIC, in its Model Holding Company Act, further recognized that while the organization or acquisition of subsidiaries whose business function is ancillary to that of the insurance operation was the minimum that was necessary, some states might wish to permit insurance enterprises even broader authority to own and operate subsidiaries. Therefore, they included as an alternate provision in the model holding company act authorization for an insurer to organize or acquire one or more subsidiaries which would be permitted to engage in any type of business activity. A pertinent summary of the reasons that the NAIC felt that insurance company diversification was desirable is found in the Appendix to the NAIC Model Holding Company Act which is set forth as follows: (1) Findings (a) It is hereby found and declared that it may not be inconsistent with the public interest and the interest of policyholders and shareholders to permit insurers to: (1) engage in activities which would enable them to make better use of management skills and facilities; (2) diversify into new lines of business through acquisition or organization of subsidiaries; (3) have free access to capital markets which could provide funds for insurers to use in diversification programs; (4) implement sound tax planning conclusions, and (5) serve the changing needs of the public and adapt to changing conditions of the social, economic and political environment, so that insurers are able to compete effectively and to meet the growing public demand for institutions capable of providing a comprehensive range of financial services. The prohibitions imposed by section 8 of H.R. 5700 would operate contra to this recognized need for the ability of property and casualty insurance companies to diversify. The provisions of this section offer a property and casualty insurance company two choices, neither of which is reasonable or desirable. The company could either totally abandon any diversification program to provide broader insurance and financial services, or it could embark upon a program of acquiring or organizing subsidiaries with the knowledge that once having obtained an interest in the subsidiary it would be unable to direct the business activities of that subsidiary because it would be precluded from having any of its officers or directors serving on the board of that subsidiary. 500 In effect, the second alternative would be asking the insurance company to provide the capital for a subsidiary operation, and then walk away from that operation without any control over how the capital which it provided is being utilized by that subsidiary. Therefore, the practical effect of the provisions of section 8 would be to eliminate the ability of property and casualty insurance companies to diversify through the mechanism of a holding company or owned or controlled subsidiary companies. As pointed out previously, a stock property and casualty insurance company could avoid the prohibitory effect of section 8 by the organization of what is termed a "upstream" holding company. In this situation, a holding company could be formed which would purchase the stock of the insurance company. The holding company could then proceed to organize or acquire subsidiary companies engaged in any number of business activities. Since the insurance company would own no stock of the holding company, but would, in fact, be owned by it, and since the insurance company might own no stock in the subsidiaries, the prohibitions contained in section 8 would not be applicable, and the officers and directors of the insurance company would be entirely free to serve as directors or officers of the holding company or any of its subsidiaries. This alternative is not open to a mutual property /casualty insurance company. By the very nature of its corporate structure, a mutual property/casualty insurance company cannot be owned by anyone but its policyholder members. It cannot form an 1 'upstream" holding company since it has no stock to sell to such a holding company. The only way in which a mutual property/casualty insurance company can employ the holding company mechanism is to form what is known as a "downstream" holding company. In this situation, the mutual property/ casualty insurance company would supply the capital to form a holding company and would either wholly own, or own a controlling interest in the stock of that holding company. The holding company would then proceed to organize or acquire subsidiary companies in various fields of business activity. However, in this situation, the prohibitions contained in section 8 of H.R. 5700 would be applicable. Since the mutual property/casualty insurance company would own something in excess of 5% of the stock of the holding company, it would be precluded from having its directors or officers serve on the board or as officers of the holding company or any of its subsidiaries. Thus, a mutual property/ casualty insurance company would be precluded from any form of diversification either through direct ownership of subsidiaries, or through the holding company mechanism. The prohibitions contained in section 8 of H.R. 5700 would operate in diametric opposition to the need recognized by both industry and regulatory officials for property and casualty insurance companies to diversify. When a property and casualty insurance company diversifies, it not only improves its own competitive position by being able to offer a broader range of services to the public in general, but it also would tend strongly to improve the competitive position of its subsidiaries in their particular fields. The provisions of section 8 would operate to destroy the competitive position of mutual property and casualty insurance companies, since they would be unable either through direct ownership of subsidiaries, or through the holding company mechanism, to diversify to provide the broad range of insurance and related services that their competitors would be able to supply. To this end, the provisions of section 8 are unjustly discriminatory in their effect on the operations of mutual property and casualty insurance companies, their policyholders and the public in general. HOLDING COMPANY EXEMPTION Section 8(b) contains an exception to the prohibitions contained in subsection (a) of that section. It provides that an individual may hold any number of positions as director, trustee, officer, or employee of any number of companies within any given group of companies if one of the companies is either a bank holding company or a savings and loan holding company, and all the rest of the companies in the group are subsidiaries of that holding company. We feel that there are equally compelling reasons for excepting property and casualty insurance companies from the prohibitions of section 8. These reasons are particularly compelling in the case of mutual property and casualty insurance companies. To fail to except such companies from the prohibitions of this section would be unjust and discriminatory and operate to the detriment of their policyholders and the insurance-buying public at large. 501 We strongly urge the committee to adopt such an exception to the provisions of section 8 of H.R. 5700. STATE REGULATION OF INSURANCE In the overall consideration of the provisions of H.R. 5700 on which we have commented, we suggest that due consideration should be given to the decision made by Congress in 1945 that the "continued regulation and taxation by the several States of the business of insurance is in the public interest." The provisions of the McCarran-Ferguson Act (Public Law 15, 79th Congress, 15 US Code, Sections 1011 to 1015) specifically state that the business of insurance and every person engaged in it shall be subject to the laws of the several States which relate to regulation or taxation of such business. The insurance business is believed to be more comprehensively regulated than any other type of business enterprise, although under a system of state rather than federal regulation. As has been pointed out, state regulation covers matters relating to interlocking directorates and ownership of holding companies or subsidiaries by an insurer. It does not appear that there has been any compilation or production of evidence of abuses or improper activities in the areas affected by the sections of H.R. 5700 which we have discussed. It is suggested that this Committee should not recommend the inclusion of mutual property and casualty insurance companies with respect to the matters discussed in this statement. The result would be a system of partial federal regulation, overlapping unnecessarily, and possibly conflicting with state regulation, in the absence of a full study and consideration of the total area of insurance regulation. CONCLUSION It is the position of the American Mutual Insurance Alliance and its member mutual property and casualty insurance companies that: 1. Inclusion of these mutual insurers within the prohibitions of sections 2, 3, and 4 would seriously handicap these companies in the appointment of knowledgeable directors, by still further reducing the pool of suitable persons available, a group which is already too small in many areas. 2. The provisions of section 7 by flatly prohibiting the use of the mutual insurer's subsidiary life company for the management of employee welfare or pension benefit plans would unreasonably limit the business purposes of the mutual in creating or acquiring the life insurer and would unfairly burden both the parent mutual and the subsidiary life insurer in their ability to contribute to the markets for insurance and their ability to serve all of their policyholders. 3. The provisions of section 8 would irreparably damage the ability of mutual property/casualty insurance companies to diversify their investments, make maximum use of their capital funds, and provide the increasingly necessary broad range of insurance and ancillary services by the use of subsidiary holding companies or direct subsidiaries. Mutual property and casualty insurance companies need to have available the widest possible number of persons in business and financial community to serve as their directors, each of whom must be himself a policyholder of the mutual or a representative of a policyholder. Mutual companies cannot seek the advantages of diversification of investments and services through being acquired by an "upstream" holding company which holds the insurer and other business enterprises. Because of the corporate structure and the legal fact that mutuals are owned by their policyholders, the mutual cannot be acquired by such a holding company. Mutuals can obtain such diversification only through "downstream" holding companies or direct subsidiaries. Although various provisions of the bill make exceptions for bank holding companies and savings and loan holding companies, there is no exception for insurance holding companies, the only diversification means available for a mutual property/casualty insurance company. The American Mutual Insurance Alliance respectfully urges this Committee that if any such legislation is to be recommended, there be incorporated in it an exception* for mutual property and casualty insurance companies and their subsidiaries, with respect to the prohibitions of sections 2, 3, 4, 7, and 8. The CHAIRMAN. A statement from Mr. Jenard M. Gross, chairman of the legislative committee, National Apartment Association has been received by the committee. The statement will be placed in the record at this point. 502 (The statement referred to of Mr. Jenard M. Gross follows:) STATEMENT OF JENARD M . GROSS, C H A I R M A N OF T H E LEGISLATIVE NATIONAL APARTMENT ASSOCIATION COMMITTEE, Mr. Chairman and Members of the Committeee, I appreciate this opportunity to present this testimony on behalf of the National Apartment Association, a trade association consisting of approximately 16,000 apartment owners, developers, and managers. Our Association endorses in principle the Administration's bill, S. 3639, which would revise and recodify as well as simplify the very complex statutes on housing programs which appear to have proliferated with increasing complexity during the thirty-six years that have elapsed since the FHA was created by the National Housing Act However, we would like to express one word of caution at what appears to be substantive rather than procedural changes in the bill's approach to assisting lower income families to obtain decent adequate shelter. Our Association has endorsed the Section 236 and the rent supplement programs which provide effective mechanisms to assist lower income families to obtain adequate rental housing. However, we detect in the bill, as explained by HUD Secretary George Romney in his July 13, 1970, testimony before the Subcommittee, an attempt, through higher income limits and highier mortgage limits, to extend the benefits of these programs to higher income families. We strongly oppose the extension of these rental assistance programs to families whose incomes are 80% of the median in the area and we are more emphatic in our Opposition to the use of 20% of the contract authority for families whose incomes are up to the median income in the area. Such income limits presuppose that this nation can afford to house with subsidies half of the families of the nation. When there are fourteen million American families earning less than $6000.00 per year, it is difficult to comprehend how we can provide subsidies for families earning up to $10,000.00 per year. Up to now, we have barely made a dent in 'assisting families that are truly in the "poor category"; how can we afford to divert our energies to families in income groups that are being housed adequately without subsidy? Our nation's housing goals will be accomplished not by expanding the rolls of subsidized tenants to embrace the great middle class, but by pursuing sound fiscal and monetary policies which strengthen the economy through a more stable price level thereby attracting more savings into thrift institutions. It is true that housing has borne a disproportionate burden of the monetary policies made necessary by an unfortunate inflationary psychology which appears to have the country in its merciless grasp. However, the answer does not lie in expanding the rolls of families to be assisted to embrace half of America's families. To divert energy and treasury to assist families earning up to the median income is to diminish the effort which must be brought to bear to solve the housing problems of the thirteen million American families who are truly in need—those earning up to approximately $6,000.00 per year. We recommend, therefore, that the maximum income limit of families eligible for Section 236 and rent supplement housing be not in excess of 70% of the median income with ample safeguards so that families of relatively low income, but with ample assets, not be eligible for these subsidies. The National Apartment Association would also further like to go on record as endorsing the Bill which would encourage rental of existing housing to qualified tenants, in authorized payments, and contract payments directly by the Secretary of Housing and Urban Development. We feel that furtherance of this program, in many instances, can reduce the quantity of expenditure proposed for public housing activities. We would like now to address ourselves to a subject which, while it is not a part of pending legislation, is nevertheless most serious and threatens the role of the private entrepreneur in multi-family construction. I refer to the increasingly prevalent custom of institutional investors requiring an equity kicker or a "piece of the action" as a condition for making a mortgage loan on the property. This practice is causing great hardship to private industry at all levels of activity within the apartment industry. The concept of participation by mortgage lenders, both long term and short term, began several years ago. This has taken several forms. Some of these have 503 been a demand for a percentage of the gross income, such as 2% of the gross; others have taken the form of a percentage of income above a defined level, such as 10% to 20% of income above 80% or 90% occupancy. Other forms have been to take a participation in future rent increases. All of these have the effect of increasing the return to the lender of the mortgage funds to an unconscionable level. Since the advent of the initial approaches as above mentioned, new concepts have been advanced which go beyond the point of trying to get added interest and end up with ownership situations. One of these is an approach whereby, in addition to making a mortgage on the property, the lender buys the land out from under the owner and leases it back for a period ranging from 30 to 70 years. At the end of that period of time, the lender owns the property and the original owner—the developer—has merely been the manager of the property in the interim. There are several other devices which have come to light recently. One, for example, involves a permanent mortgage and a percentage of the profit from any future sale of the property. One problem which arises with any of these approaches is the simple fact that the borrower is having to deal with a lender from a position of weakness. There are inadequate funds in the mortgage markets today, which have placed the borrower in the position of having to pay just about anything demanded in order to obtain funds to develop his project. The lender, having control of the most desirable commodity around these days—namely money—finds that if one borrower will not go along with the requirements, others will. In a recent case, a particular insurance company proposed a real estate investment trust and said they would make $36 million available for apartment mortgages at approximately 10%% yield, plus 2% of the gross income. The insurance company had on tile $100 million in loan applications and continued to issue commitments only to those who would accept the "kicker" until such time as this $36 million was exhausted. The problem, obviously, is one of scarcity of funds in the overall market place. Unfortunately, our industry always gets dealt the severest blow in a tight money situation, and this tight money situation today is no different from most previous ones, except in the degree of severity. Some states have laws which prohibit this type of lending, wherein an ownership participation is demanded or various other types of fringe benefits are demanded. Unfortunately, in the type of market we have, legislation at the local or state level merely makes an insurance company lend in another state. For instance, we have one large investor which will not make apartment loans in Texas today, because that State has a law which prohibits insurance companies buying the land out from under projects. Therefore, they will make these loans in other states where they can get this type of kicker. That is why national legislation is needed which places everyone on an equal footing. Obviously, if the firm which controls the lendable funds is able to have ownership of the project, it would only seem logical that they would prefer to make loans in the areas where they will eventually obtain ownership and certainly prefer to lend to a developer who will go along with that type of situation. We also feel that just as lending institutions switched from bonds to stocks gradually after World War II, when this tight money market eases, we will witness a greater trend toward equity participation kickers by lending institutions as opposed to straight mortgage loans, simply because they would hope to make greater profits. As we all must remember, though, once one goes to the equity side, the risk is greater and the public funds which are being invested by these institutions are in a greater risk position than they are in a straight loan. It is the opinion of the National Apartment Association that Congress should enact legislation prohibiting lending institutions from using the participation and equity kicker forms of lending, which are having such an injurious effect on our industry today. Unless this is done, we are confident that the combination of the equity kicker and mortgage money scarcity will result in a sharp further decline in multi-family residential construction. We are submitting for insertion in the printed hearings as part of this testimony an article which was published in the July issue of Fortune, entitled, appropriately, "The Future Largest Landlords in America." It focuses attention on this ominous blurring of the lines between those who lend money and those who 504 need to borrow in order to construct the housing which this country needs. I commend it to the thoughtful reading of the members of the Subcommittee and the subcommittee staff. Thank you. (The article, "The Future Largest Landlords in America," appears at p. 536). The CHAIRMAN. Thank you very much, sir. I want to ask Mr. Terry a question about the Columbia project. Is that the one between here and Baltimore? Will you expand on your remarks and tell us more about that project? How many units are contemplated for that project? Mr. TERRY. Well, Columbia is a new town, Mr. Chairman, between Baltimore and Washington. We, The Rouse Co., with the Connecticut General in 1963 began by acquiring 14,000 acres. And we will build enough housing, 32,000 units, that will accommodate a population of 110,000 people. We further will build office buildings, shopping centers, industrial facilities that will provide jobs. The CHAIRMAN. HOW did you get your loan? What is the length of term that you have a contract for on the furnishing of the money? Mr. TERRY. Well, we finance—in our underlying financing for Columbia, which is today $80 million, we begin to retire in 1971, I believe, and it is due 10 years after it began in 1966. The CHAIRMAN. What interest rate do you pay considering the equity participation? Mr. TERRY. It is difficult for me to answer that, because Connecticut General owns half of the entity that is developing Columbia, which is called Howard Research and Development. The CHAIRMAN. That is part of your deal, to get the money. Mr. TERRY. Right. The rate we pay to Connecticut General on borrowing is 6 percent. The CHAIRMAN. That is on your half, I assume? Mr. TERRY. No, the entity, Howard Research and Development, began by borrowing $50 million. The CHAIRMAN. And you paid 6 percent on the $ 5 0 million? Mr. TERRY. The share of Connecticut General is 6 percent. The overall interest rate is 7.3 percent. The CHAIRMAN. Since they have half the project, they do not have to pay half the expense? Mr. TERRY. NO, the borrowing entity pays the total expense. The CHAIRMAN. Will that give them an advantage? Mr. TERRY. NO, it does not give them an advantage at all. That debt is retired via land sales, selling single family house lots or shopping center sites, or what-have-you. And we retire that debt that way. Hopefully by 1980 the city will be complete, the debt entirely paid off, and we would then equally share the profit. The CHAIRMAN. The time I take must be confined to 5 minutes. And I yield to others. So I will not ask you other questions at this time. But if you wish to elaborate on your testimony to include the points we have been discussing, it will be satisfactory. I think that this is a very important hearing, and you gentlemen have made a very important contribution to the committee members in trying to arrive at a fair solution. I do not know what is right about this. But by getting information from people like yourselves who are ever}r day in the market and who know, who are engaged in 505 transactions that arc covered by this bill, H.R. 5700—and we are hearing testimony on both sides, of course—we hope to arrive at opinions that will be in the public interest at least, and not sacrifice anyone or any group on account of it, or to do any injury or harm to them. If we can do something which is of benefit to the industry which you represent, which is one of thefinestand greatest industries in the United States, we would certainly like to do it. Wo know that there are charges, rather shocking charges, about what is going on. And we just want to get at the truth about it. The housing industry, I think, is one that should be given special consideration by the Government, because, as it is now the housing industry, I think, is discriminated against. You take the big corporations and big banks. Usury laws do not apply to them. They have ways around it. They can either pay you 8, 10, 12, 15 percent interest, or they can make you pay that much interest, and not violate the law. And then whenever you have to go into the market to get your money, the homeowner, who wants to buy a home, is in competition with not only the big corporations, but the speculators. On the New York Stock Exchange, where two-thirds of all transactions in amount and number of transactions are by institutional investors. They have a great advantage over just the ordinary person. And then you take the high-interest loan people,financecompanies. They can pay a lot more than a person can pay who wants to buy a home. You take the gambling casinos and institutions like that, they can pay a lot more than the person who is trying to buy a home. So I think that the Government should do something to encourage the use of funds at a reasonable rate for your industry. I really believe that. We must do it. We all talk about environmental quality. You cannot have environmental quality in this country unless you have people with homes, sanitary homes, stable homes, good homes, in which to rear and educate children. And there are a lot of things about environmental quality that are promoted by adequate housing. And you cannot have adequate housing unless you have money. The money must be available. The discount window of the Federal Reserve banks could be used. They are letting the banker have money for 4% percent. Why just pick out the bankers and let them have money at 4% percent? They nave the privilege of taking demand deposits and not paying any interest at all on them. Last year they had $225 billion free use of money. The year before the same way. Mr. W I L L I A M S . Mr. Chairman, will you yield for a question? The CHAIRMAN. Not just now; let mefinishmy 5 minutes. Mr. W I L L I A M S . Y O U havefinishedyour 5 minutes. The CHAIRMAN. N O , I have not. You wait just a moment. Your time will come. Mr. W I L L I A M S . I would like to know, are you asking these questions for the record, or is this a housing bill we are considering, or what? The CHAIRMAN. You cannot have housing without money. Mr. W I L L I A M S . IS it a housing bill or an environmental protection bill? The CHAIRMAN. That is right, environmental quality. And we are all striving for it. 60-299—71—pt. 2 5 506 So I have a feeling that we should even go to the discount lender for housing to get money at a better rate of interest. Why should we just restrict it to the banks? The Government is paying all the expense of the Federal Reserve banks. Only 40 percent of the banks get the benefit of it. And I see no reason why the housing industry should not come in one way or another. And that is what I want to get considered, too. Mr. Widnall. Mr. WIDNALL. Thank you, Mr. Chairman. First, I want to welcome all members of the panel here before us today. I think you have been making a very wholesome contribution to our discussion andfinaldecision with respect to this pending bill. I think this is a rather unique panel, in that to my knowledge this is the first time we have brought together the person who funds the development and the developer himself. And this is in the case of Columbia, which has been an outstanding example of what can be done with a new town. We hear so much emphasis now about the fact that there should be six, eight, or 10 new towns of a hundred thousand or more throughout the United States. I would like to ask this question of Mr. Hamilton and Mr. Fey. Has your original agreement with respect to Columbia and the financing of Columbia been abrogated or changed in any way since you began because of inflation ana changes in the money marlset? Mr. FEY. If I may, I will call on Mr. Bruce Hayden, who is with Connecticut General, and who is directly responsible for this. Mr. HAYDEN. Mr. Widnall, let me answer the question first by telling you the structure that thisfinancingtook. I think it is essential to answer the question. In the first place, when we came into this about 7 or 8 years ago we made an initial equity investment which matched a much smaller equity investment made" in dollars by the Rouse Co., and a much greater equity investment in their skills and services. So that for our 50 percent we made a substantial cash investment to match their minimum cash plus their know-how and expertise. Now, since that time we havefinancedit and refinanced it time and time again. And the needs grew as the program changed. One of the essential parts of this financing—and it has been in my opinion the difference financially between Columbia, which is highly successful, and Reston which is somewhat of an economic disaster—it has been that as a 50 percent equity owner we were willing to defer all capital costs. Only within the last year has interest been paid in cash; previously all interest was capitalized. As an equity investor we could do this. If we had been a straight lender we could not have or would not have. But we have rolled thefinancingover time and time again to fit different conditions. Thisfinancingat Columbia has been restructured regularly during the development period. The interest rate has changed regularly with changes both in market conditions and in the nature of the particular aspect being financed. Rates have been as high as 12 percent and as low as 6 percent at different times and on different types of capital investments for different purposes. Perhaps the most significant thing in my opinion is that I can make the categorical statement that if Mr. Rouse had come to us 7 or 8 years ago and said that this thing looks great, it has great social impli- 507 cations as well as financial, lend us $50 or $60 million, and if all works well you will get your money back at 6 percent, if he had come in on that basis there would be no Columbia. The thing that made it successful, outside of the genius of the Rouse organization, is the willingness to finance on a very flexible basis. And, incidentally, this financing would not be possible if section 14 had been in effect at the time this was done. Mr. W I D N A L L . Let me just stop you at that point. You say if section 14 goes into effect as proposed this would prevent the construction of any new Columbias? Mr. H A Y D E N . Well, it would prevent them from being financed with private capital insofar as we know. It effectively seems to rule out the joint venture. Mr. W I D N A L L . When the discussion was taking place earlier I was a little bit lo3t on the point where you are talking about a 6-percent figure in connection with it, but the effective rate was 7.3 percent. Who is paying the 7.3 percent, Rouse or Connecticut General? Mr. H A Y D E N . The development of which we are a 50-percent owner is being charged with interest at this rate. As indicated, there have been many rates at many different times. There was one instance in which a lender who came in with a participation received one rate while another lender coming in at the same time preferred a higher rate in lieu of participation. In all instances the rate is a rate paid by the entity, HRD. It is an oversimplification to say that any partial owner of HRD is in effect paying interest to himself. Mr. W I D N A L L . I think it is extremely important that members of this committee really understand the operations that take place on these big developments particularly. And I am sure that every one of us does not want to do anything to inhibit national growth or sound construction. I know I was one of those who have expressed alarm as to the use of the equity kicker. It seemed to me that there was a great deal of possibility here of considerable profit with very little risk involved at all, and that funds were being channeled there to the detriment of other areas in our housing field. I think we all are disturbed at the lack of single-family home construction, and still the lack of low-income construction. We have been trying different means of getting at it. And it just does not seem to me, as one who has been very much interested in private enterprise in all of these things, that private enterprise has fully realized the enormity of the job, the pressing needs of the moment, and the fact that something just plain has to be done in order to make possible some new homes in the lower income class for our people. I am somewhat familiar with Columbia. I want to be more familiar with it, and understand completely what is going on over there, and the method of financing, the method of choosing property for one purpose or another, and whether or not the healthy growth is taking place there that we seek for all of these new communities. I think that the testimony so far today has shed considerable light on this. I would like very much to ask a great many questions on this. And I am going to take advantage of the fact that we can all submit questions, and hope that you will answer these for the record. Mr. H A Y D E N . I would oe happy to, sir. Do you wish any extension of Columbia at this time? 508 I would like to say that Columbia is designed to house all income groups. It was an objective of the Rouse Co. which we shared that the corporate chairman and the corporate janitor could both live in the same community, and they do. It has been part of the program to sell adjacent corners, one for about $50,000 and one for about $300,000, one to be used for low-income housing and the other for moderate and higher income housing. The whole planning has been toward the creation of a balanced, broad spread community. Mr. Rouse is very proud of the fact, for example, that the first baby born in Columbia was born of an interracial marriage. I do not think we have any statistics on the percentage of blacks and whites or other races m there. But the whole effort has been to be broad, multiracial, and the complete economic range. And we are very proud of the results achieved. We give most of the credit to the Rouse Co. But our money had a little to do with it. Mr. WIDNALL. Thank you very much. Mr. HAMILTON. May 1 have 1 0 or 1 5 seconds, Mr. Widnall, to comment also? Our member companies are property and casualty companies. As I have indicated, they have very little activity in the mortgage market or the real estate market. So far as I know none of our member companies has any interest in the equity participation matter. To the extent that our members may have life insurance company subsidiaries, those life insurance companies, I believe, probably would be associated with one of the associations represented by Dr. Fey. This particular subject is just outside our interest. Thank you. Mr. WIDNALL. Thank you, Mr. Hamilton. (The following arc written questions submitted by Mr. Widnall to Mr. Terry, along with Mr. Terry's answers:) Question 1. Why would interest rates have to go up necessarily if participations were eliminated? Answer. Since participation is a form of interest which is added to the fixed -interest rate in any, transaction it gives a lender its desired market yield. If participations were eliminated it is clear to me that that interest rate would go up by the yield loss on participations. This would directly add to the fixed burden a developer would have to pay, which is clearly to his disadvantage. Question Since many developers "borrow-out" on a project, why is it necessary to have equity financingf Answer. The term "borrowing-out" refers to a developer's ability to cover the total project cost via financing. Today it is virtually impossible to cover project costs through the traditional 75% loan. Typically financing in excess of 75% of value is referred to as "equity financing"; hence the term "equity participation." So, specifically answering your question, most borrowers today cannot borrow-out and because of low capitalization in our industry must seek equity financing. Question 8. In the past two years, could you have obtained financing for the Rouse Company without equity participationt Answer. Yes. In the last two years we have in fact received financing without •equity participation. However, there was a higher fixed interest rate than we could have obtained if we chose to offer participation. Question 4. Are equity participations a direct result of inflationt Answer. Yes. Since construction costs and land costs have been increasing at a fantastic rate, the ability of a developer to finance via traditional methods has been difficult and in some cases impossible. When any lender takes a higher risk by choosing to finance a project in excess of 75%, they necessarily must seek a •higher rate on that investment to adequately justify having taken that risk. 509 (The following are written questions submitted by Mr. Widnall to Mr. Fey, along with Mr. Fey's answers:) Question 1. On page 15 of your statement, Mr. Fey, you say that section 14 outlawing Uequity participation" would adversely affect the development of real estate projects, including multi-family housing by restricting the availability of funds. Would you please expand and elaborate upon this pointt Answer. The basic principle here is that investment funds are directed toward those outlets which offer the most attractive returns with reasonable safety. If bonds are offering a better yield than mortgage loans, investments are channeled toward bonds. If certain kinds of mortgages are more attractive than others, they will be favored by investors. In the case of life insurance companies, our investment return on policy holderfunds is a key factor in the net cost of life insurance and we feel a primary responsibility to seek the best return available in the market place. Arrangements such as income participation or contingent interest have been one form in which investors receive a return on invested funds, alongside the fixed contract rate on an income property mortgage. If income participation were prohibited, lenders would cither have to raise the fixed rate on the mortgage or re-direct their funds toward the bond market or stock market where better returns are available. Prohibiting part of the lender's return may be compared to placing a ceiling on interest rates. When competing rates elsewhere are above the ceiling fixed on certain loans, investment funds will shift away toward the more attractive outlet. In this situation, developers would find that they could not attract the mortgage capital they seek and could not construct the apartment buildings of commercial projects they had planned. Real estate development, including residential structures would clearly suffer. This is not a hypothetical situation, but has been often seen in actual practice when FHA rate ceilings filed to keep pace with rising bond yields, or when rate ceilings on state bond issues left them stranded with no bids when market rates on competing bonds had moved higher. Question Under the projects of Section 14 dealing with "equity participations" do you believe that this would prohibit the investment by insurance companies in convertible bonds and if so, what effect would that have upon the ability of businesses in this country to secure adequate financing? Answer. Life insurance companies acquire corporate bonds not only by purchasing publicly offered securities sold through underwriters but also through directly placed bonds arising from direct negotiations between borrower and lender. While we are uncertain whether public offerings of convertible bonds would be ruled out, it appears that directly placed convertible bonds would be, sincc they are loan transactions in the ordinary sense of the term. Direct placements, as we call them, are a particularly important financing vehicle to small- and medium-sized corporations which are not in position to market a public issue because of their size or their credit standing. Convertible bonds allow such corporations to keep down their borrowing costs and debt charges, since these bonds typically carry a coupon rate well below the rate on straight bonds, depending on the attractiveness of the conversion feature. If this traditional method of bond financing were ruler1 out by Section 14, the burden would fall primarily on these jounger, expanding corporations which would be confined to uouconvertible bond issues with higher coupon rates and debt service or be forced into the public market where flotation costs and registration fees would add to the cost of their financing. Moreover, the inability to convert outstanding bonds into common stock would mean that they would have to raise their equity capital through separate stock issues, which is usually more difficult for a smaller, lesser-known business than for a larger, established corporation. The very active use of convertible bonds to raise debt capital, and later provide for a stronger equity base when conversion into common stock occurs, demonstrates that this method has been an economical and desirable financing technique. Certainly, borrowers have not been forced into this approach by lenders, since corporations have been able to raise capital in a variety of ways. But it clearly serves the requirements of many firms that would find separate issuance of stocks and bonds more costly to them. Question 8. Would you discuss the effect of outlawing "equity participations" in real estate and mortgage lending as it relates to insurance investmentst 510 Answer. A full answer to your question would depend upon which of the many forms of so-called "equity participations" would be prohibited by Section 14. As I have indicated, there is some uncertainty as to which of the many practices which combine debt and equity financing would be affected in the final analysis. One thing is certain in my mind, namely, that prohibition of equity participations in commercial mortgage lending will not automatically result in a return to single-family mortgage lending by life insurance companies. It has been suggested by other witnesses that our attraction to equity participation was the basic reason for our declining interest in single-family home loans. But this is not an accurate presentation of the facts. Life insurance funds have been directed toward those areas where we can operate most efficiently with larger sums of money and receive a better return than afforded by single-family mortgages. This explains our shift in recent years toward a greater emphasis on corporate bonds and commercial mortgages, where the return is considerably higher than home loans and the expenses of originating the servicing loans are considerably less. If Section 14 were enacted to prohibit income participation, land purchase and leaseback, and joint ventures for real estate development, it is clear to me that life insurance would shift in other directions, to the detriment of builders seeking mortgages and equity capital for apartment projects and other commercial developments. The building industry has been severely undercapitalized for j^ears and this situation would be worsened by Section 14, in my view, which would stifle the growth of that important part of our economy. Question 4• We have been able to finance the country for 200 years without "equity participations" Can you tell us thai you can't continue to do so? Answer. Investment funds will obviously be available for the financing of capital expansion, so long as savers are willing to put aside funds which can be loaned to borrowers through institutional channels. But I do not feel that this process is aided by prohibiting transactions which have been beneficial to both borrowers and lenders in a time-tested fashion. For example, convertible bonds and bonds with stock purchase warrants attached have been a useful and active financial technique since the start of this century, at the least. We are not saying that the capital markets would grind to a halt without equity participations, but we do contend that this prohibition would rule out many desirable and economical techniques for mobilizing capital and would reshuffle the flow of investment funds in ways that would hold back real estate development, including multi-family dwellings, at a time when there is a recognized long-term need for encouragement to this field. Question 5. How do the States handle interest limitation laws on large real estate developments? Answer. With two exceptions, every state has a usury law limiting interest which may be charged for a loan. In 39 states and the District of Columbia, there is some form of corporate exemption from usury limitations permitting them to borrow at rates in excess of those applicable to individuals. The idea behind the corporate exemption is that a corporation does not require the protection of an interest limitation law since the loan transaction reflects negotiations between businessmen well able to understand the nature of the transaction. Following this philosophy, a few states have recently gone beyond the formality of incorporation, so that the business purpose of the loan or the size of the loan determines whether the usury law applies. While many developers utilize the corporate form of organization, others prefer to operate as individuals or partnerships because of tax considerations. Thus, the application of interest limitation laws on the borrowings of large real estate developers will depend on the form of organization and also whether the state recognizes an exemption for corporations or for larger business borrowings. In the application of these usury limitations, it is important to recognize that contingent interest arrangements do not provide a circumvention of the state laws, as one witness has suggested. Payments received by lenders from income participation are included, along with the fixed interest rate, in the interest calculations applied by state usury statutes. The CHAIRMAN. Mr. Ashley. Mr. ASHLEY. It is not very often that I find myself in agreement with Chairman Patman on financial matters, and I do not want to distress you gentlemen overly by saving that I am somewhat persuaded by certain elements of this bill. But I confess that I am not 511 dazzled by the testimony this morning with respect to equity participations. Mr. Jackson, you say 011 page two of your statement: "The equity participation is a creature of inflation." You go on to say that it is mainly during such periods that other means than the mortgage loans must be found by which money can be made available to those who wish to build large projects such as office buildings, and including hotels, motels, and shopping centers, for example. Why do we have to build these during periods of inflation? The whole point of Federal Reserve policy is to restrict credit during periods of inflation, drive up interest rates, and thereby discourage lending for, if I may say so, such activities as this. What you are saying is very much what other large corporations say when they go to the Euro market for dollars, thereby obviating the purpose 01 restrictive money policy. It is exactly the same thing that happens when companies make use of commercial credit almost to the point of disaster. So you say that this is the salvation during periods of inflation. I cannot think of a means of allocating credit on a more unfair basis than this. Because there is 110 social purpose that necessarily obtains— or is there? When we build a shopping center during periods of restrictive money policy we know the housing is taken out first. Essential public services are taken out about the same time. They are the first and the worst hit. And what I am led to gather by the testimony this morning is that this is just fine, but that there should be a continuing availability, of money, through equity participation, so that we can build these unessential facilities whether we are in a period of deflation or inflation. Mr. HOVDE. Congressman Ashley, if I may lend some examples to your remarks I would appreciate it. Mr. ASHLEY. By all means. Mr. HOVDE. I could not agree with you more, sir. In our city of Madison of 160,000 people housing for the past 2 years has been anywhere from 30 to 40 percent below the absorption market, be it single family or multifamily. And we have seen built and initiated in this period two of the largest shopping centers, one being 750,000 square feet, the other being a million and a half thousand square feet. All started during this period of tight money. And we will have enough retail area for shopping in that area to have—I do not know what the exact figures are, but it almost doubles, one would say, our existing space. We all recognize in our society of democracy and our belief in the free enterprise system the principle of homeownership, and the privilege and the opportunity and the right of being able to purchase a life insurance policy and establish security and cash value. Nevertheless we say that we have been dealing with an underwriting practice here of equity participation. But let us look at the overview of where this and other policies have taken us. Homeownership has made our country what it is today. Historically some 60 percent of our country has had the right and the privilege of having their own homes. And we are seeing a rapidly diminishing percentage of this in our total. In our city this has already dropped to in the neighborhood of 51 or 52 percent. And I would dare say, gentlemen and ladies, that by the year 1975 in our city homeownership will become less than 50 percent. And I have projected figures that by 512 1980 it may occupy somewhere in the 40 percent range. If our society is to maintain its position as a free democracy homeownership is a very important ingredient. The life insurance companies are anxious to sell life insurance policies to homeowners, so that if the father, the breadwinner of the family should pass on, this home can accrue to that particular family. They think nothing of establishing substantial insurance agents through the country in order to sell their policies, in order to establish the basis for their company, that is the very foundation of the life insurance companies. They are quick to come into our area and sell life insurance policies. We commend them for it, because it is such an important element of our total society. But nevertheless the same person who has a life insurance policy goes back to that large company and asks for a mortgage policy, and there is nothing set up, nowhere can he get that type of mortgage. So he has to go to the savings and loan that is already overburdened for homeownership purposes. Or what does he do? fle goes to banks and borrows on his life insurance policy, jeopardizing the very security that he has bought the policy for in the first place. And though we have been dealing with underwriting practice here, I question the overall lending policies that have been established. We find ourselves in this country today with overbuilt office buildings, overbuilt shopping centers, overbuilt multifamilies in some areas, and a tremendous lack of single family housing in this country. Thank you, Mr. Fey. May I request that Mr. Murray be permitted to respond to Mr. Ashley's question? The CHAIRMAN. Mr. Ashley's time will determine that. Mr. A S H L E Y . I seem to have time for one question, Mr. Chairman. Mr. FEY. We feel we do have a direct answer to this question. Mr. M U R R A Y . In response to Mr. Ashley's question and following Mr. Hovde's succeeding statement. I would like to comment on: (1) The shortage of single-family housing; (2) the question of equity participation being a creature of inflation; and (3) the construction of large projects at a time of restrictive credit policy—when housing is in short supply. THE SHORTAGE OF SINGLE-FAMILY HOUSING Single-family housing construction has languished in recent years even during periods when mortgage funds were in relatively ample supply (such as the years 1967-68). All students of the problem agree that the availability offinancingand interest rates are only a part—a moderate part—of the problem. The most important factor is that in recent years construction and land costs have risen far more rapidly than disposable income per family. Consequently, a large proportion of families find it impossible to come up with a 20 to 25 percent downpayment on a single-family home and to stay within prudent limits of carrying charges relative to disposable income. The basic reasons for the sharp increase in construction and land costs are well known. Mass production of standard single-family houses is still in its infanc}r. The labor component of house production 513 is very high. Construction labor is highly unionized and has obtained settlements far in excess of productivity gains and other union settlements. In addition, there are restrictive work and union admission practices. Part of the responsibility- also rests with widely divergent and frequently very restrictive local zoning and building codes. As to land costs, there is the inexorable pressure of rising population on limited land supply, especially around the metropolitan areas where more and more of the population is concentrating. Financing difficulties in single-family housing must be viewed in proper perspective. Measures designed strictly to cope with this question may simply lead to an even more rapid escalation in the average cost of such homes rather than to an increased supply of homes. It is true that single-family home financing has faced special difficulties during periods of highly restrictive monetary policy (1966 and 1969-early 1970) when the typical mortgage lenders have been hit by disintermediation—sharply rising policy loans in the case of life insurance companies. In such periods, wc have had to ration funds to all borrowers. It might be suggested that it would be desirable if mortgage flows to single-family borrrowers could be curbed only in proportion to all loans. The major difficulty with this proposition is that State usury laws often keep residential mortgage rates below the market rate on alternative loans. Such ceilings are adjusted only sluggishly, partly because the legislative process is slow. For example, during much of 1970 up to one-third of the States had unrealistic mortgage ceilings. This situation confronts the life insurance investment officer writh a cruel choice. Accepting below-market rates on loans shortchanges the policyholder whose net premium payment on life insurance policies is directly related to the investment return that can be obtained from the savings component of his premium payments. Basic responsibility to policyholders and the forces of competition militate against doing so. Hence, residential mortgage loans tend to be reduced sharply. The Equitable, however, has never gone out of the new residential mortgage field entirely and has no plans to do so. Wc hope for constructive solutions to the problems we have described, most of which are beyond our direct control. Undoubtedly, the inflation of construction costs—which the Government is now beginning to tackle—is the most basic difficulty. New Government programs aimed at making home mortgages a more liquid and marketable instrument are potentially very helpful. It should be especially noted that the life insurance industry is in the midst of a $2 billion program to provide low cost housing and job opportunities in the inner cities. This special effort, in which the Equitable is fully participating, recognizes social obligations and the vital interest of the industry in the improvement of our cities. We believe that our policyholders fully recognize this special problem and our vital stake in its solution, but we cannot ask them to subsidize all sectors of the economy with some claim to social priority. THE QUESTION OF EQUITY PARTICIPATION INFLATION BEING A CREATURE OF I do not believe that equity participation is solely a creature of inflation. It is entirely possible for borrowers and lenders to strike 514 mutually agreeable bargains consisting of a mixture of fixed interest and income or equity participation regardless of the inflation rate. It is true, however, that uncertainty and distrust about the future purchasing power of the dollar induced by accelerating inflation increases the incentive for lenders to seek partial protection through such devices. In fact, it is once again responsibility for policyholders' funds that has lead insurance companies to seek this partial protection. It should be realized that high loan-to-value ratio mortgages at fixed-interest rates during rapid inflation are a bargain to the borrower and a serious impairment of policyholder capital values. The rise in land and building values plus the possibility to escalate rents can enable an alert real estate operator to gain additional profits while leaving the institutional lender and the small saver he represent with eroding values of principal and interest payments. Rising interest rates and income participations are basically a defense mechanism developed at a time when governmental action cast serious doubts upon the future real purchasing power of fixed-dollar contracts such as life insurance policies. With income participations, if correctly calculated, there is at least a chance that the terms of life insurance contracts can be improved to offset some of the highly adverse effects of inflation upon policyholders. The Equitable has never sought or obtained control of a borrower through income or equity participation. Our policyholders' interest, however, requires opposition to indiscriminate legislative restraints upon all equity participations. THE CONSTRUCTION OF LARGE PROJECTS AT A TIME OF RESTRICTIVE CREDIT POLICY WHEN HOUSING IS IN SHORT SUPPLY The question of overall lending policies which permit financing of large projects such as office buildings, hotels, motels, and shopping centers during periods of inflation has been raised. The construction of large real estate projects require a substantial "lead time." Many months, sometimes years, elapse between the time that a developer acquires some land for development and the time that construction is started and completed. During these months and often }Tears, the developer must obtain necesary zoning including construction authorization. He must design his buildings and the parking for them. He must obtain tenants who will pay enough rent to support the project (and this often involves redoing the initial plans). With some of these accomplished, he then must seek permanent financing for the project that will provide enough funds, together with his equity, to complete the project—and when the permanent financing has been committed he then must obtain construction financing. Therefore, when you see a major building being constructed at a time when the economy is on a downturn, it often results from the inability of the developer to stop once he is started. Should he stop in the midst of his planning and development, he can easily lose all he has invested to that time. Mr. JACKSON. I will be glad to answer Mr. Ashley's questions which he addressed to me for the record later. Mr. A S H L E Y . I have some others. On page 3 of your statement you 515 say the equity participation benefits the lender and the developer. What about the tenant in an apartment building? Do you mean to tell me that the lender and the developer can both benefit without it being at the expense of a tenant? Mr. JACKSON. In order to understand what I propose, Mr. Ashley, let me make this blanket statement which I think would lead to the answer you are seeking. Dr. Fey mentioned and outlined, and would be glad to give you some specific details, that the initial interest charge made to the developer by the lender to build an apartment building is lower as a result of the lender's ability to participate in the future increases in rents should they ever occur, than would be the case if the lender were unable to participate in those future rents. Mr. A S H L E Y . I think it might be well, Mr. Chairman, if these gentlemen feel as strongly as they appear to, for the Connecticut General people to give us the essence of the overall agreement with the Rouse Co., the Howard Research and Development, the terms of that agreement, and what the potential return will be. The CHAIRMAN. Mr. Ashley, we will go around and come back to you. Mr. A S H L E Y . That would be fine. (In response to the information requested by Mr. Ashley from the Connecticut General Life Insurance Co., the following information was received from Mr. Ha\den for submission in the record:) REPLY R E C E I V E D FROM MR. HAYDEN Mr. Ashley, in order to answer your question, let me first give you a bit of the history of Columbia and its financing; some understanding of this is essential for a proper answer to your question. The Rouse Company of Baltimore, with whom we had long had a mortgage correspondent relationship, began to research the feasibility in the early 1960s of building a completely new city. Mr. James W. Rouse and his associates invested many man hours and a great deal of money in studies, travel, consultant services, and site selection searches. The cost of this ultimately amounted to about $750,000 which was paid for by the Rouse Company from its working capital. Research indicated both that the project might be feasible and that its most likely location was in Howard County, Md., halfway between Baltimore and Washington. Both as a starter and as a test of the availability of land in Howard County, the Rouse Company purchased 600 acres initially, in 1963. Shortly thereafter, Mr. Rouse came to Hartford to Connecticut General to state that he believed that the necessary 12,000 acres could be acquired at a cost not to exceed on the average of $1500 per acre. At that time, he invited Connecticut General to join with him in the venture first as an equity partner and second as a lender (may I emphasize that- this proposal came from Mr. Rouse to Connecticut General, not vice versa). Mr. Rouse pointed out that there were very substantial risks involved: (a) The land was primarily agricultural and was not zoned for new city development. (b) The political climate in Howard County strongly favored its remaining rural and against any such new city development. (c) The costs of all the necessary development—roads, utilities, schools, other public necessities—were unknown and not even estimated. (d) Nowhere in America had a project of such magnitude been undertaken, new cities were, to be sure, already well underway in Europe but in each instance had been heavily subsidized by Government. The proposed development was not only going to be "first" on American soil, but the first anywhere financed entirely by private capital. Mr. Rouse, however, went on to set forth not only the great potential, social benefits that might accrue from the complete planning of such a new town and 516 the example it could set to the rest of the country, but also the potential profit to be achieved if such a development were successful. He was able to convince Connecticut General that the risk was worth the taking and the basic financial structure was agreed upon: (a) Connecticut General would purchase 50% of the stock in the development company, Howard Research and Development (HRD), by matching the investment that Rouse had already made of $750,000. This additional $750,000, bringing the equity of the development company to $1J^ million, was to be used for further planning. (b) Connecticut General agreed to loan HRD up to $18 million in order to acquire the 12,000 acres of land. The rate was to be 8%, which rate was to be capitalized rather than paid in cash. The land was to be sole security for the loan. This basic proposal was approved by the Connecticut General board in May of 1963 and HRD undertook its land acquisitions. By the fall of '63, almost 15,000 acres had been acquired. Connecticut General had agreed to increase its loan to cover the additional land purchase and to provide additional funds necessary for the planning and rezoning process. During 1964 and 65 the Columbia plan was developed to call for 30,000 dwelling units to house a population of 100,000; it also provided land for business and employment totaling 30,000 primary jobs; some 20% of the land was to be set aside as permanent open space for the recreation and enjoyment of all future residents as well as existing residents of Howard County; there was to be a major downtown commercial and office center to serve as a nucleus for seven villages of 10,000 to 15,000 each. At this time Mr. Rouse defined and Connecticut General approved four major development criteria: (a) Columbia was to be a complete city not just another bedroom subdivision; it was to provide a full range of housing from corporate janitor to corporate chairman; it would provide all customary municipal services but improved so that each would support the others instead of being allowed to develop without regard to such mutual support. (b) Columbia was to respect the land. The forests, the stream valleys, the best views, the historical structures, all were to be preserved in perpetuity. (c) Columbia was to provide a better environment for the growth of people— and people of all races and economic strata. The preservation of the dignity, integrity and identity of both the individual and the family was to be uppermost; and, as a necessary means to this, the residents of Columbia were to assume responsibility for their own municipal affairs as rapidly as this could be done consistent with the orderly development process. (d) The development of Columbia was to be highly rewarding—profitable—to its developers. In fact, it was recognized that if Columbia were successful in all of its other three objectives but failed in the test of proving to America that planned development to high standards was, in fact, the most profitable way to develop a new town, Columbia would itself have failed. Columbia had to be successful in the marketplace. To focus on the profit objective and to provide discipline to meeting the other three objectives, the Columbia economic model was first developed in the spring of 1965. The model is a highly complex computerized means by which, ever since that time, the co-developers of Columbia have been able to test each decision prior to its being made by plugging into the model on a "what if" basis all proposed changes and then following through the effect of such changes on all major aspects of Columbia's development. This model has been revised regularly and is reviewed by the Board every three months. Submission of a copy of it to this Committee would seem to serve no useful purpose, for the voluminous printout at any given time is meaningless except to those who have been involved with the Columbia process continouusly. It can be summarized, however, to say that the model indicated the need for a total of $50 million before there was any possiblity that the proceeds of the land sales could support the enterprise. This led to the bringing of Chase Manhattan and Teachers Insurance and Annuity into the picture, to provide $25 million to match a total commitment by Connecticut General of $25 million. This basic financing at an average interest rate of 7.3% is secured by a first mortgage on all unsold land owned by HRD. In the spring of 1968, when in competition with dozens of other land owners andy many municipalities in the Northeast, Columbia's developers persuaded General Electric Company to locate a major appliance plant in Columbia, the 517 economic model was instrumental in keeping the Columbia plan in balance. G.E. purchased a thousand acres, some of which Columbia had to go out and buy; HRD had to provide for bringing not one but two railroads to the site, and major new planning and provision of services had to be provided not only by IiRD but by Howard County, the Metropolitan District, and the state of Maryland. The economic model indicated a need for another $30 million, of which Connecticut General provided $10 million and the remainder came from Morgan Guaranty and Manufacturers Hanover, both of New York. These latter two institutions, incidentally, were helped to make their decision to come into the Columbia picture by the tender of a small portion of the HRD stock which was given up by Rouse and Connecticut General. A major clement in the financial picture at Columbia—unique in New Town financing but absolutely essential—has been the willingness of Connecticut General and the other lenders to capitalize carrying charges on all of the debt. It has only been within the last year or so that interest has been paid in cash, and no debt has been retired as vet/in fact, in 1971, it appears that for the first time the cash flow of the overall Columbia project will turn positive. The development has been profitable as individual units developed and sold were cost accounted— but up until now it has continued to put a cash drain on the developers as costs of development outstripped sales proceeds. It is worth noting, incidentally, that despite its pioneering and its 50% interest in the joint venture, Connecticut General has not sought nor received a preferred position in financing specific developments. Home builders, apartment builders, industries, institutions and other developers have been free to seek financing wherever they choose. Of the projects financed by HRD itself and done through its development subsidiary, financing has been provided in the amount of over $61 million by seventeen differen institutional lenders. Most of these transactions include lender participation in seme way in the profitability of the developments financed. To summarize: The initial development of Columbia could not have passed beyond the bright-idea stage if Connecticut General and other institutions had been forbidden equity participation; most of the projects successfully done to date and serving a town which already numbers 14,000 people could not have been financed without equity participation. In other words, had Section 14 been enacted in 1961, Columbia simply wouldn't exist. The CHAIRMAN. Mr. Johnson. Mr. JOHNSON. Mr. Chairman, I too think we have a distinguished panel here today. There is so much in that bill, and it is so far reaching, and could be very devastating, so it is hard to know what question to really ask any more. But I think I will ask Mr. Hovde a question. He seems to be quite emotional this morning. Mr. HOVDE. We have so much at stake. Mr. JOHNSON. YOU hear a lot about interlocking directorships, Mr. Hovde. You are a real estate broker. Are you a director of any bank or insurance company or anything like that? Mr. HOVDE. Yes, Mr. Congressman, I am a director of a commercial bank, State chartered, in the city of Madison, Wis. Mr. JOHNSON. What is the name of the bank? Mr. H O V D E . Madison Bank and Trust, sir. Mr. JOHNSON. HOW large a bank is that? Mr. HOVDE. This bank has holdings of approximately $35 million. Mr. JOHNSON. Would you have any idea as to how much your mortgage portfolio would amount to on homes? Mr. HOVDE. I was appointed to the board of this bank 2}i years ago. And of course I would like to think that since my arrival on the scene that our bank, which had not previously been too heavily in mortgage loans, has seen a greater need in this area. And of course in this situation in the past 2}i years, the banks, the insurance companies, and the 518 saving and loan's have all been talking about the lack of liquidity, the disintermediation of funds. But I can say with truthfulness that we have gone into some mortgage projects for which I have been personally commended and thanked for by those people that had come to the bank and requested funds. And they are economically sound, they are properly underwritten, and they are without participation. Our bank has not been in any equity participation type loan. Mr. JOHNSON. That was my line of thought. Now, you are on that bank board. And there are other real estate brokers, I take it, in your home city? Mr. H O V D E . Yes, there are. And there are other real estate brokers doing business with the bank of which I am a director. And there has been no reluctance on the part of the others in the real estate business to do business with our bank, my bank, because of my being on the board. In fact, as I say, I think we have developed a greater—we are a very small bank, but we developed a greater awareness in the real estate mortgage field. Mr. JOHNSON. SO your being on that bank board, that type of interlocking device has not been any deterrent to your other brethern in the real estate business? Mr. H O V D E . Absolutely not. Mr. JOHNSON. Mr. Terry, I would like to in my remaining time— harking back, now, to when you first conceived the brilliant idea, I would say, of founding and building Columbia, did you have much .money to start with then? Mr. T E R R Y . N O , we were a very poor company. Mr. JOHNSON. So you went to variousfinancinglending institutions, insurance companies, and so forth, with your hat in your hand, wanting to try to get hold of $15 million, didn't you, to develop this very wonderful new town you have down there? Mr. T E R R Y . We chose to go to the Connecticut General. And we 'Offered them half interest in the project. Mr. JOHNSON. Stop right there. In other words, you invited them to be a 50-50 partner with you, and it was not the Connecticut General that demanded 50 percent of the action? Mr. T E R R Y . N O . The arrangement was that the Connecticut General puts up all the money, which they did, and we put up our ability to carry out the program of Columbia, which we did. Mr. JOHNSON. Could you have developed—and I consider it a tremendously great institution that you have there—could you have even started to do it without somebody loaning you $15 million? And in view of the fact, as you say, that many housing projects, new towns have been failures and do present a considerable financial risk, could you have done it without taking in partners? Mr. T E R R Y . N O , we could not. And we really don't believe that we at that time had thefinancialcapacity to even go through the process of developing the detailed plan of Columbia, excluding land acquisition, excluding zoning efforts, I do not think we could have even developed the plan. Mr. JOHNSON. D O you feel that as a result of this 50-50 participation with Connecticut General that they shook you down, let's say? Are you unhappy about the relationship, do you feel that you were held up? 519 Mr. T E R R Y . T O my way of thinking—and you have me at a disadvantage here with one of our investors in the room—I would usually like to say that, yes, they are holding us up, but I feel very strongly that this was one of the most creative pieces of financing ever done in the country, that there was a huge risk on the part of Connecticut General. And they are getting a very fair return on that risk. Mr. JOHNSON. I am just thinking that if you had not taken in a partner there, in view of thefinancialrisk that other new towns like Res ton and the rest of them have created, you would have never had Columbia today, isn't that true? Mr. T E R R Y . That is right. And I think that is the principal reason other new towns have failed, is that they did not have the financial wherewithal to stand the type of building up of home sales and rentals and commercial sales. It takes a huge amount of time. Mr. JOHNSON. What is the mortgage or bonded indebtedness of this enterprise today, would you say? Mr. T E R R Y . It is $ 8 0 million. Mr. JOHNSON. Eighty million dollars? Mr. T E R R Y . Right. The total Rouse Co. capital investment in Columbia is $ 7 5 0 , 0 0 0 . Mr. JOHNSON. In other words, you have started out with a relatively small loan, it would appear, of some $15 million, and it has now gone to $80 million? Mr. T E R R Y . That is correct. Mr. JOHNSON. And who has loaned you the $ 8 0 million? Mr. T E R R Y . The $ 8 0 million is from Connecticut General, the Chase Manhattan Bank, Teachers Insurance and Annuity Association, the Manufacturers Hanover Bank, and Morgan Guaranty. Mr. JOHNSON. These additional lenders besides Connecticut General, they were not into the picture, then, at the inception? Mr. T E R R Y . N O , Connecticut General was the original lender that put up all the money to acquire all the ground in Columbia. Mr. JOHNSON. Thank you. My time is up. The C H A I R M A N . Mr. St Germain. Mr. S T G E R M A I N . H O W many housing units have you built to date in Columbia? Mr. T E R R Y . I beg your pardon? Mr. S T G E R M A I N . How many housing units have you built to date? Mr. T E R R Y . Right now we have 4 , 5 0 0 units occupied. Mr. S T G E R M A I N . H O W many are low income? Mr. T E R R Y . Right now there are occupied 3 0 0 units under the 2 3 5 program, which is low income housing. And it is just under 300 units under construction. Mr. S T G E R M A I N . Out of 4 , 5 0 0 you have 3 0 0 low income? Mr. T E R R Y . That is correct. Mr. S T G E R M A I N . They were built under 2 3 5 , so they could not have been built except in the last year and a half or so, could they? Mr. T E R R Y . The first 3 0 0 units were occupied last fall. Mr. S T G E R M A I N . That is about 7 percent. And you consider this a mix? Mr. T E R R Y . N O . We feel we have not done as good a job as we should have done on low income housing. 520 Mr. S T G E R M A I N . And 2 3 5 is a program whereby the Government pays the difference between what the owner or the purchaser of the home can afford according to his income? Mr. T E R R Y . That is correct. Mr. S T G E R M A I N . S O you arc getting the same actually for your 235 units put in there as you are getting for your housing? Mr. T E R R Y . N O , these are rental units. Mr. S T G E R M A I N . YOU mean 2 3 6 ? Mr. T E R R Y . I beg your pardon, these are 3 0 0 rental units. There are some single family 235 units now, I am not sure how many there are, but there are some being built now. Mr. S T G E R M A I N . I would like to ask this question of Mr. Stastny of the Home Builders. How many members do you have, Mr. Stastny? Mr. STASTNY. Our membership presently exceeds 5 2 , 0 0 0 . Mr. S T G E R M A I N . And you call yourself a homebuilder, but these members are the people who also build apartment buildings, office buildings, and shopping centers, are they not? M r . STASTNY. Y e s , sir. Mr. S T G E R M A I N . And is it your testimony that the equity participation has been—well, it is repugnant to the homebuilders, is it not? Mr. STASTNY. I am sorry, I did not hear that. Mr. S T G E R M A I N . In going over your testimony I gather that equity participation, or a piece of the action, as it is known, is repugnant to the homebuilders? M r . STASTNY. Y e s , sir. Mr. S T G E R M A I N . Because build other buildings? M r . STASTNY. Y e s . you are not only home builders but you Mr. S T G E R M A I N . Mr. Fey, you in the insurance industrj^, your funds come in great part from—I realize you sell a lot of big policies to corporation executives and whatnot. These are great big ones that protect the corporations. Should a man who is very valuable to the firm pass away, et cetera, but a large percentage of your policies 8re the $ 1 0 , 0 0 0 , $ 2 0 , 0 0 0 , $ 3 0 , 0 0 0 , and $ 4 0 , 0 0 0 policies, are they not? Mr. FEY. The majority of them are. Mr. S T G E R M A I N . The majority of them are? Mr. F E Y . Yes. Mr. S T G E R M A I N . YOU say back in 1 9 5 0 you gave a figure of the number of home mortgages you had in effect. And what wTas that number? Mr. F E Y . We had about 6 8 , 0 0 0 F H A mortgages that averaged about $11,000 per mortgage. Mr. S T G E R M A I N . H O W many do you have toda}^? Mr. F E Y . We are down to about 4 7 , 0 0 0 . Mr. S T G E R M A I N . Forty-seven thousand. Don't the insurance companies feel that you should consider as a profit to your policyholders, the people who are giving you the money to work with, as a profit to them you should also consider the fact that—as was so eloquently stated by Mr. Hovde, isn't there a social obligation, but it should go even further, an obligation to your policyholders, the lowincome and the middle-income people who form the majority of your investors, so to speak, to help them acquire housing, to help out in the housing market? Don't you feel that is an overriding obligation on your part? 521 Mr. FEY. I do understand your question. And we do have the obligation to all of our policyholders. And this means that we must develop an investment program that will provide them risk protection at the lowest possible cost to them. This means that we may not give preferences to a particular group of policyholders. As you say, wc do have a social responsibility to provide housing. And we do. The life insurance industry is providing the vast majority of the multiple dwelling units, the apartment houses that are available, and which are not just a matter of marketing to the occupant, but they are a preference of the occupant, partly because of high cost of maintenance of a single unit dwelling, and partly because of the high carrying charges of a single unit dwelling. But the fact is that two-thirds of the construction today is in the multi-unit housing. We certainly do not have the obligation to confuse our investment program with the security elements of the risk protection involved in covering our policyholders. And we must always be mindful that we did not give preferences to any particular group of our policyholders. Mr. S T GERMAIN. The fact remains that your testimony states very clearly that you have found that you should get out of the home mortgages and go into these larger developments and apartment complexes and office buildings, is that not so? Mr. FEY. Our industry is made up of a large number of diverse types of companies, and there are many large and small companies, companies that operate locally and companies that operate nationally. If a company that operates on a national basis as we do, for a company with our size of assets, and our investment programs, it would not be to the interest of our policyholders to invest in small units of local real estate in various parts of the country. On the other hand, there are many of our member companies, members of American Life Convention, and members of the Life Insurance Association of America, who are essentially regional or local companies Mr. GETTYS. Mr. Chairman, I demand regular order. Let us not have this long count on the top row and the short count on the bottom. I demand regular order. The CHAIRMAN. Are you making a point of order? Mr. GETTYS. I am demanding regular order. The regular order of this committe is a 5-minute rule. The CHAIRMAN. Any member can make a point of order when the 5 minutes is exceeded. The point of order is sustained. Mr. Williams. Mr. WILLIAMS. Thank you, Mr. Chairman. I want to thank all of you gentlemen for being here this morning. As of today we have been listening to the testimon}T on H.R. 5700 since a week ago yesterday. I believe the testimony we have received this morning is the most voluminous of any we have received to date. It is my impression, after listening to this testimony on this bill, that this till is going to hurt in some way every type oi our financial institutions. The reaction of one type of financial institution is, it is all right to hurt everybody else, but let's not hurt us. A good example of this, I believe, is contained in Mr. Hovde's statement, where, after a very sweeping indictment of equity participation, on page 3 of your statement, Mr. Hovde, you make a statement against 60-299—71—pt. 2 (> 522 controlling the interlocking directorates, and at the very bottom of the page you say. We recommend, therefore, the deletion of these prohibitions as they apply to appraisers and brokers serving as directors of financial institutions covered by the bill. So there you are asking for an exception in this bill for people in the same business generally as you are, is that not so, Mr. Hovde? Mr. H O V D E . The statement has been submitted, and if that is the way it is interpreted, I would have to say yes. jVlr. W I L L I A M S . Mr. Stastny, on page 3 of your statement, the last paragraph, you make the statement: The lender who is also a borrower in the same transaction may tend to not be as rigorous as he would otherwise be in assuring that the risks of a particular loan are reasonable. What }rou are really stating there is that the lender is making higher risk loans under certain circumstances? Mr. STASTNY. This has been our observation, sir. Mr. WILLIAMS. In other words, you realty believe that these lending companies such as insurance companies are making high-risk loans which may not be justifiable? M r . STASTNY. Y e s , sir. Mr. WILLIAMS. N O W , Mr. Jackson, you have made some very convincing arguments in favor of equity participation. But you have also referred to the fact that equity participation is not truly equity participation. Why can't equity participation be developed which would be in effect a two-way street, where the person getting the equity participation would also participate in the losses and profits and get away from the gross income? Mr. JACKSON. That would be possible, Mr. Williams. It is interesting to me that Mr. Stastny says that we are making high risk loans. None of his members have mentioned that when they came in to apply for a loan with us. Mr. W I L L I A M S . Thank you for that additional comment. Mr. Fey and Mr. Terry, you have also made some very convincing arguments concerning equity participations. I am particularly interested in Columbia. Some questions were asked about housing for low-income families, and you state that you have 300 units of low-cost housing which were constructed under the 235 program. What type of units are these, and what are their sale price? Mr. T E R R Y . I misstated it. There were 3 0 0 units built under the 236 program. And they are rental units. Mr. WILLIAMS. What is their monthly rental? Mr. T E R R Y . For one bedroom it is $ 9 9 . Mr. WILLIAMS. And go from there. Mr. T E R R Y . It goes from there to a four-bedroom town house at $152. Mr. WILLIAMS. Your experience of course has been too short. You have no experience on maintenance costs or anything of that nature. Mr. Fey, section 14 of the bill forbids the lender to accept any equity participation in consideration of making any loan. One of the kinds of equity participation which would be forbidden is shadow warrants. If this provision should become law, do you have any clear 523 idea of what actions on your part would be forbidden by this restriction? Mr. FEY. TO the best of our knowledge, none of our companies have ever used the shadow warrant as a credit device. Mr. WILLIAMS. Would you define a shadow warrant for me? Mr. FEY. I would have very great difficulty in defining it. It actually is receiving the gain on a warrant or an equity interest without actually purchasing the interest itself. Mr. WILLIAMS. Thank you. Mr. Hamilton, I read your testimony with great interest. Yet, you want certain exceptions "made for mutual insurance companies. On page 8 of your testimony you state that there is difficulty in securing competent individuals to serve as directors. And this difficulty is being experienced by all corporations. Yet, you only asked for an exemption for mutual insurance companies under the provisions of this act? Mr. HAMILTON. We did not undertake to express any opinion on the situation of other types of corporations. However, I think it would be entirely appropriate and in the public interest to exclude insurance companies generally from the terms of these sections covered in our statement—sections 2, 3, 4, 7, and 8. Mr. WILLIAMS. Thank you. I have nothing more, Mr. Chairman. The CHAIRMAN. Mr. Gonzalez. Mr. GONZALEZ. Mr. Chairman, I do not have any questions at this time that have not alreaily been asked. The CHAIRMAN. Mrs. Heckler. Mrs. HECKLER. Thank you, Mr. Chairman. I should like to thank the witnesses today. They have really presented some of the most searching testimony I have heard in the last year. I must say I still have not perceived the situation in terms of the real role of equity participation. I would like to ask Mr. Stastny about some of the statements that he made. On page 4 of your testimony you referred to a study conducted by the National Association of Home Builders, 2 years ago, which indicated that developers building under an equity participation scheme were intending to hold the project for a much shorter period of time than those not giving any equity participation to the lender, therefore leaving the lenders with control of the profit after the 5 years or the short period of time in which the builder is involved. Could you make the result of that study available for the record? Mr. STASTNY. Yes, we can, and we shall. (The information requested follows:) JUNE A SPECIAL R E P O R T — E Q U I T Y 1969. PARTICIPATION Editor's Note.—Several months ago NAHB's Mortgage Finance and Specialized Housing Department, in cooperation with The Compendium, undertook a survey among Compendium subscribers on the general subject of equity participation in apartment financing. The purpose was an attempt to identify the magnitude of this relatively new type of apartment financing, as well as the various types of equity participation. The following report on the survey was prepared by Norman Farquhar, director of the department. Equity participation on the increase.—Although a relatively small percentage of the respondents (15 percent) noted in the questionnaire that equity participation 524 was a condition for securing the financing, many indicated that commitments now being negotiated called for some type of participation. Of the 35,000 units started by the respondents, approximately 11 percent of these units involved equity participations. Nearly all of the equity participation loans originated were by life insurance companies. These loans usually did not result in a reduction in the interest rate and/or the points being charged by lenders. In the several cases where reductions were present, the points were reduced only slightly and the only real concession was a higher loan-to-value ratio and/or a longer repayment period. Equity Participations Take Many Forms.—The most frequent found from the survey is for the developer to pay a percentage of the gross receipts from the project. The next most frequent is payment of a percentage of the net profits of the project. The leasehold (with or without option to purchase) is virtually unused, at least among respondents. The combinations of percentages of gross receipts were many. Most frequent percentage was 2 or 3 percent and a sliding scale to allow for rent increases and changes in the net receipts from the project. Those sharing an equity position based on the net profits from the project are paying between 20 and 30 percent of the net as a condition foi receiving the loan. Approximately half of those giving an equity position are planning to sell the project within five years. This is a substantially higher percentage than those developers who had not given any form of equity participation. Nearly 130 builders responded to the survey, accounting for approximately 35,000 units, or an average of 285 per builder. These production figuies indicate that the average respondent was larger than the typical NAHB builder-member. A majority (90 percent) of the units started were garden-type structures, and some 22 percent of the units started were Federally-assisted. Several conclusions on present lending practices may be drawn from the survey. They are as follows: 1. The practice of equity participation as a condition for securing permanent financing on apartment projects is increasing. 2. No general practices may be identified and each lender has his individual preference or arrangement, arrived at through a bargaining process. 3. Basing participation on a percentage of gross rent is the most common form. Also lenders are anxious to receive, in addition, a percentage of rent increases. 4. Those builders giving an equity position arc often selling the project within a five-year period. 5. Equity participations do not generally result in a reduction of financing costs, however, may occasionally result in a longer term and higher loan-to-value ratio. 6. Life insurance companies are presently the onty type of lending institutions requesting equity participation. Mrs. HECKLER. Isn't that rather a breach of good faith on the part of the borrower? Mr. STASTNY. Not really. The question was asked earlier, just what the breadth is of the practice that I bring to your attention today. I would like to point out that the one example which has been cited of Columbia is not typical of what is going on in this practice of equity participation. In fact, it is a real exception. I represent the guys who have really been bled by this practice. And you must understand, with respect to your question, that there are a number of reasons for going into a real estate development. Two-thirds of our people historically have gone into them with the intention of keeping these developments for long-term investments. Under the circumstances which have been brought about by equity participation, frequently the interest, the investment interest of the developers, has got to be shortened. I have with me Mr. Martin, who is a vice president of the National Association of Home Builders, who has had a great deal of personal experience in his own business with this kind of development, and has been close to the problem. If you will permit, I would like to ask him to comment. The CHAIRMAN. Would you like to hear from him, Mrs. Heckler? 525 Mrs. H E C K L E R . Mr. Chairman, I would like unanimous consent to have Mr. Martin submit a statement for the record of his experiences. The CHAIRMAN. All right. Without objection it is so ordered. Mrs. H E C K L E R . Since our time is so limited I would like to get on to some other things. I am concerned about your statement, Mr. Stastny, in terms of the interest rates charged for loans in which there was equity participation. You talk about mortgage loans. I wonder what the interest rates have been in cases in which the lending party was a bank—not a bank, but an insurance company. Has there been an interest rate increase, or has there been an interest rate advantage when money was scarce through the insurance funds? Mr. STASTNY. We have not been able to see any compensation in terms of interest rates because of equity participation. And we stated this in part of our statement. You must understand also that the practice is rampant during times when banks are simply not offering money for real estate loans, because apparently the supply is such that they do not have it available, or for other reasons which might exist. So the insurance companies, with the option wThich they solely control of equity participation, have exercised this force. Mrs. H E C K L E R . Dr. Fey, would you like to comment on that? Mr. FEY. Yes. I think there is, as I have said in my statement, definitely evidence—and I have studied a large number of our companies—which would indicate that there is a reduction in interest rates of anywhere from % to 1 percent in return for the equity participation, so-called equity participation. Mrs. H E C K L E R . I T is apparent, Mr. Chairman, that there is disagreement among the panel of witnesses. And if possible, with unanimous consent, I would ask that they each be allowed to answer this question, because there obviously is substantial conflict in the testimony on this point. The CHAIRMAN. Answer the question within your 5 minutes, and then they can extend their remarks on the record. Mr. GETTYS. Mr. Chairman, I make a point of order that the House is in session, and we are meeting without authority. The CHAIRMAN. The point of order is not sustained. We are operating within the rules. Mr. G E T T Y S . I appeal for the ruling of the Chair. The CHAIRMAN. Under the new rules, just for the 92d Congress commencing, it is not a good point of order. Mr. G E T T Y S . All right, I withdraw it. Mrs. H E C K L E R . If my 5 minutes is not up, I have one further question, Mr. Chairman. I wish to have the witnesses state their positions on the effect of equity participation relating to interest rates from their respective experiences in their different fields. The CHAIRMAN. Would you like each one of the panel to do that? M r s . HECKLER. Yes. The CHAIRMAN. They can do it when they look over their transcripts. M r s . HECKLER. Y e s . The CHAIRMAN. That is a good suggestion, and I hope you gentlemen can comply with it. Mrs. H E C K L E R . I am informed that my time has expired, Mr. Chairman, 526 (In response to the information requested by Mrs. Heckler, the following replies were received for submission in the record:) ADDITIONAL STATEMENT BY G E O R G E C . M A R T I N , V I C E P R E S I D E N T - T R E A S U R E R , N A T I O N A L ASSOCIATION OF H O M E B U I L D E R S My name is George Martin. I am an apartment builder in Louisville, Kentucky, and I welcome the opportunity that was prompted by Mrs. Heckler's question about the interest rate on equity participation loans to express my views on the subject. First, let me attempt to clarify the difference between an equity participation loan and a joint venture agreement, because I feel a lot of discussion has taken place in the Committee about the arrangement in Columbia, Maryland, with an insurance company. That arrangement has been referred to as equity participation, when it is in fact a joint venture or a partnership between the insurance company and the developer. As was so ably stated by Mr. Stastny, we have no objection to a life insurance company, or any other lender for that matter, becoming a bona fide partner in any kind of business venture. We do, however, object to the situation where an insurance company or any other investor says that the only way you can borrow money from them is to give them an equity participation or a kicker, or a piece of the action—or one of the many other names that describe this procedure. I feel it is important to point out the difference between a joint venture and equity participation because a lot of time was given defending the practice with respect to Columbia. The statement was made that, without an insurance company's ability to enter into this kind of agreement, Columbia would not be in existence today. I repeat we have no objection to a lender becoming a partner—a bona fide partner. The equity participation agreements that are taking place, however, are quite different than that described by Dr. Fey of the National Life Insurance Company of Vermont. He may have given the mistaken impression that in the majority of such loans the equity part of that loan only amounts to an interest increase of about H of 1 percent. In my oral testimony, I described one type of loan in which a lender said that the only way they would make any loan at all would be to buy the land and lease it back to the developer. As a further requirement to making a 75% loan, they require the project owner to pay them annually 35% of the defined cash flow. To determine what this proforma or projected cash flow is, there are first deducted certain fixed expenses such as taxes, insurance, utility bills and debt service. Then there is allowed an additional 16% for all other expenses, regardless of what they in fact amount to. They then take 35% of the remaining cash flow. In addition, they require that they be given the right to put up an additional sum of money in the form of an investment and that they be given a guaranteed 12% return on this investment, plus a 50% equitable ownership in any cash flow remaining after the 35% payment and 50% of the depreciation and the equity buildup in the apartment. Of course, they already own the land. This results in a much higher increase in the return received by the lender than an effective increase of }i% in the mortgage interest rate. Mrs. Heckler asked about specific interest rates; whether or not in fact there was a lower interest rate with participation. Let me give an example. I obtained a commitment for an apartment project loan in 1970 which called for 10J4% interest plus 2% of the gross income or 25% of the future rental increases, whichever happened to be greater. I certainly did not get any lower interest rate as a result of giving such a participation. Let me describe a little bit what that percentage of any rental increases does. Dr. Fey described rental increases as a windfall from rent that was not projected when the project was initially built but that could be charged in the future as a result of inflation. He didn't talk about the situation where taxes are increased, insurance costs go up, maintenance costs go up, or there are other requirements which may call, for instance, for a $20 rental increase. If you then had to give 25% of this $20 rental increase to the insurance company to compensate it for having made a I0}i% loan, you would then have to add 33% to the increase projected to take care of increased costs in order to break even. In the instant case, you would have to charge the tenant $27 more in order to obtain the $20 necessary to cover increased costs. In a percent of the gross situation, the alternative in this case, you have to give 527 part of every dollar that you take in, here $2 out of every $100, to the insurance company as added income. If in this project it is necessary to have 80% of the units rented to break even, and only 70% of the units are rented, the result is paying out this amount to the lender when in fact there is a negative cash flow. If in the future the apartment complex should have difficulties, it would be compounding its difficulties as a result of having given, not a share of the profit, not a share of any net income, but a share of the gross income as an added inducement to obtain a loan. In the hearing the practice of equity participation was defended by the representative of the insurance industry on the grounds that it was a hedge against inflation, in spite of the fact that insurance companies have been able to make residential mortgage loans for over 100 years successfully and considered them to be a good risk and a good yield. Suddenly now they are not a good risk and do not give a good yield. It was pointed out by one of the insurance company representatives that residential income loans would not give perhaps as high a yield, or be as safe a loan, as corporate stocks or corporate bonds which have been selling in the past six to eight months to provide yields of from 7 to 9%. At a meeting which I attended with the top economists of one of the major life insurance companies with a representative at this hearing, they described their investment portfolio on which they received an 11% yield on corporate stocks from a combination of both dividends and appreciation in the value of the stocks and a 9 or 10% yield on corporate bonds which they considered a safer risk than, for instance, loans on residential income producing property. This was perhaps 24 months ago, before the stock market dropped from the 900+ level to the 600+ level and the value of some major stocks declined one-third or more. One insurance company, which unfortunately held $145 million worth of corporate bonds in the Penn Central, I noticed in a recent issue of the New York Times had to write down this $145 million investment to a value of about $20 million. This is the type of investment which is apparently preferred to residential income property as a risk. Another major insurance company had $49 million of these bonds which the}' also wrote down to almost $20 million. I strongly doubt that all insurance companies put together have lost as many millions of dollars on residential apartment loans as was lost on this one transaction by these two insurance companies. I agree completely with the statement that was made during the hearing that insurance companies that derive most of their income from their small policy holders have an obligation to put this money back into residential mortgages at a price that people can afford to pay. With insurance companies taking bigger and bigger percentages of their portfolios out of residential loans and putting them into corporate stocks and corporate bonds and other types of investment which are considered to give a better yield, it may be necessary to look into what is happening to the money so invested. I am quite concerned about the future of our private enterprise system of producing housing. Without the access to the tremendous amounts of funds that have been available in the past through life insurance companies and savings and loan companies which I feel is being jeopardized by the practice of equity participation, the private builder, especially the smaller one, will no longer be able to produce the housing we need. I agree with the statement made by Mr. Hovde that the equity kicker route is making a mockery of the usury laws in several states. I also agree with the statement that the insurance laws or regulations of those states which prohibit loans in excess of 75% are being circumvented by using such routes as purchase and lease back of the land. The circumvention arises from the fact that the normal loan-to-value ratio is determined by considering both the land and the improvements. Where the developer receives 100% of the value of the land through the purchase-lease back strategem and also a loan of 75% of the value of the improvements, he in effect receives more than he would have under the normal approach. REPLY RECEIVED FROM M R . HAMILTON I have no comment on Mrs. Heckler's question on the effect of equity participation relating to interest rates. The member companies of the American Mutual Insurance Alliance, for which I speak today, have very small investments in mortgages and collateral loans. I have mentioned previously that the total 528 investment in mortgages and collateral loans at the end of 1969 (the latest year for which figures are available) was three-tenths of 1% of their assets, or only a little more than $17 million. As property/casualty insurance companies, our members seek greater liquidity than is found in mortgage investments. So far as I can ascertain, our members do not have any mortgage investments which include equity participation or income participation. If there are any they must be in very small amounts. REPLY RECEIVED FROM M R . FEY The common observation among life insurance companies is that the contingent interest arrangement, used in combination with a fixed contract rate, has allowed the fixed rate to be held down by perhaps % to 1 percent below the rate required on similar mortgage loans without a participation feature. In response to Mrs. Heckler's request, more specific data have been obtained from three major life insurance companies who have been active in making income property mortgage loans, with and without contingent interest features. These data relate to investment authorizations during calendar year 1970. In the case of one large company, income property mortgages with contingent interest features carried an average fixed interest rate of 9.35 percent, compared with an average fixed interest rate of 10.45 percent on income property loans without contingent interest. For this company, the volume of contingent interest mortgage lending represented 43 percent of total lending on income properties during 1970. A second major life insurance company, heavily involved in granting incomeproperty mortgage loans with equity features, followed the practice throughout 1970 of generally limiting its contract rate on apartment deals to 8%% while at the same time fixed rate mortgages were available at rates of up to 10% and more. Further, the investor in this instance utilizes a form of equity feature that does not generate any additional income for the investor, over and above the basic contract rate, until such time as the developer is in a profit position. The general investment policy indicated here is based on the premise that a good deal of the difference between the actual contract rates and the market rates available will be recovered during the life of the loans and that, additionally, the equity features will provide a certain degree of protection aginst further erosion of the dollar. A third large company reported that the average fixed interest rate on income property loans during 1970 was 9.91 percent while the average coupon rate on corporate bond investments was 10.66 percent in the same period. The reason that mortgage loans could be made at that differential was that contingent interest participation was obtained on many of the mortgage loans. A closer comparison of bonds and mortgages of similar credit quality is also pertinent to the effect of contingent interest features in holding down the fixed interest mortgage rate. During 1970, this company's average coupon rate on middle-grade bond investments was 11.63 percent, while the average fixed interest rate on mortgage loans of comparable quality was 10.02 percent. Again, the contingent interest feature produced an added long-term return which would make these mortgage loans competitive with bond investment opportunities. The CHAIRMAN. Mr. Gettys. Mr. G E T T Y S . Mr. Chairman, as unofficial chairman of the lower row I would like again to call attention to the long count on the top row and the short count on the lower row. The CHAIRMAN. Each member has his own time. Mr. G E T T Y S . I understand. I am going to take some action, if I can, Mr. Chairman, to change the rule a little bit, or let us abide by the rules, because we sit here all morning. And then it is a little bit discourteous, 1 think, to the junior members. The CHAIRMAN. They have the same protection as a senior member. Mr. G E T T Y S . Mr. Chairman, I have been sitting here because I particularly wanted to ask questions on some of the testimony which concerns me so much. 529 I am not impressed at all with the attempted justification of the piece of the action that the gentlemen talk about. And I think it is disgraceful. In addition, I have been an admirer of the Columbia City. But when I come to a committee room and hear stated that the chief development so far has been the birth of a child to a mixed marriage out of an $80 million loan it disturbs me a little bit. We need cities in the country, and I do not think that is the major accomplishment that we should aim at. And I do not believe any gentlemen on the panel have submitted their daughters to that situation, although they brag about others. Under the bill—and we have talked so little about the bill that is before us, and your testimony is splendid in that connection—but the one thing that I am most interested in relative to this bill—and you fellows are big insurance people, which is where they have most of the money in the United States, in the private sector. Dr. Burns, chairman of the Federal Reserve Board, was before us the other day. And I would like to ask this panel—and I direct my remarks, if I may, to the Equitable man, if he Avill answer—first, let me repeat. One of the factors that concerns me about the impact of this bill is the moral and ethical angle, and the conflict of interest in this interlocking directorate business particularly. What is a conflict of interest? I think today the banking industry and the insurance business in the United States are in the same boat with Congress. Our image is at the lowest level in the moral aspect, I believe, that it has ever been in the history of our country. I am worried about our attempt here to legislate morals. I do not think you can do it. I think we have got still to rely on industry responsibility, individual responsibility, individual character, and that if a man breaks a law he should be punished according to the criminal laws of the country. But to start with the presumption that every person who holds an interlocking directorship, is crooked, and base our laws on that assumption, I think we have got the wrong approach. Now. within my short 5 minutes that is left, would you comment on that phase of this bill. Mr. FEY. YOU have mentioned Mr. Murray from Equitable. I do not know whether you are referring to Mr. G E T T Y S . I just see his name here. Mr. M U R R A Y . On the interlocking directorship conflict of interest I would like to speak if I could. The Equitable Life of New York has 36 members on its board. This is a highly diverse group of people from all over the United States. We have 14 States represented in addition to New York. We seek geographic representation. It seems to me that when we get an important businessman from San Francisco, or from some other major cities almost inevitably this important citizen happens to be oil the board of one of the local banks. And this automatically is precluded in this bill. Also on our board we have six educators, four presidents of leading colleges, from Princeton on down, and we have five lawyers. Actually we have only four men who are bankers by profession. So all of the other so-called interlocks are casual and really not interlocks in the true sense, they are businessmen with important business interests 530 in their portion of the country. And I just do not believe that there is really a conflict that is ascribed to the mere fact that they are on some bank board somewhere. The CHAIRMAN. Would you yield for a suggestion, Mr. Gettys? Mr. G E T T Y S . I yield, Mr. Chairman. The CHAIRMAN. Thank you, sir. The 1968 report by this committee shows the Equitable Life Assurance Society of New York had five interlocking directors with Chase Manhattan Bank, and four with Chemical Bank & Trust Co., nine in all. Have you seen this report? M r . M U R R A Y . N O , sir. The CHAIRMAN. It was made by the committee. Our committee is the only one that has ever compiled a report on that. Mr. M U R R A Y . Did you say a director from the Chemical Bank? The CHAIRMAN. N O , interlocks, four with the Chemical, and five interlocked with Chase. Mr. M U R R A Y . This must be a fact, then, as of that date. Today we have one common director at the Chase Manhattan Bank and two at the Chemical Bank & Trust. Mr. FEY. I would like to add, Mr. Chairman, if I may, that the mere presence of a director does not constitute a conflict of interest. I can take a very dramatic case The C H A I R M A N . We are not saying one, we are saying nine. Mr. FEY. Let me give a very dramatic case of three directors of other life insurance companies that sat on a hospital board where our own life insurance company with no directors on that board made a presentation for a pension plan in that hospital. The hospital chose our pension plan in spite of the fact that our competitors had members on the hospital board of directors. To assume that there is a conflict of interest just because there is an interlocking relationship is an unreasonable assumption, I would submit. Mr. G E T T Y S . Would you think that a lawyer should be able to serve on the Judiciary Committee, for example, would that be a conflict of interest? Or a farmer on the Agriculture Committee, is that a conflict of interest? Mr. FEY. This is the kind of expertise and the kind of intelligent and informed leadership that we need on our various committees, and that we need on our board of directors. Mr. G E T T Y S . That is one of the dangers of that bill, that it would end up that the only people who would be qualified to serve on the board would be somebody who has been a failure in everything he has tried. Mr. FEY. We would end up with boards of directors that had no financial expertise or knowledge, or boards of directors made up of inside officers who would vote with the president. Mr. G E T T Y S . Thank you. I am sure my time has expired. The CHAIRMAN. I assure you that we have no intention of writing such guidelines. Mr. Archer, you are recognized. Mr. A R C H E R . Dr. Fey, you made the comment that equity participation, insofar as it related to rents, only applied to the increase in rents and not to any percentage of the existing rent at the time that the loan is made. And I was left with the impression in your testimony that 531 this was the only type of participation that is prevalent in this country. And I want to clear that up. Am I correct in that or not? Mr. FEY. NO. I said that the normal case was the type of participation which I pointed out. There are all forms of participation, and there are some that participate Mr. A R C H E R . Really, we do not want to leave the impression with this committee that the only type of participation is in increases down the line, because I happen to know myself of many, many factual situations in our community in Houston, Tex., where it comes immediately in existing rents and existing income and not just increases down the line. Mr. FEY. YOU are absolutely correct. However, the percentages which I stated are not the same in both cases. Mr. ARCHER. I would like to ask one question about the Columbia situation. Do I understand, Mr. Terry, that there was no equity capital put up initially at all, that Connecticut General furnished all of the equity capital? Mr. T E R R Y . N O . The Connecticut General put up all the money to acquire 1 4 , 0 0 0 acres, which amounted to $ 2 3 , 0 0 0 , 0 0 0 . We put up $ 7 5 0 , 0 0 0 of equity capital. Mr. ARCHER. H O W was this $ 7 5 0 , 0 0 0 raised? Mr. T E R R Y . It came from the working capital of the Rouse Co. Columbia is not the only project of the Rouse Co. We are building in other parts of the country. Mr. A R C H E R . I see. So would this $ 7 5 0 , 0 0 0 then cover other installations of the Rouse Co., or is this particularly allocated only to the Columbia project? Mr. T E R R Y . Only in Columbia. Mr. A R C H E R . Considering the amount of money, then, in equity capita], the only recourse that the lenders have in case of failures is against this $ 7 5 0 , 0 0 0 , is that basically an accurate statement? Mr. T E R R Y . Yes, that is correct. Mr. A R C H E R . S O for all practical purposes in this situation, then, you have life insurance companies that are lending money to themselves, is that a basically accurate statement? Mr. T E R R Y . Theirfinancingwas secured by the land, that was their principal security. Hopefully, after assembling that much land, which, as subsequently borne out by an appraisal, it is worth more than we paid for it, by virtue of the fact that we did acquire it in such large pieces. Mr. A R C H E R . I am not attempting to infer that this is morally wrong, as has happened in the situation. But I am trying to get a clear picture in my mind as to just what has happened. And it appears to me that rather than the Rouse Co. giving an equity participation to the insurance company, that it is just the other way around, that the insurance company has a project in which they are permitting the Rouse Co. to have an equity participation as consideration for the Rouse Co. running it for them. Again, I am not trying to say whether this is right or wrong—but in this situation it is very apparent that this is what is involved, because the insurance company is for all prime intents and purposes, with the exception of $ 7 5 0 , 0 0 0 , lending money 532 to themselves, and are going to have to look to themselves for repayment. * Air. T E R R Y . They are going to have to look to performance of the project for repayment. And we are the ones responsible for the performance of the project. We make all management decisions. Mr. A R C H E R . And you are given the opportunity to have an equity participation by the insurance company in consideration of your running the project for them? Mr. T E R R Y . We own half the project. Mr. A R C H E R . Which is the biggest half? Mr. T E R R Y . We think ours is. Mr. A R C H E R . Thank you very much. I yield back the balance of my time. The CHAIRMAN. Mr. Cotter. Mr. COTTER. Thank you very much, Mr. Chairman. I will be as brief as possible. I can understand the responsibility of banks and insurance companies to their stockholders to get the best possible returns on their dollar. But it appears to me that by requiring equity participation you are taking sums of money which would probably go to help the poor guy who is attempting to build a home or own a home. And I can see where it could act to his detriment. I can also understand that you could not get a project such as Columbia underway without equity participation because of the magnitude of it. But there is one area which concerns me. And I know of specific instances in my own home town where, say, a developer of a project, shopping center, say, of $1 million or $2 million, goes out and gets a parcel of land, and gets tenants, triple A tenants and there is absolutely no risk involved. He will go to the lending institution, and they will require participation and want a piece of action. Dr. Fey, how do you explain a situation like that? To me it is unconscionable. Mr. FEY. I could give it to Mr. Hayden, who has had a considerable amount of experience Mr. COTTER. Mr. Hayden? Mr. H A Y D E N . Let me say that this is a very good question. And I want to emphasize a point which has not been made today, and which should be made, and that is, insofar as any major institution I know is concerned, we never get an equity participation or a piece of action, or whatever you call it, for free in consideration for making a normal mortgage loan, when we get equity interest, whatever its nature, we pay for it. Mr. C O T T E R . Mr. Hayden, I agree. I know the Connecticut General and the insurance companies in the Hartford area are not guilty of this. But some of the banks are. Mr. H A Y D E N . I cannot testify as to the banks. Mr. C O T T E R . I know of specific instances. To my way of thinking there is obviously no justification for it, it is unconscionable. And it is not done in consideration of a lower interest rate either. They want a quarter, 50 percent participation. Now, how do you eliminate that abuse? Mr. H A Y D E N . I cannot really answer the question. I am really not familiar with the abuse. I certainly would not dispute your words. 533 Mr. COTTER. I can document it. Mr. HAYDEN. I think the only thing T can suggest is discussing it with the institutions in question. It has not been the practice of major lenders, however. The CHAIRMAN. Mr. Cotter, weren't you insurance commissioner of Connecticut? Mr. COTTER. Yes, I was, Mr. Chairman. I am quite familiar with the Columbia project because of it. I recall when they started this project reviewing the annual statement. And to the best of my recollection there was some $25 million in initial investment. And it being such a large sum, I was concerned about it. And I spoke to the officials of the Connecticut General at the time. It seemed to be a high-risk venture. At that time I was more concerned with policyholders than borrowers. But they convinced me at that time that it was a good venture, it was in the public interest. And they assured me that the company was not placed in jeopardy because of it. And I subscribed to this. The insurance companies in my home area have been great. They have saved the city of Hartford, they have saved the urban area. But by the same token, I think this equity participation takes a lot of money away from homeowners, people who are seeking to build their homes. And I can understand the conflict, because the stockholders of both the banks and the insurance companies want a good return on their money. And you are going to get a better return by having equity participation than you are by lending it to a fellow who is attempting to build a home and build an estate. And this is what troubles me. I am not opposed to equity participation as long as there are not abuses, but I know of areas, and I can document them, where there are abuses. And this concerns me. Mr. HAYDEN. If I can comment, first of all, we do not know of any participation in the equity of homeownership projects. Mr. COTTER. There is none whatsoever in homeowners, no lending institution wants a piece of that. But they do have apartment houses, they do have shopping centers. And I am talking about projects up to, say, $3 million. Air. HAYDEN. Let us remember one thing, and this is essential, that the homebuilding and the developing business and the building business are without question the biggest industry in the country. And it is a grossly under-capitalized industry. I do not think that any of the gentlemen herefrom the Real Estate Board or the Homebuilders would adopt a suggestion that under no circumstances would mortgages be made in the future except where there was a 25 percent cash equity. You know very well they would be out of business. There is not that much equity money around. What has happened under new conditions—and we have new conditions—we have a period of capital shortage ahead of us for the next 30 years. We have an additional need for $5K to $7 trillion for city building and rebuilding, and we need to finance everything else that the country has properly undertaken in health and medical care and transportation, mass transportation, inner city—the demands for capital are enormous. Now, development has got to compete not only for equity capital, but for mortgage capital. There has to be both kinds of money available. And I can tell you that if there is not equity capital, and if we 534 are not allowed to help provide equity capital, there is no way legally we can provide mortgage money. We cannot finance the development of this country on 100 percent mortgage loans. It is illegal, it is impractical, and the insurance companies and our law would not permit it. Mr. C O T T E R . Mr. Hayden, I agree with you completely. And I think the industry as a rule has done a good job. They have rebuilt our city, and they have made it a better place in which to live. But by the same token, I am lookiug at the little guy who is penalized because of some of these abuses in this area. And there should be some method to clean these out. Mr. H A Y D E N . Mr. Cotter, I have to say first that section 1 4 is wrong in principle, for all the reasons we have cited. If, however, this committee feels it essential that the little guy you refer to gets some protection—and I am thinking out loud here—it might be possible to afford this protection against equity participation in instances wherein the totalfinancinginvolved is less than $1 million. Developers of projects involving over $1 million are professionals. They can protect their own interests. As Mr. Terry has testified today, most of them need to be able to augment their own equity if they are to continue to grow, or even survive. Accordingly, they should be exempted from section 14 if, in fact, such a section survives. Mr. C O T T E R . Thank you very much. The CHAIRMAN. Would you like to have more time? Mr. C O T T E R . N O , that is all. The C H A I R M A N . Thank you very much. We are glad to have you participate. Now, suppose that we just have brief comments from each of you gentlemen as tojust what you have in mind that you feel has not been covered sufficiently. But make it 1 or 2 minutes if you can. And that will enable us to close up at the time that we are supposed to close. Suppose we start down here at this end. Take 2 minutes each. Mr. M A R T I N . Mr. Chairman, I am an apartment builder, and I also have had experience with equity participation loans. I would not want the impression to go forth to this committee that the only kind of equity participition, as Mr. Archer pointed out, was a percent of the increase in rent, or that it amounted to only about half a percent more, or that the interest rate was less because of this participation, because this is just not so. Dr. Fey said something about windfall, that the lender should be entitled to a part of the windfall from increased rents. Let me say that, when you have to put a lifeguard on a swimming pool because of a new requirement, you have to raise the rents. When the utility bills go up and when the taxes go up, and overhead goes up, you have to increase your rent, say, $15 to $20. With a 25-percent participation in that increased rent, you are losing that much. Or else you have to increase your rent 25 percent more to take care of this participation in the increase. I will let you be the judge of whether or not a half a percent is all that somebody is getting out of the transaction that I am about to describe. First, there is a purchase and lease back on the land. Then there is a loan on the property, with the lender getting 35 percent 535 the defined net income from the project and a 50-percent equitable interest in the property—all for making the same size loan that would be made anyway. The problem of some of this property going back to the lenders who are making these loans, the impending disaster, is not yet apparent. The problem is that with a percentage of defined net income being paid to the lender, the project owner is not allowed enough money for expenses. This will not really become apparent until after the 4 or 5 years when there have to be major repairs, replacement of carpets or drapes, or appliances, and so forth. At that time there is going to be a shortage felt. In 5 to 7 years from now when all of the money has been creamed out of these projects because of equity participation through excess overrides and percents of the gross and percents of rental increases there is not going to be any money left to take care of these needed repairs and replacements. Mr. STASTNY. May I give Mr. Martin my 2 minutes? The CHAIRMAN. N O , you go ahead and take your own. Mr. STASTNY. I have to raise some deep concerns about equity participation, because my job is not only to represent homebuilders but also to represent the people they are concerned about, the people of this country who need homes and a continued free economic system for housing. We have heard mentioned the need for hedges against inflation, but we have heard no mention of a provision in any of these equity kicker deals in the event of a deflation. We have heard statements by the mortgage bankers that the fact that there is an equity participation in the project by a lender is not reflected in the rent levels. That is just not so; higher rents have to be charged and we can document the statements that I make. We have not really seen any true joint ventures in the vast, vast majority of the situations that come under the equity kicker title. There is no suggestion that losses might be shared as well as profits, only profits, and all too often in a way that precludes the actual success of many, many a project. We think that Dr. Fey's wish that the reference should be to equity interest participation—he used a different term, which kind of cleans it up a little—does not change the facts. We seriously object to a continuance of this practice. The CHAIRMAN. All right, Mr. Hamilton. Mr. HAMILTON. I would summarize very briefly, because of our feeling that I am not qualified to speak about the major subject of the panel discussion, the equity participation. As I pointed out, our companies, to my knowledge do not have investments at all in this area. Becuase of the different character of the mutual property and casualty companies, I limited my remarks to such companies. However, I think that the same comments applies in very large degree to all insurance companies. I would urge that sections 2, 3, and 4 eliminate the reference to insurance companies. I would urge that section 7 have an exclusion at least as to affiliated insurance companies, affiliation between a life company and a property/ casualty insurance company. I would further urge that there be in section 8 an exemption as to 536 insurance companies and their subsidiaries, because of the unique corporate structure of a mutual insurance company, and because of the difference in the investment programs and investment goals of property/casualty companies. I feel that such an exemption is most essential as to mutual property and casualty companies, and I think it would be fully justified in the public interest for all types of insurance companies. Thank you, sir. The CHAIRMAN. Mr. Hovde. Mr. H O V D E . Mrs. Heckler requested that we cite our specific cases on equity participation interpreted in terms of rate. Dr. Fey said that we are primarily talking about income participation. Actually there is both equity participation and income participation, kicker being the acronym for income participation. Yes, there has in fact been equity participation. And insurance companies have required upward of 40 or 50 percent of the equity in many situations. That particular policy or position on behalf of the insurance companies has become less, and they have gone more to the kicker participation. As far as rates go, when the prime rate was at 8% percent, the commercial rates plus equity participation required in our area of Wisconsin was 10% percent plus equity participation. I think in those States that have—and our usury rate in our State is 12 percent—in the States that have usury rates of 6 or 8 percent, I am sure that the underlying rates were those specified rates, and the degree of kicker participation was substantially more. And as I said, it is a way of getting around the State usury laws. As far as the to ){ percent differential, I would question that. If so, it is only an immediate type situation. Actually we have been only approximately 2){ years into this type of practice. And I think it is far too short a period to see what the long term rate differential is going to be. And really what the equity participation or income participation does, it opens the door to the future. It is an open contract, you no longer have a fixed contract, it is an open contract, the end result, and the byproduct, the end product of what we may reach in our country because of this, of properties coming back to insurance companies. I would like to submit for the record—the article in Fortune Magazine of July of 1970 which is entitled, "The Future Largest Landlords of America." They are talking about the insurance companies of this country. Thank you. The CHAIRMAN. D O you want to put that article in the record? M r . HOVDE. Y e s , I a o , sir. The CHAIRMAN. Without objection. (The article referred to follows:) [From Fortune Magazine, July 1970] "THE FUTURE L A R G E S T LANDLORDS IN AMERICA" AGGRESSIVE LIFE-INSURANCE COMPANIES ARE USING THEIR NEW BARGAINING POWER TO BECOME PART OWNERS OP THE REAL ESTATE THEY FINANCE (tty Sanford Rose) Life-insurance companies have long wielded mighty power over commercial real estate in the U.S. They have been the single most important supplier of long- 537 term finance for the construction of housing developments, office buildings, hotels, industrial parks, and warehouses. Their portfolios hold more than $35 billion worth of mortgages on income-producing property. Traditionally, they used their financial power discreetly and were content to rent out their money on a fixed-interest basis. Over the past couple of years, however, a great strategic change has swept through the sedate offices of John Hancock, Connecticut General, Prudential, and others. Abruptly, the big life-insurance companies have turned from somnolent mortgage lenders into alert, aggressive real-estate money managers. People in the real-estate business are referring to them as "the future largest landlords in America." The key indicator of change is that today the fixed-interest loan is dead. Exploiting the opportunities of a chaotic money market, the insurance companies are writing into every commercial real-estate loan agreement a stipulation that they will receive some form of bonus interest, or "kicker," over and above the coupon rate on the mortgage; in effect this assures them a cut of the income from the property. And to a growing extent they are also demanding an equity participation. They simply present the real-estate borrower with an ultimatum: if you want our money, you must make us part owner of the property you are building. For most real-estate developers, the new terms are understandably disquieting. One southern builder was angry enough to remark: "When the Mafia muscles into a laundry business, it leaves its partner with more of a stake in his own business than these insurance boys are doing." But harsh words are about all the developers can muster in response. The supply of mortgage money is so limited that the bargaining seesaw is heavily weighted in favor of the lender. William F. Leahy, a vice president for real-estate financing at Metropolitan Life Insurance Co., puts the matter bluntly, if a trifle hyperbolically: "In today's market we can make just about any deal we care to." The developer can, as the saying goes, take it or leave it. Many leave it; that is, they don't build. Others, particularly developers with high overhead expenses, cannot afford to remain idle, so they feel compelled to accept the insurance company's terms. There are, however, a few developers who actually benefit from the insurance companies' more aggressive entry into real-estate finance. Cabot, Cabot & Forbes of Boston and Taubman Co. of Detroit have such outstanding "track records" that permanent lenders compete to make deals with them. Their bargaining power is so imposing that, tight money notwithstanding, the insurance companies are unable to insist on equity participations, but must content themselves with the bonus-interest kicker. And in return for this variable reward, the insurance companies generally agree to put more money into any given deal than they did when their return was fixed by the mortgage coupon. In consequence, these developers can get involved in many more projects than they did in the days before the money crunch. Cabot, Cabot & Forbes, in fact, has quadrupled in size over the past four years. Sa^s Mortimer B. Zuckerman, its chief financial officer: "For some real-estate developers the insurance companies' greed is a cultural shock; for others, like us, it is a boon." When they are able to insist upon equity participation, the insurance companies are not just exploiting their strong bargaining position. They are in the process of effecting a dramatic shift in the composition of their assets. Many companies are beginning to take their first serious look at real-estate equities and are concluding that these are perhaps the best of all possible hedges against inflation. A wellmanaged portfolio of common stocks might yield an average annual return of about 10 percent, including capital gains. Bruce P. Hayden, vice president for real estate at Connecticut General Life Insurance, thinks his company's portfolio of real-estate equities should earn "at least 40 percent more." Over the next five years, Hayden estimates, Connecticut General will increase its real-estate assets about 50 percent faster than it increases its total assets. At New England Mutual Life, real-estate equities now account for 3 percent of assets. According to an unofficial poll of company executives conducted by a Harvard Business School student, the proportion of assets in real estate will probably rise to 9 percent within five to ten years, and could conceivably go as high as 15 percent. MAKING MILLIONAIRES During the Fifties and early Sixties the insurance companies had neither the inclination nor the market leverage to attach equity participations to their realestate loans. Mortgage money was abundant, and the companies themselves were cash rich and eager to dispose of funds. A life company is permitted to lend up to 60-299—71—pt. 2 7 538 Lender Takes All Tom Cardtmon* 75 percent or 80 percent of the appraisal value of a real-estate project (depending on the state law it operates under). A decade ago the insurance companies were so anxious to lend that they sometimes encouraged appraisers to overestimate the value of the project. As a result, a developer could pocket an insurance-company commitment to lend the full cost of the project—and even more. Says Gordon E. Emerson Jr., senior vice president for real estate at John Hancock Mutual Life Insurance Co.: "In those days we made more 105 percent loans, and more millionaire developers, than I care to confess." Even when the insurance company did not tinker with the numbers, a developer with a promising venture might still get a commitment for everything he needed if he brought in a project whose value substantially exceeded its cost. If the cost of a project were $3 million but its capitalized value—i.e., net income discounted by an appropriate interest rate—were $4 million, an insurance company's 75 percent commitment would enable the developer to build without taking in any outside equity capital or using up very much of his own working capital. Armed with the commitment, the developer could arrange a full construction loan from a commercial bank. Upon completion of the project, the insurance company honored its commitment, and, in the language of the trade, the bank was "taken out" of the deal. From then on, the developer paid the fixed interest and pocketed all the net income from his building. LESS MONEY, FEWER OPPORTUNITIES It isn't like that any more. The world of low-cost, high-value deals no longer exists, and the life companies have turned cash poor. Within the last year and a half, those that sell insurance with high cash values have been hard hit by heavy 539 demands for policy loans. With interest rates rising, many policyholders have grasped the chance to borrow on their insurance at statutory rates of 5 to 6 percent, and put the funds into triple-A bonds at 9 percent. At most major companies, policy loans have been running from 5 to 10 percent of 1969 assets. Companies that specialize in cash-value insurance, like Northwestern Mutual or National Life of Vermont, are lending out the equivalent of 15 percent and more of their assets. Even more significant is the rising ratio of policy loans to the insurance companies' basic cash flow, that is, to funds available for long-term investment in mortgages and securities. In many large companies policy loans came close to 40 to 50 percent of cash flow during 1969. And some insurers loaned out a greater amount on policies than their net income from operations. As a consequence, the insurance companies have less money to put into real estate. There are also fewer worthwhile projects to invest in. The cost of many proposed real-estate ventures these days is greater than their economic value. In 1965 a 300-unit housing project in California would have yielded a gross rental income of $540,000 and a net income of $324,000. Today that same development would gross $720,000 and net $432,000. Since 1965, however, capitalization rates have increased from 7 percent to 11 percent, reflecting the enhanced profitability of alternative uses of money. So, whereas that $324,000 net income made the property worth approximately $4,628,000 in 1965, today's $432,000 net translates into a value of only about $3,927,000. While the value of the housing development has fallen, the cost of building it has risen substantially. Whereas it could have been put in place for about $3,600,000 in 1965, the current price is close to $5,400,000, or about $1,500,000 more than it is worth. Today the 75 percent limit on insurance-company lending works the other way. A commitment to lend 75 percent of the economic value of the project would cover less than 75 percent of the cost (versus almost 100 percent five years ago). In today's market it might be wise to abandon such a project. Yet the decision in many cases is to go ahead. One reason is that developers are a breed of single-minded, incurable optimists. Lewis N. Wolff, head of corporate real-estate development at Twentieth Century-Fox, says wryly: "What we need in L.A. is a Developers' Anonymous. A guy with an idea for a project should be able to call up a half dozen friends in the middle of the night and get talked out of it." Insurance companies, on the other hand, are supposed to be a bit more hardheaded. H. Eugene Ross, vice president for mortgages at Aetna Life & Casualty Co. of Hartford, says: "We turn down 90 percent of the deals that are currently presented. They have potential negative leverage. In other words, the return per dollar invested could work out to be less than the cost of the debt." Some insurance companies, however, seem to be betting that the cost-value equation will be improved by a rise in rental rates or by successful effort* to bring costs under control. As a matter of fact, rates of return in real estate are capable of quick and dramatic escalation. A sudden spurt in the demand for office space in a particular location, for ex irurle, can push office rentals from $9 to $11 a square foot within a few months. If (axes, the most volatile of operating costs, are not increased, total expenses might stay at, say, $4 per square foot. As a result, net yield on the property will have risen from $5 to $7 a square foot, or by 40 percent. When such fortuitous economics can be predicted—which is sometimes the case—the project can be capitalized on the basis of the higher, future earnings rather than current earnings, much like a common stock. If the insurance companies cannot find enough new ventures with such prospects, they may be able to fulfill their real-estate objectives by buying existing values rather than trying to create new ones. Connecticut General, for instance, is still financing new ventures, but it is also devoting a good chunk of its re ilestate funds to buying older buildings whose potential appreciation in value is not yet fully reflected m market price. Last year the company obtained control of three large skyscrapers—the forty-two-story Mobil Building and the fortyone-story Continental Can Building in New York City and the forty-story Erieview Plaza in Cleveland. The $27,600,000 purchase was the largest deal ever made by Connecticut General and one of the biggest in U.S. real-estate history. A THREE-COURSE SPECIAL John Hancock Mutual of Boston, on the other hand, remains almost exclusively committed to financing new ventures. Hancock has the reputation, among 540 people in the real-estate business, of being the most aggressive lender. Although it did not invent equity participation, it has refined the concept to the point of maximum sophistication. In some senses, the company has proved a model for the rest of the insurance industry. Hancock makes two types of real-estate deals—one for the star developers who are able to resist giving up part of their equity, the other for the bit players. The company's favorite proposition for the ordinary developer is a three-part package, consisting of a ground lease, a leasehold mortgage, and an equity participation. The package works something like this: A developer has land worth $5 million on which he wants to build an office building that will be valued at $25 million. If he mortgaged land and structure together, he could raise .$22,500,000—i.e., 75 percent of the value. He can borrow more by separating the land from the building. First he arranges with Hancock to buy the land for $5 million and lease it back to him. Then he mortgages his leasehold estate to Hancock for 75 percent of the value of the building, or $18,750,000. In this way the developer gets a total of $23,750,000, or $1,250,000 more than if he had mortgaged land and building together. Moreover, he can deduct the ground rent as a. business expense, whereas if he had mortgaged the land he could have deducted the interest but not the amortization of principal. Hence the first two parts of the Hancock package are all to the developer's liking. The final part, however, is often extremely unpleasant. As a condition for making the deal, Hancock demands the right to buy, through a wholly owned real-estate subsidiary, a 50 percent equity interest in the building. Hancock would probably purchase this stake for about $1,875,000, or 10 percent of the size of its mortgage loan. The insurance company, of course, would put down no cash. As was the case with the land and mortgage money, it would pay for its equity with a commitment to provide funds once the project was completed. The developer must take this three-level commitment to a bank to pick up his construction money. Just as it might have done in the Fifties, Hancock ends up, in effect, meeting 100 percent of the cost of the project. But this is not because it has inflated its appraisal or because value is sufficiently greater than cost to justify 100 percent financing. Hancock has simply elected to supply that tier of junior capital which, in theory at least, the developer formerly had to provide himself. Hancock is so devoted to the idea of acquiring equity that if the developer came forward with his own equity money and said, "Lend me 75 percent of the value of the building. I can put up the rest," the insurance company would refuse. So, in fact, would many other companies. In the Fifties scrupulous lenders worried that developers had too little of their own equity in projects. Today the developers are not allowed to put any in! DEVOURING ALL THE CASH Although Hancock's package is a three-part affair, the company's short-term reward comes in four stages. Three payments accrue to it as landlord and mortgage lender, the fourth as equity participant. Hancock usually charges 9% percent interest on the leasehold mortgage, and about 9 to 9}4 percent of the land's value as ground rent. Then comes the kicker. After deducting mortgage and rent payments, taxes, and a predetermined amount for what it considers reasonable operating expenses, Hancock insists on 25 to 35 percent of the remaining cash flow. Moreover, this bonus interest is attached to the ground lease rather than the lease hold mortgage. (Hancock, in fact, calls it a variable ground rent.) This is because the mortgage is usually fully paid off in twenty-five years while the ground lease runs twice that long. At the end of twenty-five years, therefore, only about 21 percent of Hancock's initial land and mortgage investment remains in the deal—$5 million out of $23,750,000—but the company continues to earn a bonus interest based on its whole original investment. The fourth short-term reward represents a return on equity. Since the ownership of the project is split fifty-fifty, one would expect the remaining cash flow to be divided in that proportion. But such is not the case. Hancock insists on a 12 jpercent cumulative preferred dividend. In effect, the company treats its equity just like a senior security. On an equity investment of $1,875,000, for example, Hancock takes the first $225,000 before allowing the developer any part of the cash flow. If the project throws off less than $225,000, Hancock takes all there is, then adds the difference between that amount and $225,000 to its second year's return, and so on. In practice, after expenses, taxes, ground rent, debt service, kicker, and preferred dividend have been paid, the developer usually has no 541 current return. Indeed, he is unlikely to see any cash at all during the first five years of the project's life. Although Hancock is reluctant to admit that this is so, other lenders that have on occasion applied variants of the Hancock formula are less reticent. Hayden of Connecticut General saj-s flatly: "There are situations in which there will be no cash flow to the developer for four or five years while our equity is being repaid. But even when our equity is fully amortized, we are still a 50 percent owner, if that is the deal." Prudential, Equitable Life of Iowa, National Life & Accident of Nashville, New England Mutual, and Metropolitan Life all admit to making similar arrangements. The developer gets to share in cash flow eventually, but his chief reason for building the project is the possibility of capital gains. Initially he may make a profit on the sale of the land. Eventually, as an equity partner, he gets 50 percent of the proceeds of the sale or refinancing of the building. Since good real estate tends to appreciate in value, the long-term gain is, of course, substantial. (The developer may get still another recompense. The insurance company sometimes pays him a sizable management fee for superintending the construction phase of the project.) THE PACKAGE LOOKS TOO GOOD Hancock puts a high value on the potential earning power of its three-part package. Counting ground rent, mortgage payments, kicker, and return on equity, plus its share of the estimated sales value of the building, the company expects to earn between 13 and 20 percent on its money. "We may settle for 13 percent on some apartment buildings," says Emerson, who does a lot of the negotiating for Hancock, "but we can get up to 20 percent on motels. Our average investment should bring us something in the middle teens." Many others in the insurance industry are skeptical of such estimates. "This kind of return, or even a higher one, is possible on the equity portion of the package, but I doubt that it can be achieved on the package taken as a whole," says Carl H. Huebner, senior vice president for real-estate financing at Metropolitan Life. In other words, if Hancock made an equity investment that was leveraged b.y someone else's mortgage money, a 20 percent return is conceivable; when the company provides its own mortgage funds, even 15 percent seems ambitious. Some real-estate developers are convinced that Hancock can get into serious difficulties by reaching for such a high return. As one developer puts it: "The Hancock-type deal is so potentially profitable for the insurance company that the only people with whom it may work are the speculative developer or the developer with a speculative project." To be sure, several Hancock deals have already begun to founder. Emerson himself is disappointed with the results of some projects—particularly with investments in El Dorado County, California. And bad deals allegedly played a part in the downfall of Hancock's president, Robert E. Slater, who resigned last December, giving as his reason "broad policy differences" with the company's board of directors. When it negotiates with a star developer, Hancock moderates its demands. Hancock may eventually earn as much as or even more with this kind of partner than it would with a less-known entrepreneur, because there may be more money in a modest percentage of an outstandingly sound project than in a huge stake in a border-line deal. In its deals with Cabot, Cabot & Forbes, a firm with which it has done more than $50 million of business to date, Hancock gets a kicker in the form of a variable ground rent, but no share of the equity. The kicker usually amounts to 25 to 40 percent of net income. Cabot insists upon deducting all costs, including overhead, before figuring the bonus. It claims that Hancock's "standard" expense allowance is often so niggardly that a developer can end up paying Hancock a percentage of an income flow that he has never received. Cabot thoroughly enjoys it relationship with Hancock. Before the advent of the kicker, it rarely was able to get 100 percent financing of its projects. Although Hancock and other lenders often agreed to make a full mortgage loan, they frequently attached a "holdback" provision. For example if an office building cost $10 million to build, the insurance company might make a nominal commitment for $10 million but "hold back" $2 million until the building had been completely leased. Since a commercial bank would only lend up to the "floor" of the commitment, or $8 million. Cabot still had to acquire the outside funds. In practice, this 542 usually meant taking on partners—generally doctors and dentists with surplus cash. Rounding up these partners was hard work, living with them even harder. A knowledgeable—and remote—insurance company is certainly a more desirable money partner. Less fortunate developers who have to accept Hancock's three-part special would also be happy with the bonus interest kicker as a replacement for the holdback. Still, many don't mind too much giving up a share of the equity. They do object to the insurance company's demand for a preferred dividend and its refusal to put up seed or "front-end" money—i.e., spot cash with which the developer can buy the land and meet expenses during construction. "If the lender puts its money into the project during the planning stage when there is genuine enterpreneurial risk, it deserves up to half the equity," concedes Harry Newman Jr., a prominent Los Angeles shopping-center developer. What irks developers, Newman adds, is that the lender sits back without venturing a penny, while the developer locates and buys the site, talks the tenants into leasing, and constructs the building. Then it comes in with money, but no organizational expertise, and takes most of the return. Insurance companies contribute front-end equity only rarely and reluctantly. If the company were to become an equity partner at the beginning and the project ran over budget, it would be obliged to put up its share of the extra funds, unless it had negotiated a specific agreement to the contrary. Under current practice, any cost overrun is usually met by the developer. If he cannot get the extra cash, the insurance company can simply refuse to fund its commitments. HOW TO PRESERVE RESPECTABILITY When an insurance company takes an equity position, it often forms a jointventure partnership with the developer. The company can participate in the partnership directly, but might choose to assign its partnership interest to a wholly owned real-estate subsidiary, or to a mini-sub—a subsidiary of the major real-estate subsidiary. Most insurance companies prefer not to participate directly, since real-estate ventures carry the aroma of speculation. The companies are genuinely concerned about unfavorable policyholder reactions to their new emphasis on equity participations. By placing their real-estate interests in subsidiaries, they hope to avoid "tainting" the parent. The subsidiary can also protect the parent in more tangible ways. Most realestate ventures show sizable losses in the early years of operation. If the parent owned the real estate directly, these losses would show up on its balance sheet. In the insurance business this might have serious consequences. The major insurance companies actively compete for the management of corporate pension money, and corporate officials generally choose among insurance companies on the basis of their "return on new money," defined as the amount earned by an asset during the first year it was acquired. Conceivably, real-estate losses could lower a company's return on new money sufficiently to cause it to lose a fat pension account. By placing all real estate in subsidiaries, however, the parent skirts the problem. In most states the income (or loss) of an insurance company's subsidiaries cannot be consolidated with the parent's income. The subsidiary also shields the assets of the parent from the debts of the realestate joint venture. According to some insurance-company executives, developers are not above ordering materials for the account of the joint venture and using them on other, unrelated projects. When this occurs, creditors of the joint venture can attach the assets of the subsidiary but may not be able to "penetrate the corporate veil" to threaten the parent's assets. A RUBBERY RESTRICTION Finally, some insurance-company executives view the subsidiary as a handy device for circumventing legal limits on the percentage of assets that can be invested in real-estate equities. In most states insurance companies are allowed to put no more than 5 or 10 percent of total assets into real estate. Finding these limits a bit confining, companies have been lobbying the legislatures for higher ceilings—with some success. In New York, for example Governor Rockefeller recently signed a bill raising the limitation from 5 to 10 percent. But not all legislatures have moved fast enough to suit the more ambitious insurance companies. Stock companies like Aetna, Connecticut General and National Life & Accident of Nashville have found a solution in using the holding- 543 company umbrella. The life company and the real-estate subsidiary are no longer directly connected; both are now subsidiaries of the holding company. Since the real-estate subsidiary is divorced from the life company, it is unregulated and can operate without interference from the insurance examiner. Mutual companies, however, cannot use the holding-company device, since, by definition, they are owned by their policyholders and cannot be owned by another enterprise. Instead, the mutuals set up wholly owned subsidiaries, which are subject to the scrutiny of state insurance departments. In New York the examiners have ruled that the parent life company cannot do through a subsiaiary what it is prevented from doing on its own. If the parent cannot invest more than 10 percent of its assets in real-estate equities, parent and subsidiary together cannot breach this limit. But many states are more permissive. The amount that the parent can invest is regulated by statute, but the amount that the subsidiary can invest is subject to more or less informal negotiations between the company and the examiners. Conceivably, if the parent advanced money to the subsidiary for a real-estate venture, it could label 30 percent of the money "equity" and 70 percent "debt." The examiners might charge only the equity portion of the investment against the insurance company's asset limitation, enabling it to more than triple its involvement in real estate. HAVING THE BEST OF BOTH WORLDS Although the subsidiary route offers many advantages, it also has a few drawbacks. The subsidiary pays the full corporate tax rate, 48 percent, whereas the life-insurance company itself pays its taxes at a much lower effective rate. And when the subsidiary passes dividends to its parent, a second tax must be paid on them. A number of insurance-company lawyers feel that the potential tax disadvantages cancel any gains in operational flexibility. They believe, moreover, that the insurance company can obtain positive tax benefits and limit its liability for debts by another arrangement—one that combines a direct parent-company interest and an indirect subsidiary interest in the joint venture. According to this plan, an insurance company might negotiate a 50 percent equity interest and enter the joint venture itself as a 49 percent limited partner, while putting its subsidiary in as a 1 percent general partner. A general partner is entitled to participate in the management of the joint venture, but it is also liable for all the venture's debts. A limited partner has no liability, except for its initial investment, but neither has it the right to manage. By sharing its partnership interest with its subsidiary, the parent has the best of both worlds—the right to manage without exposing its own assets. This arrangement also provides a tax bonanza. As a limited partner the insurance company has an ambiguous relationship with the joint venture. On the one hand, it is a lender to the venture, receiving interest income from its mortgage; on the other hand, as a partner, it pays out morgage interest—in effect to itself. The income it gets as lender is taxable; the interest it pays as partner is deductible. The key to the tax advantage is that, for many insurance companies, the marginal tax bite on interest income is generally about 30 percent, while deductions for for interest paid are usually worth close to the full corporate rate of 48 percent. The difference arises because the investment income of a life company is divided into two parts: the policyholders' share and the company's share. While the company pays the full corporate rate on its own share, it is not taxed on what belongs to the policyholder. So its effective tax rate is lowered substantially. If the joint venture paid the insurance company $100,010 in mortgage interest, the company's tax liability on that would be about $30,000. But when the insurance company is a 49 percent limited partner in the fifty-fifty venture cited above, it is entitled to deduct $49,000 as its share of interest paid. That deduction would lower its tax from $30,000 to $6,480 (48 percent of $49,000 equals $23,520). If the insurance company were a 74 percent limited partner—in a seventy-five to twentyfive deal—its share of interest paid by the partnership would more than wipe out its $30,000 tax obligation on the mortgage interest it received (48 percent of $74,000 equals $35,520). In other words, the more substantial its equity position, the more the insurance company makes on its loan. And if it takes a big enough equity position, it can even raise its after-tax yield on interest income above its pre-tax yield. A number of insurance companies have only just discovered this bizarre tax wrinkle and are planning to use it for the first time this year. If the Internal 544 Revenue Service acquiesces, those companies may become even more insistent in demanding equity participation. And as long as mortgage money remains as scarce as it has been, few doubt their ability to enforce this demand. Mr. HOVDE. One final item; in regard to interlocking directorates it would be our hope that the regulatory agencies or departments with respect to the various financial institutions would best be able to handle and set up regulations for this. We would certainly trust that you did not lose the expertise—and that goes into allfieldshere—that would be sitting on the board. And if the regulatory agencies can handle this, they can certainly require full disclosure be had of any debtor in any position on the loan. Thank you, sir. The CHAIRMAN. Mr. Jackson. Mr. JACKSON. First, in fairness to Mr. Ashley, I would like the committee's permission to respond in writing for the record to his question. He asked me a question, and Mr. Hovde used it as an excuse to give a speech. The CHAIRMAN. When the record comes to you—one of you will have a copy of the transcript, and you may make the corrections you want and any additions you wish. Mr. JACKSON. Thank you, sir. I would also like to submit later for the record specific examples of the reports that exist with respect to participation loans and nonparticipation loans, I think I can offer specific examples quoted to us by life insurance companies which would be most helpful and of direct interest to the committee. The CHAIRMAN. Y O U may submit that. Mr. JACKSON. Thank you, sir. (In response to the information requested by Mr. Ashley, the following letter with attachment was received from Mr. Jackson:) M O R T G A G E B A N K E R S ASSOCIATION OF A M E R I C A , Washington, D.C., April 80, 1971. H o n . THOMAS L . ASHLEY, Member of Congress, House of Representatives, Washington, D. C. D E A R M R . A S H L E Y : Y O U asked me two questions during the hearings on the equity participation section (14b) of H.R. 5700 which I agreed to answer later in writing for the record since the limits on your time did not make it possible to answer them fully during the hearing. The first question concerned the ability of builders to continue building apartments and commercial developments during periods of credit restraint by offering equity participations to a lender. You questioned whether a social purpose was obtained by such financing when the result was to divert funds from housing. In answer let me first commend you for looking at the whole picture of equity participation and its relationship to the economy and improvement of the country rather than the narrower view of builder and lender relationships. When money becomes tight, all real estate finance suffers disproportionately to the rest of the economy. Single family homes most of all. Apartments and commercial developments to a lesser extent because of their better ability to compete with others for available funds. This country as yet has no national board to determine who gets how much for what when money gets scarce. One system we now have to channel funds for housing in preference to other uses is the tax advantages and other privileges given certain financial institutions such as members of the Home Loan Banks who in turn are asked to invest their funds in housing loans. Recently even these institutions, in order to secure higher returns on their investments, have received authority to invest a larger proportion of their assets in non housing loans. 545 During the decade of the 1960s, demographic factors have been responsible for the substantial increase in demand for, and construction of apartments. Actually, the ability of apartment builders to engage in equity participation financing helps housing during tight money periods. For example, the proportion of multifamily to total housing starts rose rapidly in recent years because of this ability to compete for available funds. Since multifamily units generally cost less than single famity ones, this aids in reducing inflationary pressures while still providing housing. Your second question on the possible increased rental cost to a tenant as a result of equity participation financing indicates doubt that lenders do in fact lower their fixed interest costs on loans including participation features below that wanted for fixed return loans. To help resolve that doubt I am enclosing a copy of a letter from the Aetna Life Insurance Company to all of its loan correspondents which states the difference in rates quoted at that time on both fixed and participation type loans. It is obvious from this letter that the lender will initially receive less, enabling the builder to charge less to tenants, if the lender shares in the future increased charges the builder makes to the tenants. Any increase in rents is under the sole control of the builder not the lender. In return for a lower interest rate the lender shares with the builder in the risk of future increased rent. This lesser fixed cost should make it economically possible to build apartments and other buildings at lower rentals than otherwise possible. Thank you for this opportunity to answer your questions. If you wish them amplified, we will be happy to do so. Yours very truly, PHILIP C . JACKSON, J r . , First Vice President. AETNA LIFE & CASUALTY, Hartford, Conn., February 4, 1971. R O B E R T L . PETERSON, Regional Director, Real Estate Investment Department. To A L L CORRESPONDENTS: Recent changes in money market conditions permit us to reduce the rates acceptable to us for new applications for loans on income properties and enable us to advise you that, based on presently predicted cash flow, we can increase the volume of 1971 commitments over those of 1970 by about 35%. In addition, our allocation of funds to be disbursed in 1971 has just been increased. Under the circumstances we will be more inclined to approve loans at our most favorable rates if disbursement is possible in 1971. Effective immediately and until further notice, we are willing to consider loans in accordance with the following guidelines: (1) A gross rate of 9% with contingent interest based on 15% of rental income over stabilized gross income after vacancy allowance as established in the appraisal. We will expect a 2% standby fee, in cash or Letters of Credit, 1% of which will be returned upon execution of a "Buy-Sell Agreement" and 1% upon our disbursement of the loan, or (2) A gross rate of 9J^% without provision for contingent interest but with a 1 % non-refundable commitment fee which is to be paid to us at the time we issue our commitment. In addition to the commitment fee we will expect a 1 % standby fee, in cash or Letters of Credit, returnable to the borrower upon our disbursement of the loan. It is to be noted that these rates are to be used only when security and competitive circumstances do not indicate higher rates. We continue to prefer a basis providing contingent interest, particular^- when the income stream from the property is likely to show continual increases in gross rentals. In instances where the income stream, due to long term leases, etc., is expected to remain static a higher contract rate with a commitment fee will be preferred. In the case of a motel loan we will require a minimum rate of 9}£% with a meaningful contingent interest factor based on gross room, food and beverage sales. We will continue to require "Buy-Sell Agreements" with each loan. We continue to encourage joint ventures with experienced developers or transactions involving the purchase leaseback of land plus a leasehold mortgage loan. Such ventures will be negotiated on a case basis but it should be recognized that the combined mortgage-equity yield (but not necessarily the mortgage yield alone) should be proportionately" higher than a typical mortgage yield to offset the added risk involved. 546 Generally speaking, loans less than $500,000 should be developed without the contingent interest feature. We suggest that you contact us prior to preparing a complete loan submission, or, if you find any substantial changes in the market in your area that you keep us informed. Very truly yours, R. L. PETERSON, Regional Director, Real Estate Investment Department. T h e CHAIRMAN. M r . F e y . Mr. FEY. First, I would like to address myself to the use of the term "equity participation.,, I think the confusion that apparently exists here today very graphically explains our concern for labeling a percentage income provision as an equity participation. This is a very broad and sweeping bill that includes a large number of credit transactions, as I pointed out initially, ranging from convertible bonds to debentures, notes with warrants, to joint ventures. We should not for a moment confuse a joint venture with the loose term "equity participation" used on an income participation transaction. So I say, above all, let us keep these terms straight. If there are abuses in this particular area of lending, it is essential to approach these abuses with a clear definition of terms. The term "shadow warrant" is a term that is not well known in financial with. It only demonstrates the fact that the use of the broad term "equity participation" as a condition to making a loan is a vague, sweeping generalization that would have a very serious impact on the flow of capital, a serious impact on our securities markets, and a very detrimental impact upon borrowers. Now, reference has been made to the Fortune article. The Chairman has asked that this be introduced into the record. I think that one observation should be included in the record if that article is a part of the record. That is that our companies are restricted in the amount of real estate that they may own by State laws. These restrictions range generally from about 5 percent of their total assets to a maximum of 10 percent of the assets which may be invested in real estate operations. Currently of the one trillion 459 billion dollars of nonfarm real estate in the United States, one-half of 1 percent of this is owned by life insurance companies, of which one-fourth is used for home office purposes. If—and I say if as a hypothetical—if all of these companies used the upper limits of the State limitations, then the entire holdings would only be one and three-tenths percent of the real estate of the United States. So how the life insurance companies could become the future landlords of America is something far beyond me on these percentages. Mr. Chairman, I thank you for this opportunity. The CHAIRMAN. All right, Mr. Terry. Mr. T E R R Y . Mr. Chairman, I think it is worth commenting on what business the real estate developer is in. I think we are in the business of manufacturing real estate value. That value has to be in excess of what the project costs us. Several years ago, because of differences in money conditions, a 75percent loan enabled us to cover the cost of a project. Today that is not true. Our choices were to stop building, or to keep moving ahead. We choose to keep moving ahead in a profitable way. Therefore we 547 come around to the sale of equity to attract capital. We would prefer to attract that capital from an institutional source, banker or insurance company pension fund, rather than go the securities market. The ability to attract long-term debt is vital to us. When we make a loan with an insurance company we are doing so for 25 or 30 years. Our corporate credit is normally not involved. We have their money for a long, long time on which to make a profit. Being motivated by inflation is to us a very understandable thing. And we do not feel really that it operates to our disadvantage to give a kicker on a loan. Thank you very much. Mr. FEY. May I request time for Mr. Hayden. The CHAIRMAN. G O ahead. Mr. HAYDEN. Mr. Chairman, the insurance companies have been beaten up pretty badly on the question of housing today. I think I would like to give you an example of what our particular company is doing right now. We are involved in eight joint enterprises which currently would be creating a total of 18,274 dwelling units. This is joint enterprises, eight of them in number. Of these eight, seven would clearly be illegal under the provisions of section 14. The one which would be legal is one in which a developer at his own request has asked to do a job for a fee only, he wants no equity interest. Of course, this suggests the possibility that in future, if we cannot engage in joint ventures, joint enterprises as we have, we would be forced to do a much smaller number, using developers working for a fee. We do not think it is in the best interest of the developers, and we do not think it is in our best interest. I am appealing to you not to rule out the legitimate joint enterprise, because it is very important for the future growth of the country. Just to put thefiguresin perspective the number of units and loans in which we have one form or another of equity participation involves a total right now of about 5,400 units. Thank you. The CHAIRMAN. I predict this record will be well read by Members of Congress and by people all over the Nation who are interested. The way this is handled—of course most of you gentlemen are familiar with it—this record will be approved by the witnesses who have testified, and by the Members of Congress who participated, and then it will be printed by the Government Printing Office, and thousands of copies will be made available to the libraries of the country and the interested people who write to their Members of Congress for copies. I suggest here that every citizen of this Nation has three people that he should freely write to in the event he wants something from the Congress of the United States. First, he should write to his own local Representative, his local Congressman, or one of his U.S. Senators, or both of his U.S. Senators. And if it is a pressing thing, write to the President of the United States, because those four are elected in the election process in which you participated whether you actually voted or not, because you had a right to participate, and you have a right to call on people who are elected in the election process who represent your area. So I would suggest that you write to your own Congressman first, and either one or both U.S. Senators next. 548 Thank you gentlemen, very much for your participation. I feel this has been a very fine session. No one member wants to do any one of you wrong, we want to do right, and the only way we can do right is to know the facts. You have given us facts that we did not know. And I personally appreciate it very much. Thank you, gentlemen. The committee will stand in recess until 10 a.m. tomorrow. (The following letter from Mr. Terry was received by the committee for inclusion in the record:) JAMES W . R O U S E & C o . , INC., MORTGAGE BANKING AND R E S E A R C H May 5, 1971. H o n . WRIGHT PATMAN, Chairman, Committee on Banking and Currency, House of Representatives, Rayburn House Office Building, Washington, D.C. D E A R CONGRESSMAN P A T M A N : After reviewing the Report of Proceedings for H.R. 5700, held on Wednesday, April 28, 1971, I feel some clarifying statements are necessary concerning the financing of Columbia. I hope it will be possible to have the following clarifications included in the record. We began the Columbia venture in 1963 in cooperation with the Connecticut General Life Insurance Company. Connecticut General, via a mortgage loan, advanced sufficient funds to acquire almost 14,000 acres in Howard County, Maryland. Connecticut Generals' mortgage loan eventually built to almost $23,000,000. Our original arrangement with Connecticut General was that they would own one half of the development entity in Columbia (Howard Research and Development Corporation) and we would own the other half. We weie responsible for the management and affairs of HRD, and Connecticut General was responsible for supplying all the money needed in the early years. The Connecticut General financing was refinanced several years later by a $50,000,000 loan from Connecticut General, Teachers Insurance and Annuity Association, and The Chase Manhattan Bank. The interest paid on that loan is as follows: Percent Connecticut General, $15 million 6 Connecticut General, $10 million 8 Teachers Insurance and Annuity Association, $15 million 6 Chase Manhattan Bank, $10 million 8 The interest cost on money borrowed from Connecticut General was arrived at as being no more than we had to pay to other investors buying part of the $50,Ot0,000 issue. Therefore, the 7.3% overall average paid to Connecticut General is the same average as is paid to the other two investors. It is interesting to note that the reason the Teachers loan is at 6}4% is that they have an option to acquire a stock interest in HRD. The Chase Manhattan Bank choosing not to take that approach charged an 8}i% interest rate. Not long ago we added to the overall Columbia financing by selling further debt to Manufacturers Hanover Trust, Morgan Guaranty, and Connecticut General an additional $30,000,000 bringing our total debt to $80,000,000. It was a great honor to appear before the Committee, and I hope my testimony may have been of some value to you. Sincerely, WALTER F . TERRY III, Vice President. (The following are written questions submitted by the Honorable Frank Annunzio to the National Association of Homebuilders, along with their answers:) ANSWERS TO QUESTIONS SUBMITTED TO NATIONAL ASSOCIATION OF HOMEBUILDERS BY H O N . F R A N K ANNUNZIO Question 1. Ifou bring out some shocking facts concerning equity kickers. Could you estimate how much higher rents would be for low- and moderate-income housing when equity participation is forced on the builder by the lendert 549 Answer. Equity participation lias to cause higher rents. Certainly the increase in rents is greater in those projects where the base rent is higher. However, we have put together three examples based on a moderate size project with rents fairly typical of those in moderate income projects being built without any subsidy assistance. These examples illustrate now the rents are forced up as a result of the equity participation on top of a 9 percent mortgage interest rate. ILLUSTRATIONS OP E Q U I T Y AND INCOME PARTICIPATION AND T H E I R IMPACT ON RENT HYPOTHETICAL PROJECT—ECONOMIC DATA Type of Property: Apartment (288 units, 1,114 rooms) Cost: Land Building $580,000 3, 220, 000 Total. First year: Gross income 5 percent vacancy 3,800,000 679, 920 33, 996 645, 924 Nine percent=25 years $2,800,000 mortgage. It is assumed that net income to owner remains the same and operating expenses increase at 5% per annum. However, effective gross income will have to increase differently for each example in order to maintain the same owner's net income over the time period. These examples assume that the market will support increased rents necessary to cover the projected increase in expenses and maintain the owner's net over the time period. EXAMPLE 1 PERCENTAGE OF GROSS INCOME Participation: 3 % of all gross income collected. Assuming the rate of increase in gross income is 5 % per annum. Effective gross income Expenses Debt service Total Net operating income Owner's net Equity participation Equity participation/unit. EXAMPLE Today In 5 years In 10 years 1645,924 258,370 282,240 $712,514 322,963 282,240 $779,104 387,555 282,240 540,610 605,203 669,795 105,314 85,936 107,311 85,936 109,309 85,936 19,378 67 21,375 74 23,373 81 2 PARTICIPATION IN PERCENTAGE OF INCREASED RENT OVER PROJECTED RENT ROLL Participation: 20% of increases in rental income over projected rent net roll ($645,924). Effective gross income Expenses Debt service Total Net operating income Owner's net Equity participation Equity participation/unit Today In 5 years In 10 years $645,924 258,370 282,240 $726,665 322,963 282,240 $807,405 387,555 282,240 540,610 605,203 669,795 105,314 105,314 121,462 105,314 137,610 105,314 0 0 16,148 56 32,296 112 550 EXAMPLE 3 PARTICIPATION IN INCOME OVER B R E A K - E V E N POINT Assume amount of participation is 20% of all income over "break-even point", defined as expenses plus debt service. Today In 5 yrs. In 10 yrs. Effective gross income Expenses Debt service $645,9?4 258,370 282,240 $710,517 322,963 282,240 $775,109 389, 555 282,240 Break-even point Net operating income 540,610 105,314 605,203 105,314 669, 795 105,314 Owner's net 84,251 84, 251 84,251 21,063 73 21,063 73 21,063 73 Equity participation Equity participation/unit Question 2. Can you give us some specific cases or illustrations of the pressures ut on you as builders to allow equity participation by the lender—in other words, ow bad is it in specific instancest Answer. We have mentioned some of the cases of the pressures put on builders to give an equity participation to a lender in Mr. Stastny's and Mr. Martin's statements during the hearing. What in effect occurred over the past two years was action on the part of many lenders, primarily insurance companies, conditioning making of loans for the construction of apartment projects on the granting of an equity participation to them. As a builder-borrower you either gave an equity participation to the lender or you did not build. As a result, many builders, rather than go out of business entirely, capitulated and granted an equity participation or kicker to the lender. (The following material was submitted for inclusion in the record:) STOCKTON, W H A T L E Y , DAVTN & C o . , Be HR 5700—"Banking Reform Act of 1971". Hon. WRIGHT Jacksonville, Fla., May 5,1971. PATMAN, House of Representatives, House Office Building, Washington, D.C. DEAR CONGRESSMAN PATMAN: As one who has spent a lifetime in the real estate and mortgage loan business,. I am greatly disturbed over Section 14 of HR 5700 as I feel it is not in the public interest for the futurefinancingof real estate. If my interpretation of this section is correct, it would preclude any participation by any lender in any equity interest or contingency whatsoever in properties financed. The building and development industry is probably the nation's largest and is also the most undercapitalized. Some experts have estimated that it will take somewhere in the neighborhood of $7 trillion in long-term capital if the United States is to meet its urban growth objectively by the year 2000. The most optimistic projections of our conventional savings and institutional growth and investment patterns do not come anywhere close to providing the amount needed for real estatefinancing,and most economists support this view in predicting that we are in for a long period of capital shortage. To meet this need in the future it will require vastly more equity investment than at any time in the past. Yet, Section 14 deprives thefinancialinstitution of the option of investing in an equity unless it is prepared to put in 100% of the equity, or it can make conventional mortgage loans but only to the extent that inadequate supplies of noninstitutional equity money are available. In my opinion, neither option is viable. From a realistic viewpoint, I do not believe that 100% equity investment will be available in a prolonged period of capital shortage, nor do I believe that institutions will go beyond normal mortgage limits. It appears to me that if Section 14 is not eliminated from the Bill, it will concentrate all of the major real estate development and city building in the hands of major corporations and eliminate the individual and smaller developer which has made such a great contribution to the building of this great country 551 of ours. My personal opinion is that the conditions which we are operating under now are very good, as the small entrepreneurs can leverage their capital, skills and talents with institutional equity capital and, as a result, continue building well-planned and cohesive developments as they are doing today. The developer deprived of an opportunity to so leverage his equity capital, talents and skills, has no other alternative than to sell out to a major corporation. From my observation, most major corporations are not well-suited to real estate development except where their roll is that of afinancialpartner. Under Section 14 it would make it immensely more difficult or impossible for financial institutions to befinancialpartners. The often preferred structuring of such a partnership is for thefinancialpartner to inject dollar equity to match the developers equity investment of his skills and talents; thereafter, the financial partner puts in his money a$ a loan to the venture. Section 14 would prohibit this which I do not feel is healthy or in the public interest, as I feel the developers and builders should retain the right to leverage their equity capital and thus their skills with institutional equity money in order that the nation may enjoy the better-planned, the better-developed projects that give proper attention to amenities, open space and other environmental features. I would urge your serious consideration in deleting Section 14 from HR 5700, Sincerely, JOHN A . GILLILAND, First Vice President. R O Y A L STREET CORP., New Orleans, La., May 3, 1971. Hon. WEIGHT PATMAN. House of Representatives, Washington, D.C. DEAR CONGRESSMAN PATMAN : I am writing to you with reference to Section 14 of HR 5700, entitled "Banking Reform Act of 1971". It is my understanding that the purpose and intent of Section 14 is to prohibit lending institutions from accepting equity participation in consideration of making any loan. I am president of a company that has been involved in real estate development, which includes the planning of a large residential housing community, and all negro housing development some years ago, a small housing development in California, a regional shopping center, hotels, and now a major recreation oriented community near Salt Lake City, Utah. From my experience, I have some grave misgivings about Section 14, which I would like to set forth in this letter. In making my point, I would like to use as an example our project in Utah. Our plans call for the development of a recreation oriented community, accommodating ultimately some 30,000 people. It's recreational base is skiing in the wintertime; golf, hiking, fishing, tennis, etc. in the summer. It is only some 20 minutes drive via an interstate highway to the edge of Salt Lake City itself. One of its purposes will be to augment the Salt Lake City housing supply. A second purpose will be to develop a significant tourism activity, which is very important at this time to the State of Utah. Utah, because of its geographic location, has difficulty in attracting manufacturing or distribution businesses. Its economy now depends too heavily on mining and the state has recognized that it must look to tourism as an important future industry. Our activities, therefore, in addition to being profitable we hope to us, will serve to create many new and badly needed jobs in the somewhat depressed Salt Lake City area. It has. therefore, been heartily welcomed by the governor and other state officials. This sort of endeavor will over the years involve great sums of money and greater than average elements of risk. Projects of this sort have to be undertaken without the great pool of experience that is available for the planning of more conventional projects, such as urban housing developments, shopping centers. office buildings, etc. The markets are not nearly as well defined or as reliable. Attracting the amounts of capital necessary, therefore, becomes a serious problem. Obviously, the participation of major lending institutions is vital. In view of the risks involved, it is inequitable in my opnion to call upon lending institutions to take the exposure they must in lending to a recreational oriented project, such as ours, without giving them the opportunity to participate in the rewards should they be forthcoming. It is my opinion that if such lending institutions are prohibited from taking part in equity financing of this sort of unusual project, they would decline to participate at all, thus making the proj- 552 eot impossible. While the enactment of Section 14 of HR5700 may appear to be desirable for many reasons, it will work a severe hardship on housing and real estate developments, which are novel in concept and which are in a sense exploring new ground and, therefore, where the risks are above average. Our experience in cases such as these is that the presence of a sophisticated corporate lender as an equity partner does not work a hardship on a developer. On the contrary, it is the catalyst which makes the project possible. It is my opinion, therefore, that the enactment of Section 14 in its present form would l»e unwise for 1 believe there are many situations where it will do great harm and be a disservice to the public interest If I or any of my associates can be of assistance to your committee, we'd be most anxious to in this regard. Respectfully submitted. EDGAR B . STERN, JR., President. May 5,1971. Hon. WRIGHT PATMAN, Member of Congress, Chairman, House Committee on Banking and Currency House Office Building, Washington, D.C. DEAR CONGRESSMAN PATMAN : I am worried about the implication of Section 14 of HR 5700 now being considered by your committee. This section would make it illegal for any lender to participate in any equity interest or contingency in propertiesfinancedby him. I assure you that I have no direct personal or professional interest in the question since I neither develop nor finance development of real properties. I am worried that the effect of Section 14 will be to cut off theflowof funds to finance real estate development which the United States can ill afford in this tight property and residential market It appears to me that thefinancialorganization and the development organization are indeed partners—one to furnish finance and the other to provide entrepreneurial planning and development to the project. Why should not both elements share in any reward? The building industry today is both the nations largest and the nations most under capitalized. Please consider again before providing additional penalty to the attraction of new and additional capital which is badly needed by this vital industry. Sincerely yours, W. M. COOPER. PRESIDENTIAL REALTY CORP., White Plains, N.Y., Map 6,1971. Hon. WRIGHT PATMAN, The House of Representatives, Washington, D.C. DEAR CONGRESSMAN PATMAN : As an officer of this publicly held real estate development company, I would like to voice my opposition and the opposition of my company to section 14 of H.R. 5700 (Banking Reform Act of 1971). To legislate against lenders' obtaining a percentage of equity in real estate in consideration of their making mortgage loans will, in our opinion, lead to a worse alternative, increasing the fixed rate of interest which lenders will charge^ thereby making more hazardous to the developer the creation of new real estate. It will lead to higher fixed charges, higher rents, and an increased bankruptcy rate, especially for the medium-sized entrepreneur. Please vote against the section. Sincerely yours, JOSEPH VIEBTEL. STANDARD MORTGAGE CORP., New Orleans, La., May 6, 1971. H o n . WRIGHT PATMAN, House of Representatives, Washington, D.C. DEAR SIR : I am very much opposed to the enactment of Section 14 of H.R. 5700, entitled Banking Reform Act of 1971. As I understand it, this bill deprives . institutions such as insurance companies and mutual savings banks from investing in real estate equity unless they can put in fell the equity. I feel this will 553 greatly reduce the amount of money that will flow into our geographical area l'rom these institutions. The building and construction needs of the South and Southwest and in particular, Louisiana, are great. Our capital short area must attract capital to fulfill these needs from the institutions defined in Section 14. If Section 14 becomes law, funds from these institutions will flow into other investments and, therefore, stifle the new projects we so desperately need. Very truly yours, EDGAR BRIGHT, Jr. NORTHLAND MORTGAGE CO., Minneapolis, Minn., May 11, 1011. Re Banking Reform Act of 1971 BLR. 5700, section 14. R e p r e s e n t a t i v e WRIGHT PATMAN, Chairman, House Committee on Banking and Currency U.8. House of Representatives Washington, D.C. DEAR MR. P A T M A N : A t t a c h e d i s a copy of a letter I h a v e w r i t t e n t o m y Con- gressman, William Frenzel of Minnesota, to voice my personal opposition and that of the Minnesota Mortgage Bankers Association to the legislation contemplated by Section 14, H.R. 5700. Our company is engaged in real estate development, mortgage banking and real estate brokerage. In no capacity do we directly benefit from a lender's ownership of real estate or their participation in income or profits from a property they havefinanced.On the contrary, as developers and mortgage borrowers we end up paying the lenders the additional interest; as mortgage bankers, we take on additional loan servicing burdens without additional compensation; and as real estate brokers, we may lose the commissions from selling the equity in a project if the mortgagee buys an equity i>osition directly from the mortgagor at the time the loan is made. Nonetheless, we oppose Section 14 because we know that it will have no positive effects on the future of real estatefinancingbut instead will be detrimental to the borrower, the developer, the mortgage banker and the broker. The lenders won't be badly hurt—they'll simply jack-up their rate requirements, be more selective on real estate loans they make, and divert large amounts of investment funds away from real estate and into the bond, stock and private placement markets. We also contend that institutional lenders make good partners for the knowledgeable, professional real estate developer. Lenders have plenty of money and a sound understanding of real estate economics; their yield requirements are less •than private investors; they are generally satisfied at being passive partners who do not interfere with the developer's efforts; and, finally, they have a habit of requiring higher quality Standards which results in better real estate developments. Real estate equity money must come from somewhere! If we can't get it from financial institution's, we'll have to get it through expensive secondary financing or from large corporations, who will certainly make less agreeable partners. Very truly yours, LAWRENCE J . MELODY, Vice President. NORTHLAND MORTGAGE Co., Re Banking Reform Act of 1971, H.R. 5700, section 14. Representative WILLIAM FRENZEL, May 11, 1971. Longworth Office Building, Washington, D.C. DEAR BILL: As a friend and constituent I would like to comment on Section 14 of the Banking Reform Act to let you know how it will affect our business as real estate developers, real estate brokers and mortgage bankers. As Chairman of the Legislative Committee of the Minnesota Mortgage Bankers Association, I also want to formally announce our Association's opposition to Section 14 of the bill. 60-299—71—pt. 2 8 554 As a real estate developer, our company borrows money to provide most of the cost of our new real estate projects. As do most developers, we seek to leverage our investment by borrowing the most money at the lowest interest rate for the longest term. We certainly do not "give-away" equity participations to lenders, but we're also certainly receptive to selling to lenders all or a part of our equity interest in Teal estate projects on the same kind of basis as we would sell to any other individual, partnership or corporation. To legislate to prohibit lenders from being a "buyer" of real estate equities is to eliminate an important source of equity dollars, which are more important to the continuance of real estate development than are mortgage or debt dollars. As mortgage bankers, our role is to attract new debt and equity financing to Minnesota. To keep new money coming to our state to finance apartments, commercial and industrial properties, we must be competitive in the national money market for available funds. Our developers need equity funds as well as first mortgage funds and it is often more convenient and less expensive for them to find a joint venture partner or borrow equity funds from the first mortgagee or another lender than it is for them to otherwise try to find a partner willing to put up substantial equity dollars. Negative legislation such as that proposed by Section 14 will have a disastrous effect upon the real estate business nationally. Instead of legislating to encourage lenders to direct more funds into mortgages and real estate. Section 14 prohibits such lenders from making a valuable contribution toward solving our national housing problems; instead, it will encourage lenders to divert funds normally earmarked for mortgage and real estate investments and invest these funds infixed-yieldingbonds and common stock, where yields are equivalent, risks are lower, liquidity is higher and the mechanics of investment are simpler. Section 14 will cause lenders to charge higherfixedrates and make loans for leaser amounts than is customary where the lender either owns a part of the property or agrees to participate in future profits, if available. The only party to suffer is the borrower who will be required to pay the higher rates whether or not the property is profitable. He will also be required to put ut> more e«nity funds just to get the loan. Since most real estate developers do not have large sums of equity money, they will be required to pay high rates of interest for second mortgages. As an alternative, they will be required to find equity partners—probably large corporations with little interest in the real estate— and the price they will have to pay such partners will far exceed the price expected by institutional lenders. To illustrate the value of a lender's equity participation in a loan, I'd like to use some examples of alternative financing packages we can now offer a real estate developer of an apartment complex to cost him $900,000 and have a value upon coirwlPtiou of $1,000,000: (a) A loan of $750,000 at 9% interest for 25 years with no lender participation. (b) A loan of $750,000 at 8% interest for 27 years plus 2% of gross income as additional interest. (c) A loan of $750,000 at 8% interest for 27 years plus 15% of increases in gross income as contingent additional interest. (d) A loan of $750,000 at 8% interest for 30 yenrs plus an equity contribution of $150,000 or totalfinancingof $900,000 (100% of costs) with the developer and lender to equally share ownership and profits after payment of all expenses and debt service. Most knowledgeable developers would pick the fixed-rate, no participation alternative last. They would prefer to have the lender get the extra 1% interest onlv if the project is successful. Competition in the national money market is generallv so keen that lenders must Wretch to finance high-aualitv real estate deals. By allowing lenders to participate in profits and ownership, we encourage them to be more competitive in loan terms and more innovative in structuring various types of financing. Section 14 would, instead, encourage lenders to eliminate their competitiveness and set up similar rate structures for various types of real estate financing. We know that you are presently participating in hearings on this bill as a member of the House Committee on Banking and Currency. We hope that you 555 will oppose passage of the bill because of the potentially damaging effect of Section 14 on the futurefinancingof real estate. Very truly yours, LAWRENCE J . MELODY, Vice President. STOCKTON, W H A T L E Y , D A V I N & C o . , Jacksonville, Fla., May 12,1971. Hon. WRIGHT PATMAN, House of Representatives, Washington, D.C. DEAR CONGRESSMAN PATMAN : I am quite concerned about the potential effect of proposed Section 14, HR 5700, "Banking Reform Act of 1071" as it may vary well greatly handicap the entire housing and real estate industry. As you well realize there is a tremendous need at this time and in the future for housing and development to meet the needs of this growing nation. Section 14 would appear to preclude and prohibit equity interest participation by lenders infinancingproperties. As in many industries in this country, the individual and smaller developers have contributed greatly and this Bill would appear to restrict or eliminate their activities as they are invariably in need of capital and in many cases equity prticipations present the only method by which they can obtain such capital. If these small businessmen are eliminated from the building and development business, then such activity must inevitably be assumed or undertaken by major corporations which, 'by their very size, frequently do not appreciate the industry needs. The growth of this country will require that housing and development be well planned and that attention be given to the proper development of areas, particularly the environmental aspects. I sincerely ask that you review the many implications of Section 14 and eliminate such Section from this Bill. Very truly yours, BROWN L . WHATLEY, Chairman of the Board. H O M E R E A L T Y AND MANAGEMENT Re Banking Reform Act of 1971. H.R. 5700. Hon. WRIGHT PATMAN, CO.. Charlotte, N.C., May 12, 1971. Chairman, House Committee on Banking and Currency, U.S. House of Representatives, Washington, D.C. P E A R M R . P A T M A N : We notice under Section 1 4 of the above bill that you and your committee are considering a politically popular reform which would eliminate equity participation by mortgage lenders. We feel that this would constitute a severe hardship for the independent mortgage banking industry as well as the indejindent developer. For example, we discussed this with Mr. Henry Fnison of Mast on. Fnison and Weathersi>oon on yesterday and he agrees with us completely. We liMve winced m^rtgipe loans for this firm which has actively developed shop?»int? renters In North and South Carolina counties having populations of about fiO.OOO to 75.000 persons. This has been a real service to the little man of this country as these people were forced in past years to nurchase only at 100% plus ret oil prices from old line merchants. In other words, there was not competition in the areas. During tight money periods it would have been absolutely impossible for this service to have lieen rendered to the general public without pnrt Vrwition by the lender. Further in this general connection, we feel that the life insurance industry definitely should be excluded from this provision. The life insurance industry basically creates funds for widows, orphans, children, and the aged. Most life insurance plans today have participating features as an attempt to combat inflation for these persons. It would indeed be a disservice to them to restrict inflation protection in the form of participation by life insurance lenders. We certainly agree with you and your committee in attempting to control the financial industry. We abhor the fact that many financial institutions hnve created monoi>olistic lending practices and have entered into the general insurance. property management, property development, etc. fields. These matters 556 must be controlled and we definitely need control on 18% interest charges assessed the small borrower in this country. Small businesses and the small borrower need your help in controlling these factors. Equity participation, on the other hand, is something that should be allowed particularly on loans for terms of over twelve years and on amounts in excess of $500,000. Further in connection with equity participation, the large developer which is fast coming under the ownership of big business, will have a field day in developing through the device of convertible debentures in order to circumvent your proposed legislation. This will eventually wipe out the medium range developer who is doing the job for the small man in this country. We hope that you will consider the contents of this letter which are written to you with our most sincere belief. This is shared by the other senior members of thisfirmwho represent over 100 years of experience in the mortgage banking business, particularly associated with the life insurance industry. Very truly yours, S. T . HENDERSON, Executive Vice President. EQUITABLE OF IOWA, Des Moines, Iowa, April 28, 1971. Hon. WRIGHT PATMAN, House of Representatives, House Office Building, Washington, D.C. DEAR MR. PATMAN : It is my understanding that the House Banking and Currency Committee has begun hearings on H.R. 5700. Section 14 of this bill, relating to equity participation, contains serious long-term and far-reaching economic implications which I urge that your Committee consider. If America is to meet its urban growth objectives during the remainder of the Twentieth Century, the long-term capital requirements are staggering. There will be a need in the future for vastly more equity investment than in the past Section 14 of H.R. 5700 deprivesfinancialinstitutions of the option of investing in equity unless they are prepared to advance 100% of that equity. As an alternate, they can make conventional mortgage loans but only to the extent that adequate supplies of noninstitutional equity money is unavailable. In a period of prolonged shortage of capital, 100% equity investment will not be available and institutions such as life insurance companies cannot go beyond loan to value regulations prescribed by applicable state laws. Section 14 has the strange effect of saying that two legal separate actions both become illegal if combined. The result is both harsh and unfair and detrimental to the economic well being of the nation. In the past few years, it has been demonstrated that the developer with his "know how" and limited capital and thefinancialinstitution with its available funds can cooperatively work for that benefit of one another, as well as for the general economy and well being of the country. I respectfully urge that your Committee give serious consideration to the removal of the restrictions inflicted on both the building and development industry andfinancialinstitutions by the provisions of Section 14. Respectfully yours, JAMES B . SMITH, Mortgage Vice President. N E W Y O R K , N . Y . , May Hon. WRIGHT PATMAN, 4. 1971. Chairman, House Committee on Banking and Currency, House of Representatives, Washington, D.C. DEAR MR. PATMAN : As afinancierwho ha® dedicated a goodly portion of his life to thefinancingof real estate in this leountry, I (feel particularly qualified and compelled to present my view of Section 14 of the "Banking Reform Act of 1971", HR 5700. Clearly, this is not What I would 'term a "self-interest letter" as I and/or those who I miay (represent would seem to be the person or party which the proposed legislation is designed to protect. Uniquely, however, I "cannot support this legislation as Section 14 in my judgment portends grave implications with respedt to the futurefinancingof real estate. As concisely as possible I have below sug- 557 gested some of these implications and, most importantly. ask you and your colleagues if that which I suggest is 'that which you inltend ? Over the next few decades our country is faced with staggering long-term capital needs in the trillions of dollars. I would consider it extremely conservative to estimate that over the next decade alone our country will need some trillion to fund its urban growth. Comnpetition for sources of long-term funds is, in my judgment, not about 'to lessen for some period of time in the face of such demand. Real estate financing is a risky business which historically has, does and should justify a higher rate of return vis-a-vis other investments. If I were a trustee or lending officer of a financial institution I would obviously expect a yield differential commensurate with the added risk associated with a particular real estate loan or investment. If, for example, I could have purchased an "A" rated bond of a major U.S. corporation in the 1960's, which yielded 6% to maturity, I would have expected on a real estate transaction during that period, say, an 8% yield. Today such bonds are yielding approximately 8 % % and I would expect at least, say, a minimum of .10% return on my real estate investment. It is academic to argue what came first, high interest rates or inflation, but a greater amount of annual inflation seems to be an accepted phenomenon and I think that higher long-term interest rates have, unfortunately, come part and parcel with this acceptance. Query, during periods when our long-term markets are at present levels or higher and if lenders are prohibited from equity participations, whafc will happen? Firstly, most of your small to medium size developers will either fold up their operations or be acquired by larger companies. Both results in my judgment are undesirable. It must be clearly understood that the real estate industry is not only the country's largest but also the nation's most undercapitalized. If the competitive rate for a real estate loan is, say, 11% because single " A " corporate bonds are selling at 8%%, it is much more desirable generally from a typical developer's viewpoint to borrow at, say. 9% and give up some equity on a contingent basis which may give the lender at least another 2% return if the project works out. Clearly, the probability that a developer who is typically not overcapitalized, may fall into bankruptcy is much greater when he borrows at the 11% rate versus 9% pi as an equity contingency. Accordingly, I feel that there will be a major "shakeout" within the real estate industry if Section 14 is passed as currently proposed and I strongly suggest that the result of this among other things will be a net loss of activity to an industry which is prosl>ective)y faced with practically insatiable demands. In addition to a greater concentration of power within the real estate industry in the hands of a few companies suggested above (we are in the midst of this process already), I also foresee increased government activity in the commercial real estate field in response to any "shakeout" and the withdrawal of traditional s=ources of funds into more competitive securities in the form of "temporary1' subsidies. It is my belief that such subsidies are never "temporary" and contradict the free enterprise system that built this country. In summary, I petition your careful review of the broad implications for real estate financing inherent in Section 14 which could easily be lost within the complexity and breadth of H.R. 5700 in the name of reforms. If I can be of any assistance to you, I would be (honored to amplify my views, answer any questions you may have and, of course, would welcome your comments. Very truly yours, BISQUE D . NATIONAL ASSOCIATION OF S M A L L B U S I N E S S INVESTMENT DEANE. COMPANIES, Washington,. B.C.. May 3, 1971. R e H.R. 5700. Hon. WRIGHT PATMAN. Chairman* Committee on Banking and Currency, House of Representatives, Raybum House Office Building, Washington, D.C. DEAR MR. CHAIRMAN : Our review of H.R. 5700, the Banking Reform Act of 1971, leads us to believe that some of its provisions may inadvertently impinge upon the organization and operations of small business investment companies licensed pursuant to the Small Business Investment Act of 1958, otherwise known as the Johnson-Patman Act. As you know, SBICs are licensed to provide long-term loan funds and equity 558 capital to small business concerns. Section 302(b) of the Small Business Investment Act of 1958 authorizes banks to acquire shares in SBIOs notwithstanding the provisions of Section 6(a) (1) of the Bank Holding Company Act of 1956. Section 304(a) of the 1958 Act provides that it is a function of each SBIC "to provide a source of equity capital for incorporated small business concerns." and Section 305 of the 1958 Act permits SBICs to make loans "directly or in cooperation with other lenders, incorporated or unincorporated," to eligible small business concerns. Pursuant to these provisions of the 1958 Act, many banks insured by the Federal Deposit Insurance Corporation have acquired stock in SBICs and have cooperated or participated with SBICs in making loans to eligible small business concerns. In the case of SBICs which are wholly owned by banks and in other SBICs where banks have investments, officers, employees or directors of those banks or of their parent bank holding companies serve in official capacities with the SBIC affiliates or subsidiaries. It is our view that such practices are permitted and indeed encouraged under the 1958 Act, and that they have contributed to the soundness and the success of the SBIC program. Turning to H.R. 5700, Section 8(a) (2) of the bill would prohibit a director, trustee, officer or employee of a financial institution which holds the power 'to vote more than 5% of any class of stock in a corporation from serving as an officer or director of that corporation. Section 9 of the bill would prohibit such persons from serving on the board of directors of any corporation which has a continuing relationship with an insured bank with respect to the making of loans, discounts, or other extensions of credit. Section 14(b) of the bill would prohibit a lender from accepting any equity participation in consideration of making a loan. Section 14(a)(1)(A) of the bill defines "lender" as an insured bank and thus would not seem to include an SBIC subsidiary or affiliate of such bank. But Subsection (1) (C) defines "lender" as any bank holding company, "or a subsidiary of a bank holding company . . ." Thus, H.R. 5700 may by implication cast a shadow over certain lone-standing and approved practices of the SBIC industry, particularly with respect to the relationships between banks and SBICs. We respectfully submit that such a result is not intended by the bill and therefore request that a section be inserted exempting SBICs and affiliated lenders of SBICs from all provisions of H.R. 5700 insofar as they relate to the organization and operation of SBICs. Sincerely yours, CHARLES M . NOONE. General Counsel. R & B DEVELOPMENT CO., Los Angeles, Calif., April SO, 1971. Hon. WRIGHT PATMAN, House of Representatives, Raybum House Office Building, Washington, D.C. Snt: I'm writing in regard to HR 5700, specifically, Section 14 (a). There was a time a year ago when I would have begged for legislation such as this. Now, after reading the proposed bill, I ask that yo<u consider amending it to allow developers such as ourselves to continue large scale projects. To explain: our projects are large, ranging from 500 to as many as 1300 units. The equity capital required in ventures such as these varies from $1,000,000 to as much as $3,500,000. We have found the most expedient method for obtaining this equity capital to >be insurance companies. They are just about the only one's who have the sophistication to put that much money into a major apartment project. We feel it important to bui'ld these large projects to achieve the better planning and long-term management control that only large projects can give. So often legislation is passed to correct for excesses in which it works out that an overcorrection is made. Let me trace the history of insurance company loan practices, particularly as we see it. For years and years insurance companies were sleeping giants, very seldom owning real estate. They were known to make the most conservative investments possible so if you wanted a low interest rate and were willing to put 30 or 40% equity in a deal, you went to an insurance company. Through the late 60's the savings and loans practically ran out of money and the insurance companies 559 filled the gap. During that period a new brand of management seemed to evolve in the insurance company mortgage divisions. It was a younger, more aggressive group. They became aware that higher yields were available in return for lending a larger portion of the value of a project. Then as money tightened and inflation continued on its upward spiral the insurance companies, looking for long term inflationary protection, added small inflationary hedges into their loans. This was a point or two into their gross which we, and most of the developers that we are aware of, were not really terribly unhappy about As the Government's policies squeezed the money supply even more and the pressure increased for corporate, commercial and industrial loans, real estate became the orphan investment. It was during this period that the excesses developed by some, but by no means all, of the insurance companies. They took advantage of this period of tight money in the face of continued demand for real estate loans to gauge the developer, with the developer in turn, turning back the cost to the eventual consumer. Some of the insurance companies during that period took a different route. They said, 'granted, we want a higher yield, so let's team up with developers who will provide their skill and talents and the insurance companies will provide both the equity and mortgage.' With the insurance company providing 100% of the funds and firms like our own providing the talent and the skill, we feel the American housing consumer is well served and the arrangement is indeed equitable for all parties: the consumer gets the housing, the developer gets a fair share of the profits and the insurance company gets a mortgage and a long term share of the profits which, of course, becomes his inflationary hedge. The difference here is that the insurance company is at risk—they are putting in the hard dollars. We made several transactions of this type in the last six months and are currently pursuing the development of several thousand more units in the near future using this investment formula with at least two insurance companies. We will grant you that there were excesses during the tightest part of the. money market where some of the insurance companies demanded 30, 40 and 50% of the net income just for making a normal mortgage. That practice must be corrected, but to rule out all possibility of insurance companies taking out ownership interest in any property is so broad in scope that it rules out any possibility for favorable deals such as we have described. Therefore we urge you to kill this portion of HR 5700 in committee. We would be most happy to provide you with any additional background or information. Please feel free to call upon us. Very truly yours, HOWARD P . RUBY. General Partner. STOCKTON, W H A T L E Y , D A V I N & Co.. Jacksonville, Fla., April SO, J971. Hon. WRIGHT PATMAN, House of Representatives, Washington, D.C. DEAR MR. PATMAN: I have been made aware that hearings on H.R. 5700. entitled, "Banking Reform Act of 1971", have been started by the House Banking and Currency Committee and it has also been brought to my attention that Section 14 contains some serious restrictions on the freedom of financing real estate in that It specifically legislates against lenders accepting equity participations in consideration of making loans. It is not my purpose here to argue the merits nor the danirers of this practice. It is my purpose, however, to protest any restrictive legislation that is not absolutely essential to the public interests and which would restrict the free enterprise system. Equity participations are a direct result of the supply and demand principles in the money markets. Any restriction that would inhibit this process seems to me to be more detrimental to the public than protecting the interests of the public. However, I particularly find inclusion of the definition "any insurance company". 14(a)(1)(E), onerous in that this terminology includes both stock board and mutual insurance companies. 560 It would seem to me that state and national laws concerning reserve requirements, etc., are sufficient, especially on the part of stock board insurance companies, to provide the necessary protection for policyholders who are in reality suppliers of the monies being invested by these insurance companies. Additional restrictions concerning these investments, without ample reason for such restrictions. would seem to seriously limit the investment profits of these companies and therefore increase the cost of obtaining insurance through them. This, then, would indicate that the limitations cited in Section 14 of H.R. 5700 will indeed have a detrimental effect on the general public availing themselves of the primary service of these companies (insurance) and would therefore not be in the public interest but against it. Selected restrictive legislation that seriously limits the earning capabilities of any business or Institution will, in the long run, be passed on to the consumer. It would be my hope that your committee, in its hearings on this bill, would recognize that policyholders and other investors in insurance companies have adequate protection of their interests already through state insurance commissions, et cetera, and thus would not impose an additional restriction on the earning capabilities as is included in Section 14 of H.R. 5700. Sincerely yours, RICHARD B . CATON, Vice President and Manager, Loan Administration. F I R S T FEDERAL SAVINGS & LOAN ASSOCIATION, OF PITTSBURGH, April SO, 1971. H o n . T H O M A S S . GETTYS, House Office Building, Washington, D.C. DEAR CONGRESSMAN GETTYS : Although we are generally in accord with H.R. 5700, the "Banking Reform Act of 1971", we feel that the inclusion of Section 14 carries an enormously destructive potential for the futurefinancingof real estate. Section 14, as you know, would preclude participation by a lender in any equity interest or contingency whatsoever in properties financed. The building and development industry of this country is not only the nation's largest, it is also the most undercapitalized. It is an industry where "borrowing out" has been customary practice, at least as much as a matter of necessity as a matter of preference. Moreover, virtually all economists agree that we are in for a prolonged period of capital shortage. Needed in the future accordingly, will be vastly more equity investment than has ever been needed in the past Yet, Section 14 of H.R. 5700 effectively deprives thefinancialinstitution of the option of investing in equity unless it is prepared to put in 100% of that equity. Alternatively, it can make conventional mortgage loans—'but only to the extent that inadequate supplies of non-institutional equity money are available. Neither option is viable. Realistically in a prolonged period of capital shortage, 100% equity investment will not be available nor will institutions go beyond normal mortgage limits as prescribed by loan to value regulations. In short, Section 14 says that two perfectly legal separate actions both become illegal if combined. Financial institutions, as trustees of the public savings, cannot ignore existing and prospective inflationary trends. In fact, one of the principal reasons for the development of equity interest byfinancialinstitutions has been to provide savers a hedge against inflation. Denial of the direct approach must mean the development of indirect avenues such as imposition of materially higher interest rates or a reversion to the discredited old practice of writing loans for two or three year terms, requiring renegotiation regularly to adjust rates to market conditions. We feel that the enactment of Section H of H.R. 5700 would be highly detrimental to the country's savings institutions and urge its elimination from the MIL Sincerely. HAROLD L . TWEEDY, President. 561 TUFTS UNIVERSITY, Medford, Mass., April 26,1911. H o n . WRIGHT PATMAN, Chairman, House Committee on Banking and Currency, House of Representatives, Washington, D.C. M Y D E A R M R . P A T M A N : I am writing you concerning Section 1 4 of H.R. 5 7 0 0 , Banking Reform Act of 1971, on which hearings presently are being held. It would, in my judgment, be in the public interest to delete Section 14 from this bill. There are three reasons why deletion of Section 14 would be in the public interest (1) The building industry and developers are essentially undercapitalized compared with demands now on them and likely to come forth in the years ahead. If we are to get the building done and with quality then we must look to other sources to participate in the equity financing. The flexibility afforded to developers and lending institutions alike by continuing equity participations gets the job done that the country needs. (2) Developers who do not want others to participate in the equity often have alternatives available to them. For example, developers could pay a higher interest rate for their borrowing. Moreover, additional equity capital could be raised by publicly owned corporations with greater access to the eQuity market. This would, of course, promote a trend toward bigness and size in this industry. The developer who wants to avoid these courses of action has an additional option under present practices by offering a participation in the equity. This permits him to grow, to prosper and to meet society's needs without becoming a publicly owned corporation or paying as high an interest rate as otherwise would be necessary. (3) The individual savers who provide the funds which financial institutions lend also have a vital interest in the deletion of Section 14. Failure of their financial institutions to be able to participate in equity financing deprives them of a source of protection against inflation which we have experienced steadily for many years. This, too, is in the public interest. 1 am writing you in my capacity as a private citizen. You may find this a trifle unusual since as a university president I might not be expected to have an interest, much less any competency or knowledge of such matters. However, I am a professional economist who for many years concentrated on monetary, banking, and financial institutions. I cut my professional teeth on the Banking Act of 1935, followed your own contributions to our legislation carefully over the years and worked on the Commission on Money and Credit a decade ago. In more recent times I have become acquainted more fully with the building industry as Chairman (for over two and one-half years until liast February) of the Massachusetts Housing Finance Agency and as a trustee of a real estate investment trust. I know that you have been a watchdog for us all over the years in financial matters, but as you analyze Section 14 more carefully I believe you will find it wise to eliminate it in Committee. Sincerely, BURTON C . HALLOWELL. GALBREATH-RUFFIN CORP., New York, N.Y., April 27,1971. H o n . WRIGHT PATMAN, Chairman, House Banking and Currency Committee, Washington, D.C. D E A R REPRESENTATIVE P A T M A N : With respect to your proposal H R - 5 7 0 0 entitled "Banking Reform Act of 1971" on which hearings are now being held, permit me to advise that I am strongly opposed to this pending bill, and particularly Section 14 of the same. From a political or theoretical approach, I can understand why you feel that such legislation would possibly benefit the American public, but on the other hand, such a bill, if passed, would prove in my opinion, detrimental to the overall economy of the country. Galbreath-Ruffin Corporation are the owners and developers of real estate specializing in major office buildings throughout the nation. For many months, we have found it practically impossible to finance these facilities. There are many inherent reasons why we, in this profession, are caught in an 562 insurmountable dilemma. Inflation is rampant, not to mention exorbitant increases in labor contracts involving the construction unions, extreme tightness of money, excessive real estate taxes and operating costs are creating a destructive potential for the future financing of real estate. Your bill, as I understand it, would preclude insurance companies making loans wherein they would share with the owner-developer in part of the equity financing. Recognized leaders in our field today haven't the necessary equity that is required to finance these major operations. The construction industry, as such, is the second largest contributor to the nation's gross national product, and therefore, it is of paramount importance to keep this segment of our economy healthy. I trust that you will give this subject your serious consideration. Very truly yours, PETER B . R U F F I N . T H E M Y R I C K C o . , REALTORS, Re "Banking Reform Act of 1971"—H.R. 5700. H o n . WRIGHT April 30, 1971. PATMAN, House of Representatives, Washington, D.C. D E A R S I R : The above referenced proposal has been recently brought to my attention and 'as this bill is coming up for consideration in the very near future I felt I should make my views on it known. As a commercial and industrial Realtor engaged in the day to day business of negotiating with real estate developers and financial institutions, Section 14 of the above referenced proposal is of particular concern to me. It is my understanding that Section 14 precludes lender participation in equity interests in any project or properties financed by the lender. I seriously question the wisdom of this proposal and specifically request that the "Banking Reform Act of 1971"— H.R. 5700, and more particularly Section 14 be killed in the Committee as not being in the best interest of the general public for the following reasons: 1. Most financial institutions are charged with the proper investment of funds that generally belong to and flow back to the general public and therefore have the responsibility to obtain the highest possible yield. This is particularly true of life insurance companies, pension and profit sharing trusts, and real estate investment trusts which are the largest source of real estate financing. 2. Whether or not a developer should or has to give a lender an equity position in the project or property is based <on the law of supply and demand but also takes into consideration the financial strength and capabilities of the borrower—developer, the economics of the real estate transaction itself and the magnitude of the project. Without equity participation on the part of the lender a good many projects would not be feasible. I can name you at least ten (10) major projects that have been very essential to the growth of the Metropolitan Atlanta Area that would not have been possible without equity participation on the part of the lenders. 3. The recent tight money conditions took its toll on real estate developers but this toll would have been much greater had some developers not been in a position to offer equity participation so that the returns flowing to the lender were competitive in a very competitive money market. 4. Passage of this bill will have a tendency to drive out the smaller locally oriented developers and replace them with large corporate and industrial concerns which in my opinion will result in higher cost for all real estate developments, all of which will be passed on to the consumer. I would be quick to point out to you that I am a Real Estate Broker dealing with both the developer and lender and I believe that a majority of developers are against this proposal. Although the intent is to protect the consumer, if this bill is passed it will become very detrimental to the consumer and the man on the street I urge that Section 14 be stricken in its entirety. Very truly yours, RICHARD S. MYRICK. 563 P A I N E , WEBBER, JACKSON & CURTIS, INC., New York, N.Y., May 3,1971. Hon. WRIGHT PATMAN, The House of Representatives, Washington, D.C. DEAR SIR: I am writing to you concerning HR5700 entitled, "Banking Reform Act of 1971". Section 14 thereof as presently drafted would preclude participation by a lender in having an equity interest or a contingent interest in the profits of properties financed by the lender. It is, in my estimation, an exceedingly shortsighted provision. A good part of the success of the economic system which we have developed in this country is attributable to the confidence which investors have generated in their ability to obtain an adequate return on their capital. This in turn has led investors to reinvest their capital, thereby creating an expanding and productive economy. I am sure it is apparent to all of us that the demands for goods and services, with particular emphasis on the well-publicized requirements of our great urban centers, creates a situation which for the foreseeable future will place an enormous strain on the capital resources of, even this, the most successful country in history. Inevitably, there will be a competition for such capital as there is. It seems to me that to denyfinancialinstitutions, who are perhaps the largest single source of this capital, the opportunity to earn a competitive return in certain forms of real estate investment, would only serve to channel funds away from an area which sorely needs them. Surely, this cannot be the intent of Congress. What I have to say, I say recognizing full well the short-run advantages which Section 14 would provide real estate developers. As a matter of interest to you, I am both a stockholder and a director of a real estate development company and a portion of my business activity is devoted to assisting developers in arrangingfinancingfor the various projects which they undertake. Sincerely yours, J O H N DE S A I N T PHALLE, Vice President. MOUNT KISCO, N . Y . , May 8,1971. H o n . WRIGHT PATMAN, Chairman. House Committee on Banking and Currency, House of Representatives, Washington, D.C. DEAR SIR: I am writing to you regarding the bill before your committee entiled "Banking Reform Act of 1971" (HR 5700). Section 14 of this bill contains a provision that would prohibit mortgage lenders from developing equity participation as part of the terms of any financing made by them. The effect of such a restriction will, without question, work against those that it is designed to benefit, for it will drain off large amounts of long-term capital to other investment opportunities rather than make it available for large scale well-designed housing projects where development risk warrants a contingent bonus to the lender should the project be successful. In New York, we have seen the disastrous results brought about by artifical control of rent, and more recently the usury law has prevented much needed capita) to enter the housing market. I urge you not to approve the foregoing provision so that capital may flow freely to those places where it is needed most. Sincerely, W I L L I A M J. D W Y E R , DALLAS, TEX., Hon. WRIGHT PATMAN, Jr. April 20, 1971. Chairman,, House Banking Committee, U.8. House of Representatives, Washington, D.C. DEAR MR. PATMAN: Congressman Collins today told me of your generosity in proffering the possibility of my appearing as a witness in connection with HR 564 Bill 5700, hearings upon which you are presently holding. I shall be out of the country until about April 30, but should it be possible for me to appear then or soon thereafter, I would be grateful for the opportunity to do so. I shall testify that, in my opinion, participation by the leader in the income stream and ownership of propertiesfinancedby insurance companies is of benefit to the borrowers and not a detriment to the borrowers. It is the means through which these large concentrations of capital can afford the benefits of capital strength to individual borrowers and developers such as our own company. I shall say that I think it is helpful to the small borrower and not hurtful to him. Thank you again for this opportunity, which I hope I may receive. Yours very truly, TRAMMELL S H A W , P I T T M A N , POTTS, TROWBRIDGE & MADDEN, Washington, D.C., May 5, 1971, Re H.R. 5700. HON. WRIGHT CROW. PATMAN, Chairman,, Committee on Banking md Currency, U.S. House of Representatives, Washington, D.C. DEAR MR. PATMAN : On behalf of the Committee of Foreign-Owned Banks, the members of which are listed in enclosure B, it is respectfully requested that Section 14 of H.R. 5700 be amended to limit the restrictions on equity participations so that business and financial organizations which are not engaged in banking, but which are affiliated with banks, would be excluded from the regulatory scope of this section. Enclosure A contains a suggested form of amendment to accomplish this purpose. The Committee of Foreign-Owned Banks is primarily composed of banking corporations organized under the laws of this country and owned by foreign banks. The Committee followed closely the development of the bank holding company legislation, suggesting changes to avoid unnecessary difficulties in international banking relations which were adopted with the approval of your Committee. We are therefore aware of the difficult process of bringing that legislation through to the point of enactment, an accomplishment in no small measure due to your leadership. For this reason, we believe that you personally and each of the members of your Committee will be cautious about inadvertently reopening major issues which were resolved in last year's amendments to the Bank Holding Company Act. Tn our judgment, Section 14 as presently drafted would do just that, and our proposed modification would effectively avoid overlapping those amendments and the discretion carefully granted to the Federal Reserve Board thereunder. We take no position on the application of Section 14 to banks, which has drawn comment from the agencies regulating banks and leading spokesmen of the banking industry. However, we are not aware that any of these witnesses have focused on the result of using the Bank Holding Company Act as a vehicle for extending the scope of Section 14 beyond insured banks and mutual savings banks. We appreciate that Section 14 is designed to take full advantage of federal bank regulatory jurisdiction to extend the restrictions against equity participations, and our proposal preserves this objective. Business andfinancialcorporations, which are active in providing the financing, vital to a dynamic and competitive economy, in which relatively high risks are taken on new and small enterprises for correspondingly higher returns, are obviously not intended to be prohibited from using the various mixes of loan and equity financing which would come within the scope of Section 14. However, Section 14(a) (1)(C) applies to non-banks which happen to be bank holding companies and non-banks which happen to be subsidiaries of bank holding companies. Such an application would presumably not restrain investment companies (venture capital investors, real estate investment companies) from taking equity participations in connection with loans but rather would extend the prohibitions of Section 4 of the Bank Holding Company Act to force divestiture or prevent acquisition of such companies by bank holding companies. If this result is intended, it revises the recently enacted amendments of the Bank Holding Company Act by taking away the grandfathered protection 565 available to existing banking affiliations of such investment companies. It also takes away from the Federal Reserve Board its discretion under Section 4(c) (8) to examine such affiliations and determine whether such investment company activities are sufficiently bank related to be exempted from the prohibitions of Section 4 of the Bank Holding Company Act. We think it possible that this result is not intended because the integrity of the banking operations are not affected by common ownership with an organization willing and able to take greater risks than a bank in exchange for correspondingly greater rewards, which could not and should not be expressed in terms of unusually high fixed interest charges. Accordingly, it is respectfully urged that the Committee amend Section 14 in accordance with enclosure A, thereby preserving the decision taken last year in connection with the amendment of the Bank Holding Company Act to rely upon the expert judgment of the Federal Reserve Board to determine whether investment company affiliations with banks should be allowed or disallowed in the context of the purposes of the Bank Holding Company Act. The Committee of Foreign-Owned Banks is not undertaking to comment on H.R. 5700 in general because many of its members belong to associations which have done so. It addresses this single issue solely because the point may have been overlooked in the course of hearings before your Committee. Inclusion of this letter in the record of the hearing on H.R. 5700 would be appreciated. Respectfully yours, S H A W , PITTMAN, P o n s , TROWBRIDGE & MADDEN STEUART L . P I T T M A N , Counsel for Committee of Foreign-Owned Banks. ENCLOSURE A B A N K I N G REFORM B I L L H . R . 5 7 0 0 AMENDMENT TO SECTION 1 4 ( A ) ( 1 ) ( C ) (RESTRICTING E Q U I T Y PARTICIPATIONS) "(C) [company] bank which is a bank holding company as defined in the Bank Holding Company Act of 1956, or bank which is a subsidiary of a bank holding company; or a company which is a savings and loan holding company as defined in section 408 of the National Housing Act, or a subsidiary of a [bank holding company or a] savings and loan holding company;" [Additions italic and deletions bracketed] ENCLOSURE B COMMITTEE OF FOREIGN-OWNED B A N K S Bank of Nova Scotia, 37 Wall Street, New York, New York Bank of China, 40 Wall Street, New York, New York 10005 French-American Banking Corp , 120 Broadway, New York, New York 10005 Societe Generale, 66-68 Wall Street, New York, New York 10005 Commerzbank A. G., 55 Broad Street, New York, New York 10004 Israel Discount Bank Limited, 51 Fifth Avenue, New York, New York 10017 The Hongkong & Shanghai Banking Corporation, 80 Pine Street, New York, New York 10005 The Chartered Bank, 76 William Street, New York, New York 10005 Skandinaviska Banken, One Wall Street, New York, New York 10005 Westminister Bank Ltd.. One Wall Street, New York, New York 10005 Royal Bank of Scotland, 63 Wall Street, New York, New York 10005 European-American Bank & Trust Co., f>2 Wall Street, New York, New York 10005 Barclays D.C.O. 300 Park Avenue, New York, New York 10017 Bank Leumi Le-Israel B M, 60 Wall Street, New York, New York 10005 First Israel Bank & Trust Company of New York, 60 Wall Street, New York, New York 10005 Bank of Montreal, 2 Wall Street, New York, New York 10005 J. Henry Schroder Banking Corporation, 61 Broadway, New York, New York 10006 566 BUILDING INDUSTRY ASSOCIATION OP CALIFORNIA, INC., Los Angeles, Calif., April 1, 1971. RESOLUTION Whereas Representative Wright Patman introduced in the 91st Congress H.R 18676, a bill to prohibit lenders from accepting any equity participation in consideration of the making of any loans, and Whereas the National Association of Home Builders supports the adoption of this bill, in accordance with the NAHB policy on fair and equitable lending practices, and Whereas the Multifamily Builders of the Building Industry Association of California are in accord with the intent of the bill and with the NAHB policy on this subject: Now, therefore, be it Resolved, That the BIA make known its support of the bill and of the NAHB policy to Congressman Patman and to the National Association of Home Builders. Adopted March 30, 1971, Executive Committee, Building Industry Association, of California, Inc. E R I C A . WITTENBERG, President GEORGE C . G A L V I N , Executive Vice President. GREENWAY P L A Z A — C E N T U R Y DEVELOPMENT CORP., May 13,1971. Hon. WRIGHT PATMAN, House of Represenatives, Washington, D.C. DEAR MR. PATMAN : We recently learned of the hearings presently being held by the House Banking and Currency Committee on H.R. 5700 entitled "Banking Reform Act of 1971." As a major developer of commercial real estate in the City of Houston, we are seriously concerned about the potential disastrous effect of the provisions of Section 14 which prohibits equity participation t>y certain specifically designated lenders. Thefinancingof major developments such as ours would have been impossible had we not been able to utilize the equity participation and "staying power" provided by our financial partners who are large insurance companies. The wedding of an institution's capital and a developer's expertise is a healthy marriage. At first glance, it may appear that developers should welcome this outright prohibition and that, additionally, the public interest would be served. However, in view of the trillions of dollars of long-term capital investment required to meet the needs of urban growth in this country, it would seem that there is no realistic alternative to the equity participation and joint venture approach. In short, where will the money come from during the present and anticipated' prolonged period of capital shortage? The quality of urban, life in major cities requires responsible development which cannot be accomplished solely within thefinancingcapabilities of real estate development companies. Unless and until immediate solutions are found for the problems of inflation, high interest rates, and the resulting effect on the general public, we think that the present financing concept of institutional participation should be preserved. We, therefore, urge that the proposed bill not be reported out of committee. Sincerely, KENNETH SCHNITZER, Chairman of the Board. PROCTOR HOMER W A R R E N , INC., Detroit, Mich., May 17,1971. Hon. WRIGHT PATMAN, House of Representatives, Washington, D.C.: The passasre of this Bill will have disastrous effects on the real estate and home building industry. These effects will seriously damage the entire economy of our country. The restrictions imposed by this Bill would seriously limit the* flow of capital into our industry. The damage would be incalculable. I belong to the Mortgage Bankers Association of Michigan, the National Asso- 567 elation of Home Builders and the National Association of Real Estate Boards. I have the best interest of each of these organizations in mind when I urge you to listen carefully to the arguments of the Mortgage Bankers. Their position is the correct one. It is unfortunate that NAHB and NAREB have favored the restrictions on participation in mortgage loans. They are being terribly shortsighted as would the Congress if this Bill became law. EDWARD A . PROCTOR, Jr., President. JERSEY MORTGAGE CO., Elizabeth, N.J., May 17,1971. Hon. WRIGHT PATMAN, U.S. House of Representatives, Washington, D.C. DEAR MR. PATMAN : I would like to present my views as Chairman of the Board and Chief Executive Officer of Jersey Mortgage Company, one of the largest mortgage banking companies in the east, in respect of HR 5700, particularly section 14 that deals with equity participation. To begin with, I would like to make it crystal clear that as far as diverting funds from the single family housing market is concerned, especially funds of insurance companies, most have not been in the single family housing market for almost 10 years and, from what I can gather, have no plans to return to that market in the foreseeable future. In the past several years much progress has been made in aiding medium sized to very large building contractors in thefinancingof multi-family housing projects, shopping centers, office buildings and warehouses where equity participation financing became part of the total financing package. In every case with which I have any knowledge the builder did not sacrifice a part of the equity ownership without receiving adequate compensation, therefore making it possible to generate sufficient funds to finance a given project without undue financial burden on the contractor. Equityfinancingof real estate transactions has been a practice since beyond the memory of all of us—the only difference now is that lenders are taking on an additional role of an equity participant. If this is prohibited, as contemplated in the legislation being considered, the volume of new construction of projects as described above, and particularly multi-family housing, will be reduced to historical depression levels. Sincerely, CARTON S . STALLABD, Chairman of the Board. 1 POST O A K PLACE, Houston, Tex., May 14, 1971. Hon. WRIGHT PATMAN, House of Representatives, Washington, D.C. DEAR MR. PATMAN : I recently saw an article in the newspaper which indicated that your Committee would be studying legislation to regulate insurance companies with regard to the type of investments and participations in real estate which they are now engaging in. I am in the real estate development business and have continued dealings with the insurance companies for long-term mortgages on income producing properties. It is my opinion that if some sort of regulation is not undertaken that the insurance companies in this country will end up owning a large portion of the prime real estate in the country in the very near future. I do not believe that this is a healthy situation for the country because it makes it very difficult for the developer to function in his best capacity, and will put undue power in the hands of one industry. I can give you several classic examples of insurance companies abusing the powers that they already have in this area and would be glad to appear before your Committee at any time, at my own expense, to air my views on this subject. I would also like to point out that I own considerable amounts of bank stocks in several banks in Houston and elsewhere and have continually supported your efforts at regulating the banking industry for the same reasons that I believe 568 that the insurance industry should be regulated. If these two sources of capital which dominate the American business community are not regulated, we would undoubtedly see the kind of abuses which have necessitated your continued efforts in the banking field, and which make it imperative that we have some regulations for the insurance companies. Yours very truly, DAN M . MOODY, Jr. (Whereupon, at 12:48 p.m. the committee recessed, to reconvene at 10 a.m., Thursday, April 29, 1971.) THE BANKING REFORM ACT OF 1971 THURSDAY, APRIL 29, 1971 H O U S E OF REPRESENTATIVES, COMMITTEE ON BANKING AND CURRENCY, Washington, D.C. The committee met, pursuant to recess, at 10:05 a.m. in room 2128, Rayburn House Office Building, Hon. Wright Patman (chairman) presiding. Present: Representatives Patman, Barrett, Sullivan, Ashley, Stephens, Gonzalez, Minish, Hanna, Gettys, Annunzio, Bevill, Brasco, Chappell, Koch, Cotter, Mitchell, Widnall, Johnson, Stanton, Brown, Williams, Rousselot, McKinney, Lent, Archer, and Frenzel. The CHAIRMAN. Gentlemen, the committee will please come to order. This morning we have before us representatives of various banking associations who will testify on H.R. 5700. These include the following: Mr. Clifford C. Sommer, president of Security Bank & Trust Co. Owatonna, Minn., and president of the American Bankers Association; Mr. Donald M. Carlson, president of the Elmhurst National Bank, Elmhurst, 111., and president of the Independent Bankers Association of America; Mr. William S. Renchard, chairman of the board of Chemical Bank, New York, and president of the New York Clearing House; and Mr. Edward Herbert, senior vice president, First National Bank, Montgomery, Ala., representing Robert Morris Associates. Before we hear from these gentlemen, I would like to submit for the record several letters that I have received concerning this legislation. We have received letters both for and against. We will give consideration to them, of course. And I will place them in the record. We want to do what is right about this. The object of a hearing is to find out, and that is the reason we insist on people from both sides of the controversy. Wc have heard the argument, for instance, that the interlocking directorate provisions of this bill would impair the operations of various financial institutions, especially in small towns. It may be surprising for some to learn from reading this correspondence that a number of officers and directors of small town banks and savings and loan associations support these provisions. For example, the president of a bank in Tacoma, Wash., wrote that "although your bill would broaden the prohibition (against interlocking directorates) to include insurance companies, brokerage firms, credit unions, bank holding companies, and savings and loan companies, I can see no serious objection to such an extension." A director of a bank in a small upstate New York community wrote 60-299—71—pt. 2 9 (569) 570 me indicating his great concern over his bank's difficult}" with an interlocking directorship involving a competing bank. The chairman of the board of a medium-size bank in New York State with total deposits of $109 million and nine branches wrote me supporting 1>rovisions which "outlaw interlocking directorships among commercial >anks, savings and loan associations, et. cetera." And a longtime director of a bank in Lewiston, Maine, wrote, "In my opinion, this bill is long overdue and I hope it is enacted without any deletions." After enumerating the substantial number of interlocking directorships among commercial banks, savings banks, and bank holding companies in his State, he goes on to say, "What exists iu other parts of the country I do not know. But the interlocking directorates and large blocks of stock that the savings banks own, is not, in my opinion, good banking practice." A director of a savings and loan institution in Peoria, 111., wrote: In the last half dozen years, men have been elected to the board—by proxies— who were also directors of commercial banks. So now of the nine members, four are also directors of different banks. With the support of management, they exert great influence on our policies. Although we are to a degree, competitors of the banks, they are conditioned with the thinking of commercial banking, which carries over to our savings and loan. Peoria is not an extremely large city, but this interlocking of directors exists in almost every savings and loan and bank. This city is, however, large enough 83 that capable men are available to serve on only one boaid. I would heartily endorse your recommendation that there be no interlocking directors with savings and loans and banks. Of course, I have also received mail opposing many provision s of H.R. 5700. However, I think that the committee ought to be aware that there is no uniformity of opinion among those in the banking industry on this matter. (The letters referred to by Chairman Patman follow:) PACIFIC NATIONAL B A N K OF W A S H I N G T O N , Tacoma, Wash., April 5,1971. H o n . WRIGHT PATMAN, Chairman, Committee on Banking and Currency, House of Representatives, Rayburn House Office Building, Washington, B.C. D E A R C H A I R M A N P A T M A N : Thank you for the opportunity to provide my views on your recently introduced H.R. 5700, the Banking Reform Act of 1971. As you noted, the Comptroller of the Currency's Advisory Committee on Banking, of which I was a member, recommended in its report in 1962 that "the prohibitions of the present law on interlocking directorates should be made applicable between banks, savings and loan associations, and mutual savings banks, whether chartered under Federal or State law." Although your bill would broaden the prohibition to include insurance companies, brokerage firms, credit unions, bank holding companies, and savings and loan companies, I can see no serious objection to such an extension. I believe that Section 7 would unduly penalize many of the major corporations of this nation by depriving their boards of directors of the business acumen and wisdom afforded by senior banking officers' memberships thereon. The banking industry would be unfairly penalized to the advantage of investment advisory services, which may -be less qualified to manage employee benefit accounts than the trust investment divisions of major banks. My misgivings concerning Sections 8 and 9 of your bill would follow a similar vein. I am unconvinced regarding the value of prohibiting commercial banks, savings and loan associations, and mutual savings banks and their officers, directors, and immediate family members from controlling title companies, property appraisal firms, or companies offering services in connection with the closing of real estate transactions. It is difficult for me to imagine possible abuses sufficient to warrant such prohibition. I further feel that the provision is contrary to certain pro- 571 visions in recently enacted bank holding company legislation and Federal Reserve Board rulings relating thereto which appear to appropriately enlarge legitimate commercial bank activities in these areas. The sections of the bill dealing with the performance of legal services in certain interlocking relationships seem entirely proper to me and will, I am certain, receive the support of the legal fraternity and their authorized spokesmen. While I support the intent contained in Section 11 of the bill, I am gravely concerned regarding its actual workings. Certainly flagrant abuses of corporate trust and responsibility for private gain should be dealt with severely, and are appropriately covered by current legislation. However, a great danger for misinterpretation of the relationships between financial institutions and the senior officers and staff of their customers exists in Section 11. and the entire fabric of relationship between a bank and the senior officers of its corporate accounts, so necessary for the proper conduct of the business of both, would be called into question. I am at a loss to discern how responsible implementation of Section 11 could occur and immeasurable damage to the financial institutions of this nation be avoided. The provisions of Section 10 prohibiting the ownership of stock in financial institutions by mutual savings banks are indeed timely and beneficial. A real danger in restricting competition now exists which your legislation would wisely close. I would suggest several revisions in Sections 12 and 13 of the bill which deal with the stock holdings of commercial bank trust departments. First, it would seem that any prohibition regarding stock holdings should be directed not at the holding per se, but toward the voting responsibilities related thereto. I would agree, and our bank has always followed the precept, that a trust department Should not vote the stock of its own bank. It further seems reasonable that, in the case of a subsidiary of a bank holding company, voting prerogatives should not be exercised on any of its holding company's stock in the trust department. I most definitely feel, however, that it should be permitted to hold such stock when operating "as prudent men" in a trust fiduciary capacity. To do otherwise would place commercial banks at a great disadvantage vis a vis their trust and investment competitors. 1 also feel that the provision for annual disclosure of trust department stock holdings should be temi>ered by the inclusion of a minimum percentage figure. To report on every stock held in the manner intended would be most burdensome and would tend to increase the price of trust services. Such disclosure has merit where a stock aggregating, say, 10% of the corporation's outstanding stock is held by a trust department, but has little significance under more diluted conditions. The portions of H.R. 5700 dealing with loan disclosures, insider loans, and equity "kickers" cause me the gravest concern, Mr. Chairman. First, as regards equity participation of the lender, 1 do agree that the activity is one to be closely observed. It would appear, however, that the examining staffs of the Comptroller of the Currency and the Federal Deposit Insurance Corporation, in coordination with state regulatory authorities where appropriate, are most capable of monitoring this activity and reporting possible abuses. Current studies by the Comptroller of the Currency indicate that the present volume of such loans is nominal, and it would not appear necessary to legislatively foreclose further development of this financial technique. The bill's requirement of "public" disclosure of the credit relationships of bank officers, directors, their families, and so on, runs counter to the absolute necessity for confidentiality in banking relationships. I well realize, as Chairman Wille of the F.D.I.C. has pointed out, that too great a proportion of current bank failures are the result of improper credit transactions between the banks and their officers/directors. The solution, however, would seem to lie in more effective and comprehensive regulatory examination techniques rather than in the destruction of confidentiality so necessary to the appropriate func-. tions of banking. It should also be noted that administratively, at least, it is preferable to have the officers of a bank conduct their borrowings from their own institution so that such activity can be monitored. The prohibition of the extension of credit by a bank to corporations where 5% or more of any class of st<x?k of the cori>oration is owned by directors, officers, employees, and so on, of that bank seems to me to be the most deleterious pro- 572 vision in the Act Properly managed banks have historically sought business leaders from the communities and companies they serve to lend their expertise and acumen to the bank's board of directors. Many of these men have achieved their success in closely held corporations, or even proprietorships. To create a situation wherein these leaders could not serve on a bank's board of directors and still have their legitimate corporate banking requirements accommodated is, in my judgment, completely unwarranted. In a commercial banking system of over 14,000 banks, there will always be those instances of malfeasance and perfidy which call stern measures to mind, but we must be careful not to "toss the baby out with the bathwater." I sincerely hope that an amendatory correction is available for this provision of the bill. Certainly the restrictions H.R. 5700 would place on "brokered" deposits as well as the use of gifts and premiums to attract deposit accounts would be healthy and in the best interest of the banking industry. Both practices are not only demeaning to the industry but contain the seeds of serious problems as frequent past experience has indicated. The bill's extension of applicable insurance coverage to the extent of 100% of deposits of federal, state, and local governments seems to me to be both proper and timely. Certainly the taxpayers should not be penalized through the loss of such deposits in the event of failure of a financial institution when tMe mechanism for their protection exists and functions so well as in the cases of Federal Deposit Insurance and Federal Home Loan Insurance. Respectfully yours, GOODWIN C H A S E , President. FULTONVILLE, N . Y . , Hon. WRIGHT PATMAN, January 25, 1971. Congress of the United States, House Office Building, Washington,, D.C. DEAR CONGRESSMAN P A T M A N : On December 30, 1970, I sent to you a copy of my letter to the Comptroller of the Currency, concerning Daniel Vooys, President and Director of Mechanics and Farmers Bank of Albany, and Director, Central National Bank of Canajoharie. Also, I enclosed a copy of my letter of December 3, 1970, to Mr. Charles M. Van Horn, Regional Comptroller of the Currency, located in New York City. I called to Mr. Van Horn's attention that contrary to a letter he had received from an officer of Central National Bank, there was a branch of Mechanics and Farmers in a township contiguous to a township in which a branch of Central National was located. Therefore, Mr. Vooys serving as a director of both banks was contrary to Section 8 of the Clayton Antitrust Act, 15 U.S.C. 19. On January 5, 1971, more than a month after my letter was sent, Mr. Van Horn replied, saying the matter had been referred to the Federal Reserve Bank of New York for further consideration. On January 15, Mr. John D. Gwin, Deputy Comptroller of the Currency, replied to my letter of December 30 to the Comptroller of the Currency, saying their office in New York City had referred the matter to the Federal Reserve System since they had the responsibility for "interpreting this statute." In the meeting of January 18 of the Board of Directors of Central National Bank, Mr. Vooys was not renominated for director (annual meeting in March) as a part of management's slate, but nevertheless it would seem that an answer should be received to our inquiry with reasonable promptness. As I previously endeavored to explain, the Bank of New York Company made an offer for Central National stock; they would consolidate Central National with Mechanics and Farmers, their subsidiary, with Mr. Vooys as president of the consolidated blank. I have a feeling there is great reluctance to.make a ruling in this case. Originally both the Regional Comptroller and the Federal Reserve Bank of New York ruled favorably very promptly (within a week) on the letter sent to them by Donald C. Cartmell of Central National relative to Mr. Vooys serving on both boards. But on receipt of my letter setting forth what seems to me to be an obvious violation of Section 8 of the Clayton Anti-Trust Act, it takes months to get an answer. Why is this so? 573 I was told at our last Board meeting that Mr. Vooys said that "the Federal Reserve had been in to see him," but "everything was all right." If that is the case, why don't they advise the bank? I realize that asking for your help in getting an answer would be strictly a favor on your part, but a letter from your office would be a great help. The real issue, is, of course, saving our country bank for our local depositors and customers. My observation is, in our area at least, the giant city banks, while interested in deposits in the rural or country areas, aren't much interested in giving these same areas good banking service. As a matter of fact, this whole matter of bank holding companies is a problem which a lot of people should be showing concern. If you can get this matter expediated for us, the small stockholders and customers of our bank will appreciate it. Sincerely yours, HERBERT R . KLING. 3 6 UNION STREET FULTONVILLE, N.Y., February 8,1971. H o n . WRIGHT PATMAN, House of Representatives, Raybum House Office Building, Washington, D.C. DEAR CONGRESSMAN PATMAN : Thank you for your letter of January 18. I delayed a little in replying to your Question as I was trying to get a final answer out of the Comptroller's Office in reply to my letters of December 3 and December 30. Attached are copies of letters to Mr. C. M. Van Horn, the Regional Ad* ministrator of Regional Banks, and Mr. John D. Gwin, the Deputy Comptroller of the Currency. You will note that the matter of the Mr. Daniel Vooys directorships on both Central National Bank and Mechanics and Farmers Bank of Albany boards has been resolved to our satisfaction, but not in a manner I like. I will be pleased to come to Washington and testify before the House Banking and Currency Committee, if you feel I can contribute anything. I would, of course, need your direction on the subject and length of statement. I am only a director of a small bank, certainly no expert on banking, and can only tell what goes on in our particular situation. I am reasonably familiar with your efforts to improve the banking system. It would seem to need a lot of improvement! I greatly admire your tireless efforts in this direction. A little while back one of my friends remarked that, "banking is a form of legalized larceny." He was joshing me, he knows very well of the contribution of our banking system to the general welfare. But I do strongly feel that if trends in our commercial banking system continue, then there will have to be, one way or another, better means of making retail credit available. Recently in our State, the larger savings banks are being permitted to absorb the smaller savings and loan associations. Yet the Savings and Loan Association, in single unit size, if permitted to offer a wider range of services, might well provide more competition to the commercial banks and perhaps better service to the "retail" i.e. individual credit user, than commercial banks. Maybe this is not as true in metropolitan areas as in rural areas such as ours. We have in our community a Production Credit Association. It doesn't have an elaboraate building, its staff is small, yet it does a lot better job for farmers than any banks in our county, and probably handles more farm credit than all the l>anks in the county put together. I am exceedingly grateful for your interest in our particular situation. Thanks again. Sincerely, HERBERT KLING, Director, Central"NationalBank, Canajoharie. LEWISTON, MAINE, H o n . W R I G H T PATMAN, March 18,1971. Chairman, Committee on Banking and Currency, Washington, D.C. DEAR M R . P A T M A N : Thank you for your letter of March 11th and copy of H.R. 5700. 574 In my opinion, this bill is long overdue and I hope it is enacted without any deletions. Let us look at the local situation where I was l*orn and have lived all my life, namely Lewiston and Auburn, Maine, commonly known as the Twin Cities. 1. The First-Manufacturers National Bank of Lewiston and Auburn, Maine in which I was formerly a director, said bank being part of the Northeast Bankshare Association, a multiple bank holding company, has on its l>oard the following directors of other banks, as follows: (a) Mr. Philip Watson and Mr. Willis Trafton. Jr., both directors of the Auburn Savings Bank are directors of both the First-Manufacturers National Bank of Lewiston and Auburn and also directors of the bank holding company. Northeast Bankshare Association. (b) The Peoples Savings Bank of Lewiston, Maine have as directors one Joseph Cronin and one William Lindquist who are also directors of the First-Manufacturers National Bank of Lewiston and Auburn. Mr. Cronin is also a director of Northeast Bankshare Association. (c) The Federal Savings & Loan Association of Lewiston, Maine has as a director one Aurele Bosse who is also a director of the First-Manufacturers National Bank of Lewiston. 2. The Federal Savings & Loan Association of Lewiston, Maine has a director by the name of James Longley who is also a director of the Casco Bank & Trust Company of Portland, Maine with four or five branches in Lewiston and Auburn, Maine. Both the Auburn Savings Bank and the Peoples Savings Bank are substantial holders of stock of the Northeast Bankshare Association having exchanged their stock of the First-Manufacturers National Bank for the multiple bank holding company stock the early part of 1970. In addition thereto, the Mechanics Savings Bank of Auburn, Maine holds a substantial block of Northeast Bankshare Association stock (and the Androscoggin County Savings Bank of Lewiston, Maine has a very substantial block of stock of the Northeast Bankshare Association, all being exchanged for original stock of First-Manufacturers National Bank. It seems rather unusual for a country commercial bank, namely First-Manufacturers National Bank to have five interlocking directors. What exists in other parts of the country I do not know, but with interlocking directorates and large blocks of stock that the savings banks own, it is not, in my opinion, good banking practice. You may submit this statement to the Committee if you so desire and I will be glad to answer any questions you may request. Some years ago, I testified before the Bank Housing and Currency Committee on the Financial Institutions Act, being personally opposed to elimination of cumulative voting in national banks. Having been a Receiver of a closed national bank during the banking holiday. I think I am qualified to express a fairly good opinion. With best wishes and thank you for your many courtesies, I remain Very truly yours, ERNEST M . SHAPIRO. PEORIA, III., April it, 1911. Representative WRIGHT PATMAN, Chairman. House Banking Committee, House of Representatives, Washington, D.C. HONORABLE MR. PATMAN : This letter is to congratulate you for your consistent efforts to reform the banking system, as is exemplified in the Banking Reform Act of 1971 (H.R. 5700). It is of especial interest to me, as I have been a director of a Savings & Loan Association for over sixteen years. During this entire period, we have always had money to lend to build homes, even in periods of depression. Perhaps this was because our policies have been quite conservative, and we have made no speculative loans, with the result that we have not grown as rapidly as some of our competitors, although we now are approximately seventy million in size. However, in the last half dozen years, men have been elected to the Board— 575 by proxies—who were also directors of commercial banks. So now of the nine members, four are also directors of different banks. With the support of management, they exert the greatest influence on our policies. Although we are to a degree, competitors of the banks, they are conditioned with the thinking of a commercial bank, which carries over to our Savings and Loan. However, I wish to make it very clear that there is no forcible action taken by them as a group, rather it is a group mentality. Peoria is not an extremely large city, but this interlocking of directors exists in almost every Savings and Loan and bank. This city is however, large enough so that capable men are available to serve on only one Board. I would heartily endorse your recommendation that there be no interlocking directors with Savings and Loans and banks. As for a grandfather clause, it would seem feasible for one such director to resign each year, until the situation is as it should be. Best wishes on the success of your bill. Sincerely, W I L L I A M R . WATSON. The CHAIRMAN. Let us now proceed to hear the witnesses. It would be appreciated if you would give a summary of your statement in approximately 10 minutes each and then we can ask questions. And at the end, if you are not satisfied, and you feel that you must make another statement emphasizing points that you are trying to put over, let us know and we will give you additional time at the end. Thefirstwitness is Mr. Sommer. You may proceed, sir. STATEMENT OF CLIFFORD C. SOMMER, PRESIDENT, AMERICAN BANKERS ASSOCIATION; ACCOMPANIED BY RICHARD P. BROWN, PRESIDENT, ABA TRUST DIVISION; AND B. FINLEY VINSON, CHAIRMAN, ABA FEDERAL LEGISLATIVE COMMITTEE Mr. SOMMER. Thank you very much, Mr. Chairman and members of the committee. I am Clifford C. Sommer, president of Security Bank and Trust Company, Owatonna, Minn., and president of the American Bankers Association. I am accompanied by Richard P. Brown, senior vice president and executive trust officer, the First National Bank, Denver, Colo., who is president of the ABA Trust Division; and B. Finley Vinson, chairman of the board, First National Bank, Little Rock, Ark., who is chairman of the ABA Federal Legislative Committee. We appreciate the opportunity to appear here today on behalf of the American Bankers Association, to express our views on H.R. 5700. This is an extensive piece of legislation, embodying a series of complex proposals, some with which we agree and some with which we do not. In order to expedite this presentation, and to make the views of the American Bankers Association most clear, I thought it best to go through the legislation topic by topic. My presentation today, as j-ou requested, is a summary of our formal statement in order to save the time of the committee. But I request that my entire statement be printed in the record. The CHAIRMAN. Without objection it is so ordered. Mr. SOMMER. Thank you. Mr. Brown and Mr. Vinson will join me in answering questions the committee may have. 576 INTERLOCKING MANAGEMENT If all sections of the legislation dealing with bank interlocking management were enacted—sections 2, 7, 8, and 9—we fear that the present effective functioning of bank boards of directors would be destroyed. Banking is a broadgaged business urgently requiring the counsel of a wide range of knowledgeable and experienced individuals currently active in many segments of the economy. Banking requires their advice, if it is to adequately serve the public interest. Conversely, other corporations elect bankers to their boards to draw on their knowledge and experience in the field of finance. This proposed legislation would eliminate most outside directors. It would damage all banks and would be especially harmful to banks in small communities. Despite the foregoing comments, the American Bankers Association recognizes that potential anticompetitive effects may seem to result from interlocking management between directly competing depository institutions. According^, we endorse the prohibition of certain interlocks among deposit-type institutions, namely: Commercial banks, mutual savings banks, saving and loan associations and credit unions. However, we do not believe that this prohibition should be extended to cover interlocks among less directly competitive financial institutions; for example, insurance companies. In endorsing the prohibition of interlocks between banks and other directly competing deposit-type institutions, we believe it should be limited to institutions in the "same, contiguous or adjacent cities, towns or villages," as now provided in section 8 of the Clayton Act. However, the appropriate regulatory agency should be given authority to ban interlocks beyond such areas if they might substantially lessen competition. On the other hand, the appropriate agency should be authorized to allow interlocks even within the defined area in those very unusual cases where a scarcity of experienced financial talent makes it necessary. Interlocks resulting from common stock ownership, including holding company and chain banking arrangements, should be specifically excluded from the prohibition. We recommend a 5-year time period for corporations to bring their board membership into compliance with the proposed legislation. The above represents the position of the American Bankers Association on the prohibition of management interlocks of depository institutions. We oppose all other prohibitions on interlocks with nondepository institutions; namely, interlocks between depository institutions and: insurance companies; brokerage firms; title companies, appraisal firms and settlement companies with which there is a substantial and continuing relationship; companies with a pension fund managed by the bank; corporations where the bank holds 5 percent or more of the stock; and companies with which the bank has a substantial and continuing loan relationship. We also oppose the ban on directors, officers or employees performing legal services in connection with transactions involving the bank. The ban on interlocks with companies where there is a substantial and continuing loan relationship would force nearly all outside direc- 577 tors off the board. This would seriously impair, if not virtually eliminate, the reservoir of competent talent available for all sizes of financial institutions; or, in the alternative, it would force unnatural credit arrangements—that is, borrowing from institutions other than those on which the company has board representation. Enforcement of this provision could be chaotic to business relationships in small communities, particularly those with only one bank. In the case of the ban on interlocks with firms which have a pension fund managed by the bank, this provision would be anticompetitive rather than increase competition. It could deprive a corporation of the advantage of a full range of competition for its pension account. The ban on interlocks with companies in which a bank trust department holds 5 percent of the voting stock would introduce unnecessary concern about how close the trust fund is to the benchmark percentage instead of concentrating on the quality of a particular investment. In summary, aside from interlocks among competing depository institutions, the effects of the interlock provisions of this bill on all corporations and financial institutions would be traumatic. Its impact would be especially harsh on the small communities. INFLUENCING OFFICERS AND EMPLOYEES OF CUSTOMERS Section 11 would, with certain qualifications, forbid a financial institution from conferring "any substantial benefit,, upon an officer, director, agent, or employee of a corporation or other employee of a corporation or other employer with the intent to influence his conduct with respect to affairs between the financial institution and the employer. We agree that conduct of this sort is reprehensible. We are certainly not in favor of improper influence. However, the language of the proposed section is so vague as to put normal business relationships in question. Therefore we cannot support this section. MUTUAL SAVINGS BANK STOCKHOLDINGS IN OTHER FINANCIAL INSTITUTIONS Section 10 of H.R. 5700 would prohibit mutual savings banks from owning stock in any commercial bank or any other financial institution. While we realize this could have major effects on some banks, particularly in the New England area, nonetheless our association does not oppose enactment of this section, provided it is limited to institutions within the confines of State boundaries, and a 10-year divestiture period is afforded. The latter is necessary in order to avoid adverse impact on the market for many commercial bank stocks, including such stocks held by individuals. TRUST DEPARTMENT STOCKHOLDINGS Section 12 would require each insured bank to report annually to the FDIC all the securities it holds in a fiduciary capacity, its voting authority with respect to such securities, and the manner in which it voted the proxies on such securities. This reporting requirement would engulf the FDIC in a virtual 578 torrent of data as 3,500 trust departments file their annual reports. The following are illustrative of the quantity of data which would be generated. One bank recently reported stockholdings in over 1,700 companies, another bank reported holdings in 13,000 separate issues and maturities of municipal bonds, 5,000 corporate and agency issues, 4,500 issues of common stocks and 500 issues of preferred stocks, and a third bank reported its holdings encompass more than 10,000 items. These figures relate to the reporting of securities held; none of the three banks is in New York. The extent of the paperwork involved in extending this to all trust departments and including all three reporting reauirements would be enormous and expensive. As far as we know neither the FDIC nor any other regulatory agency has stated and defined any problems which are to be solved by the analysis of the data required by section 12 and no programs for the analysis of such data have been established. It is said that this reporting requirement would not invade individual privacy. However, take an example of the death of a person in a small- or medium-size community; the holdings of his estate would probably show up quite clearly in the next year's report of his executor, if it were a local bank. This would be particularly true if it were a closely held local business. For these reasons the American Bankers Association is opposed to this section. However, we do not oppose the reporting of truly meaningful information which has significance to the national economy. If the Congress determines such additional reporting is necessary the association would not oppose reporting to the bank regulatory agencies under regulations which they promulgate. The banking regulatory agencies should have the authority to determine what is to be reported and when. The requirements should not be frozen into statute. Section 13 prohibits an insured bank from holding in a fiduciary capacity more than 10 percent of the stock of any corporation registered under the 1933 Securities Act, or holding in a fiduciary capacity any stock of the bank itself or its parent. This provision strikes at the heart of private ownership and management of personal property. Absolute and arbitrary limits are placed on forms of property ownership and management. If this provision is enacted, competition between banks will be reduced. A lifetime customer of a bank may find his wishes as to choice of trust institutions completely frustrated if forced to name a competitor of his own bank as executor or trustee. On occasion, if this measure were enacted, some banks would find themselves unconsciously in violation of the law. The bank may qualify as an executor, not realizing the estate includes above-thelimit stock. To say the bank may sell the excess stock is not an appropriate answer. If considered as a proper investment, from which of its accounts should the bank sell—from the new one or from one of the old ones? For the foregoing reasons we oppose this section. PROHIBITION OF EQUITY PARTICIPATION IN LOANS Section 14 of H.R. 5700 would prohibit commercial banks, savings and loan associations, savings banks, bank holding companies, 579 savings and loan holding companies, and insurance companies from arranging for an equity participation in consideration of the making of any loan. It covers both direct equity ownership, from whichmember banks and most State banks are barred, and the supplemental return or interest override type of participation. In the latter case the lender receives additional compensation from the borrower, tied to income or the price of the stock, without taking an actual.ownership position. It is used as a hedge against inflation. Commercial banking as an industry has not been heavihT engaged in making loans involving even supplemental income arrangements. In a recent survey conducted by the Comptroller of the Currency, only 42 national tianks out of 520 sampled were found to have made loans which also included supplemental income arrangements. The loans involved accounted for only one-fourth of 1 percent of the total commercial and industrial loans held by those 520 banks. We understand that the agencies believe they have the necessary authority to regulate adequately in this area, and therefore we believe this legislation is unnecessary. In any event, if the Congress decides to legislate in this area, then we urge that section 14 explicitly state that it does not apply to bank investment in small business investment companies (SBIC's), to corporations for housing partnerships; to Edge Act corporations; to trust department acquisitions of convertible bonds or warrants, now permitted by law; nor to bank holding companies and the nonbank subsidiaries of those companies. INSIDER LOANS The American Bankers Association opposes section 15 of H.R. 5700, which would prohibit insured banks from extending credit to any corporation where the bank's directors, trustees, officers, employees— and members of their immediate families—own in the aggregate, 5 percent or more of any class of the corporation's stock. We cannot realistically imagine any potential credit abuse or benefit to the public significant enough to demand such a broad and burdensome prohibition. There are statutory tools available to the supervisor}' agencies for handling self-dealing by officers, directors, and employees. Examination procedures are currently adequate to identify and protect against potential "insider" credit abuses. Moreover, the bill would prohibit, for specific example, the hiring of the daughter of an individual owning a small incorporated construction business borrowing at the bank; or hiring the daughter of the owner of a small incorporated agricultural business. Those are specific examples from m}r own bank. Section 15 is so constructed that there is no way for a bank to protect itself against unintentional violation of the proposed law. A bank cannot compel the families of its personnel to disclose their stockholdings. Yet a bank would violate the proposed provision if it extended credit to a company, 5 percent of whose shares were owned by wives, children, and parents of bank employees. Section 15 would also require all insured banks to report—and the FDIC to disclose publicly—all loans made to all insured-bank em- 580 ployees and their families. Present law already prohibits all but certain specific types of loans to executive officers of Federal Reserve member banks, and requires disclosure of the permitted loans to the FDIC. Generally, State laws require such disclosures by State nonmember banks. PROHIBITION OP BROKERED DEPOSITS The American Bankers Association supports the prohibition of brokered deposits, at which sections 19, 20, and 21 are aimed. However, the prohibition should be limited to brokered deposits involved in link financing; that is, those arrangements in which a deposit is made contingent upon a loan being granted to a specified customer, wherein the transaction is arranged by a third-party broker. By limiting this prohibition of HR. 5700 to link-financing arrangements, the Congress can avoid possible unintended effects of the legislation. For example, we doubt that the legislation is intended to preclude the purchase of negotiable CD's in the money markets through banks or brokers where a small commission is paid: nor to prevent money center banks from acquiring funds through brokers in the Eurodollar market; nor to prevent banks from using incentive campaigns among employees to attract new customers. All of these practices are sound banking procedures. PROHIBITION OF GIVEAWAYS The American Bankers Association believes that sections 22, 23, and 24 of H.R. 5700 which would prohibit "giveaways" to attract deposits, are unnecessary and undesirable. We believe the regulatory agencies are satisfactorily handling this practice now. A recent survey of FDIC regional directors showed that the use of "giveaway" campaigns has not resulted in supervisory problems for that agency. We believe the existing regulatory approach to giveaways is much preferred to a statutory prohibition. This permits flexibility to allow the use of this tool to encourage new savings and to enhance competition. Historically, giveaways have been used to encourage thrift and savings, which in turn are helpful in channeling more funds into housing and other consumer areas. 100 PERCENT INSURANCE FOR PUBLIC FUNDS The American Bankers Association opposes sections 25 and 26 of H.R. 5700 which would extend insurance coverage on public deposits, including those of Government agencies, to 100 percent. The provision would also authorize the insuring agencies to limit the amount of public funds which insured banks and savings and loan associations could legally accept. Under present arrangements, protection of public deposits in banks is accomplished by means of pledging securities for the protection of such deposits in excess of the insurance limit. In our judgment, 100percent insurance of such funds as provided for in H.R. 5700 could have some adverse effects on our financial system. 581 It is assumed, of course, that if there is 100 percent insurance for these deposits, pledging of acceptable assets would no longer be required. Thus, banks would be freed from holding an estimated minimum of $30 billion in securities now pledged against State and local deposits, exclusive of Federal Government deposits, which I may say would add about $7 billion. Accordingly, this could adversely affect the municipal and U.S. Government securities markets. The reduced demand for such securities could raise borrowing costs for Federal, State, and local governments. The proposal for 100-percent insurance coverage of public accounts could open the door to pressure for similar treatment of all accounts. Private account holders, some with quasi-public responsibility, could well ask why their savings or checking accounts above $20,000 are any less important than Government funds. When the county sewerdistrict receives 100 percent of its deposits under Government insurance, the local hospital will come in and say, "Where is ours?" These possibilities must be weighed in considering 100-percent insurance for public units. Should insurance coverage become complete for all types of accounts, there is little reason for depositors to rely upon the soundness, capital structure, and integrity of management of individual banks. It has been said that, as far as safety of deposits is concerned, up to the insurance limit, one bank is as good as another, so why worry about how well managed or how sound it is; the FDIC will be fully responsible. Mr. Chairman, if, despite the arguments against 100-percent insurance for public deposits, Congress still decides it to be appropriate, we urge that the ceiling rates payable by savings and loans and banks on the share accounts and time deposits of public units be identical. H.R. 3287, LOANS ON HYPOTHECATED BANK STOCK Mr. Chairman, we understand your committee is also interested in our views on H.R. 3287, a bill introduced by Congressman Gonzalez to prohibit federally insured banks from making loans for the purchase of bank stock, bonds, debentures, or other obligations of any bank. We oppose this absolute prohibition of banks to lend funds or extend credit for such purposes, particularly the purchase of bank stock. The legislation would reduce capital flows into banking and would result in making bank stocks a less desirable investment. It would have an adverse effect on the market for bank shares, hurting individuals and institutions holding such stocks. The language of the bill is so broad as apparently to prohibit a bank loan for the purchase of even a single share of stock. We appreciate very much this opportunity to present these views. Thank you. The CHAIRMAN. Thank you, sir. You did a good job reading your testimony. Mr. WILLIAMS. May I make an observation. I believe that Mr. Sommer has only read his summary of 12 pages. He has presented another statement of 20 pages. Is that not correct, Mr. Sommer? M r . SOMMER. Yes. Mr. WILLIAMS. And you want that statement included in the record? 582 M r . SOMMER. Yes. The CHAIRMAN. That request has already been taken care of. (The prepared statement of Mr. Sommer follows:) P R E P A R E D STATEMENT OF C L I F F O R D C . SOMMER, P R E S I D E N T , B A N K E R S ASSOCIATION AMERICAN Mr. Chairman and members of the Committee, I am Clifford C. Sommer, President of Security Bank and Trust Company, Owatonna, Minnesota, and President of The American Bankers Association. I am accompanied by Richard P. Brown, Senior Vice President and Executive Trust Officer, The First National Bank, Denver, Colorado, who is President of the A.B.A. Trust Division; and by B. Finley Vinson, Chairman of the Board, First National Bank, Little Rock, Arkansas, who is Chairman of the A.B.A. Federal Legislative Committee. We appreciate the opportunity to appear here today on behalf of The American Bankers Association, to express our views on H.R. 5700. This is an extensive piece of legislation, embodying a series of difficult subjects. Some of these topics relate to just one section of the bill; others involve two or three sections. In order to expedite this presentation, and to make the views of The American Bankers Association most clear, I thought it best to go through the legislation topic by topic. If we were asked to give our views on H.R. 5700 as one package, without consideration of the individual parts, we would oppose it. However, we find in the proposed legislation sections which we can support and I will note these as I go through the presentation. We question the implication left by the title "Banking Reform Act." A high level of performance of banks and other financial institutions is consistently achieved to maintain the necessary public confidence in our financial system. Let me now turn to the various topics for discussion. INTERLOCKING MANAGEMENT If all sections of the legislation dealing with bank interlocking management were enacted—Section 2, 7, 8 and 9—we fear that commercial bank boards of directors would be decimated. Banking is a broad-gauged business urgently requiring the counsel of a wide range of knowledgeable and experienced individuals currently active in many segments of the economy. Banking requires their advice, if it is to adequately serve the public interest. American business and industry have learned over the years that the public interest, as well as the interest of stockholders, is best served by a corporate board of directors which includes high caliber responsible people with varying backgrounds and experience. This proposed legislation would eliminate most outside directors. It would damage all banks and would be especially harmful to banks in small communities. An all "inside" board would lack broad perspective. In our smaller cities and towns, business and civic leaders serve on the boards of the local banks as a matter of community pride and duty. The choice of these leaders is not just a happenstance. Indeed, it is a necessity for the proper functioning of the banks in the interest of their communities. Conversely, other corporation elect bankers to their boards to draw on their knowledge and experience in the field of finance. The most disturbing part of all this is that no need has been shown for such a drastic curtailment of the reciprocal use of talent. Bank directors are held by the courts to a higher standard of conduct than is required of other directors. Despite the foregoing comments, The American Bankers Association recognizes that potential anti-competitive effects may seem to result from interlocking management between directly competing depository institutions. Accordingly, we endorse the prohibition of certain interlocks between banks and other deposittype institutions; namely, mutual savings banks, savings and loan associations and credit unions. However, we do not believe that this prohibition should be extended to cover interlocks among less directly competitive financial institutions, such as insurance companies. In endorsing the prohibition of interlocks between banks and other directly competing deposit-type institutions, we believe it should be limited to institutions in the "same, contiguous or adjacent cities, towns, or villages," as now provided in Section 8(a) of the Clayton Act. However, the appropriate regulatory agency 583 should be given authority to ban interlocks beyond contiguous areas if they might tend to substantially lessen competition. On the other hand, the agency should be authorized to allow interlocking relationships even within the defined area if such an interlock is necessitated by a scarcity of experienced financial talent. Interlocks resulting from common stock ownership including holding company and chain banking arrangements should be specifically excluded from the prohibition no matter where the institutions are located. The regulator}' agencies or State law could determine what common ownership is. This flexible administrative approach will permit the agencies to bar interlocks where competitive harm could result, while at the same time it will permit interlocks where they are, on balance, advantageous to banks and the public they serve. We recommend a five-year time period for corporations to bring their board membership into compliance with the proposed legislation. With this general statement let me now make specific comments on particular sections of H.R. 5700. MANAGEMENT INTERLOCKS AMONG FINANCIAL INSTITUTIONS (SECTIONS 2, 3 AND 4) Subject to the limitations described above, we endorse the prohibition of management interlocks among competing deposit-type institutions. However, Sections 2, 3 and 4 of H.R. 5700 would also prohibit interlocks between deposit-type institutions and insurance companies and brokerage firms, as well as title companies, appraisal firms and settlement companies with which there is a substantial and continuing relationship with the lender. We oppose these prohibitions. These businesses and depositoy institutions are not major competitors. Banks need the expertise of competent financial advisers in the insurance field, and vise versa. Prohibition of such interlocks would significantly diminish the supply of talent in these financial areas. If ourfinancialinstitutions, both depository and others, evolve in such a way as to make insurance companies and banks more directly competitive at some time in the future, reassessment would be in order. But we firmly believe such interlocks should not now be prohibited. With regard to depository institution interlocks with title companies, appraisal companies, and settlement companies, the barring of these individuals from depository institution boards will result in a loss of considerable knowledge in real estate matters, including the secondary mortgage market, to the detriment of the communities served. It should be noted that the Banking Act of 1933 prohibits interlocks between banks and securities dealers. Federal Reserve Regulation R implements this provision of the Banking Act of 1933. MANAGEMENT INTERLOCKS INVOLVING TRUST OFFICERS (SECTIONS 2 AND 8) One particular problem arising from section 2, as well as from section 8 (discussed later) relates to closely held or family corporations, the stock of which may come to the bank as a part of the assets of an estate or a trust. Often such holdings will represent a substantial part of the outstanding shares of the company. Normally, the market for such stock would be limited and in many cases the bank may lack authority to sell the stock. Moreover, the bank's role may be only to act as a conduit, that is, to hold the stock temporarily until the estate is distributed to bfeneliciaries of the decedent or to hold it in trust until children are old enough to take over the business. To deal effectively with such stock as required by its fiduciary responsibility the bank may find it necessary to place a trust officer on the board of directors. The purpose of such action is to protect the interests of the estate or trust beneficiaries. A man who has spent his lifetime building a business, may decide in detail how a trustee bank should manage the company after his death, during the life of his widow and/or during the younger years of his children. There may be special circumstances which make such an arrangement desirable. In these cases, the bank trust department may be asked to manage his trust, including the company. Without the right to have a trust officer on the company's board, the bank would probably be unable to fulfill its duty. In such instances the American people should not be denied access to the expertise of the corporate fiduciary. Accordingly, we oppose the provisions of Sections 2 and 8 which woulc do this. 584 MANAGEMENT INTERLOCKS AND EMPLOYEE BENEFIT PLANS (SECTION 7) The American Bankers Association opposes Section 7 of H.R. 5700. Section 7 would prohibit a bank officer, director, or employee from serving as a director of a corporation which has a pension fund managed by the bank. The same prohibition would apply to other financial institutions handling pension plans. This provision would be anti-competitive rather than increase competition. In many instances, it could reduce the number of banks competing for specific pension business. A large corporation may have several bank related directors. It may have several pension plans. In fact in many cases large corporations divide a pension fund among several trustee banks to see which one performs best. Section 7 could deprive a corporation of the advantage of a full range of competition for its pension account. In some medium sized and smaller communities, corporations with pension plans trusteed by local banks might have to look to banks in other communities for trustees, giving rise to inconveniences as well as eliminating sources of competition in the field. This also applies to otherfinancialinstitutions that compete with banks as investment managers for pension funds. Corporations, of course, could place their pension funds with individual trustees, investment advisers or mutual funds without concern over Section 7. There is no justification for diverting pension business to such other investment managers. To provide full competition, banks should have the same opportunity for pension business as individual trustees, investment advisers, and mutual funds. Before leaving Section 7, I want to comment briefly on current governmental regulation of pension funds and their management. One of the incentives for establishing pension plans is the tax benefit allowed to qualified plans. The tax law restricts self-dealing and a number of other specified practices relative to pension funds. The bank or other trustee must annually state, subject to penalty of law, whether any of the prohibited activities have or have not taken place. If they have taken place, the fund will lose its qualification and consequently its tax benefits. The Federal Reserve, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation scrutinize pension fund investments during their examinations of trust departments. These examinations are concerned with protecting trust beneficiaries as well as depositors. This concern is essential for the protection of the bank and its capital against possible liabilities for non-performance of its duties as trustee. The Comptroller indicates that he gives particular attention to pension funds in which stock of the employer corporation is held; and further if there is a management interlock, the examination would be even more stringent. If employee contributions are used to purchase employer stock for a pension fund, the Securities Act of 1933 requires that the pension plan be registered with the S.E.C.; thus a third federal regulator is involved. A fourth government agency, the Labor Department, is also involved through the Welfare and Pension Plans Disclosure Act. Section 7 would not be in the best interest of the millions of American workers who are covered by pension plans. MANAGEMENT INTERLOCK AND VOTING CON1ROL OF SECURITIES (SECTION 8) The American Bankers Association opposes Section 8 of H.R. 5700. This section would prohibit an officer, director or employee of afinancialinstitution from serving at the same time as an officer or director of a corporation if the institution holds 5 percent or more of such corporation's stock, with the power to vote. As mentioned before, this provision would cause serious problems relative to closely held or family corporations. If the purpose of this provision relates to control, there is no evidence that 5 percent of voting stock, plus a corporate director or officer interlock, constitute control. To impose such a sweeping prohibition without such evidence is not justified. Further, if any percentage is used the following problems clearly exist. Section 8 would cause a real problem of policing investments and voting rights in the many individual trust accounts. A trust department would have to keep a running tally of its aggregate holdings and voting rights in corporations with which it has a management interlock. This task would be onerous not only because the stock could be held in several hundred separate accounts but the voting power could only be ascertained by reviewing each of the hundreds of trust instruments setting up these accounts. 585 The enactment of this section would seriously affect investment judgment. The bank would not only have to consider whether a particular stock is a prudent and good investment for a particular trust but, if the benchmark percentage would be reached it would also have to consider whether the investment is worth forcing the resignation of an officer or director from the bank or from the corporation involved. A similar problem would arise where the bank is designated executor of an estate which contains more than the benchmark percentage of the stock of a corporation with power to vote, or an estate which contains only a few shares of a corporation, but, when they are combined with other shares held by the bank, the benchmark is exceeded. The bank in some instances may be forced to chooso between the estate of a lifelong customer and a director who has served the bank faithfully and well for many years. Another problem would arise when a bank qualifies as an executor for an estate and subsequently learns on marshalling its assets that the limit has been exceeded. The bank would have been unknowingly in violation of the section, but how would it correct the situation—remove the director interlock; give voting rights to someone else; sell stock from the estate; sell stock from other accounts, and if so, from which ones? Another problem would arise with regard to the securing of loans. Would the section apply to corporate stock pledged with voting rights to secure a loan? I merely raise it as a question. If it does so apply, it would certainly complicate matters. Section 8 applies to bank holding companies as well as banks, but it allows interlocks between corporations which are part of a bank holding company group. So a bank holding company or affiliate would be allowed an interlock with a corporation if it held less than 5 percent of its stock with voting power or more than 25 percent of its stock with voting power, but not in between. Of course, Federal Reserve Board approval would be required to acquire the latter amount of stock except for nonbank stock acquired by a bank in a fiduciary capacity, in which case the company would not become a member of the holding company group and the exception would not apply. Section 8 is an arbitrary attack on ownership and management of personal property. Both it and Section 7 vitiate fiduciary responsibility. MANAGEMENT INTEROCKS AND LOANS (SECTION 9) The American Bankers Association vigorously opposes Section 9 of H.R. 5700. This Section would prohibit any officer, director trustee or employee of a commercial bank, mutual savings bank, or savings and loan association" from serving at the same time on the board of directors of any corporation with which the institution has substantial and continuing loan relationships. The Federal Reserve Board and the Federal Home Loan Bank Board would make the determination of what constitutes a "substantial and continuing relationship." This is a sweeping section that could be devastating to all financial institutions but particularly those in small communities. As I discussed earlier in my statement, banking is a broad-gauged business that requires expertise from many segments of the economy if it is to adequately serve the public interest. As pointed out before, in many cases, perhaps a majority of cases, this would force all outside directors off the bank's board, limiting the board to insiders. This would seriously impair, if not virtually eliminate, the reservoir of competent talent available for all sizes of financial institutions; or, in the alternative, it would forcc unnatural credit arrangements—that is, borrowing from institutions other than those on which the company has board representation. Enforcement of this provision could be chaotic to business relationships in small communities, particularly those with only one bank. CONTROL OF TITLE COMPANIES, APPRAISAL FIRMS AND SETTLEMENT COMPANIES Certain subsections of Sections 2, 3, 4 and 5 would prevent officers and directors of insured commercial banks, mutual savings banks and insured savings and loan associations, or the immediate families of such persons from controlling (directly or indirectly) any title company, appraisal company or closing company. It seems unreasonable to infringe on the activities of individuals with such broad restrictions on their rights to engage in normal business transactions. 60-299—71—pt. 2 10 586 INTERLOCKING RELATIONSHIPS OF FINANCIAL (SECTION 2) INSTITUTIONS WITH ATTORNEYS The American Bankers Association opposes those subsections of Section 2, which provide that a person who is a trustee, director, officer or employee of an insured commercial bank may not perform legal services in connection with a loan or other business transaction with such institution, for or on behalf of any person. Sections 3 and 6 would place similar prohibitions on savings and loan associations and mutual savings banks. The "Study of the Savings and Loan Industry," directed by Irwin Friend, contains statistics indicating that many lawyers serve on boards of savings and loan associations. There are not comparable figures with respect to the number of lawyers on the board of directors of commercial banks, but it is a very common practice for large as well as small banks to have one or more members of law firms serving on their boards and in many cases an in-house general counsel may serve on a bank's board of directors. Sometimes the outside lawyer who serves on the bank's board of directors is the bank's counsel or a member of that firm which acts as the bank's counsel. In other cases, the outside layer or his firm may do no legal work for the bank. Many banks have legal staffs performing legal service for them, sometimes headed by general counsels. This in-house counsel frequently works with outside law firms, either generally or on specific types of cases. The effect of this prohibition would be to outlaw in-house legal staffs entirely. Moreover, under the language of the bill, it would be impossible for any lawyer practicing independently to be a director of an insured bank. It seems most unlikely that the legislation was intended to have these purposes. Before leaving the general issue of interlocks I want to repeat that the effect of this bill on all corporations and financial institutions would be traumatic. Although this is very true for all corporations, its impact is accentuated in the case of the smaller communities. INFLUENCING OFFICERS AND EMPLOYEES OF CUSTOMERS (SECTION 11) The American Bankers Association opposes Section 11 of H.R. 5700. This section would forbid a financial institution, without the consent of an appropriate superior, to confer "any substantial benefit" upon an officer, director, agent, or employee of a corporation or other employer with the intent to influence his conduct with respect to the affairs between the financial institution and the employer. A financial institution violating this provision would be subject to a fine of not more than $25,000, and the recipient of the benefit would be subject to a fine of not more than $10,000 or imprisonment for not more than one year or both. We are certainly not in favor of improper influence. The problem is that the proposed legislation is so vague as to put normal business relationships in question. Therefore we oppose it. MUTUAL SAVINGS BANK STOCKHOLDINGS IN OTHER (SECTION 10) FINANCIAL INSTITUTIONS The American Bankers Association is not opposed to Section 10 of H.R. 5700, which would prohibit mutual savings banks from owning stock in any commercial bank or any other financial institution. The provisions would probably have major effects on the ownership of some banks, particularly in the New England area. For example, 21 savings banks in New Hampshire and 18 savings banks in Massachusetts own 10 percent or more of the stock of commercial banks. Nonetheless, our Association would not object to this prohibition, with two modifications: First, the prohibition should be limited to competing institutions within a market area. For convenience we would recommend that this be the State boundaries. Second, a reasonable divestiture period should be provided. Under Section 27 of the bill, Section 10 would become effective on the first day of the fourth calendar year after enactment. This is too short. We believe ten .years would be more reasonable in order to avoid adverse impact on the market for many commercial bank stocks, including such stocks held by individuals. We would like to call to the Committee's attention a complication that will have to be resolved. The application of Section 10 to mutual savings banks in Massachusetts would involve constitutional problems, since many mutual 587 savings banks in Massachusetts are not members of FDIC but belong to an insurance fund run by the Commonwealth of Massachusetts. TRUST DEPARTMENT STOCKHOLDINGS (SECTIONS 12 AND 13) Mr. Chairman, I now turn to the provisions of the bill which directly affect bank trust departments. The first group found in Section 12 relate to reporting and the second group found in Section 13 prohibit certain stockholdings. Section 12 requires an insured bank to report annually to the FDIC all the securities it holds in a fiduciary capacity, its voting authority with respect to such securities, and the manner in which it voted the proxies of such securities. The American Bankers Association is opposed to this section. This reporting requirement would engulf the FDIC in a virtual torrent of data as 3500 trust departments file their annual reports. The following are illustrative of the quantity of data which would be generated. One bank recently reported stock holdings in over 1700 companies, another bank reported holdings of 13,000 different maturities and issues of municipal bonds, 5,000 corporate and agency issues, 4,500 different common stocks and 500 different preferred stocks, and a third bank reported its holdings encompass more than 10,000 items. These figures relate only to the reporting of securities held; none of the three banks is in New York. The extent of the paper work involved in extending this to all trust departments and including all three reporting requiremeuts would be enormous. We believe the FDIC would find it most burdensome, to cope with it in any meaningful way. Neither the bill, the FDIC, nor any other regulatory agency has stated and defined any problems which are to be solved by the analysis of the data required by Section 12 and no programs for the analysis of such data have been established. It is said that this reporting requirement would not invade individual privacy. However, take an example of the death of a person in a small or medium size community ; the holdings of his estate would probably show up quite clearly in the next year's report of his executor, if it were a local bank. This would be particularly true if it were a closely held local business. The reporting of voting authority as to all stockholdings would impose an almost impossible burden on some trust departments because they keep no aggregate figures and would have to check each trust instrument against each holding of stock. The American Bankers Association is aware of the important portion of the security holdings of the nation which has been entrusted to its member Trust Departments, and is devoted to the principle that the trusts which hold these significant assets shall be properly administered in the interests of their beneficiaries and in accordance with the law of the land. The Association is also aware that knowledge of the manner of the handling of these assets can have significance to the Congress and the regulatory agencies in their studies of the economy. We do not oppose the reporting of truly meaningful information which has significance to the national economy. We do oppose most strongly, however, blanket reporting requirements covering even the most insignificant transactions, sought to be imposed without analysis or consideration of the burden which they would impose on the banks required to report, and without delineating the objectives to be accomplished by the reporting or the manner in which the information to be reported will contribute to such objectives. If the Congress determines additional reporting is necessary the Association would not oppose reporting to the banking regulatory agencies under regulations which they promulgate. The banking regulatory agencies should have the authority IO determine what is to be reported and when, and this should not be frozen by statute. Section 13 prohibits an insured bank from holding in a fiduciary capacity more than 10 percent of the stock of any corporation registered under the 1933 Securities Act, or holding in a fiduciary capacity any stock of the bank itself or its parent. We are opposed to this section. This provision strikes at the heart of private ownership and management of personal property. Absolute and arbitrary limits are placed on forms of property ownership and management. These prohibitions seem to be aimed at two different issues: (1) economic concentration and (2) management perpetuating itself through trust department holdings. Some comments are applicable to both provisions. They both prohibit the holding of stock without regard to voting authority, 588 investment authority, the manner in which the stock is obtained, or the degree of judicial or administrative regulation. It makes no difference under these provisions if the stock were voted by someone else, if the investment decisions were made by someone else, if the stock came to the bank in the estate of a decedent who named the bank executor or trustee, if it came to the bank as a part of some other type account established by an individual, or if the account in which it is held is subject to judicial review. The 10 percent limitation provision could interfere with the right of an individual to dispose of his estate or handle his property as he wishes. A person who owns a substantial portion of a public corporation might have a most difficult time finding a bank to name as executor or trustee; and once he found one, he could never be sure that the bank's position with regard to such stock might not change before his death. In fact, if his holdings exceeded the 10 percent mark he could not use a corporate fiduciary for his executor or trustee at all. Even a person with a small investment in a public corporation could never be sure but that his holding would be enough to put the bank he selects as trustee or executor over the 10 percent mark and result in the bank refusing his account. If this provision is enacted, competition between banks will be reduced. Lifetime customers of a bank may find their wishes completely frustrated as they are forced to name competitors as executors or trustees. On occasion, if this measure were enacted, some banks would find themselves unconsciously in violation of the law. The bank may qualify as an executor, not realizing the estate contains prohibited stock. It is no answer to say the bank may sell the excess stock. If the bank considers it a proper investment, from which of its accounts should it sell—the new one or one of the old ones? Over the years banks develop good relationships with certain families which control local businesses. These customers know the bank and want them to administer their estates and their trusts. The wishes of such persons will often be thwarted if this provision is enacted. The complete lack of validity of this provision can be seen in the fact that no size limit is placed on individual ownerships; yet this provision applies a 10 percent limit when the stock is probably held in several, if not hundreds, of accounts, each with its own individual considerations. The bank cannot sell, buy or vote the stock without considering its impact on each account affected, and without being liable to each beneficiary affected. On occasion a bank will be buying and selling a single stock for different accounts on the same day. Where the bank does have investment authority the provision would interfere with investment judgment once 10 percent is reached or approached. Many of my comments on the 10 percent limitation are equally applicable to the limitation on a bank holding its own stock, or that of its parent. It would interfere with a person's right to dispose of his estate or handle his property as he wishes. A director, officer, employee or customer of the bank who owned bank stock would have to turn to a competitor bank or an individual to be his executor or trustee. This is unreasonable. If carried to its logical conclusion, each bank in a community could be controlled by its competitor. It is unlikely that the Justice Department or the Federal Reserve Board would allow this, so a person holding bank stock might have to leave his home community to find an executor or trustee in whom he would have the necessary confidence. The bank limitation, like the 10 percent limitation, disregards the voting authority and the investment authority. Banks are precluded under the common law of trusts from buying their stock or that of their parent unless expressly authorized under provisions of a trust instrument. Similarly they sell any stock of the bank or its parent coming to the bank as a part of an estate or trust, unless there is authority to retain it. Present law prohibits a national bank from voting its own stock at an election of directors. It is unreasonable to prohibit a bank from holding its own stock or that of its parent, if it comes to the bank in an estate or trust with authority to retain, or from a customer who opens an account of some type and directs its retention. Also it is unreasonable to prohibit a bank from buying its own stock for its employee profit sharing plan. Thus, the A.B.A. opposes the bank limitation of Section 13. PROHIBITION OF EQUITY PARTICIPATION ON LOANS (SECTION 14; Section 14 of H.R. 5700 would prohibit commercial banks, savings and loan associations, savings banks, bank holding companies, savings and loan holding 589 companies, and insurance companies from arranging for an equity participation in consideration of the making of any loan. The American Bankers Association opposes this blanket prohibition. Basically, equity participations are of two distinct types. On the one hand, there are simple equity participations in which the lender receives an ownership interest in the borrowing business enterprise, in addition to the interest received on the loan. The second type of equity participation involves a supplemental return to the lender sometimes referred to as an interest override. In this case, the lender receives additional compensation from the borrower without taking an actual ownership position. This compensation may be granted as a certain percentage of specified income from the business, or it may be based on the market action of the stock, or on some other device. Typically, banks arranging for an equity participation in connection with a loan have been restricted to the supplemental return or interest override type of participation. Laws governing national banks and most state banks prohibit commercial banks from obtaining a direct ownership in a borrower's business. Most lenders arranging for equity participations have done so as a hedge against rapidly rising prices, which reduce the nominal yield on straight, nonconvertible debt instruments. It is not surprising, therefore, to find this practice to have grown somewhat over the past several years. We believe a supplemental income arrangement or an equity participation is essential to persuading prudent lending institutions to grant long term financing, as a hedge against inflation. Commercial banking as an industry has not been heavily engaged in making loans involving equity participations. In a recent survey conducted by The Comptroller of the Currency, only 42 national banks out of 520 sampled were found to have made loans which also included equity participation arrangements. The loans involved accounted for only one-fourth of one percent of the total commercial and industrial loans held by those 520 banks. Rather than prohibit banks and other financial institutions from engaging in equity participations by legislation, the matter should be left to the regulatory agencies. It is our understanding that the agencies believe they have the necessary authority to regulate in this area. If the agencies find that they need additional powers, appropriate legislation could be provided. In any event, we urge that it be made explicit that Section 14 not apply to bank involvement with small business investment companies (SBICs), corporations for housing partnerships, nor Edge Act corporations. It should be made clear that it does not preclude trust department acquisitions of convertible bonds or warrants, now permitted by law. The management of equities is an inherent part of trust department business. Further, we see no valid reason why this section of the bill should apply to bank holding companies or to the nonbank subsidiaries of those companies, since these companies operate as separate entities, whose functions do not impinge on the bank subsidiary. INSIDER LOANS (SECTION 15) The American Bankers Association opposes Section 15 of H.R. 5700. The final provision of Section 15 would prohibit insured banks from extending credit to any corporation where the bank's directors, trustees, officer, employees—and members of their immediate families—own in the aggregate, 5 percent or more of any class of the corporation's stock. Sections 16 and 18 would similarly restrict insured savings and loan associations and mutual savings banks. I cannot realistically imagine srny potential credit abuse or benefit to the public significant enough to demand such a broad and burdensome prohibition. There are statutory tools available to the supervisory agencies to handle selfdealing as it relates to officers, directors and employees. Examination procedures currently identify and are equipped to protect against these potential "insider" credit abuses. As pointed out earlier, this would have a seriously detrimental effect on the ability of banks to obtain competent directors. This would affect banks of all sizes, particularly in the small communities. I would add that Section 15 is burdensome, if not inequitable, for present and prospective employees of banks. Under this section a bank would have to require each of its employees to disclose, as a condition of employment, his and his immediate family's holdings of all corporate securities. Further, the bank would have to require any person who accepts bank employment to report all subsequent stock transactions and those of his famity. A bank would have to withhold credit 590 from a corporate loan-application where the bank's employees and their families, in the aggregate, own 5 percent of the credit applicant's stock; or alternatively it would have to release, or refuse to hire, bank employees associated with such companies. This could have unanticipated effects. For example, it would prohibit the hiring of the daughter of an individual owning a small incorporated construction business which is a borrower at the bank. The same would be true of a family member of the owner of a small incorporated agricultural business. Section 15 is so constructed that there is no way for a bank to protect itself against unintentional violation of the proposed law. While a bank can require its personnel to disclose their stock holdings, it cannot compel the families of its personnel to do so. Yet a bank would violate the proposed provision if it extended credit to a company, 5 percent of whose shares were owned by wives, children and parents of bank employees. Section 15 would also require all insured banks to report—and the FDIC to disclose publicly—all loans made to all insured-bank employees and their families. The Association vigorously opposes this provision. Present law already prohibits all but certain specific types of loans to executive officers of member banks, and requires disclosure of the permitted loans to the FDIC. Similarly, State laws require such disclosures by State non-member banks. We believe the extension of these laws embodied in H.R. 5700 serves no reasonable purpose. To make loans for automobiles, furniture or education a matter of public record merely because the borrower chose to work for a bank or because the borrower chose to marry a bank employee, in our view amounts to an unjustified interference in his personal life. PROHIBITION OF BROKERED DEPOSITS (SECTIONS 19, 20, AND 21) Sections 19, 20 and 21 of H.R. 5700 would amend the Federal Deposit Insurance Act and the Federal Home Loan Bank Act to prohibit Federally insured banks and savings and loan associations or any of their officers, directors, agents or substantial stockholders, from paying or agreeing to pay any person, including a broker or finder, compensation for obtaining deposits. In the definition of the term "payment of interest," the legislation would include any payment, or agreement to make a payment, to a depositor or other person as an inducement to place a deposit, if the bank or savings and loan association either knew or reasonably should have known of the payment or agreement for payment when the deposit was accepted. The American Bankers Association supports the prohibition of brokered deposits, at which these sections are aimed. However, the prohibition should be limited to brokered deposits involved in link-financing, that is, those arrangements in which a deposit is made contingent on a loan being granted to a specified customer, with the transaction being handled by a third party broker. By limiting this prohibition of H.R. 5700 to link-financing arrangements, the Congress can avoid possible unintended effects of the legislation. For example, we doubt that the legislation is intended to preclude the purchase of negotiable CD's in the money markets through banks or brokers where a small commission is paid; nor to prevent money center banks from acquiring funds through brokers in the Euro-dollar market; nor to prevent banks from using incentive campaigns among employees to attract new customers. All of these practices are sound banking procedures. We do not believe that the bill is intended to prohibit the foregoing transactions. However, this can be made certain by simply restricting the prohibition to linkfinanced deposits. Moreover, such a limited provision would zero in on the key problem. PROHIBITION OF GIFT GIVEAWAYS (SECTIONS 22, 23 AND 24) The American Bankers Association opposes Sections 22, 23 and 24 of H.R. 5700 which would flatly prohibit "giveaways" to attract deposits. There is no need for this outright prohibition. The regulatory agencies have all stated in these hearings that they have adequate regulatory authority to control any abuses in this area. In February 1970, the Federal banking agencies and the Federal Home Loan Board issued rulings interpreting these premiums as advertising or promotional expenses rather than the payment of interest or dividends if the premium is given to a new depositor or as an addition to an existing account; is not given on a recurring basis; and the wholesale value of the premium does not exceed $5.00 on deposits up to $5,000, and $10.00 on deposits over $5,000. 591 A recent survey of FDIC Regional Directors showed that the use of "giveaway" campaigns has not resulted in supervisory problems for that agency. We believe the existing regulatory approach to g i v e a w a j ^ s is much preferred to a categorical prohibition. This permits flexibility to allow the use of this tool to encourage new savings, to enhance competition and for other good purposes. Moreover, it can prevent potentially adverse interpretations of what a gift giveaway is. For example, it should not prohibit a bank from offering such items as free checkbooks or checking account services to its customers, nor normal business relations with customers. The Association urges a continuation of the regulatory approach to this problem, and it therefore opposes Sections 22, 23 and 24 of the H.R. 5700. 100 PERCENT INSURANCE FOR PUBLIC FUNDS (SECTIONS 25 AND 26) The American Bankers Association opposes Sections 25 and 26 of H.R. 5700 which would extend insurance coverage on public deposits, including those of government agencies, to 100 percent. The provision would also authorize the Federal Deposit Insurance Corporation and the Federal Savings and Loan Insurance Corporation to set limits on the amount of public funds which insured banks and savings and loan associations could legally accept. Under present arrangements protection of public deposits in banks is accomplished by means of pledging securities for the protection of such deposits in excess of the insurance limit. In our judgment 100 percent insurance of such funds as provided for in H.R. 5700 could have some adverse effects on our financial system. It is assumed, of course, that if there is 100 percent insurance for these deposits, pledging of acceptable assets would no longer be required. Thus, banks would be freed from holding an estimated minimum of $30 billion in securities now pledged against State and local deposits. Accordingly, 100 percent insurance of public funds would have adverse repercussions in the municipal and U.S. government securities markets, as the inevitable result of the reduced need for pledging securities. The reduced demand for such securities could raise the borrowing costs for State and local governments. There would be similar effects on the markets for Federal Securities. Undoubtedly, in most cases, investments would continue to be made prudently, but under 100 percent insurance of public deposits banks would have greater freedom to pursue less conservative policies in the management of their assets. By providing 100 percent insurance for public deposits, this provision would greatty expand the ability of savings and loan associations to accept such deposits. These associations, if authorized by State law, can accept such funds only to the extent of present deposit insurance. Thus, savings and loan associations would be in a position to greatly increase their acceptance of public deposits, expeciallv because they are authorized to pa.y a higher rate of interest than banks under regulations of the Federal Home Loan Bank Board, as authorized by the Interest Rate Control Act. These institutions are not appropriate depositories for public funds. The basic function of savings and loan associations is to channel long term savings into home mortgages. As Chairman Preston Martin of the Federal Home Loan Bank Board advised the Committee on April 20, Section 26 would run counter to this objective. The favorable taxation and regulatory structure under which savings and loan associations operate are designed to hold them to these investments. In the past, they have sometimes found themselves in a tight money position, and available statistics indicate that public time deposits may be drawn down at the same time that such institutions face large withdrawals of private deposits. Thus, the existance of large deposits of public funds would only aggravate the tight money position of savings and loan associations when it would hurt them most. State and local government time and savings deposits, as shown by the experience of commercial banks, appear to be highly volatile. For example, from the beginning of 1968 until the end of that year state and local time deposits of weekly reporting banks increased by 27 percent. One year later, at the end of 1969, these time deposits had been cut in half. This decline coincided with the decline in savings and loan share accounts as a result of the disintermediation which accompanied the pressures of tight money and the rapid increase in market rates of interest. Finally, 100 percent insurance coverage of public accounts could open the door to pressure for similar treatment of all accounts. Private account holders, some with quasi-public responsibility, could well ask why their savings or checking 592 account above $20,000 are any less important than government funds. The test would come at the first institution failure. When the county sewer district receives 100 percent of its deposits shortly after the closing of the institution, the local hospital will come in and say "where is ours?" Then the man on the street will say, "where is mine?" These possibilities must be weighed in considering 100 percent insurance for public units. Should insurance coverage become complete for all types of accounts, there is little reason for depositors to rely upon the soundness, capital structure and integrity of management of individual banks or savings and loan associations. It has been said that, as far as safety of deposits is concerned, up to the insurance limit one bank is as good as another, so why worry about how well managed or how sound it is; the FDIC will be fully responsible. Mr. Chairman, if despite the arguments against 100 percent insurance for public deposits Congress still decides it to be appropriate, we urge that the ceiling rates payable by savings and loans and banks on the share accounts and time deposits of public units be identical. H . R . 3287, LOANS ON HYPOTHECATED B A N K STOCK Mr. Chairman, we understand your Committee is also interested in our views on H.R. 3287, a bill introduced by Congressman Gonzalez to prohibit federally insured banks from making loans for the purchase of bank stocks, bonds, debentures, or other obligations of any bank. We oppose this absolute prohibition on the ability of federally insured banks to lend funds or extend credit to a borrower for the purpose of purchasing the stock of a bank. It would have adverse effects. The legislation would reduce capital flows into banking and would result in making bank stocks a less desirable investment. The language of the bill is so broad as apparently to prohibit a bank loan for the purchase of even a single share of stock. Further, it would have an adverse effect on the market for bank shares, hurting individuals and institutions holding such stocks. It would make it difficult, if not impossible in some cases to transfer bank stock ownership. It may mean that only the wealthy would be able to buy banks. We are also concerned about the impact of this legislation on an important supervisory tool, namely, the enlistment of a financially strong institution to finance the purchase of a weak one. The CHAIRMAN. Mr. Carlson, you are recognized, sir. You may present your testimony. STATEMENT OF DONALD M. CARLSON, PRESIDENT, INDEPENDENT BANKERS ASSOCIATION OF AMERICA; ACCOMPANIED BY ROD L. PARSCH, CHAIRMAN, FEDERAL LEGISLATIVE COMMITTEE Mr. CARLSON. Thank you, Mr. Chairman. Mr. Chairman and members of the committee, my name is Donald M. Carlson of Elmhurst, 111., where I am president of the Elmhurst National Bank. I appear here today as president of the Independent Bankers Association of America, an organization representing over 6,500 banks, about one-third of which are national banks. We appreciate the opportunity to give you our views on H.R. 5700. This proposed legislation is directed to actual or potential abuses in several types of financial institutions, not merely commercial banks. For this reason, we feel stronglv that the bill should not be titled the "Banking Reform Act of 1971." We appreciate and understand the need to control unsound practices in all financial institutions, including conflicts of interest, self-dealing, and anticompetitive practices. However, we note that the data upon which H.R. 5700 is based largely concerns less than 50 banks in 10 large cities, and that there is no like data as to the more than 13,000 593 other banks and several thousand other financial institutions throughout the country. At present there is no evidence that similar undesirable practices exist in any significant degree in banks and other financial institutions. In the absence of adequate information, we recommend that this committee make a general survey of the suspected practices in all financial institutions—commercial banks, savings banks, savings and loan associations, insurance companies, brokerage firms, credit unions, and financial holding companies in all of the States. This will require time and effort, but is the best way to develop wise and sound legislation. At this point, we believe that indesirable practices on the part of any or all of the financial institutions mentioned will not be found to exist generally throughout the country as was found in the 10 large cities surveyed. Until a national survey of all of these institutions is made and evaluated, we think it unwise to provide for such sweeping prohibitions and severe penalties as are contained in this bill. Further, we think it is unfair to place all of these institutions, which with rare exceptions are honorably operated, under severe restraints because of the wrongdoings in a few. Some of the provisions of the bill, aimed at a few offending institutions, actually are unnecessary and are harmful to smaller institutions. The failure to make this distinction, in our view, is a major oversight in the bill. It can be cured and better ways found, if more essential data is gathered. After that, a bill could be drawn to control the varying practices to the extend reasonably required. For the reason that we are not better informed as to the extent or nature of the supposed undesirable practices by all institutions, we feel unable at this time to offer more than the general observations of our Federal Legislative Committee. INTERLOCKING RELATIONSHIPS As to sections 2 through 9 of the bill dealing with interlocking relationships between financial institutions, and between these institutions and others, we agree that the type of practices described in these sections are undesirable and must be controlled. However, in each section the bill provides a flat prohibition and, in some cases, severe penalties. In some sections arbitrary standards are used. The prohibitions apply to all deposit-type institutions, and in some cases to the other institutions mentioned above. No distinction is made between large institutions operating in major cities and smaller ones operating in medium and small-sized communities. What justification is there for a ban that would decimate boards of directors of financial institutions throughout the Nation? Until this committee has more information, we feel that instead of outright prohibitions, aibitrary standards and severe penalties, the wiser course would be to provide adequate rulemaking power to the regulatory agencies, and await the action of the Judiciary Committee on the bill before it to expand the scope of section 8 of the Clayton Act dealing with this same subject matter. 594 STOCKHOLDINGS OF MUTUAL SAVINGS BANKS We support the principle that it is not proper for a mutual savings bank to own stock, and perhaps controlling interest in, another type of financial institution. However, we fail to understand, in the draft of section 10, how a State-chartered mutual savings bank can be prevented by Federal law from owning stock in a State-chartered insurance company. Also, section 10 fails to indicate how Federal agencies would enforce this section, and in what manner. CONFLICT OF INTEREST AND BRIBERY Section 11 calls for criminal penalties covering eight types of financial institutions to give, or its officers, directors or employees to accept, any substantial benefit intended to influence transactions between these financial institutions and others. We certainly agree that the conduct described in the bill should be prohibited and violators punished. However, we are not aware of any such conduct, and we are unable to assist the committee with any specific suggestions. TRUST DEPARTMENT STOCKHOLDINGS Sections 12 and 13 contain three subjects: (1) Bank trust departments are prohibited from holding more than a total of 10 percent of any class of stock of any corporation whose stock is required to be registered with SEC. We agree that as little as 10 percent may constitute working control of a corporation, and that if a bank, for its own advantage, through its trust department, deliberately gains and exercises working control of a commercial corporation, this would be improper. This practice is not a legitimate part of the business of banking. On the other hand, there are many situations where a trust department holds clear control of a corporation as part of a customer's estate plan. It is often the intent and purpose of such a customer to use a trust in order to hold together in a bloc for the benefit of his family the control of his corporate business. This is often the only practical way whereby one can prevent family control of a business from becoming fragmented through a series of probates. The bill makes no distinction between a predatory intent on the one hand and legitimate estate planning on the other. We could offer other examples, but this illustrates that such a flat prohibition is neither wise nor workable. We would like to suggest that this problem be left to the regulatory agencies. If they require more rulemaking power to handle the problem, the bill should be modified accordingly. (2) Trust departments are prohibited from holding their own bank stock or stock of a parent holding company. We understand the purposes of this prohibition is to prevent improper perpetuation of management. Again, however, the bill fails to recognize the legitimate purpose of holding family control of the bank together through a trust, as part of the family's estate plan. Rather than to provide an outright prohibition, we feel the bill should be modified to give the regulatory agencies the necessary power to deal with improper situations. 595 (3) The bill provides for public disclosure annually of all holdings of stock in the trust department, and how the voting rights were exercised in the previous year. We feel this is unduly burdensome. It would appear to us to be sufficient that such disclosures be limited to the regulatory agencies. Bank examiners have the power and routinely make inquiries into these matters, and require the bank's board of directors to review the report. If necessary, the regulatory authority in problem cases can arrange an audience with the directors and, if deemed advisable, with stockholders of the bank in a special meeting. If further regulatory power is required, the bill could so provide. We can see no useful purpose in requiring every bank trust department to make public disclosure of how voting rights are exercised as to all of the securities held, without regard as to the good or bad purpose of the creator of the trust or of the bank. In smaller communities, this would be considered a breach of confidence and could destroy a bank's trust department. EQUITY PARTICIPATION Section 14 prohibits financial institutions from obtaining part of the equity in a business enterprise in return for extending credit. We support section 14. We feel that equity kickers are not a proper or legitimate condition for obtaining a bank loan. INSIDER LOANS Sections 15 through 18 flatly prohibit deposit-type institutions from extending credit to a company where 5 percent or more of its stock in the aggregate is owned by principals or employees of the institution. We feel that this is an arbitrary standard. We are awrare of no abuses among our banking membership in this respect. We feel there is sufficient regulatory power to handle any actual problem cases, without resorting to an across-the-board prohibition. If not, the bill should provide adequate regulatory power. These sections further require these institutions to publicK- disclose the nature and amount of credit extended to directors, officers and employees, or members of their immediate families It requires disclosure to the lender of the identity of persons receiving benefit from any loan where the loan is made to an agent, trustee or nominee. Again, we feel there is presently sufficient regulation to control any abuses in the field of insider loans. If not, the bill should provide the necessary regulatory power to handle abuses, rather than to fix an arbitrary standard arid public disclosure of all such transactions. Our impression is that abuses in this area are rare. BROKERED DEPOSITS Sections 19 through 21 prohibit paying a broker or anyone else for obtaining a deposit, and prohibit anyone from receiving anything of value for obtaining funds of others for deposit or investment in banks or savings and loan associations. We support these sections. We feel that it is an improper device 596 for obtaining deposits and has no place in banking. This is especially true where the deposit is contingent upon the making of certain loans. The principle should apply equally to all deposit-type institutions. We note, for example, that savings banks, industrial banks, and credit unions are not covered. GIVEAWAYS Sections 22, 23, and 24 prohibit financial institutions which accept deposits from offering anything of value as an inducement to obtain deposits. We do not oppose these sections, but feel that the present regulations limiting giveaways are adequate and are working, and that no statutory law on giveawa}rs is needed at the present time. 100 PERCENT INSURANCE FOR PUBLIC UNITS Sections 25 and 26 provide 100 percent insurance coverage of deposits of Federal, State and local governments, and permit the agencies to limit the amount of such funds that can be accepted by insured institutions. In principle, this appears to be a desirable objective. However, there are reasons for opposing these sections in their present form. We note that the FDIC would place conditions upon such full coverage, namely: (a) Limiting "the public unit deposits to those located within the State of the institution; (b) Requring uniform restrictions as to the aggregate amount of public funds that could be deposited be limited uniformly among the financial institutions in relation to criteria such as liquidity, total deposits, or capital that both insuring agencies would prescribe; and (c) requiring that the maximum interest or dividends payable on comparable deposits be the same for all banks and savings and loan associations. We have serious doubts as to whether these three conditions can be effectively established. For example, condition (b) assumes that the two insuring corporations would be able to agree on uniform deposit restrictions. Without amendment of several other statutes, these three conditions could not be established and enforced. In many States savings ana loan associations are not permitted to accept public unit deposits. These laws probably recognize that there is a distinct difference between demand deposits in a commercial bank and shares in a savings and loan association which can be restricted as to withdrawal, to the possible detriment of public units. The effect of this bill is to create conditions whereby many savings and loan associations throughout the country for the nrst time will be permitted to accept public deposits. This considerable benefit to them does not take into account the nature of share deposits and the various State laws which regulate the acceptance of such deposits by these associations. It is difficult for us to conceive of how Federal legislation can ignore the effect of changing State laws. Over half the States require the pledging of securities by banks against public unit deposits. Adding 100 percent insurance would 597 amount to double collateral, and would be unnecessary in those States. The bill assumes the repeal of these State pledging statutes. We cannot see how this assumption is justified. It is a matter which can be determined only by those State legislatures. Some of them may not wish to depend totally on deposit insurance. Due to the potential flaws we have pointed out, which could well make the idea unworkable, we oppose these sections in their present form. I thank the members of the committee for their kind attention, and I would like to ask permission that my prepared statement on H.R. 5700 and the statement of Mr. Rod L. Parsch, the chairman of our legislative committee, be placed in the record to present our views on H.R. 3287, which would prohibit all bank stock loans. The C H A I R M A N . Y O U may extend your remarks and add anything you wish. (The prepared statement of Mr. Carlson and statement referred to, of Rod L. Parsch on H.R. 3287, follows:) S T A T E M E N T BY D O N A L D M . C A R L S O N , P R E S I D E N T , I N D E P E N D E N T B A N K E R S TION 5700 OF AMERICA, TO HOUSE BANKING AND CURRENCY COMMITTEE ASSOCIAON H.R. Mr. Chairman 'and members of the Committee: My name is Donald M. Carlson of Elmhurst, Illinois, where I am President of the Elmhurst National Bank. I appear here today as President of the Independent Bankers Association of America, an organization representing over 6,500 banks, about one-third of which are national banks. We appreciate the opportunity to give you our views on H.R. 5700. This proposed legislation is directed to actual or potential abuses in several types of financial institutions, not merely commercial banks. For this reason, we feel strongly that the bill should not be titled the "Bank Reform Act of 1971." We appreciate and understand the need to control unsonnd practices in all financial institutions, including conflicts of interest, self-dealing, and anticompetitive practices. However, we note that the data upon which H.R. 5700 is based largely concerns less than 50 banks in 10 large cities, and that there is no like data as to the more than 13,000 other banks and several thousand other financial institutions throughout the country. At present there is no evidence that similar undesirable practices exist in any significant degree in banks and other financial institutions* In the absence of adequate information, we recommend that this Committee make .a general survey of the suspected practices in all financial institutions— commercial banks, savings banks, savings and loan associations, insurance companies, brokeragefirms,credit unions and financial holding companies in all of the states. This will require time and effort, but is the best way to develop wise and sound legislation- At this point, we believe that undesirable practices on the part of any or all of the financial institutions mentioned will not l>e found to exist generally throughout the country as was found in the 10 large cities surveyed. Until a national survey of all of these institutions is made and evaluated, we think it unwise to provide for such sweeping prohibitions and severe penalties as are contained in this bill. Further, we think it is unfair to place all of these institutions, which with rare exceptions are honorably oi>erated, under severe restraints because of the wrongdoings of a few. Some of the provisions of the bill, -aimed at a few offending institutions, actually are unnecessary and are harmful to smaller institutions. The failure to make this distinction, in our view, is a major oversight in the bill. It can be cured, and better ways found, if more essential data is gathered. After that, a bill could be drawn to control the varying practices to the extent reasonably required. For the reason that we are not better informed as to the extent or nature of the supposed undesirable practices by all institutions, we feel unable at this time to offer more than the general observations of our Federal Legislative Committee. 598 INTERLOCKING RELATIONSHIPS As to Sections 2 through 9 of the bill dealing with interlocking relationships between financial institutions, and between these institutions and others, we agree that the type of practices described in these sections are undesirable and must be controlled. However, in each section the bill provides a flat prohibition and, in some cases, severe penalties. In some sections arbitrary standards are used. The prohibitions apply to all deposit-type institutions, and in some cases to the other institutions mentioned above. No distinction is made between large institutions operating in major cities and smaller ones operating in medium and smallsized communities. What justification is there for a ban that would decimate boards of directors of financial institutions throughout the nation? Until this Committee has more information, we feel that instead of outright prohibitions, arbitrary standards and severe penalties, the wTiser course would be to provide adequate rule-making power to the regulatory agencies, and await the action of the Judiciary Committee on the bill before it to expand the scope of Section 8 of the Clayton Act dealing with this same subject matter. STOCKHOLDINGS OF MUTUAL SAVINGS BANKS We support the principle that it is not proper for a mutual savings bank to own stock, and perhaps controlling interest in, another type of financial institution. However, we fail to understand, in the draft of Section 10, how a statechartered mutual savings bank can be prevented by Federal law from owning stock in a state-chartered insurance company. Also, Section 10 fails to indicate how Federal agencies would enforce this section, and in what manner. CONFLICT OF INTEREST AND BRIBERY Section 11 calls for criminal penalties covering eight types of financial institutions to give, or its officers, directors or employees to accept, any substantial benefit intended to influence transactions between these financial institutions and others. We certainly agnee that the conduct described in the bill should be prohibited and violators punished. However, we are not aware of any such conduct, and we are unable to assist the Committee with any specific suggestions. TRUST DEPARTMENT STOCKHOLDINGS Section 12 and 13 contain three subjects: (1) Bank trust departments are prohibited from holding more than a total of 10% of any class of stock of any corporation whose stock is required to be registered with SEO. We agree that as little as 10% may constitute working control of a corporation, and that if a bank, for its own advantage, through its trust department, deliberately gains and exercises working control of a commercial corporation, this would be improper. This practice is not a legitimate part of the business of banking. On the other hand, there are many situations where a trust department holds clear control of a corporation as part of a customer's estate plan. It is often the intent and purpose of such a customer to use a trust in order to hold together in a bloc for the benefit of his family the control of his corporate business. This is often the only practical way whereby one can prevent family control of a business from becoming fragmented through a series of probates. The bill makes no distinction between a predatory intent on the one hand and legitimate estate planning on the other. We could offer other examples, but this illustrates that such a flat prohibition is neither wise nor workable. We would like to suggest that this problem be left to the regulatory agencies. If they require more rulemaking power to handle the problem, the bill should be modified accordingly. (2) Trust departments are prohibited from holding their own bank stock or stock of a parent holding company. We understand the purpose of this prohibition is to prevent improper perpetuation of management. Again, however, the bill fails to recognize the legitimate purpose of holding family control of the bank together through a trust, as part of the family's estate plan. 599 Rather than to provide an outright prohibition, we feel the bill should be modified to give the regulatory agencies the necessary power to deal with improper situations. (3) The bill provides for public disclosure annually of all holdings of stock in the trust department, and how the voting rights were exercised in the previous year. We feel this is unduly burdensome. It would appear to us to be sufficient that such disclosures be limited to the regulatory agencies. Bank examiners have the power and routinely make inquiries into these matters, and require the bank's board of directors to review the report. If necessary, the regulatory authority in problem cases can arrange an audience with the directors and, if deemed advisable, with stockholders of the bank in a special meeting. If further regulatory power is required, the bill could so provide. We can see no useful purpose in requiring every bank trust department to make public disclosure of how voting rights are exercised as to all of the securities held, without regard as to the good or bad purpose of the creator of the trust or of the bank. In smaller communities, this would be considered a breach of confidence and could destroy a bank's trust department. EQUITT PARTICIPATIONS Section 14 prohibits financial institutions from obtaining part of the equity in a business enterprise in return for extending credit. We support Secton 14. We feel that equity kickers are not a proper or legitimate conditions for obtaining a bank loan. INSIDER LOANS Sections 15 through 18 flatly prohibit deposit-type institutions from extending credit to a company where o% or more of its stock in the aggregate is ownfcd by principals or employees of the institution. We feel that this is an arbitrary standard. We are aware of no abuses among our banking membership in this respect. We feel there is sufficient regulatory power to handle any actual problem cases, without resorting to an across-the-board prohibition. If not, the bill should provide -adequate regulatory power. These sections further require these institutions to publicly disclose the nature and amount of credit extended to directors, officers and employees, or members of their immediate families. It requires disclosure to the lender of the identity of persons receiving benefit from any loan where the loan is made to an agent, trustee or nominee. Again, we feel there is presently sufficient regulation to control any abuses in the field of insider loans. If not, the bill should provide the necessary regulatory power to handle abuses, rather than to fix an arbitrary standard and public disclosure of all such transactions. Our impression is that abuses in this area are rare. BROKERED DEPOSITS Sections 19 through 21 prohibit paying a broker or anyone else for obtaining a deposit, and prohibiting anyone from receiving anything of value for obtaining funds of others for deposit or investment in banks or savings and loan associations. We support these sections. We feel that it is an improper device for obtaining deposits and has no place in banking. This is especially true where the deposit is contingent upon the making of certain loans. The principle should apply equally to all deposit-type institutions. We note, for example, that savings banks, industrial banks and credit unions are not covered. GIVEAWAYS Sections 22, 23 and 24 prohibit financial institutions which accept deposits from offering anything of value as an inducement to obtain deposits. We do not oppose these sections, but feel that the present regulations limiting giveaways are adequate and are working, and that no statutory law on giveaways is needed at the present time. 600 100 PERCENT I N S U R A N C E FOR PUBLIC UNITS Sections 25 and 26 provide 100% insurance coverage of deposits of Federal, state and local governments, and permit the agencies to limit the amount of such funds that can be accepted by insured institutions. In principle, this appears to be a desirable objective. However, there are reasons for opposing these sections in their present form. We note that the FDIC would place conditions upon such full coverage, namely, (a) limiting the public unit depositors to those located within the state of the institution; (b) requiring uniform restrictions as to the aggregate amount of public funds that could be deposited be limited uniformly among the financial institutions in relation to criteria such as liquidity, total deposits, or capital that both insuring agencies would prescribe; and (c) requiring that the maximum interest or dividends payable on comparable deposits be the same for all banks and savings and loan associations. We have serious doubts as to whether these three conditions can be effectively established. For example, condition (b) assumes that the two insuring corporations would be able to agree on uniform deposit restrictions. Without amendment of several other statutes, these three conditions could not be established and enforced. In many states savings and loan associations are not permitted to accept public unit deposits. These laws probably recognize that there is a distinct difference between demand deposits in a commercial bank and shares in a savings and loan association which can be restircted as to withdrawal, to the possible detriment of public units. The effect of this bill is to create conditions whereby many savings and loan associations throughout the country for the first time will be permitted to accept public deposits. This considerable benefit to them does not take into account the nature of share deposits and the various state laws which regulate the acceptance of such deposits by theee associations. It is difficult for us to conceive of how Federal legislation can ignore the effect of changing state laws. Over half the states require the pledging of securities by banks against public unit deposits. Adding 100% insurance would amount to double collateral, and would be unnecessary in those states. The bill assumes the repeal of these state pledging statutes. We cannot see how this assumption is justified. It is a matter which can be determined only by those state legislatures. Some of them may not wish to depend totally on deposit insurance. Due to the potential flaws we have pointed out which could well make the idea unworkable, we oppose these sections in their present form. I thank the members of the Committee for their kind attention, and I would like to a«k the Chairman of our Legislative Committee to present our views on H.R. 3287, which would prohibit all bank stock loans. May I introduce Mr. Rod L. Parsch. who is immediate past president of our Association, and president of the Lapeer County Bank and Trust Company, Lapeer. Michigan. S T A T E M E N T BY R O D L . P A R S C H , C H A I R M A N , F E D E R A L L E G I S L A T I V E C O M M I T T E E , I N D E P E N D E N T B A N K E R S A S S O C I A T I O N OF A M E R I C A ON H . R . 3 2 8 7 , A B I L L TO PROHIBIT B A N K STOCK L O A N S OPENING SUMMARY The proposal to outlaw bank stock loans, when the money borrowed is to be used to finance purchase of a bank is harsh and offers a serious hazard to the future of independent banking. Almost without exception, a business transaction involving the transfer of assets requires financing. A primary function of banks is the lending of monev. Why should they be barred from making a loan, secured by bank stock, to help an individual or corporation from purchasing a bank? We fear that enactment of an outright prohibition against bank stock loans eventually would mean the demise of independent banking. A banker retiring because of health or age rarely is able to find a buyer with enough cash for the full price of the bank. A younger officer of the bank, or a group of such employees, would have the management skills to continue successful operation, but likely would need financing to complete the purchase. 601 In this connection, tax considerations often dictate the use of a one-bank holding company when an individual or group purchases a bank. When a one-bank company is used to buy a bank, there are more after-tax dollars left with which to repay a bank stock loan. In most oases, such a loan constitutes a major part of the price of the purchased bank. Presumably, introduction of this bill was prompted by reports of abuses in this particular area of financing. Any such abuses can be corrected by statutory authority setting guidelines for bank supervisory agencies to follow when considering applications for ownership transfer of banks. Our proposals for standards to guide the appropriate supervisory authority include the requirement that a loan secured by the stock of a bank being purchased shall not exceed 75% of the collateral pledged to secure the loan. FULL STATEMENT ON H.R. 3287 We understand and appreciate the author's reasons for introducing H.R. 3287. Undoubtedly, there have been abuses in this area, and these abuses must be controlled. We have reviewed the letter from the Department of Justice concerning possible criminal offenses in connection with these loans. However, we understand that this letter is based upon the embezzlement statute, particularly that portion having to do with the misapplication of bank funds; that is, the agreement to make substantial deposits in the bank making the bank stock loan on terms favorable to the individual purchaser of a bank. We have discovered no court decision to support this letter from the Justice Department and feel that there is some doubt as to whether the embezzlement statute would apply in these situations. In short, we agree that some control is needed, but that this need does not require the outright prohibition of all bank stock loans. We are here today to plead the case for independent banking in regard to this subject. We are speaking of the clean and deserving case where a bank stock loan is required in order to transfer a smaller bank from one independent owner to another. Our Association represents over 6,500 banks, mostly locally-owned banks in smaller communities. We know from the 40 years' experience in our Association that locally-owned banks serve their communities well because the local owner has a stake in the economic future and success of the community. He is responsive to their needs. He provides competition which only separately-owned banks can provide. They furnish alternate sources of bank credit and services at fair rates which only competition can provide. LOANS NEEDED FOR OWNERSHIP TRANSFER An outright prohibition against bank stock loans would eventually kill independent banking. A banker who retires because of health or age would rarely find a buyer with cash to pay the full price of the bank. If the buyer is a younger officer in the bank, or a group of employees of the bank, possessing the necessary management skill to operate the bank successfully, in almost every case such buyers would need a bank stock loan to purchase the bank. In most cases the loan would cover the major portion of the purchase price of the bank. This has been a time-honored practice for generations in this country. Such loans should not be prohibited simpfy because there are a few abuses. Should this bill pass in its present form, it would mean that the smaller banks of which we speak would be forced to liquidate or to sell out to a branching system by merger or to sell out to a multibank holding company. We feel sure that the author and this committee would not want to see this result. This would be like razing a house because it has a small crack in the plaster. Our position is that this bill must be modified to prevent abuses while at the same time preserving independent banking in this country. TAX CONSIDERATIONS A FACTOR This problem is complicated by the fact that tax considerations often dictate the use of a one-bank holding company to service a bank stock loan involved in the transfer of a bank from one independent owner to another. The one-bank holding company's only activity in many cases is the operation of an insurance 60-299 O—71—pt. 2 11 602 agency. The agency is incorporated and holds the stock of the bank. The corporation makes the bank stock loan. Under regulations proposed by the Federal Reserve Board this insurance activity would be severely restricted, making it extremely difficult for the agency corporation to service the loan. Further, we understand there is a rule of thumb in the Federal Reserve System that the bank stock loan must not exceed 30% or 40% of the purchase price of the bank. This rule has been applied in the past with regard to acquisition of banks by a multibank holding company and, we understand, will be applied to the one-bank holding companies of which we speak. The combination of these two rules by the Federal Reserve Board, even if the bill before you did not pass, would make it extremely difficult to preserve independent banking in this country. This Association shares with the Congress and the supervisory agencies the desire to rid the banking industry of fast buck artists and other undesirable elements. Nor do we wish to encourage any situation in which a bank lending money on bank stock would exercise any kind of domination over the policies of the bank whose stock was pledged as collateral for a loan. DISTINCTIONS MUST BE MADE Attitudes in this Congress that we consider unfriendly to independent banking and similar attitudes in the Federal Reserve Board are most discouraging to our members. Unless something is done to distinguish between situations which cause abuses on the one hand and which are clean and deserving on the other, Congress and the agencies may well cause the demise of independent banking. Before we make suggestions for modifying this bill we would like to explain the practical reasons for use of a one-bank holding company for the purpose of servicing a bank stock loan needed in the transfer of a smaller bank from one local owner to another. Assume a situation where an owner of a smaller bank desires to sell his bank to a competent officer-employee of the bank. The bank has been opeiating a general-type insurance agency and this also is to be sold to the buyer. The buyer is able to raise 25% of the price of the bank and needs a bank stock loan to finance the balance. He can service the bank stock loan with more after-tax money by forming a one-bank holding company whose principal activity will be operation of the insurance agency and, of course, the company would hold the stock of the bank. This structure does two things. First, it avoids the personal holding company tax penalty. Second, it provides more after-tax dollars in the hands of the holding company with which to repay the bank stock loan. Let us explain these two benefits. The personal holding company tax penalty is 70% on undistributed income. Debt service is not considered to be a distribution of income in this computation. To avoid this penalty, more than 40% of gross income must be derived from an active trade or business, in this example the insurance agency; and less than 60% must be in the form of passive income, in this example, dividends from the bank (see Section 542 of the Internal Revenue Code). ADVANTAGE GAINED FROM OBHC The one-bank company in this example will have more after-tax dollars than an individual because the tax rate on a small corporation is less and the dividends from the bank can be received by the holding company 100% tax-free if it holds 80% or more of the stock of the bank, and 85% tax-free if it holds less than 80% of the stock of the bank. In contrast, without the holding company, an individual buyer of the bank would find it difficult, if not impossible, to repay the bank stock loan because the more salary taken from the bank, the higher will be the income tax bracket, resulting in fewer after-tax dollars with which to repay the loan. (Please refer to Exhibits I and II attached for illustrations of this contrast.) Thus, it can readily be seen that only the one-bank holding company affords the opportunity to repay the bank stock loan in a reasonable time and, without it, an individual might not live long enough to ever repay the loan. To preserve this method of transferring bank ownership from one independent owner to another, the insurance agency operation must be of the general-type in 603 order to generate enough gross income to avoid the tax penalty mentioned. If the permitted scope of this activity is limited to selling insurance only in connection with extensions of credit by the bank, the gross income in commission earnings by the one-bank company would be drastically reduced, most probably to a point where the agency operation would not produce more than 40% of the total gross income of the holding company, including bank dividends. Exhibit I attached to our statement show3 that in a typical situation where the price of the bank requires a bank stock loan of $450,000, there is a $185,000 advantage in taking the one-bank holding company route. Exhibit II illustrates what happens in the case of a bank stock loan of $900,000; the saving being $464,000 over the 15 year period for repayment of the loan when a one-bank holding company is used. Now to our suggestions for handling this problem without an outright prohibition against bank stock loans. We believe that the distinction between deserving situations and those which result in abuses can best be determined by promulgating regulations, rather than to attempt the distinction by statute. SUGGESTED GUIDELINES FOR STATUTE However, the statute should lay down guidelines for the FDIC in making its regulations Following are standards which we believe are reasonable and should be inserted in the bill: 1. The FDIC shall have authority to make exceptions to the prohibition by regulation promulgated under the Administrative Procedures Act, which regulations shall conform with the standards following. 2. A loan secured by the stock of a bank being purchased shall not exceed 75% of the collateral pledged to secure said loan. 3. The exception shall apply in the case where a one-bank holding company is utilized for the purpose of making the bank stock loan, and where the individual purchasers guarantee repayment. (Note that this is a distinguished feature because the note is an individual obligation enforceable against the individual and his estate and creates, in effect, a personal loan while recognizing that the holding company device is used only for tax purposes.) 4. No management fees may be charged the bank by the holding company owner, and dividends payable to the holding company by the bank must be reasonable as to amount. 5. Conformance with the foregoing standards must be demonstrated to the satisfaction of the FDIC. Application must be made fully disclosing the facts as to who will be the ultimate beneficial owners, their character, financial resources, and bank management experience. The application will require an order, after investigation or hearing, approving or denying the application. 6. None of the foregoing provisions shall apply in any state whose statutes are equally restrictive. We believe that the foregoing standards and procedures would make it possible for the FDIC to eliminate abuses. EXHIBIT I U S E OP H O L D I N G C O M P A N Y FOR F I N A N C E D B A N K ACQUISITION C O M P A R A T I V E R E V I E W — A F T E R T A X R E S U L T S ACQUISITION D E B T INCURRED OF $ 4 5 0 , 0 0 0 ASSUMPTIONS Backer with salary of $20,000 purchases bank with borrowed funds of $450,000 at percent, level principal payments plus interest over 15 years. Dividend paid by bank of $26,000 per year. Insurance agency purchased with bank earns commission income of $25,000. Expenses of $4,000 are paid to the bank for use of employee time and bank space utilized for the agency operations producing net income of $21,000. 604 Federal income taxes computed on basis of rates in effect for 1969 without consideration of temporary surcharge. Total 15-year debt service period Banker uses a holding company Banker alone Taxable income: Salary Insurance agency, net Dividends from bank Interest expense Corporation $300,000 771,000 300,000 771,000 300,000 81,000 390,000 (450,000) 381,000 390,000 (450,000) (269,000) (66,000) (23,000) 5,000 (89,000) 5,000 52,000 234,000 3,000 237,000 (450,000) Total $315,000 $300,000 315,000 (234,000) (234,000) 81.000 381,000 Cash balance summary: Banker and corporation Banker alone 237,000 52,000 Difference 185,000 EXHIBIT USE OF HOLDING REVIEW—AFTER Total $300,000 315,000 390,000. (234,000) Total Cash flow: Taxable income Dividend deduction (a noncash charge to income) Retirement of debt Federal income taxes: Paid to IRS Benefits received from bank for use of losses Banker II COMPANY FOR FINANCED B A N K ACQUISITION COMPARATIVE T A X RESULTS ACQUISITION DEBT INCURRED OF $900,000 Assumptions Banker with salary of $30,000 purchases bank with borrowed funds of $900,000 at 6H percent, level principal payments plus interest over 15 years. Dividend paid by bank of $52,000 per year. Insurance agency purchased with bank earns commission income of $50,000. Expenses of $8,000 are paid to the bank for use of employee time and bank space utilized for the agency operations producing net income of $42,000. Federal income taxes computed on basis of rates in effect for 1969 without consideration of temporary surcharge. Total 15 year debt service period Banker uses a holding company Banker alone Taxable income: Salary lnsuranceagency.net Dividends from bank Interest expense Total Cash Flow: Taxable income Dividend deduction ( a noncash charge to income) Retirement of debt Federal income taxes: Paid to IRS Benefits received from bank for use of losses Total Cash Balance Summary: Banker and corporation Banker alone Difference $450,000 630,000 780,000 (468,000) Banker $450,000 Corporation Total $630,000 $450,000 630,000 (468,000) (468,000) 1,392,000 450,000 162,000 612~00(T 1,392,000 450,000 162,000 780,000 (900,000) 612,000 780,000 (900,000) (617,000) (118,000) (45,000) 10,000 (163,000) 10,000 (125,000 332,000 (900,000) 7,000 339,000 339,000 (125,000) 464,000 605 The CHAIRMAN. All right, Mr. William S . Renchard. STATEMENT OF WILLIAM S. RENCHARD, PRESIDENT, THE NEW YORK CLEARING HOUSE ASSOCIATION, AND CHAIRMAN OP THE BOARD, CHEMICAL BANE, NEW YORE, N.Y.; ACCOMPANIED BY RICHARD S. SIMMONS, COUNSEL Mr. RENCHARD. I am William S. Renchard, president of the New York Clearing House Association and chairman of the board of Chemical Bank. I appreciate the opportunity to appear before your committee on behalf of that association to discuss H.R. 5700. That bill contains provisions dealing with a great diversity of subjects having farreachms consequences—too many, in our opinion, for one bill. The Clearing House does support the principle behind some provisions of H.R. 5700. However it strongly opposes other provisions. Our views on each provision of the bill are set out in detail in our memorandum of comments submitted with this statement. Mr. Chairman I would like that included as part of the record. The CHAIRMAN. Would you like to have that memorandum included in the record? M r . RENCHARD. Y e s . The CHAIRMAN. Without objection it is so ordered. Mr. RENCHARD. We support in principle the concept that the Federal regulatory agencies should nave adequate authority to deal with any abuses which might arise from the misuse of funds received as a result of brokered deposits. We concur with Chairman Martin of the Federal Home Loan Bank Board in opposing a complete prohibition against brokered deposits. If contrary to what seems to be the case the Federal agencies do not have adequate authority to deal with the misuse of giveaways to attract deposits we would support legislation designed to confer such authority. Further we do not object to any amendment of section 8 of the Clayton Act along the lines recommended by Chairman Wille of the FDIC at page 6 of his prepared statement before this committee on April 20 1971; however we strongly recommend that the appropriate regulatory agency be empowered to permit interrelationships among deposit institutions which do not have a significant anticompetitive effect particularly where they are in different geographic areas and even if in regional competition in a particular case where it would be helpful to the small regional bank as for example a bank formed by minority groups. Other provisions of H.R. 5700 in our judgment could have however a seriously adverse effect on the functioning of our financial system. The bill's provisions concerning directorships are one area of greatest concern. In restricting outside relationships of the directors of commercial banks, the bill rests on a mistaken premise. The bill then would implement that mistaken premise so extremel yas to impair the responsiveness and ability of commercial banks to compete, both of which are essential to our economy. That mistaken premise has to do with the role of the director of 606 the modern large corporation, including the large commercial banks. The bill's position as to directors is apparently founded on the idea that directors, individually or as a board, are solicitors or guardians of privileged or sinister relationships among the corporations on whose boards they serve. This is not true. Today, the antitrust laws, the legal standards applicable to the public accountability of directors, to disclosure, and to insider preferment and self-dealing, and the general ethical norms surrounding the exercise of fiduciary functions, all make—I repeat— all make any misuse of a directorship unacceptably hazardous, likely of detection, and subject to severe penalties. These laws and standards are rightly directed at stopping improper conduct and actual abuses. They have been effective in doing so and continue to be effective. They nave not, as I believe the bill would, caused major changes in the structure of corporations because of presumed but unsubstantiated infirmities in that structure. Today, directors of large banks are not involved in day-to-day operations. They do not allocate credit any more than the directors of a soap concern sell soap. Corporations, typically, have credit relationships with several banks. They could not, and do not need to, use a common director to reinforce the credit relationship with one bank. Given the intensive competition among the larger commercial banks—competition in seeking funds, in making loans, and providing financial services—a credit worthy company does not need a friend on the board to attract the interest of that bank or its competitors. If not credit worthy, no such insider could prevail in causing an uneconomic use of resources to continue in the face of competition and stockholder, depositor and regulatory pressures. If the contemporary role of the directors of a bank in a large commercial center is not, therefore, to connive to suppress competition, nor to betray the interests of one corporation to those of another, not to make loans, nor even to run the daily business of the enterprise, what then is their role? Put simply, the principal and unique role of the directors is to oversee and control, in the broadest sense, the policies of the bank and the composition and conduct of top management. It is to make sure, on a continuing basis, that we, at the top management level, are competent. It is to arrange for changes ana successions in top management. It is to champion the long-term interests of the bank as a continuing institution in the rare case in which they are in danger of being subordinated to more immediate objectives of top management. At Chemical Bank, we need and rely on our outside directors for advice and counsel in the areas of their varied expertise both as to their specialized knowledge of industry and also as to new managerial techniques and concerns. They and we know that under law their jobs as directors are not mere sinecures but are charged with real responsibilities—higher than those of a director of a nonbank corporation. For example, they must make an examination, which New York law requires, into our credit, audit, and control policies. This report must be filed with our banking department. In that connection, I point out that, pursuant to law, our bank's directors axe specifically charged with the statutory obligation of giving particular attention in such examination to the loans or discounts made 607 directly or indirectly to [our] officers or directors, or for the benefit of other corporations of which such officers or directors are also officers or directors, or in which they have a beneficial interest as stockholders, creditors, or otherwise. The public interest mandates that top management of large metropolitan banks be under that kind of supervision. But only a board of directors which, as a whole, is familiar with large organizations, with the realities of top management and withfinance,can know when top management should be prodded, overruled, or replaced. If those decisions are to be made—if the directors are to be willing and able to take on top management—they must be independent of it and must be at least equal in strength, stature, and experience* In short, the public interest requires that large banks have strong, predominantly outside boards of directors. Yet the present bill would bar from our boards any director or officer of another financial institution, regardless of whether it competed with the bank. It would bar any director of a nonfinancial corporation whose pension fund was managed by the bank. It would bar any director of a customer with which the bank had a substantial and continuing credit relationship. That excludes from consideration as a director what I assure you is the broadest class that could have been selected—all those who now do business with a bank or with whom a bank in the future would wish to do business. The practical effect would be to increase the proportion of directors who are members of the bank's management or who are retired. This will not result in a board which would be able or inclined to exercise the most effective scrutiny and control over top management. Such a result is neither in the public interest nor in the interest of a healthy and responsible banking system. Turning now to the proposed limit on trust investments, just as the provisions of the bill on directors are based on an unrealistic premise, so also are the bill's provisions on trusts based on a mistaken premise as to banks' trust holdings. The premise is that banks can and do through such holdings bend corporations to their will. On that premise is based section 13 of the bill, which would limit a bank's holdings in a fiduciary capacity to 10 percent of any one publicly held stock. The premise is wrong. Banks do not use their fiduciary holdings to control, let alone even attempt to dominate, corporations. The SEC has just completed a 2%-year study of precisely that question: Do institutions, in fact, exercise improper control over the corporations whose stock they hold? That study found that although banks and other institutions sometimes have potential voting power to influence such corporations, there was no evidence to indicate that they exercised this power. Banks and other institutions simply do not use their stockholdings to try to control management of other corporations. If they lose confidence in management, they sell their stock. In view of these facts, there is no public purpose justification for the 10-percent limit and the SEC found none. Not only would that limit serve no public purpose, it would be disruptive and unfair when applied, in practice, to banks' various fiduciary activities as executor, trustee, administrator, or guardian. 608 If aggregate holdings by a bank as fiduciary in several accounts exceeded the 10-percent limit, it would be required to select those fiduciary relationships whose holdings must be disposed of, even though it considered the security in question to be an excellent investment. Selecting which of such fiduciary relationships so to disadvantage would present an insoluble quandary to the bank trying to be fair to those whose affairs are entrusted to it. The absolute prohibition against holdings by a bank in a fiduciary capacity of its own stock appears to be based on the fear of bank management self-perpetuation. The solution does not require a blunderbuss approach. Federal law forbids national banks from voting their own stock for the election of directors. The same restriction could be placed on all insured banks and made applicable to their holding companies as well. With respect to the proposed prohibition against equity participations, we, at Chemical Bank—and I believe our experience is true of the other clearinghouse banks—have taken equity participations rarely, and when we do they involve basically two situations. First, where, as a result of unforeseen developments, a borrower must defer the payment of a loan and is unable to pay interest in whole or in part, we agree to such deferral and waiver of interest in the expectancy that the borrower's operations will become profitable in the future. In exchange for such deferral and waiver, we believe that we are entitled to be recompensed out of future profitability if the same occurs. The second situation is where we are asked to make a creditworthy loan but the long-term amortization is such that, when considered in light of almost certain continuing inflation, the rate of return becomes unattractive in comparison with other alternatives. This is particularly true in the case of the real estate mortgage area. We wish to retain this flexibility in the future in credit-worthy situations—a flexibility to price in accordance with competitive conditions. As to 100 percent insurance of public deposits, we oppose this provision as do Chairman Burns and Chairman Martin. With regard to the proposed reporting requirements of section 12, we believe strongly that legislation in this area should initially be drafted and administered by the SEC. This accords with the belief of the SEC as to the importance of regulation on an overall basis for all financial institutions, of which commercial banks are only one segment. In conclusion, let me say that time prohibits me from discussing other provisions of H.R. 5700, about which we have equally strong objections, and I hope no quantitative inference is imputed from our inability to discuss these provisions. These are detailed in the memorandum of comments, and I respectfully commend them to your attention. Thank you, Mr. Chairman. The CHAIRMAN. Thank you, sir. (The memorandum of comments of the New York Clearing House Association on H.R. 5700 follows:) 609 MEMORANDUM of COMMENTS of the NEW YORK CLEARING HOUSE ASSOCIATION on BL R . 5700 The following Comments on H. R. 5700 are appended to the statement (the''Statement") of Mr. Renchard, who is appearing before the Banking and Currency Committee of the House of Representatives to present the views of the New York Clearing House Association (the ''Association") on H. R. 5700. The Comments deal with sections of the bill which are not covered in the Statement and aleo present additional detail with respect to other sections which are discussed in the Statement I. SECTION 2 A. Relationships Between Insured Banks and Other Financial Institutions Section 2 of the bill would add a Section 23 to the Federal Deposit Insurance Act to forbid interlocking relationships between directors, trustees, officers and employees of an insured bank and certain other financial institutions. The basic position of the Association with respect to interrelationships between banks and other financial institutions is presented in the Statement of Mr. Renchard. Briefly, the Association recommends amending Section 8 of the Clayton Act along the lines recommended by Chairman Wille at page 6 of his April 20, 1970 Statement before the House Banking and Currency Committee. We believe that any prohibitions should be confined to interlocks between deposit-taking institutions and that the Federal Reserve Board and the FDIC should be authorized to establish regulations permitting interlocks between deposit-taking institutions where there is no significant anti-competitive effect or where the benefits to the community outweigh any anticompetitive effects. 610 Definite benefits can accrue through interlocks (between large regional banks and small banks located outside the area in which the large regional banks may branch. The broad experience of an officer or director of a large metropolitan bank can be of great assistance to the small out-of-town bank. Even within metropolitan centers, banks formed by minority groups may require the assistance of experienced personnel which can be obtained from the large banks. Access to such personnel should not be foreclosed, -but the proposed bill would effectively bar access. When one bank acquires a controlling interest in another bank or otherfinancialinstitution in satisfaction of a debt previously contracted in good faith (which is permitted, for example, by Sections 3(a) (A) (ii) and 4(c)(2) of the Bank Holding Company Act), the acquiring bank should be permitted representation on the board of the acquired financial institution for the limited period of time during which the acquiring bank is permitted to hold the stock. The proposed prohibition against relationships with broker-dealers is quite puzzling, since, under Section 32 of the Banking Act of 1933, a member bank cannot interlock with a securities underwriter but can interlock with a concern engaged purely in the brokerage business. No justification has been offered for obliterating the distinctions presently made by Section 32. Some bank employees with non-executive functions supplement their incomes by taking jobs at other banks or financial institutions where there could be no anti-competitive effect. The Association's position is that the prohibition should not cover employees who do not exercise executive functions. B. Bank Holding Company Exemption As H.B. 5700 recognizes, an exemption is required in connection with bank holding company systems, but interrelationships should be permitted not only with "subsidiaries" of a bank holding company but also with banks in which a bank holding company has been allowed to invest to the extent of between 5% and 25% of the stock pursuant to permission granted by the Federal Reserve Board under Section 3 of the Bank Holding Company Act. 611 C. Connections with Real Estate or Title Companies Section 24, as proposed to be added to the Federal Deposit Insurance Act, would prohibit every insured bank, every officer and director of an insured bank and every member of their immediate families from controlling title companies, real estate appraisal companies and companies which handle real estate closings. The prohibition is absolute, whether or not there is any conflict in the particular case and whether or not there are any abuses. In the absence of abuses, this is entirely too far-reaching an infringement on the right of the individual to engage in legitimate business activities. Can Congress constitutionally forbid a person to own stock because he is related to the assistant cashier of a bank? Furthermore, the phrase 4 imember of the immediate family" is entirely too vague. It is to be noted that Section 24 would, in effect, amend the Federal Bank Holding Company Act, which was amended as recently as December 31,1970. Section 24 would re-create a "negative laundry list,% which Congress specifically refused to adopt when the Bank Holding Company Act Amendments of 1970 were enacted. D. Prohibition on Legal Services Under the proposed Section 25 of the Federal Deposit Insurance Act, it would be virtually impossible for any lawyer practicing independently to be a director of an insured bank. In fact, the language of the proposed section raises some doubt as to whether an insured bank could employ house counsel. The questions of lawyers' conflicts of interest are extensively dealt with in the Code of Professional Responsibility of the American Bar Association, which has superseded the former Canons of Ethics of the American Bar Association. Section 25 would set up a special set of restrictions on professional relationships between lawyers and banks, which would not apply to lawyers' professional relations with any other type of client. This is a matter which should be left to the -Code of Professional Responsibility. II. SECTIONS 3 , 4 , 5 a n d 6 Relationships of Other Types of Financial Institutions These four sections contain prohibitions, similar to those in Section 2, directed against other types of financial institutions. The Association opposes these prohibitions for the reasons outlined in the discussion of Section 2. 612 In subsequent sections of the bill, there are provisions which apply to other types of financial institutions similar to provisions which we oppose when applied to insured banks. We believe the same criticisms apply to the sections relating to financial institutions which are not banks, as apply to the sections relating to banks. III. SECTIONS 7 , 8 a n d 9 A. Relationships with Non-Financial Entities Generally These three Sections, as well as Sections 2, 3 and 4, appear to be based on a key misconception: that interlocking directors are detrimental to the banking system in particular and the economic structure of the nation in general. A single bank director, who was also a director of an outside corporation, could not, even if he so desired, control or dominate a board of 15 men—all legally liable to act in the best interests of the bank's shareholders. It is to be noted that the courts have imposed' on bank directors duties of fidelity and responsibility which exceed those of directors of other corporate enterprises. McCormick v. King, 241 F.737 (9th Cir. 1917), aff'd sub. norn. Browerman v. Hamner, 250 U.S. 504 (1919); Broderick v. Marcus, 152 Misc. 413, 272 N.Y.S. 455 (1934). Sections 7 through 9 ignore both the positive benefits of outside directors and the adverse effects of a prohibition against them. If banks cannot use employees or officials of non-financial corporations as directors, as Sections 7-9 would seemingly require, banks would virtually be restricted to inside directors and older men who have retired. Such a situation would have serious adverse effects. Almost all corporations which are neither closely held nor very small in size use outside directors, not with the intention of restricting competition, but rather to add breadth and expertise to their boards. As Melvin T. Copeland, at the time a George Baker professor at the Harvard Business School, wrote in the Harvard Business Review: Competent outside directors serve to bring a wide range of experience and independent judgment to bear on the problems of the companies on whose boards they sit. They also have an objective view. And there are many instances in which the interests of the stockholders and employees of a company are better safeguarded by having outside men on the board. 613 The elimination of outside directors from the boards of many of our corporations would weaken substantially the private management of American industry. The Federal Trade Commission Indicts Itself, 29 Harv. Bus. Rev. 25, 30. Chairman Burns also made this point in his letter of December 16,1970 to Chairman Patman: [E]oonomic benefits flow from a high standard of performance by corporate boards of directors. This entails a free interchange of advice, ideas, and experiences among directors of varied backgrounds. Bankers often have experience and expertise that qualify them to render valuable service in this role. Interlocking directorates, in other words, are not inherently wrong. They may be good for the corporations involved and the public they serve.* The limitation on outside directors does more than impose federal regulation on state banks; it runs counter to the state banking policy as specifically expressed in existing law. New York, which is generally recognized as one of the states providing the most enlightened and comprehensive banking legislation, requires at least two-thirds of bank directors to be "outside" directors. New York Banking Law § 7001(4). The New York ''outside" director requirement represents a legislative judgment that 'banks will be strengthened if the majority of the directors bring experience in other fields to bear on the problems of the bank of which they are directors. B. Section 7—Relationships with Welfare or Pension Plans Section 7 of the bill would prohibit a director, trustee, officer or employee of afinancialinstitution from serving at the same time on the board of directors of any corporation with respect to which such financial institution manages an employee welfare or pension benefit plan. It is difficult to see even a glimmer of a "potential conflict of interest" in the situation which Section 7 would prohibit, especially since nothing is said about corporations which manage their own funds. Moreover, Section 7 would diminish competition for the management of pension * See also, Travers, Interlocks in Corporate Management and the Antitrust Laws, 46 Texas L. Rev. 819,835 and 863; Towl, Outside Directors Under Attack, 43 Harv. Bus. Rev. 135,147; and Lombard, The Corporate Management Interlock Bill, 21 The Business Lawyer 879,890. 614 funds, since a 'bank could not solicit a corporation with which it had an interrelationship except at the cost of driving a director off its own board if it were successful. There is existing legislation which prevents abuses in this area. Section 503 of the Internal Revenue Code specifically forbids selfdealing with respect to employee welfare and pension benefit plans. The penalties are severe. An organization which engages in self-dealing or any of the other transactions prohibited 'by subsection 503(b) loses its tax exemption. If it is believed that the list of prohibited transactions set forth in subsection 503(b) is not sufficiently broad, then this subsection should 'be amended. Section 7 it too sweeping an approach to the problem, particularly in view of the considerable potential for barm which this Section entails. Moreover, in its sweeping prohibitions, Section 7 entirely ignores the realties of the market place for management of employee welfare or pension benefit plans. Not only is there severe competition among banks themselves, but there has recently 'been a sharp increase in competition from investment bankers and others who claim expertise in the field. Profit and pension cost pressures have made every company acutely aware of the need for performance by its pension funds, and this awareness has made it virtually impossible to award the management of such funds on any basis other than performance or expected performance. In addition, it is a demonstrable fact that more and more pension funds are being split up among several managers so that relative performance can be judged by the corporation involved. Such a trend certainly does not indicate that any one banker can "lock-up" such business by being on the board of directors of the corporation involved, or by having an officer or director of the corporation on the bank's board. C. Section 8 — Relationships with 5% Owned Companies Section 8 of the bill would forbid any director, trustee, officer or employee of afinancialinstitution from serving at the same time as an officer or director of a company in which the financial institution has, with power to vote, more than a 5% interest in any class of stock, making an exception for companies within the same bank holding company system. The havoc which would be wrought by the adoption of 615 Section 8 is clear, but the supposed puiblic benefit is almost impossible to discern. Consider, for example, a few of the absurdities which would be produced by Section 8: (1) The chairman of the board of an insurance company could not serve as a director of any of the company's subsidiaries, nor could the chairman of the board of a bank which was not in a bank holding company system serve as a director of the bank's safe deposit company or Edge Act corporation. (2) An owner of 75% of a small manufacturing company decides to name a bank as executor under his will. While he does not expect the bank to manage the corporation on a day-to-day basis, he does expect it to exercise general oversight over the estate's investments, a practice which is of course facilitated enormously if the executor bank can have one of its officers serve as a member of the board of directors of the corporation. Such service would be prohibited by Section 8. (3) Mr. S, a retired businessman in a medium-sized city, serves as a director of one of the local banks and as a director of the local professional baseball team. Another resident of the same city owns 10% of the baseball team and wishes to borrow from the bank of which Mr. S is a director, using his 10% stock interest in the team as collateral. The pledge agreement used by any prudent bank provides that, at least after a default, power to vote the pledged securities passes to the bank. If Section 8 were to become law, Mr. S would have to resign either from the bank's board or from the board of the baseball team the instant a default occurred, although it is hard to see any public benefit which would result. (4) A bank with a large trust department concludes that the stock of Z Corporation would be an excellent investment for a sizable number of its fiduciary accounts. Unfortunately, however, Mr. T, a university president, is a director of both the bank and Z Corporation. The bank cannot acquire more than 5% of the stock of Z Corporation until Mr. T resigns from one board or the other, and the net result of this sort of situation could be an unsatisfactorily high turnover ratio so far as 'bank boards are concerned. 616 All of the foregoing, rather bizarre results, which are only a few of the many examples which could be given, might be put up with if there were some overriding public advantage to be gained. However, no such advantage is apparent. No one has offered a plausible explanation as to the "evils" or "abuses" which arise from interrelationship between a bank and a company whose trust department owns more than 5% of that company's stock. D. Section 9 — Interrelationships with Corporations with Which There Are Business Relationships Section 9 would forbid any director, trustee, officer or employee of any insured bank, institution insured under the National Housing Act or mutual savings bank from serving on the board of any corporation with which such bank or other institution has a "substantial and continuing relationship with respect to the making of loans, discounts, or extensions of credit". Section 9, even more than Sections 7 and 8, would dangerously weaken bank boards and thus inhibit these boards from carrying out their proper functions. In view of the desirability of a strong outside board of directors, banks naturally and quite properly turn to officers of corporations which are present or potential customers in order to obtain such qualified persons. A complete bar on all officers of a corporation with which the bank has a substantial relationship might indeed produce anti-competitive side effects which are more drastic than the dangers against which the provisions seek to protect. If, for example, a bank selects as a director an officer of a corporation, this Section would presumably require the bank to choose between not soliciting a credit relationship with that corporation, or, if it successfully does solicit the relationship, terminating that director's position with the bank. Thus in order to preserve the integrity and continuity of its board, a bank may have to forego competing for the business of a significant number of corporations. IV. SECTION 1 0 Limitation on Stock Ownership by Mutual Savings Banks Section 10 of the bill would forbid mutual savings banks from owning any stock in certain named types of institutions, including in- 617 sured banks and bank holding companies. It is impossible to see any public policy goal which would be served by prohibiting a New England savings bank from owning a few thousand shares of a major commercial bank, at least one which served a territory different from that served by the savings bank. While questions can perhaps be raised about the desirability of control of commercial banks by savings banks, proposed Section 10 proscribes an entire class of investments, a class which has on balance almost certainly proved profitable for the depositors of mutual savings banks. V. SECTION 11 Influencing Banking Relationships Section 11 creates a Federal crime of "commercial bribery" in connection with certain types of financial institutions. There has been no evidence presented 'by anyone that state legislation in this area is deficient, and, as Chief Justice Burger aptly cautioned in his 1970 address on the state of the judiciary, the federal court system is for a limited purpose, and lawyers, the Congress and the public must examine carefully each demand they make on that system. VI. SECTION 1 2 Reporting Requirements Enactment of Section 1 2 of H . R . 5 7 0 0 would require banks to report on securities held in a fiduciary capacity and voting activities with respect thereto. We believe there may be some merit to the recommendation made in the SEC's recent Institutional Investor Study for periodic reporting of security holdings by all institutions. Even here, the subject must be treated with some sense of discrimination. Banks lack investment or voting authority in many of their accounts, and hence reporting should be limited to significant aggregate holdings in only those accounts where this authority exists. Any legislation in this area should be drafted by the SEC, which has made an extremely comprehensive study of the problems involved with institutional reporting. Further, any legislation should be part of one of the Securities Acts so that the expertise of the SEC together with its rule-making and exception-granting experience in this field will be 60-299 O - 71 - pt. 2 - 12 618 fully applicable. The FDIC does not have the special qualifications which make -the SEC such an obvious choice to administer a disclosure statute covering security investments. We also strongly urge that legislation in this limited to banks alone. On page 3 of its letter of Institutional Investors Study, the SEC stressed regulation on an over-all basis for all institutional VII. area should not be transmittal for the the importance of investors. SECTION 1 3 Restriction on Fiduciary Ownership of Stock by Insured Brnks Section 13 of the bill would add a Section 26 to the Federal Deposit Insurance Act to forbid any insured bank to hold in a fiduciary capacity: (1) more than 10% of any class of stock of any corporation for which a registration statement has been filed under the Securities Act of 1933*; and (2) any bank stock which it has itself issued, or stock which has been issued by its parent company. This Section would work a distinct disservice to the puiblic interest. Banks are uniquely qualified to handle large estates and trusts with sizable holdings in a stock of a particular issuer and should not by a blunderbuss approach be prohibited from serving this public need. We note SEC Commissioner Smith's suggestion at page 19 of his Statement before the House Banking and Currency Committee that "in considering a possible flat percentage limitation on institutional holdings, there are several reasons which weigh rather heavily against it." The 10% limit would be disruptive and unfair when applied, in practice, to the banks' fiduciary activities. If aggregate holdings by the bank as a fiduciary in several accounts exceed the 10% limit, the bank would be required to select those accounts whose holdings should be disposed of. This problem cannot be equitably solved by simply reducing the holding in each account pro rata. For example, the income tax basis of the holdings will vary in different accounts, thus suggesting different treatment among accounts. Furthermore, some fiduciary instruments specifically require retention of a particular stock and in other cases the bank must (assuming the limitation were to apply to those situations where it acts as a co-fiduciary) obtain the consent of * We assume the Securities Exchange Act of 1934 was intended. 619 other co-fiduciaries, which may not be obtainable. Hence <the potential conflicts of interest between different fiduciary accounts of the bank, with the possibility of surcharge actions, are very real. Serious problems are raised with respect to the prohibition against a bank holding in a fiduciary capacity shares of its own or its parent's stock. Such a prohibition would be particularly onerous for smaller banks and multi-bank holding company systems which include smaller banks. The shares of such banks are frequently locally owned and local stockholders of these banks naturally utilize and will want to continue to utilize their bank as corporate fiduciary. The very factors which convince a local resident to purchase shares of a local bank would also lead him, because of his familiarity with and trust in that institution, to name it as trustee or executor of his estate. Similarly, when such banks are acquired by multi-bank holding companies, bank shares are typically converted into shares of the holding company, which the local bank continues to hold as fiduciary. The undesirable consequences of the prohibitions contained in Section 13 are readily apparent. Presently held shares would have to be liquidated, which in the case of a small independent bank would be particularly unfair 'because the markets for such shares are traditionally very thin. In the future, it would also force stockholders of local banks to choose between selling their bank shares before they die or facing the possibility of a disadvantageous liquidation by the estate if the local bank is chosen as executor or trustee. The only other option available to such persons is to name as fiduciary a bank with which they may not be familiar and would otherwise not prefer to utilize. The prohibitions in Section 13 would effectively deny to officers and directors of a bank (who can be expected to be shareholders) the ability to name their bank as executor or trustee. Section 13 also would prohibit banks' own employee benefit plans, wherein the bank acts as a fiduciary and one of the options is to invest in the shares of the bank itself or its holding company. Similar plans are widespread in commerce and industry and are valued because of the opportunity afforded employees to have an equity stake in the company for which they work. This Section also fails to provide for the situation in which the purchase or retention of bank stock or bank holding company stock is directed by someone other than the fiduciary bank. 620 The Association agrees completely with the proposition that bank management should not be able to perpetuate itself by voting stock in the bank which is held by its trust department. But the solution for this problem is already present in 12 U.S.C.A. § 61, which forbids national banks from voting their own stock for the election of directors. Similar restrictions can be placed on all insured banks and made applicable to their holding companies as well as to the banks themselves. Vin. SECTION 1 4 Restriction on Equity Participation by Lenders Section 14 of the bill would forbid lenders, as therein defined, from taking any equity participation in consideration of the making of any loan. This provision goes entirely too far in regulating a field where any abuses can adequately be taken care of by the state or federal regulatory authorities. It constitutes interference with a legitimate pricing mechanism, under which a borrower is enabled to reduce initial cash outlay in consideration of future participation in income. Section 14 does not take into account the practical situation that arises when a borrower has difficulty in meeting his payments on a loan, and it becomes necessary to relieve him in whole or in part of his obligation to pay interest at a fixed rate and at fixed installments. Frequently this relief can be effected and the loan salvaged only by giving the lender a contingent interest in the borrower's earnings. Further, fixed rate mortgages have not demonstrated sufficiently attractive yields in comparison with other loans and investments. Increasing inflation with the accompanying constant erosion of dollar purchasing power has resulted in a declining rate of increase in mortgage portfolios. The trend to equity participation in real estate financing is a logical development to counteract the erosion in mortgage portfolios that results from the repayment of mortgage loans with progressively cheaper dollars. In the absence of equity involvement, higher interest rates would have to be charged, thus imposing a greater burden on the developer or builder and substantially increasing the cost of housing and other real estate development. 621 IX. SECTION 1 5 A. Loans to Bank Personnel Section 15 restricts and regulates loans by banks to their directors, trustees, officers and employees and members of their "immediate families", by adding new Sections 27 and 28 to the Federal Deposit Insurance Act. It is unnecessary for national banks and state banks which are members of the Federal Reserve System, 'because it merely duplicates existing statutes and regulations. With respect to state non-member banks, it duplicates state regulations and represents an unwarranted breach of the dual regulatory system. Here, again, H.R. 5700 would impose regulations on top of regulations in what is already a highly regulated area of business. In addition to the prolific regulations in this field by statute, matters of this character are normally inquired into on examination by the various supervisory authorities. Under 12 U.S.'C. § 375a, loans by member banks of the Federal Reserve System to executive officers are sharply restricted, and reports of all loans to executive officers must be made in connection with reports required for the FDIC under 12 ILS.C. § 1817(a)(3). See also Regulation 0. Section 27(a) broadens the reporting requirements in that it applies to all employees. However, does the FDIC really want reports of all loans to bank employees, whatever the amount? A car loan for a teller would hardly endanger the bank's deposits. The mere act of reporting, standing alone, would in no way protect the bank's deposits or call to the FDIC's attention any state of facts that would not normally be turned up by a bank examination. Consequently, there is no valid reason for the imposition of this federal requirement on state banks. B. Disclosure of Loans to Bank Personnel Section 27(b), which would require the FDIC to make public information furnished it on loans by insured banks to directors, trustees, officers and employees and members of their immediate families, would amount to an entirely unjustified invasion of privacy that would serve no useful purpose. 622 C. Extensions of Credit to Fiduciaries Section 27(c) would prohibit any insured bank from extending credit to a person acting in a fiduciary capacity without requiring that the identity of the person receiving the beneficial interest in the loan be revealed to the bank. Aside from the fact that it would be impossible for a bank to enforce such a requirement, beyond asking the borrower the direct question, this provision is highly ambiguous. Who would be the person receiving the "beneficial interest" in a loan? If a loan is made to an executor to enable him to pay estate taxes, who receives the beneficial interest of that loan? All the legatees who receive fixed dollar legacies? The specific legatee of the diamond necklace? The unborn contingent remainderman of the residuary trust? The Association recognizes that there have occasionally been supervisory problems in connection with loans to "dummies" or "strawmen", but it believes that these problems should be solved by legislation empowering the bank regulatory agencies to make rules and regulations where necessary and appropriate. D. Loans to Corporations Owned in Part by Bank Personnel or their Families The proposed Section 28 would prohibit insured banks from making loans to a company with respect to which 5% of the total outstanding shares are owned in the aggregate by bank directors, trustees, officers and employees and the members of their immediate families. There is no evidence of abuses that the proposed Section 28 would cure which are not covered by existing legislation and consequently no compelling reason for passage of Section 28. Section 28 is so broad and vague that it would be impossible for the FDIC to administer and equally impossible for the subject banks to comply with its provisions. How can a bank of any size know whether all of its employees (and not just officers and directors) and all the members of their immediate families, taken in the aggregate, own any particular percentage of any particular company? If Section 28 becomes law, the enforceability of a loan could depend on whether a judge thought that a bank trainee's rich mother-in-law was a member of his immediate family. 623 X. SECTIONS 1 9 , 2 0 AND 2 1 A. Brokered Deposits The Association supports giving the Federal regulatory authorities adequate tools with which to cope with abuses arising out of the misuse of funds derived from brokered deposits. The Association, however, concurs with the position taken by Mr. Preston Martin in his recent testimony before the House Banking Committee to the effect that an aibsolute ban on brokered deposits is inadvisable. B. Brokered Deposits-Criminal Offense Section 21 would make it a criminal offense for a person to solicit a commission from an insured bank for obtaining or assisting in obtaining funds for deposit with such bank. Such criminal penalties are unnecessary and should not be enacted. XI. SECTIONS 2 2 , 2 3 AND 2 4 Prohibition on Giveaways Sections 22, 23 and 24 would forbid giveaway programs by insured banks and other lending institutions. We believe that there is presently adequate authority to prevent abuses. XII. SECTION 2 5 Extension of Deposit Insurance under the Federal Deposit Insurance Act Section 25 would extend federal deposit insurance coverage to 100% of U.S. Government, state and municipal deposits. We oppose this provision as do Chairmen Burns and Martin. Respectfully submitted, N E W YORK CLEARING HOUSE ASSOCIATION 624 The CHAIRMAN. The next witness is Mr. Edward Herbert. STATEMENT OP EDWARD HERBERT, SENIOR VICE PRESIDENT, FIRST NATIONAL BANE, MONTGOMERY, ALA., ON BEHALF OF ROBERT MORRIS ASSOCIATES, NATIONAL ASSOCIATION OF BANE LOAN AND CREDIT OFFICERS Mr. HERBERT. Mr. Chairman and members of the committee, I am Edward Herbert. I will give you a brief summary of our testimony but I do request that the entire testimony be made a part of the record. The CHAIRMAN. Without objection it is so ordered, it will be placed in the record. Mr. HERBERT. I appreciate this opportunity to appear before you on behalf of Robert Morris Associates. RMA is an association of commercial loan officers and credit men whose banks comprise 80 percent of the total resources of the American banking system. A number of provisions of H.R. 5700 apply to the area in which we function. Section 9 prohibits banks, bank officers from serving on the board of directors of corporations where substantial and continuing loan relationship exists. Gentlemen, there are times when it is essential to have an officer of the board of the bank on the board of a firm that is infinancialdifficulty. It is the most practical way to stay fully informed of the condition of business. There are also times when a new business is in dire need of financial advice of an experienced bank officer. And generally these bank officers serve at the invitation of the corporation. When abuses occur in this area the examining authorities could be empowered to correct the situation. If additional authority is needed, then give it to them. Section 14 on equity kickers is similar to our position on section 9. It is not necessarily a bad practice. And there are times when it will be the only way a business can get the needed funds. No one forces a borrower to give a lender a piece of the action. He is free to go wherever he can get the most attractive financing, and banks are not the only place he can borrow. This too can be controlled by the examining authorities. SECTION 15 This section prohibits directors from borrowing from their bank if they or their families own 5 percent of the stock of the corporation. This will not be much of a problem for the very large bank, but it becomes increasingly critical as you go into the smaller communities and smaller banks. These directors are generally the leaders of their communities, and in a position to contribute much to the soundness of a bank's operation. True, some directors will use their position to their advantage. But the examining authorities can put a stop to that. Included in every bank examination is a detailed list of all loans to directors, officers and employees. And to go a step further and require that this information be made public knowledge goes in the face of Congress' concern for personal privacy. We are in favor of the intent of sections 19, 20, and 21 concerning 625 the prohibition of brokered deposits. It should be declared illegal to make a loan where a brokered deposit is tied to it, because this is where the trouble develops. But there are times when brokered loans are essential to the financial stability of banks. Clearly, banks should have the ability to purchase negotiable CD's, or acquire funds through brokers in the Euro-dollar market, or through their incentive campaign among employees to generate new customers and new deposits. Gentlemen, coins have two sides. And we ask you to have an open mind. It is not necessary to put the banking business in a straitjacKet to correct abuses of a few. Arm the regulatory authorities with the powers that you desire and let them make the desired corrections. Thank you, gentlemen. The CHAIRMAN. Thank you very much, sir. We will place your prepared statement in the record at this point. Mr. HERBERT. Thank you, Mr. Chairman. (The prepared statement of Mr. Herbert follows:) P R E P A R E D STATEMENT OF E D W A R D H E R B E R T , SENIOR V I C E P R E S I D E N T , F I R S T N A T I O N A L B A N K , M O N T G O M E R Y , A L A . , ON B E H A L F OF R O B E R T M O R R I S A S SOCIATES, N A T I O N A L ASSOCIATION OF B A N K L O A N AND C R E D I T OFFICERS Congressman Patman, I am here as a representative of Robert Morris Associates, the National Association of Bank Loan and Credit Officers. Our Board of Directors has authorized me to appear before your Committee to present what we hope will be helpful comments upon H.R. 5700. RMA's 1,230 member banks comprise approximately 80% of the total resources of the American banking system and our 4,600 individual representatives are the decision-makers on a great preponderance of the commercial loans in those banks. We very much appreciate the opportunity to appear before you today. Robert Morris Associates is a specialized professional organization. Our interests are solely in commercial lending, and we will try to restrict our constructive suggestions to those Sections dealing with our particular field of expertise. We believe that banking's performance record over the past ten years has been excellent and the result has been an absolute minimum of loss to our depositors. There have been a few bank failures which have served to point up some operational discrepancies. It is our opinion, however, that the mechanism for correcting these discrepancies already exists in the form of the regulatory authorities and that they should be given whatever additional powers they deem necessary in order to accomplish this goal. Section 9 We would like to comment first on Section 9 which prohibits officials of commercial banks from serving on boards of directors of corporations which have a "substantial and continuing'7 loan relationship with the bank. RMA well recognizes that there are potential abuses involved in interlocking directorships and other close ties between the corporate borrower and his bank. We agree that these abuses ought to be eliminated. On the other hand, there are times when everyone benefits from a banker serving on the board of directors of one of his corporate customers. Two types of situations in particular stand out as arguments against an absolute prohibition of these activities: 1. Where there is a necessity for the bank to obtain absolutely current and accurate operational data in order to help prevent financial collapse of a borrowing customer. If the bank, using the means provided by a shared relationship, is able to assist its corporate customer in turning around his business from a loss operation to a profitable one, an economic benefit is produced. This is good not only for the bank's depositors and stockholders and for the stockholders of the revitalized corporation, but also for the economic well-being of the community of which they are both a part. 2. There are burgeoning businesses which have a need for bank credit and financial advice far beyond that which would normally be extended. Bankers are sometimes willing to make additional loans because of a close intercorporate relationship 626 which provide&i a complete exchange of necessary information and advice and thus reassures the bank that its customer is worthy of increased loan accommodations. As an example, a well-known franchise concern, now of gigantic proportions, freely admits today that it owes its successful launching as a national "name" to the creative lending and sound advice available to it because each of its two banks had an officer on its Board of Directors when it was just beginning to grow. It should be mentioned that in very few cases do banks request membership on a corporate customer's board of directors. On almost every occasion such a relationship is instigated by the borrower. In summary on this point, we do acknowledge, as noted earlier, that there always exists the possibility of abuse of interlocking corporate relationships, although we do not believe there have been very many such cases. But, we also feel that the Federal and State examining authorities now have the capacity to scrutinize such interrelationships carefully and that they, in fact, are presently well aware of them. We strongly suggest that the best method of obviating these occurrences would be to give the Federal Reserve Board, the Federal Deposit Insurance Corporation, and The Comptroller of the Currency discretionary authority to require that such corporate interrelationships be dissolved if their examinations reveal any sign of favoritism or preferential treatment or misuse of confidential information on the part of the bank or its customers. Section 14 Our position on "equity kickers" is similar to that which we have expressed regarding Section 9. We appreciate that there could be a potential conflict of interest situation when a banker finds himself in the position of creditor and investor at the same time. He might, in an effort to protect an equity investment, be tempted to advance additional loan funds beyond the limits which ordinary business prudence would dictate, thus weakening the bank's loan portfolio. We think this has been a rare occurrence, even during the most recent tight money period, however. RMA believes that the absolute prohibition of equity participations would be detrimental to our national goals. Federal Home Loan Bank Board Chairman Martin offered a number of convincing arguments in this direction during his testimony before this Committee on April 20. In the commercial loan field, we do have borrowing customers who prefer to offer their bankers equity participations rather than, say, in interest rate which is fully commensurate with the credit risk involved. We believe that the borrower should be free to make whatever arrangements are most suitable to his own situation in order to obtain the funds he needs tofinanceor expand his business. We would prefer to leave the regulation of equity participations to the examining authorities. The data on these transactions is available to them already and they should be given sufficient authority to force the bank to divest itself of an equity participation if a conflict such as the one previously described should develop. FDIC Chairman Wille testified that "from a purely supervisory point of view, there appears to be no reason at the present time for the blanket prohibition contained in H.R. 5700." RMA supports Chairman Wille's testimony. Those banks who do not see the necessity for equity participations can elect not to employ them. On the other hand, those bankers and borrowers who decide that the equity participation route is the best method of arriving at a fair and equitable arrangement for both sides should not be arbitrarily estopped from its uise. Section 15 We would next like to comment on Section 15. This section prohibits commercial banks from extending credit to any corporation in which directors or officials of the bank or their immediate families have even a small (5%) ownership interest. We believe that such prohibition would be inimical to the best interests of the economy. The country needs strong banks, and strong banks are, among other things, a product of strong boards of directors. We can envision innumerable occasions when an able local businessman, managing a very successful familyowned firm, might decline to serve on his bank's board because his company's established borrowing relationship would have to be severed; we can also conceive of occasions when a bank would pass over the best candidate for a vacancy on its board rather than lose a good customer. A bank should not have to choose between having a good customer and a good director. This should not be an either-or concept, especially in a smaller community which might have a shortage of eligible directors and/or alternative loan sources. 627 We would also like to comment on that part of Section 15 which would require that the Federal Deposit Insurance Corporation make public certain information about credit accommodations made by banks to directors, officers, employees, or their immediate families. We believe that this information should be available to the FDIC (it is usually obtained even now as a routine part of the examination process) but we also feel that public disclosure would involve an invasion of personal privacy and deny the customer the confidentiality which he has a right to exptect in connection with his financial transactions. Personal privacy is already being threatened today from too many directions. Sections 19, 20, 21 We are in favor of the legislative intent of Sections 19, 20, and 21. We believe that brokered deposits, if tied to a credit accommodation, should be prohibited and that the penalties for violating these Sections should be quite heavy, applying to the broker as well as the bank. Banks are not usually the entities which pay brokers in cases where a borrowing customer needs compensating deposits to support a loan request. Ordinarily, it is the loan applicant who pays the broker a fee, part of which eventually goes to the supplier of the funds. While the wording starting on line 11 of page 20 does extend the restriction to other parties, we feel that a clearer statement might be made which would directly prohibit the payment of fees by anyone to a third party as an inducement to supply depository funds to a banking institution. I thank you once again for the privilege of speaking to you about H.R. 5700. Let me assure that Robert Morris Associated would be happy to supply you with whatever additional information you might need as you continue your deliberations on this Bill. The C H A I R M A N . NOW, then, we will have questioning by the members, going around the first time for 5 minutes. I would like to ask Mr. Sommer a question. I notice, Mr. Sommer, that you used the word "opposed" 21 times in your testimony. However, I would like to look on the positive side a little bit. On page 3 of your testimony you state: The American Bankers Association recognizes that potential anticompetitive effects may seem to result from interlocking management between directly competing depository institutions. Accordingly, we endorse the prohibition of certain interlocks between banks and other deposit-type institutions, namely, mutual savings banks, savings and loan associations, and credit unions. Do I gather from this statement that you endorse generally the prohibition against interlocking personnel among these competing financial institutions along the lines supported by Chairman Wille of the Federal Deposit Insurance Company and Dr. Burns, Chairman of the Federal Reserve Board? Mr. SOMMER. Yes, sir; we do with respect to competing depository institutions. The CHAIRMAN. Why did you mention credit unions? They do not receive deposits subject to check. I just wonder why you put them in. Mr. SOMMER. They are included in the bill, but we have no objection either way on that. The CHAIRMAN. If it were stricken out you would have no objection? Mr. SOMMER. We would have no objection to that, sir. The CHAIRMAN. Mr. Renchard, I gather that your organization's position is similar to the ABA's. You support some form of strengthening of the prohibition against interlocking personnel among competing deposit institutions along the lines of the testimony of Chairman Wille, is that correct? Mr. RENCHARD. We make no objection to it, Mr. Chairman. The CHAIRMAN. Is it not also correct that your testimony, starting 628 with the last paragraph on page 2, through the bottom of page 6, does not deal with sections 2, 3, and 4 of the bill concerning interlocking personnel among financial institutions. It is concerned with the prohibition in the legislation about interlocking personnel between financial institutions and nonfinancial institutions; is that right? Mr. RENCHARD. I am sorry, I do not follow your question, Mr. Chairman. The CHAIRMAN. All right. Is it not also correct that your testimony, starting with the last paragraph on page 2 through the bottom of page 6, does not deal with sections 2, 3, and 4 of the bill concerning interlocking personnel among financial institutions. It is concerned about the prohibition in the legislation against interlocking personnel between financial institutions and nonfinancial institutions; is that correct? Mr. RENCHARD. I believe my comments are confined to interlocks between deposit institutions. The CHAIRMAN. Deposit institutions. Mr. RENCHARD. I see no objection to some limitation on interlocks between deposit institutions, but we think it should be limited to that. The CHAIRMAN. Thank you, sir. On page 10 of your statement, Mr. Renchard, pages 9 and 10 of the attachment, you seem to agree that some form of disclosure of equity assets held by various financial institutions would be useful, along the lines that the SEC recommends in its financial institutions study, is that correct? M r . RENCHARD. Y e s , sir. The CHAIRMAN. IS it not true that today the public can find out on a quarterly basis the stockholdings of mutual funds, and on an annual basis the stockholdings of insurance companies, but there is no way that the public has access to the aggregate, stockholdings of a commercial bank trust department? Shouldn't we at least keep public disclosure for trust departments on a par with mutual funds and insurance companies until some time in the uncertain future when the proposals of the SEC are adopted? Mr. RENCHARD. I think we would see no objection to publishing such a compilation, were it limited to stocks where the bank has the control over the voting power. The CHAIRMAN. N O W , then, on the giveaways—any one of you may anwser this—it is my understanding that the four agencies involved, the Comptroller of the Currency, the FDIC, the Federal Home Loan Bank Board—and the Federal Reserve Board agreed on certain rules and regulations involving premiums or giveaways? M r . RENCHARD. The CHAIRMAN. Y e s , sir. What would these maximum premiums or giveaways, if used to the extreme, be? Mr. RENCHARD. We also have a limit, Mr. Chairman, imposed by the State Banking Department in New York. The CHAIRMAN. The State Banking Department in New York. But take the national one, that is what we are concerned with right now. How much would that aggregate in interest rate if converted from premiums to interest? Mr. RENCHARD. I believe the maximum is a premium giveaway of $5 on deposits up to $5,000. 629 The CHAIRMAN. HOW long a time, though, would that deposit be required to remain in the institution? Mr. RENCHARD. As far as I know they can take it out the next day if they want to. The CHAIRMAN. Take it out the next day if they want to. Mr. RENCHARD. Mr. Sommer may have a different view on that. The CHAIRMAN. Mr. Sommer, what would you consider—if you translate the premiums into interest rates, how much would it be on those accounts? Mr. SOMMER. I don't believe there is any way of telling unless we know the length of time the deposit was made for, and the amount. The CHAIRMAN. I thought the length of deposits was always required when a deposit was made where a premium is expected or given. Mr. SOMMER. Mr. Chairman, I believe that depends on the rules of that bank—sometimes the deposits run for 3 months before interest is paid. And that may be from the next 3 months' date, so you would have up to 6 months. On the other hand, there are other types of accounts that pay interest daily. So I agree that it is very possible that a deposit could be made one day to get a premium and be drawn out the next day, or it could be left on deposit over a period of time. And to relate a $5 premium to a particular deposit for a short period of time could increase the rate of return substantially. The CHAIRMAN. I do not understand why you do not have some rule of thumb where you could ascertain about how much it would be, and translate it into interest. Mr. RENCHARD. Mr. Chairman, in cases where we have used this type of giveaway for the promotion of a branch, we have maintained a record subsequently on retention of savings deposits. And generally it has been quite impressive as to how many stay. The CHAIRMAN. I did not understand the last phrase you used. Mr. RENCHARD. Generally thefiguresare quite impressive on how much of the deposits are actually retained. The CHAIRMAN. And you think it is worthwhile, then, to encourage thrift? Mr. RENCHARD. Yes, sir. It can be very useful in attracting thrift deposits. Mr. SOMMER. Mr. Renchard talks about one aspect of it, and that is the retention. In our own bank we do have premiums that we give away, always of course within the regulations and the law. We have taken two surveys over the period of the last 5 or 6 years, and have found that, at the end of the year, between 80 and 90 percent of the accounts that open through the use of premiums were still on the books; and a good share of them—I cannot tell you the exact percentage—but a good share of them were active. We feel that on the question of giveaways, if you single out banks and savings and loan associations to prohibit giveaways you are singling out these institutions as compared to the whole gamut of commercial institutions— filling stations and everybody else who is doing it. We do not think banks and savings and loan associations ought to be singled out. But we do very strongly feel that premiums are an important part of thrift and savings. And I am sure that there are many, many instances where the money goes into the savings account that might be spent some other way, thus adding to the personal assets of the individual. 630 The CHAIRMAN. From the standpoint of encouraging thrift I am impressed that it could have some influence. M r . SOMMER. Y e s sir. The CHAIRMAN. Mr. Widnall. Mr. WIDNALL. Thank you, Mr. Chairman. I would like to welcome all the members of thefinepanel here before us this morning. You have given some very constructive testimony, and some suggestions I am sure that the committee will work on, and will listen to. This is a highly controversial bill, and I am afraid that the title to it is a bit misleading, the Bank Reform Act. We have not yet been shown by actual evidence in the record that reform as such is what is needed. There are certainly things that should be clarified in the operation of banks. And I think that among them two things that we have been talking about, the interlocking directorship and the ance that need consideration, ement. And I find the basis of r . your objections to the provisions of H.R. 5700 relating to interlocks consistent with those voiced by previous witnesses. As I understand your statement, the American Bankers Association supports a prohibition against interlocks between depository type institutions in the same contiguous or adjacent cities or towns or villages, with authority for regulatory bodies to extend or modify the rule as they find appropriate. It seems to me that this is a good approach, sufficient to restrict interlocks which are most apt to reduce competition. Furthermore, this would be consistent with what Dr. Arthur Burns requested for a basic rule of law to govern the majority of cases, but would give enough administrative flexibility to treat the unusual case. Do you think this prohibition would best be imposed by new law, such as we are considering, or by modifications to the Clayton Act? Mr. SOMMER. Mr. Widnall, we have not attempted to define which regulatory authorities should take on this duty, and I understand that some feel that to suggest the exceptions would be much work. But, generally speaking modification of the Clayton Act would be satisfactory. But we have no objection to a new law. Mr. WIDNALL. Mr. Carlson, on page 8 of your statement you comment on brokered deposits and express your support for these prohibitions. You correctly state that anyone is prohibited "from receiving anything of value or obtaining funds of others for deposit or investment in banks or savings and loans." M r . CARLSON. Y e s , sir. Mr. WIDNALL. That prohibition also applying to "investment" would make it impossible for an underwriter to sell a bank stock or a 'ly needed capital. Do you really )t in our consideration. Mr. WIDNALL. Would you clarify further your own statement? Mr. CARLSON. When we talk about investment in banks or savings and loans, while the law provides today that when customers deposit funds in savings and loans we know those as investments, and it is not a depositor-bank relationship in a savings and loan. As we understand it they are purchasing investment shares, not actually making 631 deposits. That is how I grew up in the business, and that is how you remember it. Mr. WIDNALL. Thank you. Mr. Sommer again, relative to your testimony on pages 11 and 12, would you care to comment on the kind of assistance your in-house legal staff provides to the public which would be prohibited by section 2? Mr. SOMMEB. Mr. Widnall, we are concerned that the in-house legal counsel would be prevented from really doing legal service for the bank in any of its transactions if the counsel were on the board of directors involving any transactions with our customers. Mr. WIDNALL. I can see that. On page 14 you show some interesting figures on the volume of securities which just three banks would have to report under the provisions of section 12, among the securities you mention are just stocks and bonds. However, H.R. 5700 uses the word "securities" without definition. Couldn't that definition also include mortgages, notes, warehouse receipts, or anything symbolic of an interest or something of value? Mr. SOMMER. May I ask Mr. Brown, our trust man, to answer that? Mr. RICHARD BROWN. I consider that it would include all holdings in trust departments with the possible exception of real estate. I do not believe you could call that a security. But certainly a mortgage is a security, and a warehouse receipt is so regarded. Mr. WIDNALL. That would greatly increase the amount of reporting that would be necessary to the institution, isn't that so? Mr. RICHARD BROWN. Yes, sir, that is so. Mr. WIDNALL. Mr. Sommer, on page 6 you oppose the prohibitions of section 7 which prohibit bank directors and others from serving on the boards of companies for whom the bank manages a pension fund. I suppose if a local automobile dealer serves on the board of a bank and also the board of a local company manufacturing gravestones the bank would be precluded from managing the pension fund of the latter company? Mr. SOMMER. May I again ask our trust representative to answer that, Mr. Widnall? Mr. RICHARD BROWN. That would be so, Mr. Widnall. Mr. WIDNALL. What you are saying is that that could hardly be anticompetitive or in any way against the public interest, except that the gravestone company would have to get another bank or individual to manage its pension fund, isn't that right? Mr. RICHARD Brown. Yes, sir. Mr. WIDNALL. That is all at this time. My time is up. The CHAIRMAN. Mr. Barrett. Mr. BARRETT. Thank you, Mr. Chairman. I want to ask Mr. Carlson a question. As I understand your statement, you oppose section 14 on equity participation, and sections 19 and 21 on brokered deposits. As for another section of the bill, you suggest further study is needed before any conclusion can be drawn. How and by whom do you suppose these studies should be undertaken? I know you are all knowledgeable men. Are you also familiar with the study of Professor Darnell of the University of Colorado? 632 M r . CARLSON. NO, I a m n o t . Mr. BARRETT. He indicates, if you are familiar with it, that there have been detailed studies carried out by the University of Colorado on practices of chain banking. These studies cover hundreds of small and medium size banks in several midwestern cities and States. These studies disclose similar interlocks to those existing in the larger cities. How do you justify your statements indicating that further study is needed when there has been a full study made and full coverage of both small and large States in the interlocking relationship? Mr. CARLSON. I did not know, sir, that there had been a full study of all of the States. I do know that there was a 984-page study of 50 banks in 10 cities, which I believe is a matter of record, and from which much of this bill is drawn. I know in various States there are some studies that State banking departments, State legislators and State banking associations have drawn. But 1 was not aware that these had been submitted, sir. Mr. BARRETT. I think such testimony was offered here the other day—if you will look the record over. Thank you very much, Mr. Carlson. M r . CARLSON. Y e s , sir. Mr. BARRETT. I have a question for you. Mr. Renchard. On page 3 of your testimony you point out that: "All make any misuse of directorship unacceptably hazardous, likely of detection, and subject to severe penalties. These laws and standards are rightly directed at stopping improper conduct of actual abuses." On your page 3, as you stated, there are antitrust laws which "make any misuse of directorship unacceptably hazardous, likely of detection and subject to severe penalties." Where the interlocking directorship is not in violation of the Clayton Act, could you tell us specifically what antitrust laws apply to the interlocking relationship? Mr. RENCHARD. I am not a lawyer, Mr. Barrett, but I believe there are remedies in the antitrust laws where there is a conspiracy of any kind involved. Mr. BARRETT. Could your legal adviser give you some help to try to embellish that statement, because we do not consider that an interlocking relationship. Thank you very much. Mr. Chairman, I do want to ask Mr. Sommer a short question here. I am just a little bit confused on your page 3. You indicate in the second paragraph: "Interlocks resulting from common stock ownership, including companies and chain banking arrangements, should be specifically excluded from the prohibition." And in the next part of that paragraph you say: "We recommend 5 years' time period for corporations to bring their board membership into compliance with the proposed legislation." Do we understand this to mean that you agree that there are some irregularities in some of these banks? Mr. SOMMER. Mr. Barrett, we are talking now about the interlocks between depository institutions. We do not say that there are any irregularities, but depository institutions are competitors in many 633 ways, and sometimes very close competitors. We feel that it might seem like there could be differences 01 attitude and opinion, and we therefore think it wise that the director interlocks between the depository institutions be eliminated. And we think the 5 year period is necessary in order to have a smooth transition from that. I give you an example in our own bank. When I came to Owatonna we had two directors from our bank on the board of the local savings and loan association. As these members finished their duties with us we made sure that we did not put any more directors on with a competing financial institution. Mr. B A R R E T T . Thank you, sir. The CHAIRMAN. Mr. Johnson. Mr. JOHNSON. Thank you, Mr. Chairman. I too want to join my colleagues here in welcoming you gentlemen here. You have certainly given us some very wonderful statements. And you have very succinctly, I would say, set forth your various positions. I agree with Mr. Widnall, this bill is much more serious than may be even the chairman of our committee wants to realize. And if it were to pass, the banking institution as we know it now would be, let us say, a shadow of its former self. So we are going to watch this bill very carefully. Now, I was quite surprised that you gentlemen are against the 100 percent insurance for public funds. Having been on a banking board myself for over 20 years—and I am no longer on a banking board—but it was a little country bank, and my, how we used to worry about sending these Government securities to and from the Philadelphia Reserve Bank to guarantee public deposits. And I thought this would be one thing that you bankers would say you were for. But in reading your testimony I find you take a very statesmanlike stand on it, and despite the real nuisance to the bank and all, you think it would be a bad thing for the country to fully insure public deposits. Do 3'ou want to comment on that, Mr. Sommcr? Mr. SOMMER. Thank you, Mr. Johnson. I too hoar from our operating officers about this transfer of securities for the pledging of assets. But we feel the comments that we made in our testimony really are pertinent. We think that should there be 100-percent insurance, and should all the States do away with the pledging of assets, there would be freed about $30 billion of money that is now invested in municipal bonds and Government securities pledged against State and local deposits, plus perhaps another $7 billion if the Federal Government deposits were handled in the same way, which I assume they would be. We think that this could have an impact on the municipal bond market around the country, and also on the market for Government securities, if the banks should decide to take a substantial part of this money and put it into loans or other types of investments.We think that this could have a detrimental effect. We cannot say how much, because we do not know. But it is our opinion that it would have considerable effect. The second thing is, we pride ourselves that, as an industry, we have handled the financial affairs of our institutions well, and have worked for the good of the country and the economy as well as ourselves, of 60-299—71—pt. 2 13 634 course. We take pride in the financial stability of our institutions. We feel that should this eventually lead to 100-percent insurance for all deposits, that much of the need for careful management or aggressive management or prudent management will ke taken out of the banking system. Again we cannot measure that. That will be an evolutionarv process. But we are concerned about it. Mr. JOHNSON. Another thing on that point, I have always felt that in the case of the banks which have large holdings of Government bonds, the mere fact that you hold them and have them deposited as security for public deposits, and so forth, means that the Federal bond market is not depressed by the dumping of Government bonds. So I can see by reason of your testimony that the requirement that Government bonds be used to secure public deposits has a very stabilizing effect on the U.S. Government bond market, is that true? Mr. SOMMER. Mr. Johnson, I do not know how significant we would feel if Government bonds were a part of the whole market, but they could very well have that effect. And it is very possible that in order to get Government bonds to pledge against these deposits so you do not have to change them every 3 or 6 months, we might extend our maturities somewhat, but not so far as not to be liquid. Mr. JOHNSON. I would like to ask a question of your trust representative. Would you state your name, please. Mr. R I C H A R D B R O W N . My name is Richard P . Brown. Mr. JOHNSON. Mr. Brown, my time has expired. I am sorry. The CHAIRMAN. Mrs. Sullivan. Mrs. SULLIVAN. Thank you, Mr. Chairman. I would like to ask, do any of you gentlemen have an answer to Mr. Barrett's question of Mr. Renchard on which antitrust laws would cover or apply to the interlocking directorships? Mr. CARLSON. Section 8 of the Clayton Act, our counsel tells us. Mrs. SULLIVAN. I think he said, whether the interlocking directorship is not in violation of the Clayton Act. Could you tell us specifically what antitrust laws would apply to the interlocking directorships? Mr. CARLSON. N O , I could not. Mr. RENCHARD. I might ask my counsel, Mr. Simmons, to comment on that, Mrs. Sullivan. Mr. SIMMONS. Mrs. Sullivan, what we are referring to is if there is a common director, let us say, of a bank and a sales financial company, and as a result of that common director there is an agreement that the sales financial company will not compete in the market in which the bank is engaged in business, and the bank agrees not to compete in the market in which the sales financial company is engaged in business, that of course is a violation of the antitrust laws. Now, obviously a premise is that if interlocks are bad because of the effect on competition, it must flow from that that there is some tacit agreement or understanding that one party will not compete with another party. If that flows, that is a violation of the Sherman Act. Mrs. SULLIVAN. But is it not the agreement that would be made, not just the fact that a person is a director? Mr. SIMMONS. N O , the interlock would not be a per se violation of the Sherman Act. Mrs. SULLIVAN. I wish you would enlarge upon that when you go 635 over your testimony. I think we need some more information on that from any of you on that question. (The New York Clearing House Association declined to elaborate on the above question.) Mrs. SULLIVAN. In an answer—this is to either Mr. Sommer or Mr. Renchard—in answer to a question that was discussed with Mr. Widnall, I want to say that Dr. Bums also supported a nationwide prohibition on interlocks among depository institutions, where their assets were more than a billion dollars. And I would like to know how you react to that. Mr. RENCHARD. I agree with Chairman Burns that thatis an arbitrary figure. And the way things are going in this country, in Washington and New York, a billion dollars is not very big. There are, according to my figures, 76 banks in the country now which are a billion dollars or more. And I do not regard those" as all competitive institutions, in the sense that they are certainly not what you would call money center banks. Mrs. SULLIVAN. Would you comment on that, Mr. Sommer? Mr. SOMMER. Mrs. Sullivan, 1 would be happy to. Our association would prefer the more flexible approach that was riven by Mr. Wille, Chairman of the Federal Deposit Insuranco Corporation. We do support largely the position of Dr. Burns, as I pointed out before. But we have some concern that when you make a precise cutoff, whether it be very small or very large, that may need to be changed and would not be consistent with our position. We would opt for a more flexible approach and give the regulating authority some responsibility in this area. Mrs. SULLIVAN. Thank you. And this is to you also, Mr. Sommer. On page 4 of your statement you say: If our financial institutions, both depository and others, evolve in such a way as to make insurance companies and banks more directly competitive at some time in the future, reassessment would be in order. The recent SEC study, I understand, shows that there is also substantial competition in the investment field between banks and insurance companies. And only yesterday we learned of three major banks cooperating with an insurance company in thefinancingof the town of Columbia. Is it your opinion that director interlock between banks and insurance companies should be prohibited if direct competition can be shown? Mr. SOMMER. Mrs. Sullivan, I did not learn about these three major banks and the insurance company collaborating until this moment. But in general our statement would be that wo feel there is some competition in the matter of savings, and some competition in the matter of pension plans, and the like. But, despite the comments of the SEC and the quote that you gave us, we do not feel that overall it is substantial enough vet to ban interlocks. Mrs. SULLIVAN. Thank you. I have another question, but my time has expired. Thank you, Mr. Chairman. The CHAIRMAN. Mr. Stanton. Mr. STANTON. Thank you, Mr. Chairman. 636 Mr. Sommer, I have been sitting here listening to the testimony, and I cannot help but get rather personal. This is the first time I have met somebody from the American Bankers Association since I presumably received $2,500 last fall from the Bankers' Political Action Committee. And I cannot help but think—you know the reputation of your organization. I wonder if you knew that you are not living up to your reputation by your performance. I have not seen anybody in my office—I think maybe once last year—from your organization. Is this deliberate? Anyhow, let us not change it, because I do not want to see somebody tomorrow, whatever you are doing. You know, there is no banking organization that has contacted me on this particular bill. There were a few at the time of the One Bank Holding Company Act, individual bankers. But I have come to the conclusion that probably everybody realizes this is such a bad bill, in its present form that there is no need to contact anybody. I cannot help but think that we have got such a conglomerate bill before us, so far reaching—it is a 27-page bill with 27 different sections covering half a dozen different subjects—I cannot begin to tell you how this committee will ever unravel it. But I want you to know~ we will try to do our best. I am impressed that with the one exception of the college professors, there has been nobody from the regulatory agencies or the industry that would admit that about 10 percent of this bill should be passed and 90 percent should be referred for further study. We recognize that we will get into far-reaching ramifications if we should ever accept H.R. 5700 as it now exists. Perhaps, Mr. Renchard, you could tell me, if you know, has your bank, for example, ever taken H.R. 5700 and applied it to your present board of directors? How many would it affect on your particular board? Mr. RENCHARD. I think literally it would practically eliminate the whole board except the insiders. Mr. STANTON. YOU could do another thing for me, Mr. Renchard. We have had some outstanding professors before this committee, people who are very knowledgeable, and who have studied the subject of interlocks in great depth. I would appreciate it if you would send them your testimony—you can get the names from the staff, or I would be glad to get them—because there is a basic difference of principle involved. These professors, almost, I think, with one exception, do not accept the basic premise of what are the duties of a director of a bank. I have never been on the board of any bank, but I have felt that the operation of a board of directors was primarily to keep an eye on and to watch the senior officers of that bank, and how they perform the day-by-day^ operation. Without exception the college professors did not look at that. They were more interested in more people getting a piece of the action. And I think you should send them a copy of your testimony so that the college students in the future could have a little broader outlook on life than they now get. Mr. RENCHARD. I feel sure that the responsibilities of corporate directors have been well discussed and certainly in some of the business schools. I think they are pretty well educated on this. Mr. STANTON. They have been educated to death with a bunch of statistics. But they have not been educated in the primary purposes, 637 as far as I can see, of what you have so eloquently stated in your testimony, Mr. Renchard. This should be brought out to them just as a comparison if nothing else. Mr. R E N C H A R D . I will try to do that. Thank you. Mr. STANTON. Mr. Sommer? Mr. SOMMER. I feel very definitely, regardless of the size of the bank, that one of the most important functions of the board of directors is to be a check on management and to see that management does what it should, and that there is good management selection to follow up and conduct the affairs of the bank, or any institution. In our own bank we have nine outside directors, two inside and nine outside. If this bill were to be passed, I would have one outside director left as of December 31, 1971, assuming the bill was effective, because I am losing two who are not affected, six are affected, I am losing two of the others who are not affected, and I would end up with one man on the board as of the end of this year, and he is a director in a comEany with which we do not have business, and I would very much ke to get the business. Mr. STANTON. I would say this, that if you gentlemen have some figures there as to how it would directly affect banks and how much it actually affects savings banks and credit unions throughout this country, don't put it in the record. Send it to individual members. Mr. B A R R E T T (now presiding). The time of the member has expired. Mr. Stephens. Mr. STEPHENS. Thank you, Mr. Chairman. I have read the statements you gentlemen have made with a great deal of interest. I believe that without having read your statements that I could have said what you have testified to today anyway. I am very much in favor of what is in Mr. Carlson's statement here, that this should not be entitled a bank reform bill unless we reform the bank reform bill, and then perhaps we could give it a title that would be helpful. The thing that I believe you have said in most of the items dealing with sections of the bill is that we have got enough regulation now to take care of people who are crooked, people who are abusing the privileges that are inherent in the banking field, and the institutions that are dealing with finances, and that with many more details spelled out, we can make it impossible for the public to get the service that the public needs. Am I right in assuming that that is part of the criticism you are making of these? Mr. SOMMER. That certainly would be true, Mr. Stephens. Mr. STEPHENS. It is the public that needs to have the services performed. And if you destroy the leadership, for example, in the financial world by eliminating the brains that are bound to be in some interlocking directorate, you are not doing the public any real service by categorically prohibiting the interlocking of directorates. Mr. SOMMER. Mr. Stephens, I personally, our association, our member banks, are very cognizant of the public interest and the service of the public. We feel very strongly about it. If anybody wishes to count the number of times we talk about the public interest in our testimony, it probably would not be quite the 21 that was referred to, but it will be quite a few times. We are very conscious of that. 638 We are doing our best and we are going to continue to do our best to serve the public. Mr. STEPHENS. Thank you very much. Mr. B A R R E T T . Mr. Brown. Mr. B R O W N . Thank you, Mr. Chairman. Mr. Sommer, in your colloquy with the chairman, the Chairman suggested—made comment upon the fact that your statement on 20-some occasions has expressed opposition to the provisions in this bill. He suggests that such opposition is somehow a bad attitude. Frankly, to the extent that your opposition amounts to objections to the almost McCarthvistic guilt by or with association which is manifested by this legislation, I suggest that your opposition is shared by many. It seems to me that this Congress, and our several regulatory agencies, should be able to appropriately, effectively, and summarily, deal with improper conduct, practices, or operations without the associations which is obvious in this legislation. I was interested in your comments about the provision relative to 100 percent insured accounts, because this is an area where there is certainly some difference of opinion. Hasn't there been a general objection over the years to the full coverage concept, since it tends to relieve the deposit institution from any liability exposure with respect to deposits? As a general principle isn't that true? Mr. SOMMER. Thank you very much, Mr. Brown, for your comments. This certainly is true. And as I mentioned, we take great pride in our financial institutions, now speaking particularly for banks and management of banks, and in our conscious public responsibilities to the public, to the economy, and of course to the governments that govern us. We feel that 100-percent insurance would tend to say to any depositor, it does not make any difference where you do your business, the FDIC is going to take care of it anyway, and we think it would take a lot of impetus and a lot of real steam out of management to do a better and better job. Mr. B R O W N . There has been much discussion this morning about the present effectiveness of control, shall we say, which exists in the Clayton Act with respect to anticompetitive activities. I remember the hearings on the one-bank holding company legislation we held when Mr. McLaren from the Justice Department and others testified regarding this whole area. In the course of the hearings we discussed at some length the Fortner decision, in which case the U.S. Supreme Court held that credit can be a tie-in product, where it had not been so held before. To those who are the legal beagles, as we sometimes say in our fraternity, wouldn't you speculate that the courts will continue to extend the interpretation of the Clayton Act to many other activities which have not been considered covered before by the Clayton Act, such as the very thing we are talking about here this morning? Or do you think that the Clayton Act is so restricted that it would not permit, for instance, the consideration of other anticompetitive activities not within the coverage of the tie-in decision? Mr. SOMMER. Mr. Brown, I am not an attorney, and I am not familiar in detail with all the laws. But my observation of court 639 procedures over a period of years has been that they will take the wider viewpoint as we move through this evolutionary stage of life that we are going through. And I would think that they would take appropriate positions to cover what you suggest. Mr. BROWN. Since my time is very limited, and I cannot go into some of the things in detail in the way in which I would like to, would any of you comment in a general way upon the possibility of legislating presumptions in the trouble areas, as you have admitted there are some trouble areas, and then leave the determination as to whether or not an anticompetitive situation exists, to the regulatory agencies? What would be your attitude toward such an approach rather than specifying the prohibitions that exist in this legislation? Mr. SOMMER. Mr. Brown, certainly if there are things that need to be covered we would rather have broad laws and have the leeway given to the regulatory agencies. Mr. Renchard, do you want to answer that? Mr. RENCHARD. I may add, Mr. Brown, that even in approving, or not objecting to, some of the provisions of this bill, we are not admitting that there are any real abuses that arc existing now as far as these interlocks are concerned. I know of no abuse in my personal experience where we have had an interlock between our bank: and a beautiful savings bank in New York, for example. However, we do not object to it if somebody thinks that should be eliminated. We do objcct to more far-reaching legislation that restricts us. I think you recognize that banking is a highly regulated industry already, one of the most highly regulated. And if you look around at what has happened to some of the overregulated industries in this country, I think it should give you pause in putting another one in that position. Mr. BROWN. Thank you very much. My time has expired. Mr. BARRETT. I wonder if it would be an imposition to ask the panel to answer the questions as briefly as they can. We are hopeful that we can give everybody on the committee here an opportunity to ask some questions. Mr. Minish. Mr. M I N I S H . Thank you, Mr. Chairman. Mr. Renchard, on page 7 of your statement you say that the SEC stud}* found "that although banks and other institutions sometimes have potential voting power to influence such corporations, there was no evidence to indicate that they exercised this power." Isn't this true that the SEC studies stated that they were not looking for such evidence but only the filing of statistical data on the interlocking relationship between bank and portfolio companies? Mr. RENCHARD. I really could not answer what they are looking for. All I know is what they concluded. Mr. RICHARD BROWN. My name is Richard Brown, sir, from Denver. I think what you have said as to what the SEC stated in its statement is accurate, that they were not looking for specific instances. But certainly, sir, there is no inconsistency between that and the observation that this study did not find specific instances in which they felt the voting power had been abused. Mr. M I N I S H . But the}' did not go into it, that is the point I am trying to make. 640 Mr. RICHARD BROWN. I think that is precisely correct, sir. Mr. M I N I S H . Mr. Renchard, don't you believe that a bank director who is also associated with a manufacturing company would have a better chance of obtaining a loan than a man representing a competing manufacturing company who is not represented on the Sank board of directors? M r . RENCHARD. N O , sir. Mr. M I N I S H . YOU do not? M r . RENCHARD. N O , sir. Mr. M I N I S H . YOU don't honestly believe that—if you were on a board of directors—and I was not on the board of directors of a bank— I would have as good a chance of getting a loan from the bank as you would? Mr. RENCHARD. Mr. Minish, are you speaking of a personal loan? Mr. M I N I S H . A corporate loan. M r . RENCHARD. N O , sir. Mr. M I N I S H . I just find it hard to believe. But that is your opinion. Mr. RENCHARD. In an institution of our size I can tell you that that is not a factor. Mr. SOMMER. May I answer M r . M I N I S H . Y e s , sir. Mr. SOMMER. I come from that? a smaller bank, and I would say absolutely that any customer will have an equal chance of getting loan consideration if the loan is warranted, whether a director or not. As a matter of fact, inside my own mind I scrutinize loans to directors personally and loans to the companies with which they are associated even more than others. Mr. M I N I S H . That is all, Mr. Chairman. Mr. BARRETT. Thank you, Mr. Minish. Mr. Williams. Mr. WILLIAMS. Thank you, Mr. Chairman. I want to thank you gentlemen for being here this morning. Your testimony has been excellent. Probably one of the reasons that so much of your testimony has been directed against the provisions of H.R. 5700 is because you are looking at the operations of ourfinancialinstitutions as they are. Mr. Sommer, m your statement you say, "We fear that the present effective functioning of bank boards of directors would be destroyed if sections 2, 7, 8, and 9 of this bill would be enacted." And then you go on to say, "The American Bankers Association recognizes that the potential anticompetitive effects may seem to result from interlocking management between directly competing depository institutions." Would you agree that this potential anticompetitive effect could be corrected by amending the Clayton Act? Mr. SOMMER. Mr. Williams, yes; we feel that it can be handled bv amending the Clayton Act. And to the question Mr. Widnall asked I answered that if there was another course that the Congress in its wisdom chose, that that would be satisfactory. If I may, I want to emphasize what Mr. Renchard said. We are not saying that there are problems with interlocks withfinancialinstitutions, but we are willing to support such legislation. Mr. WILLIAMS. Y O U also state that the reporting requirements required by sections 12 and 13 of this bill would engtilf the FDIC in a 641 virtual torrent of data as 3,500 trust departments file their annual reports. Of course, the compilation of this data is very expensive. Do you believe that the benefits provided by this data would outweigh the cost? Mr. SOMMER. May I ask Mr. Brown to answer that, sir? Mr. RICHARD BROWN. I welcome the opportunity to respond to that, Mr. Williams. We do not believe that any benefit which would be gained from such a massive inflow of data could match the cost. Mr. WILLIAMS. I think that fully answers my question. Also in section 14 which deals with equity participation, couldn't equity participation be developed to be a two-way street so that anybody obtaining equity participation would also participate in the losses as well as the increased profits, and the revenue that an equity participant would receive would not be based on gross revenue? Wouldn't this make equity participation a much more desirable thing? Mr. RENCHARD. I think, Mr. Williams, the first requirement in making a bank loan is to be sure that you get your money back. If you add a little incentive to it where you can be fully compensated on the interest rate, that is the only purpose. But we certainly would not want to make a loan where the amount of principal were reduced. Mr. WILLIAMS. Mr. Carlson, you do say that this bill is incorrectly entitled when it is called The Bank Reform Act of 1971. I agree with your statement. I have explained my statement in past testimony. As far as Mr. Parsch is concerned, you stated in your testimony, which you did not have a chance to present, that you feel that an outright prohibition against bank loans would mean the demise of independent banks. I certainly think that this would be a very sad situation, and I think you have agreed with me also. Mr. PARSCH. Thank you, sir. Mr. WILLIAMS. And as far as the statement of Mr. Renchard is concerned, you are dealing with the fact that the regulatory agencies should have adequate authority to deal with any abuses which might arise from the misuse of funds received as a result of brokered deposits. Now, I made the suggestion that as far as brokered deposits are concerned, we could completely separate brokered deposits from anv loans that were tied directly in with these brokered deposits and, therefore, eliminate the dangers of the brokered deposits. Mr. Burns liked my suggestion and Mr. Martin has some reservations about it. How do you feel about it? Mr. RENCHARD. We have no objection whatsoever to the elimination of brokered deposits where it is directly tied in with the loan. Mr. WILLIAMS. I was interested to see, Mr. Renchard, that your testimony included the word "straitjacket." I have used that same word as an adjective to describe H.R. 5700 in previous hearings. Thank you. Mr. BARRETT. Thank you, Mr. Williams. Mr. Gettys. Mr. GETTYS. Thank you, Mr. Chairman. It is 2 minutes until the House meets. Some years ago in a campaign down home one of my opponents was talking. He said, "You know there are a hundred ways to make a living, but there is only one honest way." 642 And I jumped up and said, "What is it?" And he said, "Oh, I knew you wouldn't know." And so that is just about the way this bill is. As a country lawyer, I have never been on any financial institution board. But I recall one time I was chairman of the United Fund Campaign, and a deacon of my church, I was on the YMCA board, and one or two other boards, and you know, we were all competing for money, all those three. And I wondered if I had a conflict of interest. And then another example. I doubt if there is a man in the United States who knows more about the subject of money than our chairman, Mr. Patman. He is well informed on the subject. Now, I wonder because of his expertise, I wonder if he has got any business serving on the Banking and Currency Committee, because we do not need competent men on these boards, you know, we have got to get somebody who absolutely knows notliing about a subject in order to serve on some of these financial institution boards. I think I have got my point across. Thank you, Mr. Chairman. Mr. BARRETT. Thank you, Mr. Gettys. But I do think, as deeply as I love you, that it certainly would be amiss on my part if I let that go by "without saying, I think Mr. Patman is the greatest representative of the public interest of the people of America since Andrew Jackson fought the British. Mr. GETTYS. You are talking on my time, Mr. Chairman. I won't yield to anybody in my love for the chairman. But I was making a point. And if you take offense, then I would have no quarrel with that. Mr. BARRETT. Mr. Rousselot. Mr. ROUSSELOT. I would be glad to yield to the gentleman. Mr. BARRETT. D O you desire to be recognizcd? Mr. ROUSSELOT. I would desire to be recognized now. Consume your time. Mr. B R O W N . He yielded to the gentleman. Mr. BARRETT. The gentleman yielded back his time. That is the reason I made the statement. Mr. BROWN. The gentleman may yield to the gentleman from South Carolina, the House rule3 so provide. Mr. BARRETT. He has yielded back his time. If the gentleman had asked me for time I would have given it to him. But I do not think any member, whether he is on the minority side or majority side, should be condemned in absence here. Do you want to be recognized, Mr. Rousselot? Mr. ROUSSELOT. If it is all right. Mr. BARRETT. It is all right. You are a very good member, you are very knowledgeable, and everybody has a great deal of respect for you. Mr. ROUSSELOT. I would just like to comment that I do not believe our colleague was attacking the chairman, in fact he was commenting on the fact that our chairman, Mr. Patman, knew a lot about money. That is all. Mr. BARRETT. There are many ways of commenting. Mr. ROUSSELOT. Gentlemen, thank you for appearing. First I hope you understand that because this bill attacks banks, some of us as committee members have been greatly disturbed that you have not 643 been allowed sometimes to complete your statement. Some of our colleagues have cut you off when you have tried to more fully answer questions. And I think it has been wrong and unfair. I think it is perfectly understandable that you are here in opposition to a bill that I believe would destroy in many ways the banking system of this country. I think that you should have every right to oppose the bill without being set down. We constantly talk about free speech here, and then when we have a bill that actually attacks an industry we do not allow the witnesses to always complete their statements. And I want you to know that many of us, though we are limited by certain rules here, have felt that whenever you feel that you have to complete a statement, go ahead and complete it, because you arc defending your own industry. And I think you have the right to be afforded that courtesy. No. 2, I want to compliment each of you on very complete statements, commenting directly ot the bill. I think it needs to be done. One of the gentlemen of our committee here has commented on the number of professors that we have here. And I would like to offer some suggestions to you as a banking industry, because I think it is needed. If you think for 1 minute that those teaching banking in the colleges today understand banking you are absolutely wrong on the basis of what we have seen here in many cases. And I am not attacking all professors who teach banking. But for you to be so naive as to believe that the people, at least some of the ones we have seen here, understand banking you are wrong. They do not, and to live under that illusion is a mistake. We had one professor here who admitted he knew very little about banking, and yet he was testifying on this bill and said ho was all for it. I believe your industry is going to have to be alert, because a lot of us have forgotten or do not know what is being taught in the schools and colleges today. And frankly, they know little or nothing about banking. And I think we all have an obligation to see that more is done in that direction. On the statement that was made by Mr. Sommer, regarding the 3,500 trust departments that would have to file annual reports, could you give us for the record through your association some kind of an idea of what the cost involved would be in this kind of reporting that is recommended in this bill? Of course that cost would have to be added to all the other costs of your business. And we have a great number of complaints, especially on this committee, that interest rates are too high. Well, one reason that interest rates are too high is because, frankly, your business is so overregulated, with all the reports that you have to make to all the Government agencies at all levels that I think we on the committee should know if we do impose these restrictions on you what the cost will ultimately be to the customer. The consumer is the one that has to pay that cost. I have no further comments. I think that you people have done an excellent job in presenting your subject, and I think you have every right to oppose this legislation, because I agree with one of our colleagues here, I think it should be named the "Bank destruction bill." That is what it is. 644 Mr. SOMMER. Mr. Chairman, could I answer him briefly? Yes, indeed; we will attempt to do that. It will have to be approximations and estimates, but we will furnish the committee with that estimation. Thank you very much, Mr. Chairman. (In response to the information requested by Mr. Rousselot, the following information was received from Mr. Sommer for inclusion in the record:) REPLY RECEIVED FROM M R . SOMMER The American Bankers Association took a brief survey of nine trust departments over the country, asking each to estimate its cost of supplying the data proposed in Section 12. The banks were chosen with an eye toward broad geographic spread—banks from Maine to California were included, with no two from the same State. Also diverse sizes were selected—from several billions in trust assets to under $50 miUion. Each estimate included two figures, the first being the initial expense of "tooling-up," that is, preparing the system and designing the necessary programs to provide the needed information; the second estimate was the annual expense of maintaining the system and providing the data. The costs reported were as follows: Very large trust departments ($1,000,000,000 or more in trust assets): Bank A Bank B BankC Medium-sized trust departments ($350,000,000 to $700,000,000 in trust assets): Bank D BankE Bank F Small trust departments ($100,000,000 or less in trust assets): Bank G Bank H Bankl Startup cost Annual $40,000-$45,000 15,000 4,000-5,500 $10,000-$15,000 45,000-50,000 6,300 3,000 3,000-4,000 2,000 10,000 2,500 7,400 36,000 4,000-5,000 1,600-2,000 23,300 15,000-16,000 i, 600-3,000 One small bank pointed out that its estimated annual reporting costs approximated 10 percent of last year's gross trust fees. The great differences in costs are due to the many different systems currently in use and the varying degrees of automation of the various stocks. One general assumption was made—"Value," as used in Section 12, is defined as book or carrying value. In most cases, to report market value would substantially increase costs. Mr. BARRETT. D O any of the other panel members want to respond to anything the gentleman said? Mr. RENCHARD. I would like to thank him. Mr. BARRETT. I think he is deserving of being thanked. But I do want to say, I do not think any member of your panel has been cut off here this morning. Mr. ROUSSELOT. There have been three or four occasions before they were allowed to complete their statements. Mr. BARRETT. Has the gentleman finished? Mr. ROUSSELOT. Yes; I think my position is abundantly clear. Mr. BARRETT. Gentlemen of the panel, this is Mr. Gonzalez. He is the father of H.R. 3287. I think in your testimony you indicate that you are not for his bill. He would like to address himself to the panel. Mr. Gonzalez. Mr. GONZALEZ Thank you, Mr. Chairman. First, let me say this. It is good to laugh and have a good joke at the expense of the chairman and the intention of those that in good faith have offered some of this legislation. But I think it would be a 645 lot funnier if you could get some of the Americans who have lost their money as a result of some of these malpractices that we are trying to correct, I think it would be a lot funnier. Maybe you can get them to laugh sometime. But let me say this. I have read your statements. And of course they echo the sentiments predominantly expressed not only by bankers, but by some of the regulatory agencies, with respect to my specific bill that would prohibit the acquisition of banks through the hypothecation of bank shares. And what I had in mind, I think, is" pretty obvious. And yet I have said all along that I am open to suggestions. I just cannot conceive of any of you gentlemen representing the tremendous enterprise that is the American banking system, nor for that matter the regulatory agencies through their spokesmen, or the Members of the Congress, saying that it is all right, for example, to have the situation you have right here in this area with the Public National Bank, which has been taken over. It has been taken over in mute. It is teetering. Everybody wants to hide what is happening. Nobody wants to say anything about it. But it has been taken over by a holding company interest m Michigan. Now, it is very interesting, why would a company in Michigan come all the way over here to this particular bank, milk it, unload bad paper on it, to the point where innocent depositors are not only hurt already, but will be further hurt, and further innocent depositors who are not being told anything about this will be hurt, simply because of this approach of a bank takeover, which seems to have no qualifications whatsoever? I cannot understand any reasonable mind finding anything wrong with trying to control this when, if you are going to have a bank merger, you not only have to report it, you have to go in in anticipation of your bank merger and get regulatory authority and permission for it. If you are going to have a holding company formation you have to do the same thing. What is so wrong about knowing something about this in the case of a bank acquisition where most of your questionable practices have arisen? We had the Chairman of the FDIC—and I am pretty sure that he is a little bit more concerned than he was at the beginning of these hearings, because he is the man with the bag—they are the ones that are paying out the money, they are paying out the money, Sharpstown $50 million, and in Michigan another hundred or so million. And in the dealings with Sharpstown the FDIC record shows that on March 28, 1968, both they and the banking examiner of Texas went in and discovered that Sharpstown had diverted $22 million for the acquisition of three banks. Less than a month and a week later, on May 7, they went back and discovered that Sharpstown had used about $875,000 in the acquisition of another bank in Illinois. No questions asked, no objections interposed. The Sharpstown bank folded later. The FDIC is going to have to shell out $50 million. A bunch of innocent people are hurt, I have them in my district, credit unions that said, well, this is a good bank because it is an insured bank, and we have regulatory authorities on a State and national level, and surely their imprimatur means they are all right, we will deposit our money there. But even in the face of that the regulatory authorities could not 646 come up with any suggestion—your bill is no good, it will destroy us, as the discussion here by Mr. Parsch would indicate, but not one suggestion about, what do we do in lieu thereof. So your bill is too comprehensive, it is too severe, but it will offer this, because we recognize there is a problem. Yes, I am sure that you will agree with me, unless I am wrong, that you do not approve the kind of takeovers that I have been describing. Do you think it is all right for the Sharpstown bank to go ahead and divert $23 million of its resources—for what, for bank takeovers— merely because the banking industry feels that they ought to have this right unimpeded? Is there any suggestion about what can be done if this bill I am suggesting is too harsh? I am open to suggestions. But I am saying that right now there are banks that have been taken over that are teetering. And the regulatory agencies, their philosophy is that their first duty is to the banking industry, they have got the erroneous idea that the Congress set them up to protect the banking industry, and to look out for its ease and convenience. And the truth is that they are supposed to be looking out for the public interest. You as bankers have one of the greatest privileges that the Government can provide any class of citizens. In exchange for that you subject yourselves supposedly to regulations. All we are saying is that we as Members of this Confess have been on notice for a few years that grave abuses have crept into the system. We have a duty to do something about it. None of us wants to unduly bridle or handicap the banking industry. We are fully aware that the overwhelming majority and preponderance of the banks are OK. But I am saying to you that if you do not join us in doing something constructive, you are going to be hurt too, because confidence and trust will be eroded. And your whole operation depends on confidence and trust. What I want to know is, besides being against the bill, what suggestions do we have. That leaves very little room for answering the question. I would think that if my time has expired, that the gentlemen are free to enter into the record any comment or anything by way of a response to the statements I have made. Mr. BARRETT. Will the gentleman yield? Mr. GONZALEZ. Certainly. Mr. ROUSSELOT. The time of the gentleman from Texas has expired. Mr. GONZALEZ. I ask unanimous consent that I be allowed to formulate additional questions to this array, and that they be given a chance to answer for the record. Mr. BARRETT. In writing? Mr. GONZALEZ. In writing. Mr. BARRETT. Would you be kind enough to do it for us? Mr. PARSCH. Yes, we will. Mr. ROUSSELOT. There are two that held up their hands to answer. Will they be allowed the opportunity to answer in writing? Mr. BARRETT. The gentleman cut his time off. (In response to the information requested by Mr. Gonzalez, the following reply was received for inclusion in the record:) REPLY RECEIVED FROM M R . SOMMER The American Bankers Association sees no need for legislation to prohibit the use of bank credit to purchase bank stock. We see no difference between the 647 extension of credit to purchase the stock of a bank and the extension of credit to purchase the stock of any other corporation. Prohibitions such as those contained in H.R. 3287 would have the effect of making bank stock an undesirable investment. The availability of this type of loan to buy bank shares increases both the liquidity and saleability of the* equity shares of banks, particularly small banks. As you know, insured banks are already required to disclose changes in bank ownerhsip to the appropriate bank rcgulatorv agencj-, where 10 percent or more of the stock is involved. In addition, the federal Reserve can impose margin requirements on bank stock traded on the major stock exchanges. If necessary, we feel that the bank regulatory agencies should be given the flexibility they may need to enforce regulatory powers in this regard. As FDIC Chairman Wille noted in his letter of April 12 to this Committee: "Changes in the remedies available to the regulatory agencies when a cease-anddesist order is violated would materially assist the agencies in curbing a variety of unsafe and unsound banking practices, including those that might arise following a change of control financed by bank stock purchase loans extended by another bank." We can understand the concern which Mr. Gonzalez may have with regard to loans to purchase bank stock. However, we do not feel that a few isolated cases in which the failure of a bank appeared to be somehow related to use of bank credit to purchase bank stock is an adequate reason to prohibit a type of loan which is commonly and prudently used, both in banking and elsewhere in the economy. Mr. BARRETT. Mr. McKinney. Mr. M C K I N N E Y . Mr. Chairman, I am going to make a very brief statement, and then I will be glad to yield the remainder of my time for the gentlemen to answer the questions. Mr. BARRETT. Thank you, Mr. McKinney. Mr. PARSCH. Mr. Gonzalez, we would like to refer to the testimony that I asked to be made a part of the record that I did not have an opportunity to deliver in oral form this morning. I was going to deliver a summary. But on pages 8 and 9 and 10 of that testimony we have suggested quidelines for the statute to implement laws to the F D I C . And we in our association would be very happy to have correspondence with you. And we agree that there are abuses, and we agree that many of these should be corrected. And we would be very glad to correspond with you. You will have a chance to study these in more detail, and then we would be open to your suggestions. Mr. BARRETT. Any other panel member? Mr. Renchard. Mr. RENCHARD. If I may, Mr. Chairman, I would like to say that fortunately the abuses to which Mr. Gonzalez referred are few and far between. Also under the terms of his bill, as I understand it, it would prohibit a bank making a loan against any amount of bank stock even down to one share, which I think is a little too restrictive. There is in the Bank Holding Company Act a provision now that requires the approval, I believe, of the Federal Reserve on any acquisition of as much as 25 percent of a bank. Also we have in New York State a law which requires anyone acquiring as much as 10 percent of a bank to submit to the sort of examination on the part of the banking authorities which is very similar to that required of people organizing a new bank. So there are ways to handle this without such a sweeping prohibition as your bill proposes. Mr. BARRETT. Any other panel member? (No response.) Mr. BARRETT. All time has expired. 648 Mr. M C K I N N E Y . Mr. Chairman, I do not believe my 5 minutes has expired. Mr. B A R R E T T . I thought you said you would give it away. Mr. M C K I N N E Y . I was going to yield the time to them to answer. I want to say that I am delighted to hear your testimony. I consider this bill, H.R. 5700, to be a disaster to tlie financial community. I think your testimony pretty well backs this belief up. There are certain things, liowever, that I would like to see. We have had college professors who have implied that every banker and everybody involved in business, in fact the entire free enterprise system of the United States, is full of collusion, sinister implications, and corrupt men. I do not believe that. But we have had, I think, a lack of alternatives. There has been a great deal of suggestions made that the Clayton Antitrust Act.be amended and changed. It is already a voluminous law, but I think this is one direction in which to go. We have had many suggestions that the FDIC and the SEC change some of their regulations. You know, I think, as well as I do, that there are abuses. I agree with Mr. Gonzalez; there are abuses. We have seen them. They are documented. I think what this bill is doing now is reaching far beyond the abuses in destroying thefinancialcommunity of the United States, one of the rare nations in this world where we can manufacture capital and move ahead at such an incredible rate. What I would like to see—for instance, I am a great admirer, though not a resident, of New York State's banking laws. I consider them to be among the very best in the United States of America. But I am not knowledgeable on them. And I am sure that there are a great many members of this committee who are not knowledgeable. You have been very nice to come here and spend this time. You have large staffs. And I would like to impose on them. I think that this committee would be well served if you could get together with a minimum of disagreement, because together you are going to swim or together you are going to sink, and come up with some ideas as to how the regulatory agencies, or amendment to existing legislation, could solve the abuses that this mammoth sledge hammer of a bill is trying to solve. And that would just be my request. I think that you could probably give us information which would be of great value to the committee as a whole. And I am sure each member on the committee would love to receive it individually by mail. Thank you very much. Mr. B A R R E T T . Thank you, Mr. McKinney. Mr. Annunzio. Mr. A N N U N Z I O . Thank you, Mr. Chairman. I have one question. But at the outset I would like to make a statement. During 1970 we have all seen profits of corporations down to their lowest level. But, fortunately, for us we have seen the profits of banks the highest in the history of this industry. So, I am not ready to join any of my colleagues with a crying towel for the bankers of America, nor am I interested, as I have stated before, in discriminating against or hurting any particular industry. I think we must always realize that we are living in an era of big business. Big business is good for the country and big unions are good for the country. 649 W e are living in an era of bigness. And in all fairness to the staff of this committee, it has been working for over 2 years doing research on interlocking directorships and on trust funds—all under the authorization of this full committee. They did not under take the studies without authorization of this full committee. On the basis of these studies that have been going on for the past several years, this legislation was formulated. But I do not like to see tempers flare as I have seen this morning. I think that the men who Jut their names on this bill—and I am one—did so in good faith. represent LaSalle Street in Chicago, and I probably have more banks in my entire district than any other member on this committee. W e did it in order to have in airing out, and when the final markup time comes, this bill will go up or down. Each section will go up or down. A bill might never come out of this committee, but at least we will have had the benefit of a hearing and the views of the professors, the banking industry, and the associations, so that the members of this committee can be guided by your good judgment. I know that every member of this committee is sincere and honest in wanting to do what is best for the people of America. With that I want to ask one question of Mr. Renchard. On page 4 of your statement you state that an insider on the board of directors would not secure an unwise loan in the face of competition, stockholder, depositor, and regulatory pressures. This committee must assume that these pressures did not operate in the case of the loans to the Penn Central Railroad, since substantial loans were made to the Penn Central even after their shaky financial condition became known to the bank. And before you answer that question, I want you to know, I am not one that talks from both sides of my mouth. I have voted on the floor of the Congress to give the appropriation of moneys to the trustees in order to get the Penn Central Railroad out of hock if we can possibly do it for the good of this country. But at the same time I do not like what has happened with the Penn Central and its relationship to some of the banks and some of its fiduciaries or companies that they control. Mr. RENCHARD. IS that a question? Mr. ANNUNZIO. Yes. On the basis of your statement on page 4 : A creditworthy company does not need a friend on the board to attract the interest of that bank or its competitors. If it is not creditworthy, no such insider could prevail in causing an uneconomic use of resources to continue in the face of competition, stockholder, depositor, and regulatory prices. Mr. RENCHARD. I might say this, sir. As far as our bank was concerned, there was no interlock with Penn Central. Mr. ANNUNZIO. I can appreciate that. The gentlemen representing the ABA, would you like to answer that question for the record later, Mr. Sommer? M r . SOMMER. Y e s . Mr. ANNUNZIO. I ask unanimous consent that Mr. Sommer be requested to answer as best he can my question. Mr. SOMMER. Later, sir? M r . ANNUNZIO. Y e s . Mr. BARRETT. That may be done without objection. Mr. ANNUNZIO. When you get the written transcript. 60-299—71—pt. 2 14 650 Thank you very much, Mr. Chairman. (The information requested of Mr. Sommer by Congressman Annunzio follows:) REPLY RECEIVED FROM M R . SOMMER The American Bankers Association cannot speak for the indiyidual banks involved in making credit available to Penn Central or its affiliates. We feel confident, however, that the extension of any credit to Penn Central was made on the basis of customary prudent and sound lending practices consistent with information available at the time. As these hearings have brought out, competitive pressures, shareholder and depositor interest, and regulatory scrutiny all argue against a bank ignoring prudence in the extension of credit, even to a firm with which a member of the bank's board is associated, if that firm is not credit worthy. We know of no loans that were made by U.S. banks between the time serious weaknesses were revealed and the Penn Central bankruptcy. Some loans were made in the early stages of need. This should not be taken to mean, however, that it is an unusual or questionable banking practice to extend credit to a firm temporarily in need of funds and where longer-term prospects would not be considered unusually risky. Indeed, it may be sound and prudent lending, particularly if the bank had a satisfactory credit relationship with a firm, but which for one reason or another additional funds were needed to tide the company over. The bank would cooperate, obviously, only in the full expectation that the firm would remain solvent. Unfortunately, in the Penn Central case, the extension of additional credit did not have the desired effect. However, in other instances it has enabled firms to remain in business.To grant the request for additional credit to supplement an initial loan is often the most prudent decision for a lender to make. In addition, public interest aspects may nave played an important role in the decision to provide additional funds to Penn Central. In the financial crisis of the summer of 1970, after the failure of the Penn Central, the banking system of America made loans to many big U.S. corporations which were in very serious financial trouble. The chairman of the Federal Reserve Board said that the actions of the banking system in taking these risks (without publicity) was a major contributor to saving our economy from grave difficulty. In the case of Penn Central, the banks tried to save it for reasons discussed above, but they simply judged wrong, That's the nature of the credit business. We live in a risk society. While banks judged wrong on Penn Central, they assessed correctly in dozens of other unnamed corporations which are alive and well today because banks fufilled their role as the key commercial lenders of society. Mr. BARRETT. Mr. Frenzel. Mr. FRENZEL. Thank you, Mr. Chairman. Welcome to the panel, and thank you for your testimony. Mr. Sommer, you were questioned by one of the members of this committee about your testimony in opposition to sections 2 to 9— which is of course supporting the position of the regulatory agencies with respect to the interlocks. You were asked what that would do to your board. You indicated that it would wipe your board out pretty well. I think that some of the members here may have an idea that Iou serve some vast octopus of a bank of which you are president. wonder if you would tell them the size of your town and of your bank. Mr. SOMMER. Mr. Frenzel, I would be very happy to. Owatonna is a town of 15,000 in southern Minnesota. Our bank does happen to be the largest in the county, with total assets of $33 million. Mr. FRENZEL. And its tentacles extend throughout the whole county? Mr. SOMMER. Mr. Frenzel, I think that would be true. But Steele County is one of the two smallest counties in the State of Minnesota, and Minnesota is not the largest State in the United States. We have 651 11 directors, two inside directors, and nine outside directors. Six of the nine outside directors would be immediately affected by this bill. There are two others who arefinishingtheir responsibilities as of the end of this year. So if this bill went into effect, I would have to find eight new directors out of nine this year. And as I mentioned, the ninth is one whose business I would like to get. Mr. FRENZEL. May I interpret your statement, then, to say as a small town banker that if this bill were passed in its present form that it would make it difficult for you to get directors of the same quality, and that the management of your bank would suffer? Mr. SOMMER. It would be impossible to get that many directors of the same quality in our community. I think this very seriously affects banks in smaller communities. But I would also say that it would very seriously affect banks in any size community. Mr. FRENZEL. Thank you. We are also indebted to you for your discussions on the 100-percent insurance, where you have made the point that you eliminate soundness of management as a consideration for the placement of deposits, and also that it changes the competitive factors between forms of institutions. One of the things that I did not feel was brought out in the testimony was, what happens to the costs? We have just heard testimony here that indicates extra cost of reporting in trust departments that has to find its way back into the bank's schedule of charges. Is it not true also that I, as the minimum depositor who does not get advantage of the 100-percent insurance, if I borrow from the bank, or use any of its services, that I am in fact going to be paying those costs? Mr. SOMMER. Mr. Frenzel, there is no question but what anyadditional regulation or reporting involves cost—and some of this reporting would involve large costs—it would be added to the costs of the banks. And despite the fact that banks did have quite a good year last year, over the long run this certainly will add to the cost of doing business, which will have to be passed on to the customer. Mr. KOUSSBLOT. Would the gentleman yield? Mr. FRENZEL. I yield. Mr. ROUSSELOT. I thank the gentleman. I wonder if your American Bankers Association could also give us some idea, by surveying your membership across the country, especially among the smaller banks, as to how many would be affected adversely by this law. That is, would the provision require them to eliminate bank directors and, in addition, could we have some kind of idea actually how many bank directors would be affected. I do not want to create more paperwork for you than we have already created for you in the Federal Government, but if you could give us some idea of how this legislation would affect all banks it would be helpful. Mr. SOMMER. I would be happy to do that. Mr. ROUSSELOT. Especially the small country banks that Mr. Patman wants to protect. Mr. CARLSON. We would be glad to do so. Mr. BARRETT. I wonder if the gentleman would yield? Mr. FRENZEL. I yield. Mr. BARRETT. On the basis of what you said, Mr. Sommer, are you associating this with the proposed legislation, or the inability due to the area in which you live? 652 Mr. SOMMER. NO, I am associating it with the terms of this proposed legislation if they were passed as they now are in the bill. Mr. BARRETT. Which part of the bill and which terms? This is. what I am trying to get in the record. Mr. SOMMER. Thank you, Mr. Chairman. In particular, the two areas where a director could not serve on a board of directors if there was a substantial and continuing lending relationship with the company with which he is a director, and also the provision that if any director, officers, employees, or trustees—or members of their immediate families—own collectively 5 percent or more of a corporation, the bank could not make loans to that corporation. As I pointed out in my testimony, this could affect a lot of small corporations. Mr. BARRETT. YOU have implied that you are just about to lose two members. M r . SOMMER. Y e s . Mr. BARRETT. Let me ask you that question. If you took these two points out that you referred to, what effect would that have? Mr. SOMMER. We would lose six out of our nine outside directors. M r . BARRETT. Mr. SOMMER. Yes. If these two provisions were eliminated from this bill, then oui board would be intact. But this might not necessarily be true in all banks, with the inhouse legal counsel and the other provisions. Mr. BARRETT. That is what we are trying to get in the record. Mr. FRENZEL. Mr. Chairman, I would like to address a question to Mr. Renchard. Your testimony indicated that sections 12 and 13 of the banking trust restrictions would tend to externalize the ownership or take the control away from the management. Yet it seems to me that sections 2 through 9 have the stated intention of inbreeding the management or making the board of directors internal. Do these seem to be contradictory provisions, too? Let me restate it. Sections 12 and 13 relate to how much of your own bank you can own or hold in some kind of afiduciaryrelationship. It seems to me that would tend to externalize the ownership of any particular bank, and that therefore you would have less control internally and more control externally. Sections 2 through 9 would kick out everybody on the board except your own officers and employees. Do not these provisions contradict one another? Mr. RENCHARD. I think in a way they do, yes, sir. Mr. FRENZEL. D O you have any comment on them? Mr. RENCHARD. N O . T W O through nine obviously are the sections that would decimate the forces of a great many banks, because they cover a variety of areas where a director would be disqualified. I do not know that there is too much of a tie-in here. This is another subject, this question of the ownership of the stock. We have a number of situations where we in a fiduciary capacity have to hold the stock of the bank because we are named executor under the will and there is a specific requirement for holding it, and you either have to observe that or the appointment would go to some other bank. Mr. FRENZEL. Thank you very much. If I have a trust account in your bank, could I direct you to buy under the terms of this bill, for my trust account, for my incompetent 653 aunt or minor children, stock in your bank? If this bill were the law, you could not do that, could you? Mr. RENCHARD. That is correct. Mr. FRENZEL. If I still wanted to buy your bank's stock I would have to take my trust elsewhere, wouldn't I? M r . RENCHARD. Y e s . Mr. FRENZEL. S O if you had a good bank and I wanted to buy your stock I could not use your good trust department? Mr. RENCHARD. That is right. Mr. FRENZEL. S O the better you were the less able I would be to use your services? Mr. RENCHARD. That is the way I understand the bill. Mr. FRENZEL. That is the way I understand the bill all the way through. Mr. B A R R E T T . Mr. Chappell. Mr. CHAPPELL. Mr. Carlson, let me say that I read your statement, and in general concur with it. I want to ask you—there are two particular areas that I have considerable interest in. One is the equity participation facets of this bill, and the other is the one dealing with the brokered deposits. Now, with reference to your comments on page 7 dealing with equity participations in section 14 of the bill, do you think that this prohibition should also extend to insurance companies? M r . CARLSON. Y e s , s i r . Mr. CHAPPELL. Y O U say it should M r . CARLSON. Y e s , s i r . Mr. CHAPPELL. That is my view, extend to all lending institutions? and I appreciate that. With reference to brokered deposits—and may I again commend your stand on that—and I assume from your statement that if the bill were limited to those two particular propositions, you would have no objection at all to the bill? Mr. CARLSON. That is correct, sir. Mr. CHAPPELL. With its extension to all financial institutions? Mr. CARLSON. That is right. Mr. CHAPPELL. With reference to your comments on page 9 on giveaways, I notice that in general you concur with the intent of the bill, but oppose those particular sections. Do you oppose the wording? Mr. CARLSON. We do not oppose the sections. M r . CHAPPELL. I s e e . Mr. CARLSON. But we do feel the present F D I C Mr. CHAPPELL. Y O U feel that it can be controlled by regulation alone? M r . CARLSON. Y e s , s i r . Mr. CHAPPELL. Aren't there instances of abuse today with the present regulations? Mr. CARLSON. There have been, I have seen them. Mr. CHAPPELL. I S that a fault of the regulations, or a fault of the enforcement of the regulation? Mr. CARLSON. I really don't know. I would guess the enforcement. Some bankers do not report that other bankers are doing things wrong. Mr. CHAPPELL. If these giveaways were handled inside of the statutory limitation presently existent, would there be any objection to that? 654 M r . CARLSON. N O , s i r . Mr. CHAPPELL. It is only when they go outside of the limitation that you would find it objectionable? M r . CARLSON. Y e s , s i r . C H A P P E L L . And is that where you find M r . CARLSON. Y e s , s i r . Mr. CHAPPELL. Then actually there would Mr. the abuses today? be no objection if it were spelled out in the law in that way, there would be no objection to that on your part if it were spelled out in the law? Mr. CARLSON. That is correct. Mr. C H A P P E L L . S O in these three areas of the bill you would concur with those explained changes. Mr. Sommer, let mo ask you a question, if I might. With reference to section 11 on your page 4 you seem to concur with the intent and purpose of section 11, but disagree with the language. Do you have any proposed language which would satisfy your concurrence? Mr. SOMMJER. Mr. Chappell, this is influencing by officers and employces of customers? M r . CHAPPELL. Y e s , sir. Mr. SOMMER. N O , we do not at Mr. C H A P P E L L . I wonder if you this time, Mr. Chappell. would submit that. The Chairman, I would like to ask unanimous consent. Mr. SOMMER. We would be very happy to study it and try to submit language. It is a difficult area, so I would not want to promise that we could submit exact language. Mr. B A R R E T T . Without objection that may be done. Mr. CHAPPELL. I would like to have the gentleman's suggestions on it, because that is the way we can always take the intent of what is good in a bill and protect it, and arrive at what all of us generally agree on and that which would maintain the proper amount of competition in the banking industry as well as other nelds. M r . SOMMER. Y e s , s i r . Mr. C H A P P E L L . Mr. Chairman, I notice that a number of these statements in general concur with many of the intents of the bill, but disagree with the wording, and do not specify how that wording ought to be changed. I would Eke to request as a general thing that where these gentlemen in their statements have in general agreed with the intent but disagreed with the wording, that they each be requested or given the opportunity to submit wordings so that we might consider those, and therefore get more input from their industry. Mr. B A R R E T T . In other words, you are asking them section by section to indicate what they object to and what they think they should be? Mr. C H A P P E L L . Yes; whether they agree generally with the intent but disagree with the language of the bfll, to give us some alternative language. Mr. B A R R E T T . Would the panel agree to comply with the gentleman's request? Mr. SOMMER. Yes, sir; we will make every attempt to do that. Mr. B A R R E T T . That may be done. Without objection it is so ordered. Mr. C H A P P E L L . That is all, Mr. Chairman. Mr. B A R R E T T . All time has expired, gentlemen. You have been very 655 fine witnesses here this morning. We are grateful for having you. I think, as it was pointed out here, much will be discussed in general debate in marking up the bill. And I do think wo will come up with something that will satisfy everybody. Mr. SOMMER. Mr. Chairman, on behalf of all the panel, thank you very much for your attention, your questions, and your listening to our testimony. Mr. BARRETT. Thank you, sir. This committee will stand in recess until 10 a.m. tomorrow morning. Thank you very much. (Whereupon, at 12:40 p.m. the committee recessed to reconvene at 10 a.m., Friday, April 30, 1971.) THE BANKING REFORM ACT OF 1971 F R I D A Y , A P R I L 30, 1971 HOUSE OF REPRESENTATIVES, COMMITTEE ON B A N K I N G AND CURRENCY, Washington, B.C. The committee met, pursuant to recess, at 10:05 o'clock a.m. in room 2128, Rayburn House Office Building, Hon. Wright Patman (chairman) presiding. Present: Representatives Patman, Sullivan, Reuss, Hanna, Gettys, Chappell, Widnall, Dwyer, Brown, Heckler, and Rousselot. The CHAIRMAN. The committee will please come to order. This morning the witnesses are Harlan J. Swift, chairman of the Committee on Relations with Federal Supervisory Authorities of the National Association of Mutual Savings Banks; Mr. John Bryan of the Granite State Bank, Granite Falls, Wash.; Dr. Harold Oberg of Arthur Lipper Corporation; and Dr. Harley H. Hinrichs, chief economist for the Saver Incentives Premium Industry Committee. It would be appreciated very much if each one of you gentlemen would summarize your statement and then we will proceed to questioning. We will first hear from Mr. Swift then Mr. Bryan, Dr. Oberg and Dr. Hinrichs. So, Mr. Swift, you may proceedfirst,sir. STATEMENT OF HARLAN J. SWIFT, PAST PRESIDENT, NATIONAL ASSOCIATION OF MUTUAL SAVINGS BANES, AND CHAIRMAN OF THE NAMSB COMMITTEE ON RELATIONS WITH FEDERAL SUPERVISORY AUTHORITIES; ACCOMPANIED BY EDWABD P. CLARE, PAST PRESIDENT OF NAMSB; AND P. JAMES BIOBDAN, CENERAL COUNSEL Mr. SWIFT. Mr. Chairman and members of the committee, my name is Harlan J. Swift and I am president of the Erie County Savings Bank in Buffalo, N.Y., past president of NAMSB and chairman of the NAMSB Committee on Relations with Federal Supervisory Authorities. Accompanying me is Edward P. Clark, president of the Arlington Five Cents Savings Bank in Massachusetts, past president of NAMSB, and president of the Mutual Savings Central Fund, Inc., Massachusetts. Also appearing with us is P. James Riordan, general counsel of our national association. We appreciate this opportunity to testify, on behalf of the mutual savings bank industry, on H.R. 5700, the Banking Reform Act of 1971. (657) 658 Mr. Chairman, in order to effect a summary, I am planning to omit sections of our complete statement, but would ask that the complete statement be placed in the record. The CHAIRMAN. The whole statement will be placed in the record. Mr. SWIFT. We agree with much that is in the bill. We find it impossible, however, to support the entire bill, because some provisions would have a seriously adverse impact—unintended by the sponsors, we believe—on savings banks and the depositors they serve. Specific amendments which we urge on behalf of the savings bank industry are attached to this statement. The chairman and other members of the committee are already familiar with aspects of mutual savings banking. Mutual savings banks, which exist in 18 of the 50 States, had their origin in this country 155 years ago. The organizers of mutual savings banks regarded their position— and the law so treated them—as analogous to trustees of a public trust. In choosing trustees, two elements were—then as now—considered essential: (1) That trustees be experienced in the management of money; and (2) that trustees be willing to serve with no profit to themselves. The Nation's mutual savings banks are still operated by men who are bound by the strictest fiduciary standards, and State savings bank statutes still refer to savings bank directors as "trustees." While oriented fundamentally to local community needs in the 18 States where they exist, savings banks do place' their excess funds in capital shortage areas throughout the Nation. California, Texas, and Florida residents have benefited especially from the availability of mortgage credit from mutual savings banks. Our industry today holds over $8 billion of mortgage loans in these three nonsavings bank States. Billions of dollars of savings bank mortgage credit have also been channeled into Georgia, Alabama, Michigan, Illinois, Missouri, South Carolina, Mississippi, Virginia and other nonsavings bank States. Because H.R. 5700 is intended to assure high standards for banking institutions and an absence of conflicts of interest, it is important to stress that the very foundation of mutual savings banking has been the high fiduciary standards to which it has adhered. By law and by custom, savings bank trustees and officers are held to the highest standards and are barred from self-dealing or conflict-of-interest situations. With this introductory statement, Mr; Chairman, we would like to address ourselves to the specifics of H.R. 5700. Our industry has taken this legislation with utmost seriousness. Section 2 of the bill would prevent savings bank trustees from serving as directors of any other financial institution. Since the enactment of the Clayton Act in 1914, mutual savings banks have been exempt from the provisions of section 8 of that act, which in general prohibits directors of member banks from serving as directors of other banks. In spite of our conviction that interlocks have not in fact diminished competition, we would be unrealistic not to take cognizance of the increasing number of persons who have raised questions about in- 659 terlocking relationships between depository institutions in the same competitive market. While not opposing such a prohibition, we regard certain amendments as absolutely necessary. First, we request in amendment No. 1, that any prohibition apply only to interlocks between institutions accepting deposits from the general public in the same competitive area and not to nondepository institutions. There is no reason to deny the legitimate requirements of bank management in seeking competent directors in the securities or insurance industries or among companies providing service "in connection with the closing of real estate transactions." As Chairman Burns of the Federal Reserve noted in his letter of December 16,1970, to Chairman Patman, "Bankers often have experience and expertise that qualify them to render valuable service in this role—director. Interlocking directorates, in other words, are not inherently wrong." The second amendment we urge is that if any prohibitions against interlocks is enacted, a grandfather clause be appended, allowing those trustees which presently serve on savings bank boards to continue otherwise proscribed interlocking directorships for the remainder of their period of eligibility to serve, as limited by State law or corporate by-law. This amendment will at least prevent the serious dislocations of the rather abrupt dissolution of management structure provided for in the bill. Third, it is necessary throughout the bill for certain institutions to be granted technical exemptions from proposed prohibitions. Of acute importance is the situation of the savings banks in Rhode Island, where the State legislature, in order to increase the competitive ability of mutual savings bank, has authorized them to own and operate a commercial bank subsidiary. Profits of this subsidiary accrue to depositors of the mutual savings bank. Obviously dual board membership is necessary in such a case, if these banks are to continue to function. Another technical amendment would be necessary if the prohibition of interlocking directorates between banks and insurance companies were enacted in the form proposed in H.R. 5700. It should be made clear that the term "insurance company" does not include deposit insurance associations like the Mutual Savings Central Fund, Inc. of Massachusetts, the sole function of which is to ensure the security and liquidity of Massachusetts savings banks, and the directors of which must, by law, be officers or directors of mutual savings banks. Section 2 of the bill adds a new section 24 to the Federal Deposit Insurance Act, providing that no insured bank, officer, director of any insured bank, or member of the immediate family of such, shall control any title company, appraising company or company which provides "service in connection with the closing of real estate transactions." Although we do not interpret the language to so require, this section might conceivably be considered as preventing mortgage companies or any real estate institution from being owned by a savings bank even though such ownership can provide great cost savings, of benefit for savings bank depositors and borrowers. The intent of this section should be clarified so as to show that savings bank ownership of mortgage companies or other wholly owned service corporations was not intended to be prohibited. 660 Section 2 adds a new section 25 to the Federal Deposit Insurance Act, which would prohibit persons who are trustees of an insured bank from performing legal services on behalf of any person undertaking a business transaction with such bank. We presume that the prohibition is directed only at an individual lawyer, and not to his entire firm. Further, the section should be clarified to make clear that a trustee would not be prohibited from representing his bank as its attorney. Section 8 of the bill prohibits trustees, et cetera, from serving as directors of any corporation in which the bank holds more than 5 percent of any class of stock with voting rights. This provision requires technical amendments and exceptions such as are contained in amendment No. 3. As pointed out earlier, the laws of the State of Rhode Island have specifically authorized mutual savings banks in that State to acquire the entire stock of one commercial bank and to operate such a bank as a subsidiary. These Rhode Island savings banks have been exempted from the Bank Holding Company Act and so it is not clear that they would enjoy the exemption from section 8 set forth in section 8(b) for holding companies. These institutions and all situations involving either wholly owned subsidiaries of a savings bank, institutions wholly owned by savings banks or institutions wholly owned by savings banks and other financial institutions should be exempted. Section 9 prohibits directors, trustees, officers or employees of insured banks from also serving on the board of a corporation with which the bank has a "substantial and continuing" relationship with respect to the making of loans. This section and also section 8 should provide for an exemption for "Savings Bank Trust Companies" and other organizations formed by the savings bank industry to perform services for savings banks. To illustrate, the "Savings Bank Trust Companies" are corporations organized by savings banks in the States of New York and Washington, which have as their sole purpose, the provision of services for all savings banks in the State, and which in no sense carry on a traditional banking, investment, or other business function. The stock of these institutions is held entirely by savings banks, and some of them hold more than 5 percent of that stock. The trust companies do not perform services for, nor accept deposits from, the general public. Unless they and other savings bank-organized service companies are clearly and specifically exempted from sections 8 and 9, they cannot continue to carry out their functions. Section 10 is a prohibition that is aimed solely at mutual savings banks and which is a cause of great concern throughout the industry. It provides that no mutual savings bank shall own stock in any insured bank, insured savings and loan, insurance company, bank or savings and loan holding company, or in any securities broker or dealer. It is a prohibition that has not been extended to commercial bank trust departments or to those State commercial banks which can own bank stock. Savings bank holdings of commerical bank stocks represent about one-fifth of their total equity portfolio and less than 1 percent of total assets on an industrywide basis. 661 This section would not only prohibit further investment, but also continued ownership of equity shares which have long been legally authorized investments for savings banks. State statutory limitations on savings bank ownership of commercial bank stock are already sufficient to prohibit a savings bank from controlling a commercial bank. Further, in those very States where mutual savings banks may own commercial bank stock, competition remains most intense between commercial banks and savings banks. Consider, for example, the bitter confrontation between mutual savings banks and commercial banks which is occurring this legislative session on the subject of checking accounts for savings banks in New Hampshire, Massachusetts, and Connecticut, and the pending litigation between savings banks and commercial banks on the same subject in Maine. Furthermore, in the States of Connecticut and Massachusetts, where savings banks may own insurance company stocks, the mutual savings banks, far from abandoning competition with these insurance companies, have increased it by offering the public savings bank life insurance, a service which the savings banks constantly attempt to make more competitive. Our industry recommends that section 10 be deleted. No attempts at control have been made, nor will be made, of commercial banks and insurance companies, and State statutory safeguards are completely adequate to insure against the possibility. Our sixth amendment, in our statement would accomplish this deletion. A technical amendment should be included in section 12 to make clear that the disclosure requirement does not include securities held under so-cal led "Keogh" trusts. Section 14 of the bill prohibits lenders from accepting any "equity participation" in consideration of the making of any loan. The term "equity participation" is used broadly here to include "income participation" loans as well, in which lenders share in the income—either gross or net—generated from the property securing the loan. The savings bank industry as a whole engages only marginally in equity and income participation loans. We estimate that such loans represent less than 1 percent of total savings bank mortgage holdings, with the bulk of these involving payment by the borrower of a portion of income generated by the mortgaged property, rather than an outright ownership interest. About one-half of our industry's participation loans were made on multifamily residential properties, and the other half on commercial properties, representing mainly retail and office facilities. Such loans, of course, do not involve one-family properties for home ownership. Even though savings banks have little direct stake in participation loans, we urge that they not be prohibited. Such prohibition would be largely self-defeating, resulting in reduced lender willingness to make mortgage loans, including those on rental residential structures now in great demand, with consequent increases in interest rates to borrowers and in rental costs to apartment dwellers. Current participation loan practices represent freely entered into agreements between lenders and sophisticated borrowers and repre- 662 sent a type of variable mortgage rate practice in which returns to lenders vary with the general state of the economy and the particular experience of the property securing the loan. Section 22 of the bill prohibits bank premiums. An important development in the area of bank premiums occurred recently when the New York Senate passed a bill which prohibits New York Statechartered institutions from offering premiums to the public except on the occasion of a branch opening. The New York bill also purports to prohibit national banks, and Federal savings and loan associations from such practices, but the efficacy of such a State provision is doubtful, to say the least. It is important that State-chartered banks in New York and elsewhere not be placed in an untenable position vis-a-vis National banks and other federally chartered competitors—including Federal credit unions. Therefore the committee is urged to amend section 22 to direct the Federal supervisory agencies to make appropriate regulations in the area of bank premiums and to further provide that in any State where statutes or regulation limit bank premiums the Federal regulations adopted parallel their State counterparts. Equating the authority of nationally chartered institutions to State chartered institutions has ample precendent in the branching law which was enacted as part of the McFadden Act in 1927. Mr. Chairman, I have a one-paragraph statement which is not in our statement as filed—if I may be permitted to read it to you. Frequent mention has been made during these hearings of the bill formally introduced Tuesday by Mr. Widnall, H.R. 7809, which would authorize federally charatered mutual savings and loan associations to convert to stock institutions. The recent proposal of the FHLBB, with the support of the U.S. Savings and Loan League, to authorize the conversion of Federal mutual savings and loans to stock form does have far-reaching and very possibly adverse implications for the principle of mutuality and is, therefore, of great importance to all mutual savings banks. The NAMSB position is to urge the Congress that any legislation include restrictions which will bar windfalls or conflicts of interests in the disposal of the accumulated reserves of the converting mutual institution. Provision must be made, such as, for example, transferring these reserves to the insuring agency, to prevent depositors, management or others from benefiting from such conversions. Because we believe this problem is so serious and because we would like to have an opportunity to be heard on this aspect of the conversion bill, we urge the members of this committee not to take action on this bill without public hearings on the issues it raises. That completes my statement. The C H A I R M A N . Y O U may rest assured that we will not have public hearings on that unless we have notice to the public, and you may be a witness. We will be very glad to have you, ana other people who have knowledge in this area. This is really a big subject. I think everyone wants to do what is right about it. It is just a question of determining that we should have what we might consider a nest egg there of about $10 billion and we do not know exactly who owns it, and we must arrive at some satisfactory solution if at all possible. 663 Thank you very much for your statement. Mr. SWIFT. Thank you, Mr. Chairman. (The prepared statement of Mr. Swift follows:) PREPARED STATEMENT OF H A R L A N J . S W I F T , P A S T PRESIDENT, NATIONAL ASSOCIATION OF M U T U A L SAVINGS B A N K S , AND C H A I R M A N OF THE N A M S B COMMITTEE ON RELATIONS W I T H FEDERAL SUPERVISORY AUTHORITIES Mr. Chairman and Members of the Committee: My name is Harlan J. Swift and I am President of the Erie County Savings Bank in Buffalo, New York, Past President of NAMSB, and Chairman of the NAMSB Committee on Relations with Federal Supervisory Authorities. Accompanying me is Edward P. Clark, President of the Arlington Five Cents Savings Bank in Massachusetts, Past President of NAMSB, and President of the Mutual Savings Central Fund, Inc., Massachusetts. Also appearing with us is P. James Riordan, General Counsel of our National Association. We appreciate this opportunity to testify, on behalf of the mutual savings bank industry, on H.R. 5700, the Banking Reform Act of 1971. The draftsmen are to be complimented for the great amount of time and effort which has gone into the preparation of what the Chairman has described as "comprehensive legislation concerning certain basic reforms that are vitally needed in the field of banking and finance." I request that our complete statement be included in the record. We agree with much that is in the bilL We find it impossible* however, to support the entire bill, because some provisions would have a seriously adverse impact—unintended by the sponsors, we believe—on savings banks and the depositors they serve. Specific amendments which we urge on behalf of the savings bank industry are attached to this statement. The Chairman and other members of the Committee are already familiar with many aspects of mutual savings banking. We hope they will bear with us if we set forth some of the background and record of achievement of our industry for other members, particularly those from non-savings bank states. This information is relevant to the biU and its effect on savings banking. Mutual savings banks, which exist in 18 of the 50 states, had their origin in this country 155 years ago when, in 1810, the first two mutual savings banks were organized in Boston and Philadelphia. The men who organized these mutual thrift institutions were motivated by public service. Typically, they were distinguished citizens who saw the need for banking institutions which would encourage thrift among the less affluent members of society, and preserve and enhance their hard-earned savings through prudent investments. This was a vital need conspicuously unfilled by commercial banks and otherfinancialinstitutions of that time. The organizers of mutual savings banks regarded their position—and the law so treated them—an analogous to trustees of a public trust. In choosing trustees, two elements were—then as now—considered essential: (1) that trustees be experienced in the management of money; and (2) that trustees be willing to serve with no profit to themselves. The nation's mutual savings banks are still operated by men who are bound by the strictest fiduciary standards, and state savings bank statutes still refer to savings bank directors as "trustees." The savings bank industry's performance over a century and a half of service in this country should leave no doubt as to their usefulness in the public interest. Its fundamental purpose and characteristics remain unchanged and are well reflected in a scholary study prepared by Professor John Lintner some years ago: "Mutual savings banks are service institutions with two essential functions . . . a responsibility to encourage habits of thrift and provide convenient, safe facilities to care for the community's savings . . . [and] a responsibility to invest those funds productively with maximum benefit to the community and economy consistent with necessary liquidity and safety, as well as a good return to their depositors."1 These functions—to encourage savings and to invest them safely and productively—have been the hallmarks of savings banking for the past century and a half. In fulfilling them, the industry has grown to over $80 billion in assets, 1 John Lintner, Mutual Savings Banks in the Savings and Mortgage Marketst Graduate School of Business Administration, Harvard University, 1948, p. 211. 664 serving depositors having over 25 million savings accounts at 494 separate savings banks with over 1,500 banking offices. Nearly three-fourths of savings bank resources are invested in mortgages, mostly on residential properties. In the states in which they are heavily concentrated—mostly in New England and the Middle Atlantic areas—savings banks dominate the savings and mortgage markets. In New York, Massachusetts and Connecticut for example, savings banks hold more savings deposits than all other types of deposit institutions combined. Savings banks in these states, moreover, hold about twice the amount of mortgage loans held by commercial banks and savings and loan associations. While oriented fundamentally to local community needs in the 18 states where they exist, savings banks do place their excess funds in capital-shortage areas throughout the nation. In some particularly fast growing non-savings bank areas, savings banks have filled large housing credit gaps, and have provided for more FHA-insured and VA-guaranteed loans than have local commercial banks and savings and loan associations. California, Texas and Florida residents have benefited especially from the availability of mortgage credit from mutual savings banks. Our industry today holds over $8 billion of mortgage loans in these three non-savings bank states. Billions of dollars of savings bank mortgage credit have also been channeled into Georgia, Alabama, Michigan, Illinois, Missouri, South Carolina, Mississippi, Virginia and other non-savings bank states. Reflecting the orientation of mutual savings banks to people and communities our industry has compiled a notable record infinancinglow- and middle-income housing and community facilities. This record is evidenced, in part, by the leading position of savings banks in FHA and VA mortgage programs, which concentrate onfinancingthe nation's middle-income families. Overall, savings banks hold more permanent FHA-insured mortgages under urban development and rehabilitation programs (Sees. 220 and 221) than any other type of lender. Savings banks are also in the forefront as lenders on nursing homes, hospitals, religious structures, shopping centers and other essential community facilities. The savings bank industry has had a well-known and unrivaled record of safety and stability, free of scandal or other tarnish, over its long history. This is a record unmatched by other deposit-type institutions. In fact, reflecting the trust and confidence of people in mutual savings banking, savings bank deposit growth continued even during the years of depression in the 1930s, when otherfinancialinstitutions were experiencing widespread failures. This unique record has not gone unnoticed. A distinguished Congressional leader. Senator John Sparkman, in a 1963 statement made in the Senate of the United States* noted that: "Mutual savings banking enjoyed an eviable reputation for safety long before any system existed for insured savings through an agency of the Federal Government."a And former Supreme Court Justice Reed commented in 1954 that: "The mutual banks have been successful in attracting a large proportion of savings deposits for over a century. They have a remarkable record for soundness infinanceand profitable operation for the benefit of depositors." * Professor John Lintner concluded in his exhaustive 1948 study that: "Savings banks have generally succeeded in offering a rather extraordinary degree of safety [reflecting] credit on the soundness of the organization of the system and its ability to enlist the continuing interest and support of able, public-spirited men as officers and trustees, as well as the general quality offinancialadministration the banks have enjoyed."4 Reflecting the universally high regard in which the savings bank industry is held, this Committee in 1967 reported out a bill to provide federal charters for savings banks, the intent of which in part was to permit the establishment of these institutions throughout the nation. This bttl lacked but one vote in being reported out of the Rules Committee in 1968. Because H.R. 5700 is intended to assure high standards for banking institutions and an absence of conflicts of interest, it is important to stress that the very foundation of mutual savings banking has been the high fiduciary standards to which it has adhered. By law and by custom, savings bank trustees and * Speech in the Senate of the United States, January 31,1963. ^Associate ^nsdee ^Stanley Reed in Franklin Bank vs. New York, 347 U.S. 373, 379, 981 4 Lintner, op. cit., p.*25. 665 officers are held to the highest standards and are barred from self-dealing or conflict-of-interest situations. Indeed, our mutual form of organization and trustee management have been basic to the distinguished record of savings bank performance and safety in productively serving the public's thrift needs. The late Professor Adolf A. Berle, one of the most astute and resected authorities on corporate structure, noted in a 1903 statement before a House Banking and Currency Subcommittee: . . I firmly l>elieve that mutual savings banks organization in the long run is the safest and the best, as it has already proven the most productive . . . The mutual form is more logical when you are dealing with savings, and I think it is no accident that rhe mutual form has been in both the insurance and savings bank field on the whole more successful."3 In sum, the savings bank industry has established a long and proven record of safety, stability and high fiduciary standards. It continues to serve the nation's savings and mortgage markets effectively in competition with other types of financial institutions. Recent public and private studies are replete with evidence that the presence of savings banking has enhanced, rather than restricted, competition among financial institutions. These studies have shown conclusively that in communities where savings banks are located, mortgage interest rates are generally lower and deposit interest rates (wnenever permitted by law) are higher than in areas where savings banks do not exist. One current bit of evidence of the continued brisk competition between savings banks and commercial banks can be observed in state legislative sessions where additional powers are sought by one group and opposed by the other. There should be little fear about the diminution of competition between savings banks and commercial banks as each tries to serve more effectively markets in their areas. One final point in this introductory material should be emphasized because it bears so directly on the proposal to deny savings banks the right to hold or acquire stock of other financial institutions. It should be recognized that from their inception, savings banks in several states were granted authority to invest in corporate equities. In authorizing such investments, state legislatures recognized the fact that savings bank often hold the life savings of modest-income individuals and families and, therefore, determined that equity investments should be limited to what were considered to be the most substantial and dependable corporations. Thus, in the early years of the industry, and for a considerable period thereafter, most states limited the equity investment authority of savings banks to the shares of commercial banks, insurance companies and utilities. This is why savings banks have come to acquire the stocks of financial institutions and not for any covert purpose of control or of minimizing competition. Parenthetically, there are prohibitions and restrictions on mutual savings banks throughout the bill which may not apply to commercial banks because they can be avoided through the holding company device, which is generally unavailable to mutual savings banks. It is basic to our position that any activity authorized commercial bank holding companies should also be authorized to mutual savings banks. With this introductory statement, Mr. Chairman, we would like to address ourselves to the specifics of H.R. 5700. Our industry has taken this legislation with utmost seriousness. Throughout out testimony citation of any section is meant to apply not only to the provisions affecting FDIC-insured savings banks but to their parallel provisions for non-FDIC insured banks. Interlocking directorates—prohibition Sec. 2 of the bill would prevent savings bank trustees from serving as directors of any other financial institution. Since the enactment of the Clayton Act in 1914, mutual savings banks have been exempt from the provisions of Sec. 8 of that Act, which in general prohibits directors of member banks from serving as directors of other banks. We do not believe that this exemption was carved out by any historical accident but rather because the Congress recognized that the danger of potential abuses was far outweighed by the countervailing considerations that savings banks must have highly skilled and experienced money man5 Federal Charter Legislation for Mutual Savings Jtanks, Hearing on H.R. 258 Before the Subcommittee on Bank Supervision and Insurance of the Committee on Banking and Currency, House of Representatives, 88th Congress, 1st Session, October 1963, pp. 304 and 309. 60-299—71—pt. 2 15 666 agers to provide prudent stewardship, and that there are state and federal statutory and regulatory restrictions in force where savings bajtgcs operate that prevent any savings bank trustee from profiting from any conflict of interest. . Thus, Sec. 2 of this bill would cause a significant change in the savings bank business. A change of this magnitude is bound to cause apprehension in any industry, but particularly one that has been accustomed to operating within the disciplines of the most meticulous fiduciary boundaries, and which sincerely believes that there have been no abuses because of the relationships it has had with other types offinancialinstitutions. In spite of our conviction that interlocks have not in fact diminished competition, we would be unrealistic not to take cognizance of the increasing number of persons who have raised questions about interlocking relationships between depository institutions in the same competitive market. A prohibition against interlocking directorates will present our industry with extraordinary problems. While not opposing such a prohibition, we regard certain amendments as absolutely necessary. First, we request in Amendment 1, that any prohibition apply only to interlocks between institutions accepting deposits from the general public in the same competitive area and not to non-depository institutions such as brokerage, title and insurance companies. While interlock prohibitions between direct competitors might be thought to require restrictions, there is no reason to deny the legitimate requirements of bank management in seeking competent directors in the securities or insurance industries or among companies providing service 'in connection with the closing of real estate transactions." As Chairman Burns of the Federal Reserve noted in his letter of December 16, 1970 to Chairman Patman, "Bankers often have experience and expertise that qualify them to render valuable service in this role [director]. Interlocking directorates, in other words, are not inherently wrong." Illustrative of present day safeguards against any potential conflicts of interest arising out of service on a savings bank board and that of a nondepository financial institution is the Constitution of the State of New York, the state in which nearly 60% of the assets of the savings bank industry are located. An article in the Constitution specifically prohibits savings bank trustees from having "any interest, direct or indirect, in the profits of the savings bank." An opinion of the New Tork Attorney General has interpreted this to mean that a savings bank may not purchase from, or sell to, one of its trustees real or personal property, nor may it so deal with a partnership of which the trustee is a member or with a corporation in which the trustee is a principal officer or general manager or has substantial stock holdings (1949 Op. Atty. Gen. January 6). The only New York exception to a trustee doing business with the bank is in the case of a real estate appraiser or the bank's attorney. The kind of fiduciary restrictions found in the New York law have been characteristic of our industry for the past century and a half. The second amendment we urge, {Amendment £), is that if any prohibitions against interlocks is enacted, a grandfather clause be appended, allowing those trustees which presently serve on savings bank boards to continue otherwise proscribed interlocking directorships for the remainder of their period of eligibility to serve, as limited by state law or corporate by-laws. Both the Maryland and Massachusetts anti-interlock statutes provide for such a grandfather clause. This amendment will at least prevent the serious dislocations of the rather abrupt dissolution of management structure provided for in the bill. Some savings bank boards of trustees would be severely affected by the necessity of removing virtually all directors who also serve other institutions accepting deposits from the general public in the same competitive market. Third, it is necessary throughout the bill for certain institutions to be granted technical exemptions from proposed prohibitions. Of acute importance is the situation of the savings banks in Rhode Island, where the state legislature, in order to increase the competitive ability of mutual savings banks, has authorized them to own and operate a commercial bank subsidiary. Profits of this subsidary accrue to depositors of the mutual savings bank. Obviously, dual board membership is necessary in such a case, if these banks are to continue to function. Amendment S. Another technical amendment would be necessary if the prohibition of interlocking directorates between banks and insurance companies were enacted in the 667 form proposed in H.R. 5700. It should be made clear that the term "insurance company" does not include deposit insurance associations like the Mutual Saving* Central Fund, Inc. of Massachusetts, the sole function of which is to ensure the security and liquidity of Massachusetts savings banks, and the directors of which must, by law, be officers or directors of mutual savings banks. Companies proving services of title insurance, appraisal, or services related to real estate closings—prohibition Sec. 2 of the bill adds a new Sec. 24 to the Federal Deposit Insurance Act, providing that no insured bank, officer, director of any insured bank, or member of the immediate family of such, shall control any title company, appraising company or company which provides "service in connection with the closing of real estate transactions." Although we do not interpret the language to so require, this section might conceivably be considered as preventing mortgage companies or any real estate institution from being owned by a savings bank even though such ownership not only can provide great cost savings, of benefit for savings bank depositors and borrowers but is clearly related to the fundamental business of savings banks. The intent of this section should be clarified so as to show that savings bank ownership of mortgage companies or other wholly owned service corporations was not intended to be prohibited. Such a clarification would serve to reconcile Sec. 2 with the Federal Reserve's tentative approval (in proposed Regulation Y under the Bank Holding Company Act) of mortgage company indirect control by commercial banks through their holding companies. amendment 4. Tt istee Performing Legal Services—Restriction See. 2 adds a new Sec. 25 to the Federal Deposit Insurance Act, which would prohibit persons who are trustees of an insured bank from performing legal services on behalf of any person undertaking a business transaction with such bank; We presume that the prohibition is directed only at an individual lawyer, and not to his entire firm. Further, the section should be clarified to make clear that a trustee would not be prohibited from representing his bank as its attorney. Service on Board of Corporation for which Bank manages welfare—pension plan—prohibition Sec. 7 of the bill provides that no trustee, etc., may serve on the board of directors of a corporation with respect to which the bank manages an employee welfare or pension benefit plan. This section has no general application to savings banks. Service on board 5% owned corporation—prohibition Sec. 8 of the bill prohibits trustees, etc., from serving as directors of any corporation in which the bank holds more than 5% of any class of stock with voting rights. This provision requires technical amendments and exceptions such as are contained in Amendment S. As pointed out earlier, the laws of the state of Rhode Island have specifically authorized mutual savings banks in that state to acquire the entire stock of one commercial bank and to operate such a bank as a subsidiary, thus providing a complete range of services to savings bank customers and more effective competition with commercial hanks. These Rhode Island savings banks have been exempted from the Bank Holding Company Act and so it is not clear that they would enjoy the exemption from Sec. 8 set forth in Sec. 8(5) for holding companies. These institutions and all situations of which there are a number involving either wholly-owned subsidiaries of a savings bank, institutions wholly-owned by savings banks or institutions wholly-owned by savings banks and otherfinancialinstitutions should be exempted. Service on board of company with "substantial, continuing" relationships— prohibition Sec. 9 prohibits directors, trustees, officers or employees of insured banks from also serving on the board of a corporation with which the bank has a "substantial and continuing" relationship with respect to the making of loans. This section and also Sec. 8 should provide for an exemption for "Savings Bank Trust Companies" and other organizations formed by the savings bank industry to perform services for savings banks. To illustrate, the "Savings Bank Trust Companies" are corporations organized by savings banks in the States of New York and Washington, which have as their sole purpose, the provision of services for all savings banks in the state, and which in no sense carry on a 668 traditional banking, investment, or other business function. The stock of these institutions is held entirely by savings banks, and some of them hold more than 5% of that stock. The trust companies do not perform services for, nor accept deposits irom, the general public. Rather, they provide depository facilities, loans, liquidity arrangements, investment advice, and research and statistical services solely for savings banks. These companies reflect the savings bank tradition of self-help in solving operational problems without government intervention. Unless they and other savings bank-organized service companies are clearly and specifically exempted from Sees. 8 and 9, they cannot continue to carry out their functions. In addition it seems that Sec. 9 would prevent savings bank trustees, officers, directors and employees from serving worthy non-profit and charitable institutions in similar capacities if the institution has a substantial and continuing relationship with the savings bank with respect to credit. Surely such a result was unintended. Attached Amendment No. 5 is designed to accomplish these changes. Ownership of bank or insurance company stock—prohibition Sec. 10 is a prohibition that is aimed solely at mutual savings banks and which is a cause of great concern throughout the industry. It provides that no mutual savings bank shall own stock in any insured bank, insured savings and loan, insurance company, bank or savings and loan holding company, or in any securities broker or dealer. This prohibition would abruptly reverse a tradition of decades in our industry. Further, it is a prohibition that has not been extended to commercial bank trust departments or to those state commercial banks which can own bank stock. Savings bank holdings of commercial bank stocks represent about one-fifth of their total equity portfolio and less than 1% of total assets on an industrywide basis. Reflecting the investment considerations underlying this investment activity, savings banks generally diversify their portfolios widely among stocks of individual commercial banks. As mentioned earlier, legislatures in savings bank states historically limited savings bank investments in equities to those issued by banks, insurance companies, and public utilities. This section would not only prohibit further investment, but also continued ownership of equity shares which have long been legally authorized investments for savings banks. State statutory limitations on savings bank ownership of commercial bank stock are already sufficient to prohibit a savings bank controlling a commercial bank. Further, in those very states where mutual savings banks may own commercial bank stock, competition remains most intense between commercial banks and savings banks. Consider, for example, the bitter confrontation between mutual savings banks and commercial banks which is occurring this legislative session on the subject of checking accounts for savings banks in New Hami>shire, Massachusetts, and Connecticut, and the pending litigation between savings banks and commercial banks on the same subject in Maine. And these very states are the major states in which savings banks can own commercial bank stock. Furthermore, in the states of Connecticut and Massachusetts, where savings banks may own insurance company stocks, the mutual savings banks, far from abandoning competition with these insurance companies, have increased it by offering the public savings bank life insurance, a service which the savings banks constantly attempt to make more competitive against the bitter opposition of insurance companies. Ownership of stock does not mean community of interest between savings banks and commercial banks. We sincerely believe that the potential effffect on competition alluded to by the distinguished Chairman in his introductory remarks has not come to pass. This Committee's 1907 Report on the Federal Savings Institutions Act cited independent studies showing that local savings are higher—and mortgage money more plentiful and less costly to borrowers—in areas where savings banks are present along with other types of financial institutions.' Our industry recommends that Sec. 10 be deleted because no diminution of competition between savings banks, commercial banks, and insurance companies • Federal Savings Institutions, Report on H.R. 13718, Committee on Banking and Currency, House of Representatives, 90tn Congress, 1st Session, December 13, 1967. 669 has occurred and in fact this competition constantly increases. No attempts at control have been made, nor will be made, of commercial banks and insurance companies, and state statutory safeguards are completely adequate to insure against the possibility. If there is any evidence of any combination by savings banks to control the policies of any commercial bank or insurance company, this information should be brought to the attention of the Department of Justice. Amendment 6 attached would delete Sec. 10. Acceptance or offering of "Benefits"—prohibition Sec. 11 prohibits persons from accepting benefits from banks under an understanding that such benefit will influence their conduct vis a vis the bank. It also prohibits banks from offering i>ersons benefits with an intent to influence the affairs between the bank and the employer of such persons. The mutual savings bank industry has no reservations as to the desirability of preventing such activities. Fiduciaries; holding of securities—disclosure Sec. 12 provides that banks which hold securities in a fiduciary capacity must make annual disclosure to the FDIC describing the securities so held, and how the bank has exercised proxies with resort to the voting rights of such securities. A technical amendment should be included in Sec. 12 to make clear that the disclosure requirement does not include securities held under so-called "Keogh" trusts. (Amendment ?.) This would avoid the administrative burden of making myriad disclosures of relatively small trusts where the trustor selects the securities. Other than that, in the savings bank industry, only New Jersey savings banks enjoy trust powers. Fiduciaries; holding of 10% of any SEC corporations—prohibition Sec. 18 prohibits banks with fiduciary powers from holding in a fiduciary capacity more than 10% of the stock of any corporation registered with the SEC. The mutual savings bank industry takes no position on this provision. "Equity Participa tion"—proh ib it ion Sec. Ui of the bill prohibits lenders from accepting any "equity participation" in consideration of the making of any loan. The term "equity participation" is used broadly here to include "income participation" loans as well, in which lenders share in the income (either gross or net) generated from the property securing the loan. The savings bank industry as a whole engages only marginally in equity and income participation loans. We estimate that such loans represent less than one percent of total savings bank mortgage holdings, with the bulk of these involving payment by the borrower of a portion of income generated by the mortgaged property, rather than an outright ownership interest. About one-half of our industry's participation loans were made on multifamily residential properties, and the other half on commercial properties, representing maiuly retail and office facilities. Such loans, of course, do not involve 1-fainily properties for home ownership. Even though savings banks have little direct stake in participation loans, we urge that they not be prohibited. Such prohibition would be largely self-defeating, resulting in reduced lender willingness to make mortgage loans, including those on rental residential structures now in great demand, with consequent increases in interest rates to borrowers and in rental costs to apartment dwellers. Current participation loan practices represent freely entered into ageements between lenders and sophisticated borrowers and represent a type of variable mortgage rate practice in which returns to lenders vary with the general state of the economy and the particular experience of the property securing the loan. Participation loans in the savings bank industry have not been made with the intent to share in the control and management of borrowing corporations, but rather a9 a method of providing equitable treatment to the lender which commits its funds to a loan for a long period of years at an interest rate which may prove—because of rising interest rates and inflation—to be quite unrealistics by the end of the term. A bank seeking to maximize its return on behalf of its depositors, is not seeking to exploit the borrower (which almost always is a corporation in such cases rather than an individual) but merely asks that if, as a result of the bank's assuming the risk of extending its credit, the borrowing corporation's profits are increased, the bank and its depositors should share in this result. 670 Prohibition of equity participations could mean a lessening in the willingness of lenders to make mortgage loans (particularly long-term), including those on ' multifamily residential structures, with a consequent increase in interest rates to borrowers, rental costs to apartment dwellers, and a generally reduced volume of mortgage credit throughout the country. The prohibition is so broad that it might also be held to prohibit investment in convertible bonds or in warrants. This would deny industry an increasingly popular method of acquiring capital. Amendment 8 deletes See. 14. Loans to trustees and loans to 5% owned corporations—disclosure, prohibition Sec. 15 requires disclosure by banks of all loans made to trustees, etc., or to any member of the immediate family of such trustee. In the savings bank industry there are generally statutory restrictions on the extension of credit to trustees. In any event the industry would have no objection to such a disclosure requirement. Sea. 15 also provides that no bank shall make a loan to any corporation with respect to which 5% of the shares is owned by any trustee, etc., or a member of his family. The savings bank industry would have no objections to this provision. "Brokered Deposits"—prohibition Sec. 19 of the bill prohibits the practice of "brokered deposits." To our knowledge this practice is non-existent in the savings banking industry. Premiums—prqhibition Sec. 22 of the bill prohibits bank premiums. We believe that restrictions on premiums should be in the form of administrative regulation rather than legislation. An important development in the area of bank premiums occurred recently when the New York Senate passed a bill which prohibits New York statechartered institutions from offering premiums to the public except on the occasion of a branch opening. The New York bill also purports to prohibit national banks, and federal savings and loan associations from such practices, but the efficacy of such a state provision is doubtful, to say the least It is important that state-chartered banks in New York and elsewhere not be placed in an untenable position vis a vis national banks and other federally-chartered competitors (including federal credit unions). Therefore the Committee is urged to amend Sec. 22 to direct the federal supervisory agencies to make appropriate regulations in the area of bank premiums and to further provide that in any state where statutes or regulation limit bank premiums the federal regulations adopted parallel their state conterparts. Equating the authority of nationallychartered institutions to state-chartered institutions has ample precedent in the branching law which was enacted as part of the McFadden Act in 1927. Amendment 9 would accomplish these recommendations. 100% insured Government deposits—authorization The savings bank industry is gratified with that provision in Sec. 25 which would authorize the 100% insurance of deposits of government entities in insured financial institutions although savings banks do not typically hold large amounts of governmental deposits. ' AMENDMENT NO. 1 To Limit Application of the Interlock Prohibition to Interlocks Between Institutions Accepting Deposits from the Public in the Same Market Area Amend the amendments made in Section 2 of H.R. 5700 by deleting the semicolon at the end of the word "bank" in line 8, page 2 and inserting the phrase: "competing in the same market area as such area shall be defined by the Board of Directors of FDIC"; by removing the semicolon following the word "Act" in line 10, page 2 and inserting the phrase: "competing in the same market area as such area shall be defined by the Board of Directors of the Federal Home Loan Bank Board": and by removing the semicolon at the end of the word "union" in line 11, page 2 and inserting the phrase: "competing in the same market area as such area shall be defined by the Administrator of the National Credit Union Administration." Further amend the amendments made in Section 2 of H.R. 5700 by inserting at the end of proposed subsection 23(a) of the Federal Deposit Insurance Act the following at the end of line 2, page 3 : 671 " ( b ) In the case of a person who is a director, trustee, officer or employee of an insured bank which is a mutual savings bank, the prohibitions contained in subparagraphs 4, 5, 6 and 7 of subsection (a) hereof shall not apply." Redesignate present proposed subsection (b) as subsection (c). Amend § 4 of H.R. 5700 by deleting the semicolon at the end of the word "bank" in line 2, page 6, and inserting the phrase: "competing in the same market area as such area shall be defined by the Board of Directors of FDIC"; by deleting the semicolon at the end of the word "Act" in line 4, page 6, and inserting the phrase: "competing in the same market area as such area shall be defined by the Board of Directors of FDIC": by deleting the semicolon at the end of the word "Act" in line 6, page 6, and inserting the phrase: "competing in the same market area as such area shall be defined by the Board of Directors of the Federal Home Loan Bank Board"; by deleting the semicolon at the end of the word "union" in line 7, page 6 and inserting the phrase: "competing in the same market area as such area shall be defined by the Administrator of the National Credit Union Administration." Further amend § 4 of H.R. 5700 by deleting lines 8 through 23 on page 6. AMENDMENT NO. 2 To Permit Present Directors, Officers, Trustee and Employees to Continue to Serve in Dual Capacities through Their Period of Eligibility Amend Section 27(b) of H.R. 5700 by adding the following new sentence after the word "enactment." on page 27, line 16: "Not withstanding the effective dates set forth in the preceding sentence, any director, trustee, officer or employee of an insured bank or of a mutual savings bank other than an insured bank who on March 8,1971 was also a director, trustee, officer or employee of another insured bank, of an insured institution defined in section 401 of the National Housing Act. of a federal credit union, of a mutual savings bank which is not an insured bank, of a company which is a bank holding company as defined in the Bank Holding Company Act of 1956. a savings and loan holding company as defined in section 408 of the National Housing Act, a subsidiary of a bank holding company or a savings and loan holding company shall be permitted to continue in such capacities for the remainder of his or her period of eligibility for service as determined either by state laws or corporate bylaws." AMENDMENT NO. 3 To Exempt Rhode Island Mutual Savings Banks Which Own Subsidiary Commercial Banks from the Prohibitions Contained in Sections 2, 8 and 9 Amend proposed subsection 23(b) of the Federal Deposit Insurance Act contained in Section 2 of H.R. 5700 by inserting in line 7 on page 3 following the phrase "Bank Holding Company Act of 1956" the following: "or a mutual savings bank owning or controlling such a bank holding company," and by changing the period at the end of the word "company" in line 8 on page 3 to a comma and inserting the following: "or a mutual savings bank owning two-thirds or more of the outstanding voting stock of such insured bank." Amend Section 8(b) of H.R. 5700 by inserting in line 1 on page 10 following the phrase "Bank Holding Company Act of 1956" the following: "or a mutual savings bank owning or controlling such a bank holding company" and by changing the period at the end of the word "company" in line 4, page 10 to a comma and inserting the following: "or a mutual savings bank owning twothirds or more of the outstanding voting stock of such insured bank." Amend Section 9(b) of H.R. 5700 by inserting in line 25 on page 10 following the phrase "Bank Holding Company Act of 1956" the following: "or a mutual savings bank owning or controlling such a bank holding company," and by changing the period at the end of the word "company" in line 3 on page 11 to a comma and inserting the following: "or a mutual savings bank owning two-thirds or more of the outstanding voting stock of such insured bank." AMENDMENT NO. 4 To Exempt Mutual Savings Banks from the Prohibition Against Controlling Title, Appraisal or Closing Companies Amend the amendments made in section 2 of H.R. 5700 by inserting in line 10, page 3, following the term "insured bank" the phrase "other than a mutual sav- 672 ings b a n k a n d in line 11 following the term "insnre<l bank" the phrase, "other than a mutual savings bank" and in line 13 following the term "insured bank" the phrase "other than a mutual savings bank." On page 7 strike Section 5 in its entirety by deleting lines 7 through 18. AMENDMENT NO. 5 To proclude the Application of Sections 8 and 9 of H.R. 5700 to Directors, Officers, Trustees and Employees of Savings Banks, Trust Companies and Related Organizations Amend Section 8 of H.R. 5700 by amending line 22, page 8, to read: "Sec. 8(a) Except as provided in subsections (b) and (c), a". Further amend Section 8 by adding the following new subsection at the end of subsection (b) on page 10: " ( c ) an individual who is a director, trustee, officer or employee of an organization all of the stock or shares of which, other than stock or shares required by law to qualify directors, is owned by a mutual savings bank, mutual savings banks, or by a mutual savings bank or banks and other financial institution or institutions, shall not by virture of subsection (a) hereof be precluded from serving as a director, trustee, officer or employee of any other financial institution." Amend Section 9 of H.R. 5700 by amending line 5 on page 10 to read: "Sec. 9(a) Except as provided in subsections (b), (c), and (d), a". Further amend Secction 9 by adding the following new subsection at the end of subsection (b) on page 11: " ( c ) an individual who is a director, trustee, officer or employee of an organization all of the stock or shares of which, other than stock or shares required by law to qualify directors, is owned by a mutual savings bank, mutual savings banks, or by a mutual savings bank or banks and other financial institution or institutions, shall not by virtue of subsection (a) hereof be precluded from serving as a director, trustee, officer or employee of any corporation." " ( d ) an individual who is a director, trustee, officer or employee of a mutual savings bank shall not by virtue of subsection (a) rereof be precluded from serving in any capacity a non-profit charitable institution as defined in section 501(c) of the Internal Revenue Code notwithstanding any relationship between the savings bank and the institution with respect to the making of loans, discounts or other extensions of credit." AMENDMENT NO. 6 To Delete the Prohibition Against Mutual Savings Banks Owning Stock in Commercial Banks and Insurance Companies, Etc. Amend H.R. 5700 by striking all of Section 10 by deleting lines 4 through 17 on page 11. Renumber succeeding sections. A M E N D M E N T NO. 7 To Exempt "Keogh" Trusts From Any Disclosure Requirements By Fiduciaries Amend the amendments made in section 12 of H.R. 5700 by inserting in line 16, page 13, following the word "securities," the phrase, "and securities held pursuant to trusts organized under the Self-Employed Individuals Tax Retirement Act of 1962." A M E N D M E N T NO. 8 To Delete the Prohibition Against Equity Participations Amend H.R. 5700 by striking all of Section 14. Renumber suceeding sections. A M E N D M E N T NO. 9 To Direct Appropriate Federal Regulatory Agencies To Regulate Premium Campaigns Subject To State Statutes and Regulations Amend H.R. 5700 by amending Section 22 to read as follows: "Sec. 22. Section 18(g) of the Federal Deposit Insurance Act (12 U.S.C. 1828(g)) is amended by adding at the end thereof the following: 673 4 In addition to the payment of interest on deposits which is subject to limitation under this section, the FDIO is directed to prohibit or to limit, or otherwise regulate the extent to which any insured banks may offer or deliver any merchandise or any certificate, stamp, ticket, or any other memorandum which is or may be redeemable in merchandise, money, or credit or any inducement for any person to make or add to any deposit, provided that any such limitation, restriction or regulation imposed under this section shall be identical with any local state statute or regulation limiting, preventing or regulating such premiums.' " Further amend H.R. 5700 by amending Section 23 thereof to read as follows: "See. 23. Section 5B(a) of the Federal Home Loan Bank Act is amended by adding at the end thereof the following: 'In addition to the payment of interest or dividends which are subject to limitation under this section, the Federal Home Loan Bank Board is directed to prohibit or to limit or otherwise regulate the extent to which any members may offer or deliver any merchandise or any certificate, stamp, ticket, or other obligation or memorandum which is or may be redeemable in merchandise, money or credit or any inducement to any person to make or add to any deposit or account provided that any such limitation, restriction or regulation imposed under this section shall be identical with any local state statute or regulation limiting, preventing or regulating such premiums.' " Further amend H.R. 5700 by deleting Section 24 in its entirety and renumbering all succeeding sections accordingly. The CHAIRMAN. A letter from Rudolf P. Berle has been received by the committee and will be placed in the record at this point. BERLE & BERLE, Re: H.R. 5700—Savings Banks Trust Company. H o n . WRIGHT PATMAN, New York, N.Y., April 22, 1911. Chairman, Committee on Banking and Currency, House of Representatives, Rayburn House Office Building, Washington, D.C. DEAR M R . P A T M A N : YOU will perhaps recall that at the time the Holding Company Bill (H.R. 6778) was under consideration by your Committee in I960, I had occasion to write to you in some detail with respect to a client of this ofilce, Savings Banks Trust Company, which would have been seriously affected by the Bill as originally drafted. It was in consequence of our exposition of the unique nature of Savings Banks Trust Company that led to your consent to the inclusion in the Bill of a clause granting specific exemption from the Holding Company Act Amendments of 1970 under Sec. 2(a) (5) (B). The exemption read as follows: 4'No company is a bank holding company by virtue of its ownership or control of any State chartered bank or trust company which is wholly owned by thrift institutions and which restricts itself to the acceptance of deposits from thrift institutions, deposits arising out of the corporate business of its owners, and deposits of public monies." The exemption describes with particularity the nature of Savings Bank Trust Company. A study of H.R. 5700 reveals that in a number of instances in that Bill, Savings Bank Trust Company, despite its unique nature, might suffer serious consequences. It is for this reason that I take the liberty of writing to you again. In order that this statement may be complete, may I recite again some of the facts with respect to Savings Banks Trust Company which are pertinent to the matter in hand. Savings Banks Trust Company is a State chartered trust company under the Banking Laws of New York. It is unique in the sense that in the first place it is wholly owned by the 120 savings banks of the State of New York and its stock ownership is restricted to such savings banks. Permission for New York savings banks to hold this stock is by special provision. In the second place, it was originally designed to serve as a central liquidity agency for savings banks and has served them in that capacity since its inception in 1933. In fact, the institution was organized during the period of the Depression when savings bank assets were badly frozen and some instrumentality was necessary to assist the savings banks in this distressed situation. It does business exclusively with savings banks and savings banks agencies, meaning by that agencies such as The Savings Banks Retirement System. 674 Its unique position in the New York banking structure is recognized by the fact that there are various statutory limitations imposed upon ordinary commercial banks from which the Trust Company is exempted by virtue, as the phrase appears frequently in the statute, of its being "wholly owned by 20 or more mutual savings banks. It does no business with the general public, and except for permission to act as depository for public monies, accepts deposits only from savings banks and deposits coming from savings banks corporate business. Its service to the savings banks was never more vitally demonstrated than in providing liquidity during the "crunch" periods of 1966 and 1969r70 when the access which the Trust Company had developed to the money market through the use of its own paper supplied badly needed liquid funds to the savings banks at these times of intensefinancialpressure. The problem with which we are concerned arises from the effect that Sees. 8 and 9 of HE 5700 would have upon Savings Banks Trust Company and its stockholder savings banks. Sec. 8 would prohibit a director, trustee, officer or employee of a savings bank from serving as a director of Savings Banks Trust Company if the savings bank holds more than 5 % of the Trust Company's common stock. The Company's common stock was allocated to New York savings banks in 1933 on the basis of their deposit size at that time and 3 of the 120 savings banks shareholders presently hold more than 5% of such common stock. These are: The Bowery Savings Bank (10.56%); The Emigrant Savings Bank (7.79%); and the New York Bank for Savings (5.16%). Chief executive officers of the Bowery and the Emigrant presently serve as directors of the Trust Company and the chief executive of the New York Bank for Savings has served as director in the past. The By-Laws of the Trust Company require a minimum of 23 directors, not less than 20 of whom must be trustees of mutual savings banks of the State of New York, and at present there are 25 directors. All of the directors, with the exception of the President, are officers and trustees of share-holding savings banks. We feel certain that it is not the intention of Congress to prevent the three largest bank shareholders from being represented on the Board of Directors of a cooperative-type liquidity institution such as the Trust Company. It is our opinion also that Sec. 9 of HR 5700 could conceivably be interpreted as prohibiting any trustee, officer or employee of a shareholder savings bank from serving as a director of Savings Banks Trust Company because the Trust Company has a substantial and continuing relationship with the savings banks as a liquidity agency engaged in making loans and extending credit to them. The language of Sec. 9 could therefore result in preventing all of the Trust .Companys directors from serving with the exception of its President. This, we believe, certainly was not a result intended as one of the objectives of the Bill. The National Association of Mutual Savings Banks has prepared and will submit to your Committee various proposed amendments to HR 5700, among them Amendment No. 5 dealing both with Sees. 8 and 9. A copy of this proposed Amendment is attached to this letter. We believe that this Amendment No. 5 would solve the Savings Banks Trust Company's problem which we have outlined above. We should deeply appreciate consideration being given to this since absent this exemption through the language suggested by the National Association of Mutual Savings Banks, it seems to us that the 120 savings banks of New York State who own stock in Savings Banks Trust Company might find themselves deprived of the services of a cooperative institution which has served the savings banks community well for a period of nearly 40 years. if there is any further information needed, I shall, of course, be ready to supply it. Sincerely, RUDOLPH P . BEBLE. A M E N D M E N T N O . 5 — T o PRECLUDE T H E APPLICATION OF SECTIONS 8 AND 9 OF H . R . 5 7 0 0 TO DIRECTORS, OFFICERS, TRUSTEES AND EMPLOYEES OF SAVINGS B A N K S T R U S T COMPANIES AND RELATED ORGANIZATIONS Amend Section 8 of H.R. 5700 by amending line 22, page 8, to read: "Sec. 8(a) Except as provided! in subsections (b) and (c),a". Further amend Section 8 by adding the following new subsection at the end of subsection (b) on page 10: 675 " ( c ) an individual who is a director, trustee, officer or employee of an organization all of the stock or shares of which, other than stock or shares required by law to qualify directors, is owned by a mutual savings bank, mutual savings banks, or by a mutual savings bank or banks and other financial institution or institutions, shall not by virtue of subsection (b) hereof be precluded from serving as a director, trustee, officer or employee of any otherfinancialinstitution. Amend Section 9 of H.R. 5700 by amending line 5 on page 10 to read: "Sec. 9(a) Except as provided in subsections (b), (c), and (d), a". Further amend Section 9 by adding the following new subsection at the end of subsection (b) on page 11: " ( c ) an individual who is a director, trustee, officer or employee of an organization all of the stock or shares of which, other than stock or shares required by law to qualify directors, is owned by a mutual savings bank, mutual savings banks, or by a mutual savings bank or banks and other financial institution or institutions, shall not by virtue of subsection (a) hereof be precluded from serving as a director, trustee, officer or employee of any corporation." " ( d ) an individual who is a director, trustee, officer or employee of a mutual savings bank shall not by virtue of subsection (a) hereof be precluded from serving in any capacity a nonprofit charitable institution as defined in section 501 (c) of the Internal Revenue Code notwithstanding any relationship between the savings bank and the institution with respect to the making of loans, discounts or other extensions of credit" The CHAIRMAN. The next witness is Mr. John William Bryan. We are delighted to have you, sir. We look forward to hearing your testimony. STATEMENT OF JOHN WILLIAM BRYAN, GRANITE STATE BANE, AND THE BANE OF ARLINGTON, GRANITE FALLS, WASH. Mr. BRYAN. Mr. Chairman and distinguished members of the committee, my name is John William Bryan. I represent the Bank of Arlington, a State chartered bank which is a member bank of the Federal Reserve System. I have studied H.R. 5700 and am in favor of all of the provisions in the bill. But I am convinced that the five basic areas of concern are all problems mainly caused by the marginal reserve system of banking; and by abandoning this system and using a constitutional monetary system as set forth in the Constitution, these problems would be eliminated along with commercial bank failure. While, in addition, we would have a monetary system that would give stable money and full employment from one generation to the next, with reduced taxes and interest for nearly everybody. To accomplish this it would be necessary for Congress to occupy the monetary field and prevent the States from exercising any monetary authority as per the Constitution. The Congress should therefore: Repeal the amendment of H.R. 2 of February 1927 which made the Federal Reserve System perpetual, a serious mistake made without public knowledge. Congress should then recharter the central bank with rechartering every i0 years and establish guidelines with strict standards for its operations, goals and safeguards. All commercial banks should automatically become members of the Federal Reserve System and should keep all of their deposits with the central bank. This would eliminate our national debt under a wellordered system. Commercial banks would make loans under criteria 676 laid down by Congress for the guidance of the Federal Reserve and the commercial banks. Collateral should be held by the Federal Reserve Banks which would guarantee the loans. Commercial banks would then not be creating money. The marginal reserve system of banking is a European system of banking and is un-American. It was never used by a republic until the American Revolution. A republic should not have a national debt. The tax exemption on municipal and State bonds should be repealed and the central bank should, purchase these bonds at one-fourth of 1 percent interest if they meet the proposed criteria laid down by Congress. Under this arrangement, there would be no need for commercial banks to have surplus and undivided profit accounts. These funds would then be paid back to their stockholders and commercial banks would still be profitable institutions under a fully competitive system. Congress should direct the central bank to open foreign branches called for in language that made their establishment almost mandatory in the original Federal Reserve Act. This would alleviate our balance-of-payment problems and create vast opportunities for businessmen and skilled and unskilled workers, especially in the underdeveloped countries which would take a heavy load of welfare payments off the American taxpayers. The American central banks should be operated in the national and public interest. Thank you. The C H A I R M A N . Thank you very much, Mr. Bryan, for your testimony. The next witness is Dr. Harold S. Oberg. Doctor, we would be very glad to hear from you at this time. You may proceed in your own way. STATEMENT OF DR. HAROLD S. OBERG, VICE PRESIDENT, ARTHUR LIPPER CORP., NEW YORK, N.Y. Dr. OBERG. Thank you. I have just a brief statement on a specific phase of the proposed legislation. My name is Harold S. Oberg, vice president of the Arthur Lipper Corp. Our firm is an institutionally oriented New York Stock Exchange member firm, specializing in block trading of securities and a variety of investment services for institutional investors. I am here to testify on one specific aspect of the proposed legislation—the reporting of equity investing holdings by trust departments of commercial banks. A number of our services and publications are designed to help in the understanding of investment company portfolios. One of these services, portfolio performance perspective, analyzes in depth, the portfolio composition of larger growth objective mutual funds. A forthcoming service, tentatively entitled, "Insight" is designed to provide, on a quarterly basis, a listing and crossfile of the securities held in the portfolios of all investment companies with assets of $25 million or more. Another part of this same service analyzes the investment quality aspects of all listed securities held by these same investment companies. Our existing services and publications, as well as those which are 677 at the planning stage, are based upon publicly available information such as that provided by investment companies to the Securities and Exchange Commission on a calendar quarter basis. This "N-1Q" reporting form provides us with the basic information on the number of shares neld and the amount of shares purchased and sold during the quarter. As a service organization to institutional investors, we have natural interest in the availability of data on portfolio composition of all institutional investors. Regular periodic information of this type is currently available only on the investment companies. For other types of institutional investors, similar information has not been compiled and is not publicly available on any regular periodic basis. We feel that all such information on other institutional investors would be of benefit. It would help in providing a better basis for analyzing the various institutions in respect to the particular securities and the amounts currently held and to better understand various types and qualities of securities of interest to particular parts of the varied institutional investor population. As commercial banks in their trust operations represent a most substantial source for such individual stock information, the proposed bill asking for the reporting of equity holdings is a step in the direction of greater information availability and, therefore, is to be recommended. It provides the ability to analyze and report even further on institutional equity investments. The supplying of such information is in the historic pattern of the development of such data on a regular basis. As has been noted, one such major institutional group is already supplying such information regularly and the review provided in the recently completed institutional investor study gives a clear indication how such information can be analyzed and made to be of value. Individual investors can become aware of the securities utilized to pursue particular investment objectives. If the committee and the Congress feel it is to be in the public interest to require regular reporting by other institutional investors, we would be pleased to relate our experience in this particular area both in the preparation of collection forms and the amassing of data. We will be pleased to submit to you examples of our various services that fall in this statistical area. Thank you very much. The CHAIRMAN. Thank you, Dr. Oberg. Our next is Dr. Harley H. Hinrichs of the Saver Incentives Premium Industry Committee. Please proceed, sir. STATEMENT OF DR. HARLEY H. HINRICHS, THE SAVES INCENTIVES PREMIUM INDUSTRY COMMITTEE; ACCOMPANIED BY JOHN P. DALY, INTERNATIONAL SILVER CO.; WILLIAM M. DALTON, W. M. DALTON & ASSOCIATES; LARRY 0. EDWARDS, LINCOLN ROCHESTER TRUST CO.; AND NEIL KANNEY, GRACE CHINA CO. Dr. HINRICHS. Thank you, Mr. Chairman. I am Harley H. Hinrichs, associate professor of economics, U.S. Naval Academy, lecturer in economics, University of Maryland Grad 678 uate School, and associate professorial lecturer in economics, The George Washington University. I am here today in the capacity of chief economist of the Saver Incentives Premium Industry Committee. And I am accompanied by Mr. John F. Daly, International Silver Co.; Mr. William Dalton, William Dalton and Associates, and Mr. Neil Kanney of the Grace China Co., who are members of the Saver Incentives Premium Industry Committee. I am also accompanied by a banker, Mr. Larry Edwards, who is vice president in charge of marketing of the Lincoln Rochester Trust Co., which is a New York bank. I should also say, Mr. Chairman, that it is a great pleasure talking to you, having worked for both you and Mr. Reuss on the Joint Economics Committee. So it is good to see you again. Rather than read the statement, which is very long—and which I request to be entered into the record, as well as the statements by the gentlemen accompanying me—let me simply summarize the economic facts as we economists know them, or at least as have been developed by a survey of the industry, and then let me simply summarize the major economic beneficiaries of the proposed action by the Savers Committee. The CHAIRMAN. That will be satisfactory, sir. You may proceed. Dr. HINRICHS. The saver incentives premium industry has a long tradition; for more than a quarter of a century it has provided a marketing media for banks and other financial institutions to compete for public funds. Various studies by the American Bankers Association, the Mid-Continent Banker, Harvard University, and a survey of this industry all tend to agree on the following points: 1. Bank customers approve premiums. The ABA survey showed that 59 percent approved and liked premiums. The Mid-Continent Bank survey showed that 78 percent approved the use of premiums. 2. I think quite importantly, premium generated accounts tend to be retained. Retention rates over a period of a year tend to be 75 percent or greater, and actually exceed the retention rates for walk-in accounts. ^ And this ties in with the proposition No. 3. 3. Premium generated accounts tend not to be shifted from other accounts, 78 percent of the bank customers said they would not shift accounts. This is fairly understandable. In talking with various depositors they simply do not want to go through the bother and trouble of moving from one local bank to another bank which could be on the other side of town simply for a $5 dish or some other inducement. So that there is very little so-called churning of accounts, and therefore there is very little lost in terms of excess bookkeeping from the use of premiums. 4. Premiums tend to increase total savings. From a theoretical point of view economists have always linked marginal rates of interest and income as determinants of levels of saving. Also various econometric studies mentioned by Mr. Wallach, Gurley, and Shaw at Stanford, Harvard and Yale, suggest that the amount of savings in banks are a function of things such as the number of banks in town, marketing 679 techniques, access to banks, si^e of minimum deposits, and so forth. So there is some econometric evidence for a relationship, however marginal, between the level of savings and institutional arrangements in thefinancialcommunity. It is also possible to see this from the ABA survey of small banks in small towns where population levels and income levels have remained the same—these small oanks have experienced substantial increases in their savings deposits by the use of such premium programs. This could only be accountable as a result of the premium programs, and not by other variables. It is very difficult to do broad scale econometric research in this time of social change. But there is some positive evidence to support proposition No. 4. 5. Banks tend to approve customer premiums. This is especially true of the smaller banks, whereby smaller banks will put aside 3 percent of their advertising budget for the use of premiums while larger banks will only use 1 percent. In fact, the ABA reports that small banks tend to use premiums to catch up on some of the economic advantages of larger banks. And small banks, those with deposits below a million, are adopting premium programs 18 times faster than the very largest banks. So this has been something of a boon to small banks, which cannot afford the heavy expenditures on TV advertising and other media, which have become very expensive as of late. 6. The bank customer premium industry is larger than often realized—$100 million—long-established, characterized by small businesses and is highly competitive. A third of the firms have been in business for a quarter of a century, over half have been in business for at least a decade. They are small businesses, most of them—80 percent—with sales of less than $10 million, in terms of their total operation. And they are highly competitive. A list is attached to my prepared statement which cites 100 firms engaged in this industry. 7. Retail firms appear to benefit from bank premium programs rather than to suffer from banks offering merchandise. This is quite interesting, because you would expect opposition to premiums from competing retailers. But apparently in the studies done by the ABA and the Mid-Continent Banker the advertising of merchandise offered has tended to stimulate sales in the nearby retail stores, which is quite interesting. 8. The total net cost of bank premium programs to banks is very small. On the average only 2 percent of the bank advertising expenditures are involved in this. This represents only 0.03 of 1 percent of operating income of banks. In 1969 the net cost to banks—and the incidence of this cost is on the bank and not on the customers, which is a pretty important distinction—the net cost in 1969 was only $8 million. The banks partially offset the greater value of the sales involved by so-called continuity programs whereby the bank customer will receive merchandise at less than retail cost, but slightly above the cost to the bank, and therefore the bank is able to in some cases almost break even. 9. Bank customers receive premiums or gifts without being penalized by the payment of a lower interest rate. In other words, given what economists would call the artificial constraint of regulation Q, the small saver is prevented from receiving a true market rate of interest in periods of tight money, as last year. 680 Therefore, unlike other premium programs, the use of premiums does not result in the cost being shifted to the customer, as might be the case when you have premium programs involved with the gas stations and supermarkets, in this case, because regulation Q fixes the ceiling on interest rates, the customer really receives a marginal rate of return higher than the average rate prescribed by the law, and this is a boon to the small saver. Let me shift to the major economic beneficiaries of bank customer premium programs. These appear to be small savers, whereby the marginal rate of return or incentive for putting money in a savings account may be two or three times higher than what regulation Q sets as the average rate of return. I think this is good for the small saver. The big saver, of course, is not really putting his money into the small savings account. He is getting two or three times that rate in something else, be it Euro-dollars or second trust mortgages, or corporate bonds, commercial paper, and so forth. Likewise it is of benefit to small banks and new branches because it gives them a chance to compete with the bigger banks. And they do use this program proportionately more. It also certainly benefits the premium manufacturers and their dealers, suppliers, and employees. The amount involved is $100 million, 100 firms, and it has been estimated that some 10,000 jobs are on the line in terms of the direct production, with another 20,000 depending on those 10,000. So you have roughly 30,000 people in this area. It would seem highly arbitrary for the Congress to simply eliminate 30,000 jobs in something which has a social value and cannot be criticized on that account. So moving from the economic beneficiaries to the major economic effects, the major economic effects are advantageous relative to an improved income distribution, increased competition in the U.S. economy, and the increased social value of advertising expenditures. The conclusion from this economic analysis of the bank premium industry is fairly obvious: all the data seem to indicate that the premium programs benefit the parties concerned—banks, customers and suppliers—and are not only a legitimate, but a long established and socially valuable means of promoting increased savings accounts in financial institutions. Now, the savers committee feels that if the Congress wishes to act in this area to provide certainty as to future premium limits, it would best seek a limit keyed to the basic "promotion of savings" function of such premiums. Given the average unit cost of premiums of $3.53—based on the 1970 ABA survey—the typical dispersion around such a mean, and future gradual inflationary increases over the next decade, a limit of approximately $5 would serve the needs of the industry, the banking community, the small saver without allowing a legitimate promotional technique to be converted into socially wasteful expenditures. Such a limitation is provided by H.R. 5685. On the other hand such "merchandise in lieu of interest" offers, made last year by several large New York State banks, have led to adverse publicity and editorial criticism for the premium industry as a whole. We think this is unfair. Such prepaid interest offers give the depositor nothing more than he would have received in cash interest payments set by regulation Q, and these tend to mislead the public. 681 Sucli advertising is not in keeping with the legitimate promotion function of the saver incentives premium yidustry to promote small savings. Such excesses would be prevented by H.R. 5685. Let me conclude by simply saying a word about something I know that you and Mr. Reuss are very concerned with, and that is the increased social value of advertising expenditures. When banks are limited by the Government in the degree of price competition they can engage in, they will find means to compete by increased advertising ana marketing expenditures. The social question is the value of alternative marketing strategies while the total size of funds may not change greatly. Thus the consumer is benefited directly by receiving goods and gifts rather than by simply being bombarded by more radio, TV, or direct mail advertising where the economic benefits would accrue to advertising agencies and the various media. In the ABA survey an overwhelming percentage of bank customers, especially housewives, supported the use of bank premiums. Afurther social gam from bank premiums is the initial encouragement to newly formed households, small savers and to youth in developing patterns and habits of saving. To deny the youngster in a family from receiving a free "piggybank" for opening his first savings account would seem to run against the grain of the tradition of thrift in the history of U.S. economic development. Likewise, the inducement of a premium would tend to help consumers optimize in their placement of savings so that higher rates of return would be received—as contrasted to idle funds in checking accounts or cookie jars—so that larger purchases can be made out of savings—such as appliances, cars arid houses—rather than at the exceptionally high rates of consumer credit with which the small saver is usually confronted. This is really a program for small savers, who generally are discriminated against by the financial institutions in terms of receiving smaller amounts of money in interest on what they lend, and they pay much higher rates of interest on the amounts they borrow. In the final analysis, it is the public who benefits most from saver Eremiums. There are no apparent reasons why such premiums should B arbitrarily prohibited. Thank you, Mr. Chairman. The CHAIRMAN. Thank you, sir. We will place your complete statement in the record at this point. (The prepared statement of Dr. Hinrichs follows:) PREPARED STATEMENT OF D R . HARLEY H . H I N R I C H S , 1 T H E SAVER INCENTIVES P R E M I U M INDUSTRY COMMITTEE A N ECONOMIC ANALYSIS OF BANK CUSTOMER PREMIUMS : THE CASE FOR PRESERVATION W I T H REGULATION SUMMARY AND CONCLUSIONS The saver incentives premium industry has a long tradition: for more than a quarter of a century it has provided a marketing media for banks and other 1 Associate Professor of Economics. U.S. Naval Academy, Lecturer in Economics, University of Maryland Graduate School, and Associate Professorial Lecturer in Economics, The George Washington University. Prof. Hinrichs holds degrees from the University of Wisconsin, Purdue University and Harvard (Ph.D.) and was a Fulbright Scholar at the University of Melbourne, Australia. He is (or has been) a fiscal consultant to the U.S. Treasury (Office of the Secretary), U.S. State Dept./A.I.D., the Joint Economic Committee of the U.S. Congress, the World Bank, International Monetary Fund and United Nations. 60-299—71—pt. 2 16 682 financial institutions to compete for public funds. Various studies by the American Bankers Association, the Mid-Continent Banker, Harvard University, and a survey of this industry all tend to agree on the following points: 1. Bank customers approve premiums. 2. Premium-generated accounts tend to be retained. 3. Premium-generated accounts tend not to be shifted from other accounts. 4. Premiums tend to increase total savings. 5. Banks tend to approve customer premiums. i 6. The bank customer premium industry is larger than often realized ($100 million), long-established, characterized by small businesses and is highly competitive. 7. Retail firms appear to benefit from bank premium programs rather than to suffer from banks offering merchandise. 8. The total net cost of bank premium programs to banks is very small: only 2 percent of bank advertising expenditures and only 0.03 of one per cent of operating income. 9. Bank customers receive premiums or gifts without being penalized by payment of a lower interest rate. Existing regulations by the FRS, FDIC and FHLBB limit the wholesale value of premiums to $5 for deposits up to $5,000, and set a limit of $10 for deposits over $5,000. The major economic beneficiaries of bank customer premium programs appear to be small savers, small banks and new branches, premium manufacturers and their dealers, suppliers, and employees, and the users of savings funds thus generated, particularly the housing sector. The major economic effects are advantageous relative to an improved income distribution, increased competition in the U.S. economy, and the increased social value of advertising expenditures. The conclusion from thisi economic analysis of the bank premium industry is fairly obvious: all the data seem to indicate that the premium programs benefit the parties concerned (banks, customers and suppliers) and are not only a legitimate, but a long-established and socially-valuable means of promoting increased savings accounts in financial institutions. If the Congress wishes to act in this area to provide certainty as to future premium limits, it would best seek a limit keyed to the basic "promotion of savings" function of such premium®. Given the average unit cost of premiums of $3.53 (based on the 1970 ABA survey), the typical dispersion around such a mean, and future gradual inflationary increases over the next decade, a limit of approximately $5 would serve the needs of the industry, the banking community, the small saver without allowing a legitimate promotional technique to be converted into socially-wasteful expenditures. Such a limitation is provided by H.R. 5685. On the other hand such "merchandise in lieu of interest" offers, made last year by several large New York State banks, have led to adverse publicity and editorial criticism for the premium industry as a whole. Such "prepaid interest offers" give the depositor nothing more than he would have received in cash interest payments, and tend to mislead the public. Such advertising is not in keeping with the legitimate promotion function of the saver incentives premium industry to promote small savings. Such excesses would be prevented by H.R. 5685. INTRODUCTION This paper summarizes what data are known as to (1) the economic characteristics of bank customer premium programs, (2) existing legal regulations, (3) the economic beneficiaries of bank customer premium programs, and (4) the economic effects of such programs. One principal source of information is a survey by the American Bankers Association of nearly 10,000 member banks conducted in 1968. Additional sources of information include a survey of the major suppliers and manufacturers of bank premium products and interviews with leading bank, savings and loan, manufacturer officials as well as with economists at the Federal Reserve Board, Treasury, and congressional committees. THE ECONOMIC CHARACTERISTICS OF BANK CUSTOMER PREMIUMS Banks, savings and loan associations, and their Federal and state regulatory bodies look upon bank customer premiums as a legitimate form of promotion of 683 advertising for the use of the consumer dollar in competition with consumption expenditures, insurance, mutual funds, the stock market, government securities, foreign investments, idle cash or other alternatives. Donald R. Peterson of the Continental Bank, Chicago, pointed out in the Mid-Continent Banker, May 1970, that "As we preview the '70s, there is no question that banks will more than ever be promoting their services in direct competition with non-banking firms which are highly skilled in all phases of marketing. Our banks have little chance for success in this arena if we do not feel as free as our competitors to employ techniques selected from the entire spectrum of marketing and promotional possibilities." Bank customer premiums range from single premiums offered for opening a new account or expanding a new account to multiple premium programs (or continuity programs) which usually offer a free gift for the first deposit (or expansion) and subsequent opportunities to purchase similar merchandise (say tableware or china) at a discount from retail prices for future deposits. Such programs encourage the small depositor to return to the bank, enlarge his savings accounts, become acquainted with other banking services, and develop a savings habit. The bank generally is able to recoup part or all of its initial promotional cost by a small differential between its wholesale cost and the premium price which is up to 50 per cent less than retail. The bank typically is able to break even in such "continuity programs". Above all, the bank thus encourages a high retention rate of the initial deposit and usually experiences significant "add-ons" to the initial deposit, thus fostering a savings pattern by its customers. Distinct from these programs is "compensation in kind" , (be it a TV set or automobile) which is offered as prepaid interest for making a large deposit to be held for a number of years. These by necessity are for large accounts, require freezing deposits for a number of years, but are still subject to Regulation Q as to complying with the equivalent interest rate than can be received by such a deposit. What are the economic effects and characteristics of legitimate bank premium programs? The American Bankers Association and the Mid-Continent Banker, The Financial Magazine of the Mississippi Valley and Southwest, and Harvard University have made studies that provide the following evidence: (1) Bank customers approve premiums: The ABA survey based on returns from about 10,000 banks (more than two-thirds of the total) reports that 59 per cent favored premiums and only 28 per cent were opposed. The Mid-Continent Banker reported in its survey that 78 per cent of bank customers found premiums useful while only 7 per cent were negative. (2) Premium-generated accounts tend to be retained: A Harvard University study showed that premium-generated accounts have a greater retention value than do walk-in accounts. Both the ABA study and the Mid-Continent Banker survey verify this finding. Retention rates typically are about three-fourths of original deposits after one year and usually greater than walk-in accounts (78 per cent compared to 65 per cent based on the ABA survey). (3) Premium-generated deposits tend NOT to be switched from other accounts : The ABA survey showed that only 12 per cent of bank customers would change banks to get a premium while 78 per cent would respond to a premium by their present bank.2 In the Mid-Continent Banker survey 81 per cent stated they would not move their funds to another bank if that bank offered an attractive premium. (4) Premiums tend to increase total sewings: No economist would deny that, at the margin, offering a higher price for savings deposits (via premiums) would have some effect on increasing total deposits relative to alternatives (such as consumption, idle cash, checking accounts, etc.). Macro-economic evidence is difficult to be demonstrated at this point because of the other more important determinants of the marginal propensity to consume in the economy. However, certain micro-economic evidence would seem to support economic theory on this point: in the ABA survey a bank in Danville, Arkansas (population: 950) during seven years of customer premiums more than trebled its deposits (demand deposits more than doubled, time deposits were up more than six-fold). The ABA Retention percent One major bank in New York State has research that reveals the following retention rates on premium-induced accounts : 3 months later 96.1 9 months later 86. 0 1 year later 75. 7 2 684 survey concluded: "In this seven-year interval the economy of the area did not change materially in either payrolls or population. An aggressive marketing program is almost solely responsible for the bank's growth record". Numerous other individual bank studies are documented in the ABA Survey and provide similar results. Given the customer's time, cost and reluctance involved in "switching accounts" (especially in areas where alternative banks are limited) as cited above, these data show that some increase in assets held in the form of savings accounts at banks must have taken place. (5) Banks tend t.t approve customer premiums: On the basis of the ABA survey, about half of me banking industry (measured by deposits) have used bank customer premiums. In terms of numbers of banks, one-fourth have used premiums but the greatest growth rate in bank premium use is in small banks: banks with deposits under $1 million were adopting such incentive programs at a rate 18 times faster than banks with deposits over $100 million. The ABA survey concludes that "Contrary to some beliefs, premiums do not harm the bank's standing with the public or commercial customers. Four out of five banks that have employed premiums to build time or demand deposits consider the results either good or fair. The same success was achieved in promoting openings with premiums." Typical of this support is the experience of the Deposit Guaranty National Bank. Jackson, Mississippi, whose executive vice-president, J. Herman Hines, chaired the Special Project Committee of the ABA in conducting its extensive study of bank customer premiums. Its premium campaigns were successful in terms of increases in savings, retention rates and increases in account balances (see p. 26, Mid-Continent Banker, May 1970). (6) The bank customer premium industry (manufacturers and distributors) is larger than often realized, long-established, characterized by small businesse and is highly-competitive: Total premium use for all purposes in the United States now exceeds $4 billion according to a survey conducted by Incentive Marketing Facts (May 1968) and as later revised. This survey estimated the premium sales volume for financial institutions at $69.5 million (based on 196768 data). Given estimated growth rates of 7-10 percent per year since then, the total volume for 1971 will probably exceed $100 million. More than one hundred domestic suppliers and manufacturers (see list) are involved in providing bank customer premiums making the industry highly competitive with essentially low profit margins. A 1970 survey of firms representing total sales of $21 million (about one-fifth of the estimated total industry sales) provides this economic anatomy of the industry: (a) The industry is long-established: 60 per cent of the firms engaged in selling to banks have been in business for more than a quarter of a century; half of the firms have been selling premiums to banks for ten years or more. (6) Firms which sell to banks rely heavily on bank premiums as a major source of income and would be highly vulnerable to the abolition of premiums: 30 per cent of the firms do bank premiums exclusively: half of the firms rely on bank premiums as their major source of sales. (c) Firms which sell to banks are essentially small businesses: 80 per cent of the firms have total sales of $10 million or less; 60 per cent have sales under $5 million; and 30 per cent have sales under $1 million. The industry is labor-intensive, employing many semi-skilled workers often in smaller cities where alternative employment is not available, especially in the 1969-70 period studied: based on total sales of $100 million and salesrlabor ratios typical in this industry (based on the sample survey) about 10,000 production employees are involved (excluding transport and distribution personnel) ; given a typical 2-1 ratio of the multiplier effect between production earnings and related employment dependent on such earnings, a total of 30,000 jobs could be affected. This estimate excludes the effect on jobs of non-bank premium employees of companies with a critical dependence on the bank premium business. To the degree that such companies would be forced to close all activities because the bank premium business were eliminated, additional unemployment would result. (7) Retail firms appear to benefit from bank premium programs rather than to suffer from banks offering merchandise: Mr. Donald R. Peterson, Continental Bank, Chicago, made this point in the speech cited earlier: "The ABA report, for example, points out that many banks have hesitated to use premiums because they are afraid of offending retail accounts who sell comparable items. Experience to date seems to place this constraint in the illusory category. Banks that have had the courage to proceed with premium promotion® have found, indeed, that retailers' sales for comparable items have actually increased—per 685 haps because the bank promotion heightened consumer consciousness of the item and the bank's offering somehow did not fully satisfy some consumers' desires". Mrs. Jean G. Wofford, Assistant Vice-president, First National Bank of Spartanburg, South Carolina, makes the same point in Mid-Continent Banker, November 1970: "One popular misconception that I have mentioned earlier is that retail merchants do not like competition from the bank. Quite the contrary. Merchants find there is a sharp increase in their sales of, say, china, silver or other premium items to residents who have been made aware of their need or desire for the merchandise by the bank's advertising; but who, for some reason or other, preferred to buy in local stores rather than participate in the bank's program. (8) The total net cost of bank premium programs to banks is very small: Based on the ABA 1970 Bank Advertising Survey the net cost of bank premium programs represents only 2 percent of total bank advertising budgets, only 0.03 of one per cent of operating income, and only 0.002 of one per cent of total deposits. Based on the ABA survey of commercial banks, the total net cost was only approximately $8 million, exclusive of media advertising for such programs.' (See following table.) (The difference between this advertising cost estimate for bank premiums and the total sales value of the bank premium industry is accounted for only minorly by other financial institutions, but principally by the nature of many "continuity programs" whereby banks may recover a large share of the initial gift by subsequent sales, thus approaching a "break-even" position.) Thus, it appears that banks and other financial institutions are able to use premiums as an effective promotion technique in terms of generating new accounts, appealing to small savers, opening new branches, widening the variety of banking services but with little net cost. BANK PREMIUM NET COST AND USAGE AMONG COMMERCIAL BANKS Size of bank by deposits (millions of dollars) Number of banks Total deposits (billions of dollars) Advertising expenditure (thousands of dollars) Percentage of advertising budget on customer premiums Total net cost customer premiums (thousands of dollars) ^Percentage of banks using customer premium (1970 ABA survey) Percentage having [e of of banks ba used premiums at any time " (ABA 1968 survey) Under 1 1 to2 2to5 5to 10 10to25 25to50 50to 100 100 to 500 to 500 1,000 Above 1,000 231 1,051 3,494 3,434 3,180 1,096 476 403 59 49 0.3 2.2 12.9 24.3 42.6 32.2 28.5 76.0 39.2 142.6 277 1,958 9,306 24,880 51,605 39,370 32,908 83,048 40,750 91,738 0.5 3 3 3 3 3 2 2 2 1 59 279 746 1,548 1,181 658 1,661 815 917 4 13 17 23 32 29 37 38 46 9 17 27 37 46 54 59 » 71 >71 5 i Aggregated in one category of all banks over $500,000,000 in deposits. Source: American Bankers Association. Customers Premiums. 1969. American Bankers Association, 1970 Bank Advertising Survey. Deposits and numbers of banks: Federal Reserve System data and FDIC1969 Annual Report EXISTING REGULATIONS ON BANK CUSTOMER PREMIUMS In mid-February 1970 the Federal Reserve Board, the Federal Deposit Insurance Corporation and the Federal Home Loan Bank Board issued new regulations concerning the use of premiums by financial institutions. The new regulations limit the wholesale value of premiums to $5.00, excluding shipping and packing costs, for deposits up to $5,000, and set a limit of $10.00 for deposits above $5,000. The regulations (97 Fed Res 279) contain two other chief components: (1) Premiums can be given only at the time of the opening of a new account or for the addition in an existing account, and (2) premiums may not be given to a depositor on a recurring basis. The Federal Reserve Board's position is based on the recognition that many banks offer premiums as a legitimate form of advertising and that such promo8 Such advertising for premium programs is typically part of rather than in addition to ithe normal bank advertising budgets. 686 tion is not a breach of Regulation Q which limits financial compensation to the customer for the use of his funds. The shift in policy in 1970 reflected to a large degree the concern of the Federal Reserve Board (and FDIC and FHLBB) to encourage savings deposits in a period of inflation, a decline of new funds flowing into savings institutions, the resulting drop of funds available for housing starts, and the increase in interest rates faster than Regulation Q could be adjusted upward to compensate for more advantageous rates offered by competitive financial instruments. This move by the FRB, as a part of its general strategy to increase the money supply growth rate in 1970 relative to 1969, was by and large successful in turning around the funds shortage felt by financial institutions and the housing market during 1969-70. The Federal Home Loan Bank Board has ruled that sales of merchandise, as a part of a promotional campaign, are within the incidental powers of Federallychartered associations. Where merchandise is sold, the loss on the sale, if any, may not exceed the dollar limitation applicable to giveaways. At the present time the expansion of the supply of money has severely curtailed the premium industry. The companies remaining in the field today are those that have for a quarter of a century lived through the "highs and lows" of the industry and are able to provide service to the financial community under a variety of economic cyclical conditions. Economic beneficiaries (a) Small savers are probably the major beneficiaries of bank premium programs. Generally the low-income household is at a distinct disadvantage in its financial relations with the banking (in its broadest sense) community: as a borrower, the interest charges typically range from double to quadruple those rates (prime rate used as a benchmark) available to more affluent businesses or households. Whereas the wealthy household or large business may borrow at 6-7 per cent, the low-and-middle income household or business may borrow at rates ranging from 12-13 per cent. Likewise, on the investing side the same financial discrimination is also true. The larger lender may receive higher legal rates for depositing larger sums in financial institutions, or as more often the case, may have both the knowledge and funds to invest elsewhere (second trust mortgages, federal-guaranteed or sponsored securities, Eurodollars, commercial paper) at considerably higher rates of return. Whereas the low income saver may be limited to rates between 4-5 per cent, the knowledgeable large investor may receive twoor-three times this return. Bank premiums help redress this financial discrimination. Especially in periods of monetary tightness (as in 1969), government ceilings on interest rates for savings deposits limit an increasing return to small savers but not to big savers who can go elsewhere. Bank premiums provide a flexible instrument to increase such savings rates for low-income groups. Even in more normal monetary times, a bank customer premium results in a substantial interest rate increase to the small saver. This effect is actually greater than at first realized: for example, giving a $3.00 premium for opening a $100 savings account at 4 per cent interest is not an effective rate of return of 7 per cent but actually a return closer to 10.6 per cent (the $3 premium is at wholesale prices with the equivalent retail price equal to twice that amount, if not more: thus in reality the customer is "depositing" only $94 (the bank giving him $6 back immediately in the form of a premium) and could receive from the bank a year later $104.) Thus, under different assumptions as to the customer's valuation of the gift, the real rate of return he experiences may be two or three times the nominal rate of interest for small savers. Such a financial return, as the ABA study indicates, is sufficient to induce a greater savings flow in such institutions. As was discussed earlier, such a flow does not result in shifting minor amounts among banks (only 12 per cent of bank customers indicated they would change banks to get premiums) but represents a more efficient use of savings by customers to secure a higher return. In addition, no economist would deny that such an increase in the rate of return would have some increase in total savings relative to consumption. However, the chief consideration for the SIP ILL saver is that bank premiums offer him some upward flexibility in his possible rate of return in the institutional context whereby wealthy savers can avoid government interest rate ceilings by alternative investing patterns not subject to the interest rate ceilings imposed on savings institutions. (b) Small banks and new branches benefit in that premiums offer a means of competition with older, larger and more established banks whose size alone may tend to attract new savings accounts. The ABA 1969 survey indicated that banks with deposits under $1 million were adopting such incentive pro 687 grams at a rate 18 times faster than banks with deposits over $100 million. Likewise, 62 per cent of new branch openings reported "good" results with premium programs; this was the highest percentage of "good" results relative to other categories of the use of premium programs. In brief, as a means of competition by newer and smaller banks and branches, premiums offer an offset to the "natural" prestige advantages of larger banks and savings institutions. In the ABA 1970 Advertising Survey small and medium size banks (with deposits between $2-50 million) allotted three times as much of their advertising budget to premiums than did banks with deposits over $1,000 million. There is a paradox in the data examined in that larger banks began a more extensive use of premiums than smaller banks, thus tended to attract new savers. Thus, at the present time when smaller banks are attempting to "catch up" with the initial headstart by larger banks, the Congress is considering the prevention of such premium programs. This, at the present time, thus serves to reinforce the earlier advantage achieved by the larger banks which first adopted the programs. In the ABA 1970 Bank Advertising Survey (covering 1969) 39 per cent of the banks experienced "better than expected results" using bank premiums, 44 per cent reported "about as expected results" and only 17 per cent reported "worse than expected results" (with 14 of these percentage points in the "slightly worse" category and 3 points in the "much worse" category). The ABA summarized that "For the most part, bankers do not appear dissatisfied with the results." Since premiums "reflect an expenditure directly from the marking and advertising budget," the small bank is able to compete favorably with the larger bank for its share of the market. For example, Dallas sources report that the increased cost of time and space in advertising media have in some cases increased to the point where the small bank is incapable of effectively bringing its service message to the public. In the past four years, a sixty-second radio commercial has increased from a price of $14 to $46. Fourteen lines of newspaper advertising have increased from 63£ per line in 1966 to a current rate of 840 per line. According to advertising specialists in Dallas, "Although bank budgets for advertising have increased 25 per cent, the new budget will pay for 20 per cent less than prior years expenditures." Television sixty-second commercials in prime time in the Dallas market cost $400. This rate all but eliminates prime time television from the grasp of the "would be" small bank advertiser. Since premiums cost exactly the same amount to the "big bank" as to the "small bank," this is the only method of equal and fair competition left to the small bank. Discriminatory legislation eliminating premiums completely would cause undue hardship and make quite diflicult the task of ^small bank marketing functions." (c) Premium manufacturers and their dealers and suppliers represent a considerable amount of economic activity: production, jobs, profits and taxes that would be eliminated if bank premiums were outlawed. Total bank premium production is estimated at about $100 million representing up to 10,000 jobs (and, given some multiplier effect for changes in income, this could affect double or treble this number through economic repercussions.) The most important characteristic in the analysis of manufacturers is that, generally not widely realized, SO per cent of the firms surveyed (which represented about one-fifth of the total industry involved) rely on bank premiums as their sole activity. This would thus mean the elimination (or serious disruption) of some firms which have concentrated in this area for over a quarter of a century (the oldest firm goes back to 1945). For other firms bank premiums constitute such a large share of their total business (another 20 per cent of the firms surveyed received more than half their sales from this area) that the total business would be seriously affected with possible bankruptcy as a result. Thus 50 per cent of the firms surveyed would be seriously jeopardized by abolition of bank premiums. In a period of economic recession-and-limited-recovery such an impact on economic activity would be hardly salutary. (d) Employees of premium manufacturers and associated suppliers and dealers would have much to lose if premiums were abolished. As cited above, as many as 10.000 direct jobs may be affected (excluding transport and distribution jobs). This total could be more if one considers the nonpremium employees of companies whose major economic activity is in the premium business and which might be forced to close entirely if this activity were eliminated. With the loss of every production job there would be a "multiplier" effect on other income, production and jobs that depend on the spending power generated by such initial economic activity. The nature of these jobs makes this area exceptionally vulnerable: many such jobs are located in high-unemployment areas (California, Connecticut, Pennsylvania, New Jersey, Texas) where there would be no easy shift to alternative employment. Furthermore, the semi-skilled nature of these jobs means that 688 the employees are in a low-to-middle income group and thus would not have the financial resources to relocate or be retrained without severe hardship being experienced. (e) Users of funds, chiefly the housing sector, of savings channeled into institutions as a result of premiums would be net losers by abolition of premiums. In the ABA survey 79 percent of bank premium programs were used in connection with savings accounts—these generally flow into the housing sector in contrast to other forms of financial intermediation. Thus, any increase in total savings (due to the rate of return effect cited earlier) or shift in the composition of savings toward the housing market that occurs because of bank premiums would be affected by their elimination. Obviously, given pressing national priorities in the Seventies for a vigorous housing sector, such an absolute and relative diminution of savings could not serve Congressional housing targets in its Housing and Urban Development Act of 1968. ECONOMIC EFFECTS The overall economic effects of bank premiums can be seen as advantageous as analyzed from the viewpoint of (a) income distribution and increased competition in the U.S. economy, (b) increased output and employment, and (c) the increased social value of advertising expenditures. (a) Income distribution is improved to the degree that the effective rate of return is increased for small savers. Large savers do not generally use such small savings accounts, nor would they be enticed by $3-5 premiums relative to the time and bother necessitated by transfering funds. Likewise, on the output and employment side, the companies and employees chiefly involved comprise small and medium size businesses within a competitive framework with sales ranging from $1-8 million per firm involved for the larger firms and with half the firms surveyed having sales of under $1 million in this area. All data indicate that the cost of such programs is borne by the banking industry and is not shifted to the customer-consumer as sometimes typical in other premium areas. For example, where premiums are used in supermarkets, gas stations, "stamp" programs, etc., the cost is often shifted to the consumer in terms of higher prices. For bank premiums there is the critical distinction that government interest rate ceiHngs on small savings accounts prevent the customer from receiving his "true market" return and thus premiums result in the benefits being received by him without having to pay a higher price for other goods purchased. Indeed the provision of consumer goods to him at wholesale prices enables him to benefit by amounts greater than the "nominal" value of the premium. Surveys of banks indicate that they typically "break even" by such programs and use them primarily because of the force of competition which by its very nature serves to benefit the consumer in terms of better service and greater attention. (b) Increased output and employment, as indicated earlier, are an advantage to the economy especially when it is slowly recovering from an economic downturn. Significant at this time as well is that declining interest rates (and thus declining use of bank premiums) are already forcing a "recession" on the bank premium industry so that further legal restrictions on bank premiums would aggravate the declining economic position of the industry at the present time. Market forces in a free economy have already eliminated any earlier "excesses" that occurred during the severe tight money period of 1969-70. (c) The increased social value of advertising expenditures is a final advantage of the bank premium programs as it has existed for the past quarter century. Where banks are limited by the government in the degree of price competition they can engage in, they will find means to compete by increased advertising and marketing expenditures. The social question is the value of alternative marketing strategies while the total size of funds may not change greatly. Thus the consumer is benefitted directly by receiving goods and gifts rather than by simply being bombarded by more radio-TV-or direct mail advertising where the economic benefits would accrue to advertising agencies and the various media. In the ABA survey an overwhelming percentage of bank customers, especially housewives, supported the use of bank premiums. A further social gain from bank premiums is the initial encouragement to newly-formed households, small savers and to youth in developing patterns and habits of saving. To deny the youngster in a family from receiving a free "piggybank" for opening his first savings account would seem to run against the grain of the tradition of thrift in the history of U.S. economic development. Likewise, 689 the inducement of a premium would tend to help consumers "optimize" in their placement of savings so that higher rates of return would be received (as contrasted to idle funds in checking accounts or cookie jars) and so that larger purchases can be made out of savings (such as appliances, cars and houses) rather than at the exceptionally high rates of consumer credit with which the small saver is usually confronted. In the final analysis, it is the public who benefits most from saver premiums. There are no apparent reasons why such premiums should be arbitrarily prohibited. Partial List of Firms in the Premium Industry Thumbelina Rival Robertshaw Randon House Intermatic International Silver Rogers Van Wyck Capitol Leeds Sunbeam Utica Revere Ware Emms Websters Kodak Anchor-Hocking Beacon Therma Timex Paragon Munro Melamine VIP llonson Toastmaster Polaroid Munsey Proctor Elgin Bradley Peter Man's Capra Vornado t1 idling Pyrex Westinghouse Salton Paul Monet Dormeyer Paul Poiret Dunhill Schick Helbros Dominion Clairol Monarch Manning Bowan Bulova Starflite Naugahyde General Cory Robeson Casco Black & Decker Tensor Ingraham Wearever Motorola Washington Forge Seth Thomas General Electric Sunbeam Guard All Detecto Oneida Big Ben Agfa Panasonic Mirro West Bend Thermos Enterprise St. Mary's Regent I)azey Continental Viva Westclox Philco Chilton Shetland Crescent Hamilton Beach Accent II Roto-Broil Universal Emerson Samsonite Lifetime Cutlery Jubilee Stakmore Barcalounger S C M Electric Typewriter Hoover Atlas Bell & Howell Magnavox Spalding Singer J. Edward Connelly Associates William Dalton Associates Premium Corporation of America Ben Gross & Company Ben S. Loeb & Company Grace China Company Salem China Company 690 The CHAIRMAN. I wish you would keep in mind page 11, your table. I want to ask you about that. Dr. HINRICHS. Right, sir. The CHAIRMAN. Each of you gentlemen may file your statements in full. And if in the course of our proceedings here some point comes up that you would like to elaborate on, or if you want to extend your testimony in any way to make more clear your thoughts on the matter, you may do so by extension of your remarks, so as to make sure that you will be able to express yourselves fully and protect your own interest and get your viewpoint over. First, each member of the committee will ask questions for 5 minutes, and then we will have a second go-around where there will be no limitations. First, I would like to ask just two or three questions here of Dr. Oberg. You say on page 2, Dr. Obersr, that one major institutional investor is already reporting publicly its equity holdings on a regular basis. Which group of institutional investors is this? How long have they been making these reports? Have they suffered any serious injury because of such disclosures? And finally, what was this industry's attitude toward being required to make such disclosures before Congress required them to do so? Dr. OBERG. Mr. Chairman, the institutional group referred to in the statement is the investment companies that are registered with the Securities and Exchange Commission under the 1940 Investment Company Act. As far back as the time of the passage of the act there were requirements for disclosure in semiannual financial reports of various details of the holdings of these companies. Several years ago this was extended in terms of details of portfolio composition by the introduction of the NIR and NIQ reporting forms. The NIR form is on a fiscal basis for the full year. The NIQ is on a calendar quarter basis, and in those it is required to report each of the holdings and the activity therein, if any, in each quarter. As this series of reporting forms and procedures developed, there was discussion between the industry and the regulatory authorities— it was a give and take. The NIR lias a public and private section of information supplied—my only personal view is that this information has been beneficial, and I know of no major reaction that has occurred in the disclosure of such data. The CHAIRMAN. Thank you, sir. Do you feel that the benefits derived by the public from such disclosures outweigh the cost to the industry ? Dr. OBERG. Mr. Chairman, I would be in the value judgment there. I would like to agree myself to the fact that in my work over the years I have found it beneficial to know more and more about the institutions. The CHAIRMAN. D O vou feel that if bank trust departments were required to make such disclosures, given their massive size and participation in the securities market, such disclosure would benefit the public? 691 Dr. OBERG. In my opinion, yes. The disclosure of information which permits someone to measure the size and location of various securities holdings, the ability to look and apply quality valuations to the types of securities used, the philosophies behind the various institutional groups, is something that I as a general thing, think is most valuable. The CHAIRMAN. This committee is the only one, I think, in Congress that has ever gotten out a report on that. About 3 years ago we interrogated all the banks and we got the correct information from them. And we discovered that about $253 billion represented the size of the trust accounts of banks. But out of the 14,000 banks only 3,000 banks had trust accounts. Subsequent to that the figures were brought up to date showing about $280 to $290 billion, and 19 banks had over half of those trust assets. That is the reason we were going into it, just looking into it. Now, I would like to ask Mr. Swift a question. Several States besides these six that do not permit the ownership of bank stock by mutual savings banks substantially limit such holdings. For instance, Maine and Rhode Island limit such holdings to 10 percent of the deposit of the savings banks, and Minnesota limits such investments to 3 percent of bank's assets. Several States also limit the percentage of stock owned in any one bank. For instance, in Alaska it is 2 percent and in Minnesota it is 1 percent. In New Jersey a mutual savings bank is limited to holding not more than 2 percent of the outstanding stock of any company. The point is that at least nine of the 18 States in which mutual savings banks operate, either prohibit or severely limit the amount of commercial bank stock that mutual savings banks can own. This does not appear to have adversely affected the operation of these banks. On the other hand, there is substantial evidence that mutual savings banks in some States have invested heavily in bank stocks of competitor banks. With this in mind, do you consider it to be a severe blow to the operations of mutual savings- banks if they were prohibited or restricted as to the amount of bank stock that any one mutual savings bank could hold? Mr. SWIFT. Mr. Chairman, a lot of the differences that have arisen are historical, and there would be some adverse effects, there is no question about it, in those States that have a long tradition of stock ownership in commercial banks. I would, if I may, pass this question over to Mr. Clark, who is closer to it. The CHAIRMAN. My time has expired. And I will have to yield to another member of the committee. I would like to insert, if there is no objection, a table showing the mutual savings bank investment in commercial bank stock in the 18 States in which mutual savings banks operate. Without objection that will be inserted. (The table referred to for inclusion in the record at this point follows:) MUTUAL SAVINGS BANK INVESTMENT AUTHORITY IN COMMERCIAL BANK STOCK State and authority to invest Percentage of bank assets which may be so invested Percentage of shares of any 1 issuer which may be owned Geographical limitations or requirements Alaska: Yes. Sec. 06.15.260, Alaska stat- In all stocks—No more than 10 percent No more than 2 percent of total issued None, and outstanding shares of any one utes annotated. of assets or 100 percent of surplus issuer—nor more than 1 percent of and undivided profits, whichever is bank assets in any one issuer. less; in common stocks no more than 6 percent of assets or 60 percent of surplus and undivided profits, whichever is less. Issuing bank must be in Connecticut Investment in the shares of any one Connecticut: Yes. Sec. 36.96(10), the Total investment in stock of banks or in any city designated by the issuer shall not exceed 10 percent and holding companies shall not banking law of Connecticut. Savings Federal Reserve board as a central exceed 6 percent of assets. of the total equity securities of the banks may also invest in the shares of reserve city or a reserve city. issuer nor shall exceed H o of 6 bank holding companies registered percent of bank assets. under the laws of the United States. Delaware: Yes. Prudent man rule No limitation Indiana: No authority None Maine: Yes. Sec. 629, Maine revised No more than 10 percent of deposits statutes. Also in stocks of bank holding may be invested in bank stocks or companies, provided 60 percent of the bank holding company stocks, company's gross revenues are from banking operations. Maryland: Yes. Prudent man rule No limitation.... Other limitations or requirements None. Issuring bank must have paid dividends in cash in each of the last 5 fiscal years at the rate of at least 49 percent on its common capital stock, and provided that the combined capital, surplus, and undivided profits of any such bank located outside Connecticut shall be at least $20,000,000. None. None. None. No limitation None None None Investment in the shares of any 1 The issuing bank must be located in issuer shall not exceed 10 percent of Maine, except that if outside Maine, the capital stock of the issuer nor it must be a member of the Fed and shall it exceed more than 1 percent have total capital funds of $50,000,of the deposits of the bank. None, No lii CD to Massachusetts: Yes. Sec. 47, annotated laws of Massachusetts. Also in stocks of bank holding companies. No more than 66 H percent of total guaranty fund and surplus may be invested in bank stock (or stock of bank holding companies or fire insurance stocks). The issuing bank must be located in A Massachusetts issuing bank must Massachusetts. If not, it must be a have paid dividends in cash of last national bank, have a combined 5 years of not less than 4 percent total of capital stock, surplus, unon its common stock without having divided profits, and reserves for reduced the aggregate par value contingencies of at least $40,000,000 thereof within such 5-year period, and also equal to at least 6 percent and which has surplus at least equal of its deposits and which for last 10 to 50 percent of its capital stock. years has paid a cash dividend of at least 4 percent on its common without having reduced the aggregate par value. Minnesota: Yes. Sec. 50.146, Minnesota No more than 3 percent of savings Investment in the shares of any 1 The issuing bank must not be located No investment shall be made in any statutes annotated. bank's assets may be invested in issuer shall not exceed in amount, in the 9th Federal Reserve District corporation with assets of less than bank stocks. M of 1 percent of the assets of the $10,000,000. savings bank; in number of shares, 1 percent of the total outstanding and issued shares of the issuer. New Hampshire: Yes. Sec. 387.13, New No more than 15 percent of deposits Investment in the shares of any 1 issuer The issuing bank must be located in None. Hampshire revised statutes annotated. shall not exceed 25 percent of the may be invested in preferred or comNew Hampshire, or if not, must be a Also bank holding companies. (Registotal capital stock of such issuer. mon stocks. (387.3(2).) national bank or State member bank tered). of the Fed, located in a city of not less than 500,000, and provided capital stock, surplus and undivided profits are at least $10,000,000; combined surplus and undivided profits are at least equal to its capital stock, and a cash dividend shall have been paid in each of the last 5 years. New Jersey: Yes. Sec. 17:9A-180.5(3) No more than 75 percent of savings None Issuer must be a member of the Fed, Investment in the shares of any 1 bank surplus may be invested in N.J.S.A.—National bank stock only. must have a combined total of issuer shall not exceed 2 percent of stocks. capital, surplus reserve for continthe outstanding stock of the issuer gencies and undivided profits equal nor 3 percent of the surplus of the to at least $40,000,000 and also savings bank, whichever amount is equal to at least 6 percent of its less. deposit liability, and which in each of the last 5 yenrs paid cash dividends of at least 4 percent on its common stock without reducing the par value thereof. Investment in the shares of any 1 issuer shall not exceed 15 percent of the issuer nor shall it exceed M of the total guaranty fund and surplus of the bank. <5 CD CO MUTUAL SAVINGS BANK INVESTMENT AUTHORITY IN COMMERCIAL BANK STOCK-Continued State and authority to invest New York: No authority. Ohio: No authority Oregon: No authority.. ' a: Yes. 7 P. S. 504 Percentage of bank assets which may be so invested Percentage of shares of any 1 issuer which may be owned Geographical limitations or None.. No more than the lesser of 7 H of the assets of the savings bank or 75 percent surplus, unallocated reserves, undivided profits and subordinated securities. Investment in the shares of any 1 issuer shall not exceed 5 percent of the total issued and outstanding shares of such issuer nor M of I percent of the assets of the savings banks. Rhode Island: Yes. Sec. 19-19-7, laws of No more than 10 percent of the savInvestment in the shares of any 1 The issuing bank must be located in ings banks deposits may be invested Rhode Island. Also registered bank issuer shall not exceed 5 percent of New England or New York or be a holding companies with total invested in bank stocks, the total outstanding voting stock national bank doing business in in affiliated banks of $100,000,000 which of the issuer nor shall it exceed 3 said States, except if located outhave paid dividends of* at least 4 perpercent of the deposits of the side the above, must be a member p cent on its common for the last 5 years savings bank. of the Fed. have its principal office v and at least % of the holding com- An exception to the above restrictions provides that notwithstanding such re. .. strictions, Rhode Island savings banks are authorized to organize or purchase 0 f bank stoc1k£ . one (1) bank and trust company or national bank and to own all or a majority $5,000,000 and have been in busiof its capital stock. ness for at least 10 years. Vermont: No authority, except for reten- None None tion of stock held on date of enactment (1969) (see sec. 1157(2)). Washington: Yes. Sec. 32.20.380, RCWA. No more than 50 percent of total of No provision.. , The home office of the issuer must be located outside the State of guaranty fund, undivided profits Washington. and unallocated reserves, or 5 percent of deposits, whichever is less, may be invested in prudent man securities. Wisconsin: No authority (see sec. 222.13, None W.S.A.). Other limitations or requirements None. None. 695 The CHAIRMAN. Mr. Widnall. Mr. WIDNALL. Thank you, Mr. Chairman. I Want to welcome all the members of the panel this morning. And we appreciate your being here and giving us the benefit of your views on this proposed important piece of legislation. Mr. Swift I do not know who drafted H.R. 5700, but I cannot help but be a little bit amused, noting the compliments you paid to the draftsman on page 1 of your complete statement, after which you make it quite evident he either did not research State laws affecting savings banks or that he chose to ignore them. In view of the extensive body of State laws governing all aspects of savings bank activities, do you really see any need for the provisions of H.R. 5700 affecting savings banks? Mr. SWIFT. Well, Mr. Widnall, I think in effect our statement has indicated that we do not feel that there is evidence in our industry of the problems that are being attacked here in this bill. So far as our own industry is concerned, we do not think there have been serious abuses. We do not feel that there is a need for this kind of legislation generally. Now, I am not in a position or would not want to say that there is not some potential need perhaps for some standardization in some of these areas. As you point out, there are great differences among the States, and so it affects our industry in many different ways, depending upon their geographical location, and the charters under which they operate. But it is hard for me to say just out and out that I would agree with you on it. Mr. WIDNALL. Dr. Oberg, I have a series of questions that I would like to have you answer. I am not going to have time to offer the questions now and wait for your answer. But I would like to submit them for the record at this time. (The following are written questions submitted by Mr. Widnall to Dr. Oberg, along with Dr. Oberg's answers:) J. Is yourfirma partnership or a corporation t Answer. Arthur Lipper Corporation is a Delaware corporation. 2. Does your firm file an annual statement with the New York Stock Exchange? Answer. Yes. We are, by choice, one of the few firms to be audited by Certified PubUc Accountants twice a year: once—without prior notice to us—in accordance with New York Stock Exchange regulations and once as of fhe end of our fiscal year. S. Is this statement made available to the general public? Answer. At least once a year we send to our clients and offer to institutions a certified statement of our financial condition. In addition, monthly statements sent to customers advise the customers that a current financial statement is available for their inspection at our office or that a copy will be mailed to them upon their written request 4. Are you required to file with the New York Stock Exchange or the SEC a list of every security other than government securities that the firm owns? Answer. We are required to file at least three reports annually listing the securities owned by us as of the date of the reports. Copies of such reports are either made available to the SEC or sent to the SEC directly. The New York Stock Exchange may also request a list of such securities at any time. 5. Is this list of securities owned made available to the general public? Answer. No. We generally do not purchase securities for investment and, accordingly, these securities constitute a relatively small portion of our total capital. We also own securities by reason of our trading and arbitrage activities, but these securities are generally hfcld for very short periods of time. If investment securities ever became a significant portion of our total assets, we believe 696 (hat our auditors would require more detailed disclosure of such securities in our financial statements. 6. Would you provide a list of the securities owned by thefirmso that the list could be inserted in the record of this hearing t Answer. A list of securities owned by Arthur Lipper Corporation as of a recent date is listed below. The list primarily consists of securities in which we are trading and/or are engaged in arbitrage. Marketable Securities Owned by Arthur Lipper Corporation as of April 30,1971 U.S. Treasury Bills, due April 29. 1971 $20,000 U.S. Treasury Bills, due June 3, 1971 60,000 U.S. Treasury Bills, due August 26, 1971 270,000 U.S. Treasury Bills, due October 7, 1971 80,000 U.S. Treasury Bonds, due May 15, 1974 35,000 Continental Mortgage Investors due June 1/4, 1990 454 Itel Corp. July 1995 600 King Resources Co., May 3/4, 1988 1, 000,000 Bank of Tokyo of California shares 800 Berger-Kent Special Fund do 2,000 British Petroleum Co., Ltd do 47,600 Cowan Group Holdings do 34,850 Fuji Photo Co do 1,630 Fundex, Inc do 1,124 Menasco Manufacturing Co do 19,100 Newmont Mining $4.50 Preferred do 13 Plessy Co., Ltd do 97,914 Louisiana Land & Exploration Co warrants 21,780 7. Do you make the list of the securities owned available to your customers f Answer. No. However, where we deal directly with our customers and sell (buy) or (from) them, we inform them that we are acting for our own account; and if such is the case, that we make a market in the securities. 8. If so, do you sell the list to them? Answer. No. 9. Does yourfirmgenerally vote proxies on securities held with management of the corporation? Answer. For- securities beneficially owned by us, we generally vote our proxies for management. For securities owned by our customers, we follow their instructions. Where customers fail to give us voting instructions, we would vote the proxies for management on routine questions, but where there is a proxy fight •or a question of importance, such as a merger, we abstain from voting in the absence of customer instructions. 10. How important is routine proxy voting and what are the questions you vote upon? Answer. Routine proxy voting is important in order for a company to obtain •enough votes to have a quorum present at a meeting. Two matters which are usually voted on are the appointment of auditors and the election of directors. 11. Have you ever known of a proxy contest to be won with 5 percent of the vote? 10 percent? 25 percent? 50 percent? Answer. We are not knowledgeable in this area. 12. Do you advise your custotners or the general public on what your voting rights are and how you voted on each of the securities held in your firm's portfolio? Answer. No. Mr. "VVIDNALL. The reason I have asked these questions is to get your reaction as an institutional investor to complying with the same requirements you are asking to be imposed on bank trust departments. "Thank you. Now, a question for your corporation. This I would like to have answered now. There are approximately 3,500 bank trust departments holding up to thousands of securities in their individual trust departments. If this average only amounted to 1,000 items—and I would guess that would 697 be on the low side—that would be Sy2 million items to be correlated in arriving at your list of bank trust department holdings. Most of the information of course will be completely meaningless, and without significance, except for somebody who might be compiling an investor tout list. It would be equally useless to eager beaver investors probing the evils of real or imagined monopolistic control of American business. If we are to impose a disclosure requirement on bank trust departments holdings, what would you think of placing reasonable limitations on the disclosure requirements, for instance, confine the limit to the 50 largest dollar value holdings of stock for which there is a readily available public market ? Dr. OBERG. I certainly agree that there would have to be some limitations placed on the extent of the collection. Practical considerations have to be taken into account. The basic thought I have is the problem of the lack of periodic available data in this particular area which permit analysis from an economic and investment point of view, where those securities are, who holds them, what are the habit patterns with them, and the like. It is not practical in my opinion to get the parameters of every one of these departments on any practical basis. Mr. WIDNALL. Then how would you narrow it down ? Dr. OBERG. I would like to study the question of just how far it should be narrowed down and make a suggestion, if I may ? Mr. WIDNALL. Mr. Chairman, can we have unanimous consent that he submit an answer to that ? The CHAIRMAN. It will be satisfactory that you submit an answer for the record on the question that has been asked. Dr. OBERG. I will be pleased to do so. Mr. WIDNALL. My time is up. (In response to Mr. Widnall's request the following information was received from Dr. Oberg for inclusion in the record:) R E P L Y R E C E I V E D FROM D R . OBERG At the Hearing, Congressman Widnall asked me to comment on practical considerations in the collection of periodic data from bank trust departments. In my opinion both the securities to be covered and the number of units supplying information would have to be limited. The staff report on Commercial Banks and Their Trust Activities of July S, 1968 of your Subcommittee on Domestic Finance indicates $161.7 billion, or 64.4 percent of trust assets invested in stocks as of April 1,1968. Coverage of this area would be significant and could largely be accomplished by collection of holdings of issues traded nationally on exchanges and in the over-the-counter market. In like manner, a substantial portion of those stocks would be found in trust assets of a relatively small number of trust departments. As the number of trust departments covered increases, the larger would be the percentage of stocks covered (Volume 11, Table 8 ) : Trust Departments First First First First First 50-. 100. 150. 200. 250. 60-299—71—pt. 2 17 Percent 72.3 82.0 86.7 89.5 91.5 Trust First First First First First 300. 350. 400. 450. 500. Departments Percent 93.0 94.0 94.8 95.4 95.9 698 The CHAIRMAN. Mrs. Sullivan. Mrs. SULLIVAN. Thank you, Mr. Chairman. I would like to question Mr. Swift. In commenting, Mr. Swift, on section 10 of H.R. 5700 prohibiting mutual savings banks from owning stocks in other financial institutions, you say State statutory limitations on savings bank ownership of commercial bank stock are already sufficient to prohibit any possibility of a savings bank controlling the commercial bank. Could you tell the committee in general exactly what these limitations are, Mr. SwiFr. Yes; Mrs. Sullivan. They do vary. In other words, they, go from the States that prohibit ownership of commercial bank stock outright to those which impose limits. And then variations that have grown up over the years. And again because Mr. Clark is very closely associated with this problem, can I have him speak to the question? Mrs. SULLIVAN. Yes; for a moment. Mr. CLARK. Thank you, Mr. Swift. First, I would wish to ask to be stricken from the record, with your permission, Mr. Swift, the words "any possibility." I think those two words are perhaps a little unrealistic. The limitations basically for the States which do permit the investment in bank stock are that in Connecticut no savings bank can purchase more than 10 percent of the stock of any one issuer, in Massachusetts 15 percent, Maine 10 percent, New Hampshire 25 percent, New Jersey 2 percent, and Pennsylvania 5 percent. In the State with which I am most closely associated, Massachusetts, did not at one time permit a savings bank to invest in anything else but bank stock, and did not permit until 1950, the investment by a savings bank in any bank stock that was not located in either Massachusetts or New England. The principal question of the State legislatures was the prudence of the investment by the savings banks. The legislature also provided limitations as to having too much of an investment in any one bank. There are also limitations on the total amount of bank stock and other stock which may be held. And more recently, there have been limitations which relate to the duration of dividend payments and continuity, and indeed in the latest legislation which permits the nationwide investment in bank stocks, limitations on the minimum size of the bank invested in. Mrs. SULLIVAN. I want to ask you some followup questions, and you may want to enlarge upon your answers later. Isn't it possible for a holder of less than a majority of the shares of stock in a commercial bank to substantially influence that bank's activities? Mr. CLARK. I should think it would be possible to do so. But in my experience savings bank holders of bank stock have not done so. Mrs. SULLIVAN. Either you or Mr. Swift, how can you reconcile your statement with the facts set forth in our 1967 study? I have it before me. You mention that Massachusetts must be less than—what did you say, what percentage? Mr. CLARK. Fifteen percent. Mrs. SULLIVAN. We have Worcester North Savings Institution, shares of which are held by the Safety Fund National Bank at Fitch- 609 burg, Mass., owning 51 percent of the shares of the mutual savings bank. Then we have three of them that are over 20 percent, and three just reaching 15 percent, and others 16 percent and over in Massachusetts. Mr. CLARK. I have no specific knowledge of the cases you state. I would speculate that perhaps in those cases, which were unknown to me until you mentioned them, they may have been acquired prior to the occurrence of applicable limitations in the very early days of the savings bank history. Mr. HANNA. Would the lady yield for a clarification on what the gentleman is speaking about? Mrs. SULLIVAN. Y e s . Mr. HANNA. There would be a limitation in terms of the amount of stock in any one given bank, a differential between that requirement and the requirement of a total bank stock acquisition. Of which are you speaking? Mr. CLARK. The ownership by a savings bank of stock in one commercial bank. Mr. HANNA. In one commercial bank, and this does not refer to a limitation of any one savings bank's total amount of bank stock, right? Mr. CLARK. NO, sir; that is a different limitation. Mr. HANNA. Thank you. Mrs. SULLIVAN. Couldn't it be that these banks, that I have mentioned here, have been grandfathered in under the law ? Mr. CLARK. That is a distinct possibility. I am speculating that that is the case. Mrs. SULLIVAN. My time lias expired. But I would like to refer you to the committee report of July 31, 1967. I do not have the report number. It is "Control of Commercial Banks and Interlocks Among Financial Institutions." You can get it here from the committee. On page 24, if you look at that, you can probably enlarge on your information to me. Mr. CLARK. Counsel has made a note of the reference, and I would hope to look into it. If I can give you further information I would be delighted to do so. Mrs. SULLIVAN. Thank you. That is all, Mr. Chairman. (In response to the information requested by Mrs. Sullivan, the following letter was received from Mr. Clark:) ARLINGTON F I V E GENTS SAVINGS B A N K , INC., 626 Massachusetts Avenue, Arlington, Mass., May 5,1971. REPRESENTATIVE LEONOR K . SULLIVAN, House of Representatives, Washington, D.G. D E A R REPRESENTATIVE SULLIVAN : During questioning of me as a witness before the Committee on Banking and Currency concerning H.R. 5700 on Friday, April 30, you inquired concerning ownership of 51% of the outstanding shares of stock of Safety Fund National Bank by Worcester North Savings Institution, and the ownership of 21% of the shares of that Bank by Fitchburg Savings Bank, all three Banks having principal offices in Fitchburg, Massachusetts. This has particular relevance in view of the Massachusetts Statute which provides that a Savings Bank may not acquire more than 15% of the shares of any one Commercial Bank. I did not at the time have adequate specific information to respond thoughtfully to your question and requested an opportunity promptly to inquire and 700 answer. You helpfully referred me to Page 24 of the Staff Report for the Subcommittee on Domestic Finance of the Committee on Banking and Currency filed July 31, 1967 entitled "Control of Commercial Banks and Interlocks Among Financial Institutions." The answer to your question is that the Staff Report to which you referred is incorrect with regard to ownership of shares of Safety Fund National Bank by the two local Mutual Savings Banks. Using as a starting date, December 31, 1965, neither of the Savings Banks owned more than 5.1% of the shares and together they owned no more than 7.2%. Further the percentage ownership has declined since that time. In inaccuracy of the Staff Report is quite understandable in the light of the following facts developed by Mr. Albert Conrad, Executive Vice President of Mutual Savings Central Fund, Inc., of which I am President. His sources include the President of First Safety Fund National Bank, communications with the two Savings Banks involved, and others. I am satisfied that the information is correct. On December 31, 1965 there were outstanding 10,000 shares of Safety Fund National Bank of which 510 shares or 5.1% were owned by Worcester North Savings Institution, and 210 shares or 2.1% owned by Fitchburg Savings Bank. On March 9, 1966 Safety Fund effected a five for one stock split plus a 100% stock dividend with the result that 100,000 shares were then outstanding. Without further investment Worcester North was the owner of 5100 shares, the same 5.1% and Fitchburg was the owner accordingly of 2100, the same 2.1%. On December 16, 1966 Worcester North sold 2600 shares and continued to hold 2500 shares or 2.5% of the total. On November 1,1968 the total number of shares of Safety Fund National Bank was increased from 100,000 to 131,500 shares. The additional 31,500 shares were issued to acquire the First National Bank of Gardner, Massachusetts and were distributed to the shareholders of that Bank in exchange for all of their shares. Neither Fitchburg Mutual Savings Bank received any shares in that transaction. As part of this acquisition the name was changed from Safety Fund National Bank to First Safety Fund National Bank. In consequence of this transaction the 2500 shares of First Safety Fund National Bank then and now held by Worcester North Savings Institution amounted to 1.90% of Safety Fund shares and the 2100 shares held by Fitchburg Savings Bank amounted to 1.59% of total shares of Safety Fund. It is important that you raised this question so that a Committee Report indicating absolute control by a Mutual Savings Bank of a local Commercial Bank be rebutted when such is not the case. I submit that the facts suggest in this case very small stock ownership in proportion to the whole and a declining portion at that. I request that this letter be entered in the record of this hearing proximate to your question and my reply. In view of the interest expressed by Representative Heckler at the hearing I am sending her a copy of this letter and of course also a copy to Chairman Patman. Very truly yours, EDWARD P . CLARK. The CHAIRMAN. Mrs. Dwyer. Mrs. DWYER. Thank you,Mr. Chairman. This question is directed at Professor Hinrichs. Do you have any idea of what prompted this proposed prohibition against premiums ? Dr. HINRICHS. I really do not know. I would suspect from hearsay evidence that there might have been maybe some groups or banks in the banking community that may be afraid of excessive competition. And second, since the cost is borne by the banks and not by the customers of the banks, if there are any losers—and I do not think there are, because the banks generally favor this as a marketing device—if there are any losers, there may be some banks which are in a semimonopolistic position which might have to bear the cost of this program, because essentially, given a ceiling on interest rates, they are the ones that would bear the cost, and not the saver. Because it really 701 means an increase in the marginal rates of interest to the small saver. If a person, for example, gets a $5 gift for opening a $100 savings account, this is wholesale value, and it really represented merchandise equalling maybe $10 or even more. Now, this means that under certain assumptions the customer really puts in $90 instead of a hundred dollars, and then a year later he gets back $105. This really means a marginal inducement of 15 percent rather than the fixed rate of 5 percent on average savings. It is something like an apartment landlord who might give the first month's rent in an apartment building free in order to get a tenant. Mrs. DWYER. Another question. Do you know of any instance where this practice has jeopardized the soundness of a financial institution? Dr. HINRIOHS. Since, as I mentioned, it only accounts for between 1 to 3 percent of the bank advertising budget, and since it only accounts for .03 of 1 percent of the operating income of banks, I think any bank operating that close on the margin that could be destroyed by a fraction of 1 percent of operating income probably would have failed for some other reason. But this is very small potatoes. It is really a case of economic freedom under the American system of economics. Do we take piggybanks away from children? It is essentially a case of economic freedom and flexibility. And with the Fed putting on a ceiling by regulation Q, that, if anything, is the culprit in the whole thing. Diversity and freedom—the customers like it. jPeople are really human. They respond to a dish or a billfold more than being told, your interest has gone up from 4.6 to 4.7. Wives want the dishes, they do not want the 0.1 percent. It is psychological. Mrs. D W Y E R . This question may be repetitious, but I am going to ask it anyway. Have you ever incurred any premium program which resulted in adverse effect on competing institutions sufficient to have anv adverse economic effects? Dr. HINRICHS. I think, as Chairman Patman so well pointed out last year, that you did have in 1970 some excesses which once more were, I think, the result of the Federal monetary policies rather than the result of the industry, which has been around for 25 years. So that in the New York episode I think you did go to extremes. The group I represent is concerned that we do not have such excesses which is why the industry by and large approves of some limit to keep this as a promotional device, rather than giving away Cadillacs if you tie up your money for 25 years, rather than exploding the program into something which would result in socially wasteful expenditures. So I think the New York case was an extreme example. But I think this is a nonrepeatable case, because right now the premium industry is in a serious recession, because with falling interest rates—now the true market rate has fallen down approximately the regulation Q ceiling, so that the industry now is in serious trouble, and if we prohibit premiums, you would seriously affect at least half of the firms which rely upon this business as their major activity. Mrs. D W Y E R . One more question. Do you think the awarding of premiums in addition to interest stimulates that increase in savings? Dr. HINRTCITS. Once more, in terms of theory, no economist would deny that if you increase a reward for activity, there will be some increase in that activity. In other words, the savings function is not 702 totally interest inelastic—there is some marginal increase. Obviously there are more important factors such as macroeconomic policies, fiscal policies, monetary policies, the state of national accounts, and many variables. But in a macroeconomic sense there is some slight increase. Secondly, there is an increase in the form of savings whereby funds will tend to go into savings banks offering these programs. This money would therefore have a greater tendency to go into housing, which would be better than, let us say. Other competingfinancialinstitutions which can offer higher premiums in the form of money for savings, and therefore money would be channeled into other activities than housing. So the form of savings is changed as well as the total amount. In certain microeconomic cases ABA studies showed that in several small towns certain banks were able to increase their savings deposits substantially, even though there were no other variables that would have explained why the banks should have grown that rapidly. These were praised by the small town bankers themselves, and they primarily said, their growth was in response to a premium program. Mrs. DWYER. My time is up. But I am g;oing to ask you a quickie. How many mutual savings banks are there in the country ? Did I hear testimony that there were just 19 States ? Mr. SWIFT. Eighteen States, and it is a total of approximately 5 0 0 savings banks. Mrs. DWYER. Have you increased in the States, or are you just standing still ? Mr. RIORDAN. I would say standing still in terms of the number of banks. Mrs. DWYER. My time is over. The CHAIRMAN. Mr. Keuss. Mr. REUSS. Dr. Oberg, I was interested in your testimony. ^ Am I right in thinking that the reason for your service in connection with the investment performance of investment companies, where you do have accurate portfolio information, is so that a prospective purchaser of an investment company may have a standard of comparison as to how this company performs compared with other investment companies? That is the reason for the Arthur Lipper Corporation's services? Dr. OBERG. That is a basic purpose, to have an ability to evaluate one investment company as against the other in qualitative factors, the S and P rating of securities, for example. But also, with the periodic availability of this information on a quarterly basis, we can compare one investment company with itself over time, and they do have a tendency to change over that time period. Mr. REUSS. YOU approve the section of the bill before us which would require the reporting of equity holding by bank trust departments? I have a question to ask you on that. Bank trust departments have different sorts of portfolio holdings. Some of the poor fellows have been received under a will, and the equity investment may be a absolute dud, but for one reason or another, the trust department may for a time at least be compelled to carry it. It would not seem to me fair, therefore, to rate banks on their total across-the-board trust department performance, nor do I gather that you would want to do that. 703 How can you sort out, however, that portion of a bank trust department's activities, such as management of pension funds, and so on, or common trust funds which are really competitive, and where it would be a good idea for the public to be able to read some service like yours so it can figure out whether to keep its funds in the trust department of bank A or the trust department of bank B ? Can you give me some help on that ? Dr. OBERG. Sir, I was thinking in terms of economic and investment analysis. And the interesting thing as you view an institutional group over time, comparing period against period, is to characterize the various institutional forces which are interested in the equity field. And they are interesting in different ways. For example, I understand that the institutional investor study— at least in conversations about it—has noted that there are certain greater concentration factors among banks than against other institutional investors such as investment companies. It is beginning with these qualitative factors, and the quantitative use of various securities, and particular securities, that I think has economic and investment value. I am not addressing myself to the performance area here. Mr. REUSS. D O you think the public interest in being able to make a comparison would be adequately served only by a total disclosure of bank trust company portfolios, or could it be served by disclosure of something less than that? By which I mean, could you sort out two piles of trust company activities, one deserving of full public disclosure, and the other in which public disclosure (foes not really serve any particularly useful purpose? Dr. OBERG. I am not familiar enough to evaluate the bank trust department activities. Mr. REUSS. What I am thinking of is the example I have put before. I do not see whether it does your service any particular good to know that X bank has a trust under a will under which it is trustee continues to hold stocks in certain closed or family business corporations which it got under the will. It does not seem to me that you can compare that branch of the business with any other bank. Indeed, the will may require them to hold that stock, good, bad or indifferent. While I am interested in the full disclosure, I do not want to impose burdens on banks or anybody else that does not serve any public purpose. Would it serve any purpose for your institutions to know about those holdings under wills and trust companies ? Dr. OBERG. A S to specifically wills and the like, the form in which the securities are held could in general be of interest. ^ I might refer to what our experience has been in the investment company with the availability of such data. A number of services have developed in the investment company area in which they report on the 50 largest holdings by the industry as a whole, for example, or give an alphabetical sort of all securities held by the investment company industry. Now, these serve as bases for learning where the supply is. Mr. REUSS. Are you talking about investment companies? Dr. OBERG. I am talking about investment companies, yes. Mr. REUSS. But they do not get into the business of holding duds the way bank trust companies' portfolios do. I think it would be 704 great for your service to be able to tell unions, for example, which are shopping around looking for a trustee for their pension funds, which bank does the better job. You now cannot tell them that, is that not so ? Dr. OBERG. We cannot. Mr. REUSS. I certainly want to put you in a position where you and your competitor can do that. But at this stage of the game I cannot see any reason for a total disclosure of bank portofolios. That is why I keep asking you, are there not two piles or categories of what bank trust companies do, one that ought to be publicly disclosed and the other which really need not be ? Dr. OBERG. I wish I could clarify that, but I cannot. I am really not that familiar with the breakdown of the bank trust function operations. I am thinking more of institutional investment securities. Mr. REUSS. Thank you, Doctor. (The following letter was received from Arthur Lipper, III, president, Arthur Lipper Corp., in response to the questions above of Mr. Reuss:) ARTHUR LIPPER CORP., Reference: Hearings on H.R. 5700. May 17, 1971. H o n . HENRY S. REUSS U.S. House of Representatives, Washington, D.C. DEAR M R . R E U S S : During the testimony of Dr. Harold S . Oberg of our firm before your committee on April 30, 1971, you asked several questions to which an additional comment by me, as Chief Executive Officer of Arthur Lipper Corporation, may be helpful. I agree with you in that if Congress requires some type of disclosure of Bank Trusth Department holdings, practical limitations as to what must be reported should also be included in the bill or in the legislative history. Since any data disclosed could be used either by a firm such as our own or, for that matter, by the banks themselves to demonstrate the relative investment performance of one Trust Department versus anoher, it is my view that disclosure should be required in those cases where the bank has full management responsibility and authority. No real purpose would be served in studying trust accounts which include holdings of non-public companies or holdings which are not freely marketable at the bank's sole discretion. We appreciate the opportunity to present our views on this matter of public interest. Sincerely, ARTHUR LIPPER III, President. The CHAIRMAN. Mr. Brown. Mr. BROWN. Thank you, Mr. Chairman. Mr. Swift, in your statement and in your testimony you have indicated that there are certain exemptions, in the provisions regarding interlocks, for bank holding companies. You also mentioned the Rhode Island statute specifically authorizes mutual savings banks to have a subsidiary commercial bank. Enactment of H.R. 5700 would therefore tend to push many financial institutions into the holding company route, would it not? I think you can speak more objectively, possibly, from a savings bank standpoint than can commercial banks, because you are not quite so intimately affected. Mr. SWIFT. I think that would probably be true, since there is the 705 exemption to all bank holding companies. But you have got the same regulation and control on the other side of the holding company itself. So I am not certain that that effect would necessarily follow or be stimulated. Mr. BROWN. But there is regulation under the holding company law, 1!r''' nc1 ouldn't you agree ? Mr. BROWN. In these areas ? M r . SWIFT. Y e s , sir. Mr. BROWN. SO that under the holding company route there would be no necessity to divest many of these relationships, rather they would be regulated? Mr. SWIFT. That is correct. Mr. BROWN. In your statement you also have singled out many areas and pointed out that if they were to be enacted they should be amended. Would you mind briefly reviewing for me what you feel are those provisions as written in H.R. 5700 that are necessary and desirable ? Mr. SWIFT. That are desirable to be enacted ? Mr. BROWN. Necessary and desirable. Mr. SWIFT. A S I stated to Mr. Widnall, we do have a sincere feeling of a high standard of trusteeship in savings banking generally that has not only arisen out of tradition, I think, but has also been reenforced by State laws in all the States where savings banks operate which limit and restrict self-dealing and conflicts of interest that could be adverse to a bank. So there is nothing in the act that I think seriously covers a problem that we would recognize, and that therefore is deemed to be needed or necessary. Mr. BROWN. Could I rephrase your answer and say that there is nothing in the act that covers a serious problem. Mr. SWIFT. Insofar as it relates to our industry, I think I would agree with that. Mr. BROWN. I have no further questions, Mr. Chairman. The CHAIRMAN. Mr. Hanna. Mr. H A N N A . Mr. Gettys was here when I came in, and I think under the rules The CHAIRMAN. I called on you, Mr. Hanna. Mr. HANNA. I just want to ask one question, and you may comment on it afterward. I am interested in not only how to correct the institutions of banking, but how to use them. It occurs to me that one of the great problems this country has in in capital collection for the many jobs that need to be done. We do not have effective saving impetus any more in the land. Has anybody covered the possibility of what would happen if we made deposits in savings, for, say, a 5-year period, tax free until the savings were drawn out, and if kept in a 5-year account, they would then be taxable on a capital gains basis rather than on a straight income basis? It seems to me that what we need to have is some innovative thinking about how to get the problem of America straightened out. The Japanese are saving at an overall rate of about 40 percent, and the Swedes at about 28. When you consider all the forms of savings in 706 the United States, it comes up to about 17 percent. It would seem to me that if we could in any way, in talking about bank reform, suggest some ways in which we can create and batter utilize savings, it would be desirable. I am not against correcting things that are wrong, but I think we need to think affirmatively, ana if you have any suggestions as to what we ought to be thinking about in this line, I would certainly be pleased to hear from you. Mr. SWIFT. Mr. Hanna, that is a very broad question. We have been before the Congress before with proposals that we felt would assist in accomplishing this purpose. We were here a number of yours ago urging Federal chartering of savings banks, because independent studies show that the more institutions that are in a market competing with each other for savings, the higher is the rate of savings. Now, this is one approach that we felt would be of assistance in this regard. On your specific suggestion of a tax incentive, I suppose a tax incentive would always be of some assistance and help. Mr. H A N N A . I just think that the old-fashioned approaches for thrift have run out of gas, and that you have got to have some new incentives for thrift. I think any thoughtful person looking at our situation would have to agree that if we are going to get dynamics back into our society we have to have a greater degree of accumulation of capital in order to apply it to the jobs that we want to get done. I just feel that this is rather a central problem. I would hope that if any of you have any ideas you will put them in the record following this question. Mr. RIORDAN. My name is James Kiordan. I am counsel for the savings bank industry. The savings bank industry sought to offer income tax deferred savings accounts, but the IRS under recently proposed regulations has made that impossible. Mr. H A N N A . That is why I think the Congress should act, because I think they are being myopic. I think that you are not going to generate tax income unless you generate economic activity. You cannot have economic activity without capital application. I am not very smart, but that seems fairly elementary to me. Thank you very much. The CHAIRMAN. YOU could add to your laundry list, no debt, no money. Mrs. Heckler. Mrs. HECKLER. Thank you, Mr. Chairman. I would like to address my questions to Mr. Clark, a distinguished savings bank manager from Massachusetts, whom I welcome, as well as the other members of the panel. In Mr. Swifts' statement he states on page 2: "The organizers of mutual savings banks regarded their position"— and the law so treated them—"as analogous to trustees of a public trust." So obviously they are bound by the doctrine of the prudent investor. And I wondered from your experience, Mr. Clark, the experience you have had in recent years, particularly with the stock market plunge, with your bank stock investments, how has your stock account compared to your bond account in terms of market volatility ? 707 Mr. CLARK. In dealing with the bank stock as compared to some other stocks that are owned—last summer, for example, the bank stocks showed much less volatility on the down side than the other stocks. And the bond market at that time was so horrible it hardly deserved comment. Certainly bank stocks were less volatile than bonds. Historically savings banks have found that bank stocks are valuable media for investing depositors' money in limited amounts, because they appear to have characteristics of reduced volatility, greater price stability, accompanied by, over time growth in earnings and growth in value, which make them particularly adaptable to investing savings depositors' funds. Most investors in the stock market, I think, consider bank stocks as rather pedestrian vehicles. But we have found them to be quite otherwise. Mrs. HECKLER. Why is it, in view of the fact that savings banks can invest in all types of common stock, that you are atracted to an investment in commercial banks? Mr. CLARK. Partly, I suppose, because a savings banker feels more comfortable in his ability to appraise the present situation and future situation of a bank than perhaps some industrial concern. It also arises because historically, until 1950, approximately, we were never allowed to buy any stocks except Massachusetts bank stocks. At that time the savings banks felt the need of greater authority, and were able to persuade the legislature that it would indeed be prudent to invest in the stocks of banks all over the country, with certain historical income and dividends patterns, and indeed with limitations on the size of the bank, leaning toward the investment only in the larger banks of the country. Mrs. HECKLER. Could you tell me, Mr. Clark, what your experience has been, in terms of the effect on competition due to the fact that savings banks do invest in commercial banks and insurance stock, what has been the competitive effect ? Mr. CLARK. It has had no negative competitive effect. I have observed absolutely none. The competition between commercial banks and savings banks in Massachusetts with which I am most familiar, but also New Hampshire, Connecticut and the other New England States, and New York, has been in recent years intense, and it has been getting fiercer. I might cite three things directly of my own knowledge. Mr. Swift referred to our effort this year to increase competition by obtaining the power to operate personal checking accounts for individuals. Over the years we have successively, in Massachusetts, obtained the power to make personal loans, unsecured, for consumer purchases in relatively small amounts. In the recent controversy in Massachusetts about the control of interest rates we pay our depositors, again we had an actue controversy. On the other side of each one of those controversies, as powerfully as they could summon the strength, were the commercial banks of the State. And with the factual information in my experience about economic competition, and the ability of the commercial banks to oppose savings banks in all areas that they considered might increase the com- 708 petitive climate, we have been deeply opposed. So that I cannot see any evidence at all of any reduction in competition from what it might have been without any ownership of commercial bank stocks. Mrs. HECKLER. Could you for this committee tell us what supervisory agency would oversee the requirement of 15-percent limitation of ownership of commercial banks by savings banks ? Mr. CLARK. The State banking department in connection with their annual examinations. Mrs. HECKLER. SO therefore the question that Mrs. Sullivan asked earlier related to the holdings of 51 percent by a Worcester bank would have been studied and evaluated on the basis of the usual State audit, and therefore must have come under a grandfather clause. Is that your conclusion ? Mr. CLARK. I would conclude that whatever ownership they had was entirely proper, the banking department, which I must say in Massachusetts I consider one of the better banking departments of the country, would have moved on it quite appropriately had there been some irregularity. Mrs. HECKLER. My time has expired, but I just wanted to fit in one quickie. Is this 15 percent strictly observed ? Mrs. CLARK. Yes, indeed. Mrs. HECKLER. Thank you, Mr. Chairman. The CHAIRMAN. Mr. Gettys. Mr. GETTYS. Mr. Swift, Mr. Clark and Mr. Riordan, this is a well prepared statement. I have not studied it very closely, but the impression I get is that these proposed reforms are wonderful, and should become law, if it includes all the financial institutions except mutual savings banks, is that correct ? It is a good bill if it includes everybody except mutual savings banks, but it is a poor bill if it is going to include your industry ? Is my impression right? Mr. SWIFT. I was not attempting to say it was a poor bill, no. This is what I guess made my answers a little longer than perhaps they needed to be, but I do not think we feel it is a poor bill. We do feel Mr. GETTYS. But I notice all the amendments that you suggest— maybe if the bill is going to be passed it is a good billV but all these amendments that you suggest would eliminate the application of the reforms to the mutual savings bank. Mr. SWIFT (continuing). I do not think we feel that that is so. Mr. GETTYS. Then you would be willing to pass the bill without the exemptions? Mr. SWIFT. Oh, no; the general concept, for example, relating to interlocking directorates, and relating to stock ownership and giveaways Mr. GETTYS. D O you think it is a good thing that mutual savings banks are not included ? Mr. RIORDAN. If I may, we framed our amendments in our testimony on the basis of changes that we thought were appropriate for mutual savings banks. We did not attempt to include commercial banks or savings and loan associations or other financial institutions in our amendments, thinking that they probably should bear their own burdens, and know more about their own problems than we do. So we 709 sought to address ourselves only to the bill as it affected mutual savings banks, and as such perhaps our amendments are too narrowly circumscribed. Mr. GETTYS. But I do get my point across, don't I ? Mr. RIORDAN. Yes, I would say you did. Mr. GETTYS. Dr. Hinrichs, in brief, you say that the premiums are all right, and it is really a good social issue as well as afinancialissue provided that they are reasonably restricted ? Mr. HINRICHS. Tht is quite true. Mr. GETTYS. Mr. Bryan, no one has questioned you. Your statement intrigues me. But I know time does not permit a discussion of it. But as I understand your statement, you would do away with the whole 11,1 1 start over fresh ? th? Lat other time left I have, Mr. Chairman, I would turn over to Mr. Bryan to discuss his proposal. The CHAIRMAN. He filed his statement and made a statement. Mr. GETTYS. I saw it, and if I have 30 seconds or 25, with that great timekeeper we have got—he is a short counter—then I wouldThe CHAIRMAN. YOU have 2 minutes. Mr. GETTYS. Mr. Bryan, would you discuss your proposal. It intrigues me. Mr. B R Y A N . In what way, Congressman ? Mr. GETTYS. YOU would do away with the whole Federal Reserve System? Mr. B R Y A N . N O ; I think it would have to be rechartered. You have to have some kind of a system. Mr. GETTYS. You would have a central bank ? Mr. B R Y A N . I believe the central bank with a director from Congress should create all the money instead of the bank creating the money. Mr. GETTYS. I believe you have a sympathetic person in our Chairman. Mr. Chairman, aren't you and Mr. Bryan in some ways-— The CHAIRMAN. I have known Mr. Bryan for a long time. He is a very sound businessman and banker. Mr. GETTYS. I am sure of that. But I just wish that we had time to go deeply into your suggestions. They really are intriguing. The CHAIRMAN. I do not know of any person who has studied the Banking Act more than Mr. Bryan. I think he has come nearer answering the question than any man I know. Mr. GETTYS. That is why I would like at some time to have a great opportunity to question him. Thank you, sir. The CHAIRMAN. Mr. Rousselot Mr. ROUSSELOT. Thank you, Mr. Chairman. Gentlemen, we appreciate your being here and discussing in some detail this bill. It certainly has created a lot of discussion, and we appreciate your adding your comments about it. Dr. Oberg, I noticed in your statement that you refer to equity holdings. And you seem to be quite interested in the disclosure requirement. I can understand, being in the business that you are in, why you would 710 like lots of disclosure, maybe even at Government expense. But section 12 applies to— and let me quote—"all securities other than Government securities." Because Government securities are capitalized, that means it would be only applicable, as I understand the laws as we write them here, to U.S. securities. So this perhaps, as it is now written, and if it would remain this way, would include individual home mortgage notes and debt obligations as well as many, many other types and forms of securities. Don't you think that such broad coverage would be—and I know you have already partially commented on this—unneded and really undesirable even from your standpoint? You are familiar with section 12,1 assume you have read it ? Dr. OBERG. Yes, as you have described it, indicating that it goes beyond the equity field. The equity investment is our basic interest, it is the area in which there appears to be more excitment, more change. The limitation of the collection, I think, has to have practical limits. I do not think myself qualified— Mr. ROUSSELOT. Would you submit for the record what you think those practical limitations would be? Because this is very all-inclusive as it is presently written, and we are still trying to find out who wrote it. Dr. OBERG. I say I do not feel qualified to evaluate in specifics other type securities in the application of analysis, in that particular area. My specialty happens to be in the equity area. Mr. ROUSSELOT. You were testifying on that section, I thought maybe you would have some suggestions. (The following letter was received from Arthur Lipper, III, president, Arthur Lipper Corp., in response to the question above of Mr. Housselot:) A R T H U R LIPPER CORP., Reference: H.R. 5700. H o n . J O H N H . ROUSSELOT, May 17,1971. U.S. House of Representativesr Washington, D.C. D E A R M R . R O U S S E L O T : During the testimony of Dr. Harold S . Oberg of our firm before your committee on April 30, 1971, you asked several questions to which an additional comment by me, as Chief Executive Officer of Arthur Lipper •Corporation, may be helpful. With regard to your question concerning practical limitations which should be Imposed if Congress requires disclosure of Bank Trust Department assets, I agree with you that no, purpose is served by including debt and home mortgage obligation investments in a study of relative investment performance. I do believe, however, that there should be some mechanism established for monitoring Trust Department debt portfolios as to net yields, loss ratios, and maturity schedules. Any data disclosed could be used either by a firm usch as our own or, for that matter, by the banks themselves to demonstrate the relative investment performance of one Trust Department versus another. It is my view, therefore, that disclosure should be required in those cases where holdings are freely marketable at the bank's sole discretion. From the standpoint of measuring investment performance, it would not be equitable to include in such a study portfolios which contain holdings of nonpublic companies or mandated positions. Our firm appreciates the opportunity to present our views on this matter of public interest. Sincerely, A R T H U R L I P P E R , I I I , President. 711 Mr. ROUSSELOT. Mr. Swift, as I am sure you are aware, the provisions in this bill regarding the prohibition of certain type of people belonging to boards is rather broad. Would you be willing to submit for the record what the effect would be on your mutual associations if these provisions were passed and became law? In other words, how many people would you have to terminate, and so fast? Could you do that? Mr. SWIFT. Specific information with regard to our industry—we can certainly provide the kind of information that would approximate, I think, the answer to that. Mr. ROUSSELOT. And on the basis of that survey, some brief comment as to what the effect might be on the general management of the associations as a result of having to terminate that kind of talent. I think it might be helpful to us. ™ 1 ' ances, I think it could have an ex™ ^ Mr. SWIFT. In terms of the requirement of probably substantial numbers of resignations from our boards, and then of course the throes of replacement, and so on. Mr. ROUSSELOT. Because we are so concerned about unemployment here these days, we do not want too many people unemployed. If you could do that I think it would be helpful. Some of the other groups that have appeared have said that it would have some kind of a disruptive effect in some instances on the kind of management personnel they are trying to attract to their boards of directors. I think that it would be helpful if you would describe specifically what might cause substantial numbers of resignations. Mr. SWIFT. I might just add that in our particular case, in the largest number of instances it was savings bank trustees also serving as commercial bank directors. And these men, given the decision to choose between the two banks I am sure we would find in most instances that they would find a closer personal interest in the commercial bank directorship than they would in the sayings bank, either because of a business association or a connection with a corporation doing business with the commercial bank. So we do feel that perhaps we might suffer in this regard more than others would. Mr. ROUSSELOT. I thank the gentleman. (In response to the request of Mr. Rousselot, the following information was submitted by Mr. Swift:) NATIONAL ASSOCIATION OF M U T U A L SAVINGS BANKS OBSERVATIONS ON INTERLOCKING DIRECTORATES OP MUTUAL SAVINGS BANKS Approximately seven-tenths of the savings banks have trustees on their boards who are affiliated, generally as directors, with other types of financial institutions or financial businesses. These institutions and businesses include commercial banks, life insurance companies, other insurance companies, security brokerage and investment banking firms, savings and loan associations and mortgage companies. Interlocking relationships with commercial banks are more common than those 712 involving any other type of financial institution. In this regard, about threefifths of all savings banks have trustees who are connected with commercial banks. To measure the extent of interlocking relationships it is necessary to consider not only the number of savings banks having such relationships as above, but also the number of trustees involved. It appears that about one-sixth of the total number of savings bank trustees are connected with other financial institutions. This includes trustees affiliated with commercial banks, who represent approximately one-eighth of all savings bank trustees. It should be noted that these figures refer to both FDIC-insured and nonFDIC-insured mutual savings banks. Currently, 328 savings banks are FDICinsured, while the remaining 165 are not members of FDIC. Furthermore, the data on the number of trustees refer to individual members of savings bank boards, rather than to the number of interlocking relationships. Thus, an individual savings bank trustee who is affiliated with other financial institutions has been counted only once, regardless of whether that individual is connected with only one or with a larger number of other institutions. As a result, the figures presented above may differ somewhat from any tabulations based on a segment of the savings bank industry, such as FDIC-insured banks, or on the total number of interlocking relationships with other financial institutions. The proportion of a savings bank's trustees who are connected with other financial institutions varies widely among individual savings banks. Blanket prohibitions against interlocking relationships, therefore, would have varying effects on different savings banks. Aside from possible "grandfather" provisions permitting present interlocks to continue, such prohibitions would require few changes in some instances, but wholesale changes in the board membership of other individual savings banks. Trustees affected by such a prohibition would, in all probability, choose to terminate their connection with the savings bank. As noted earlier, interlocking relationships with commercial banks most frequently take the form of directorates. Thus, directors represent approximately four-fifths of the total number of commercial bank interlocks on savings bank boards; the remainder are salaried officers or trustees who are both officers and directors. Commercial bank directors on savings bank boards represent some seven-tenths of the total number of director-interlocks with all types of financial institutions. Legislation prohibiting commercial bank interlocks, but permitting affiliations with other institutions, would, therefore, eliminate the bulk of the interlocking relationships presently existing in the savings bank industry as a whole. Mr. Chairman, If I have any time left, Mr. Brown had an additional question. So I will yield to him. The C H A I R M A N . T W O minutes. Mr. BROWN. I thank the gentleman for yielding. Dr. OBERG. Following up on Mr. Rousselot's questions, the last sentence of section 12, of course, reads: "The Corporation"—meaning the FDIC—"shall make available for public inspection the contents of all this and all reportsfiledunder this subsection." I assume that I am correct in assuming that you would not be quite as enamored of this section if that sentence were either eliminated or if a "not" were inserted after "shall," in other words, "The Corporation shall not make available for public inspection ?" I am sorry, it is not clear to me—the FDIC, or a private corporation? Mr. BROWN. I say, section 12 provides for the disclosure, et cetera, but then the last sentence says the corporation, meaning the F D I C , shall make available for public inspection the contents of all lists, and 713 so on. I am saying that I did not think you would be quite as enthusiastic in your support of that section if that sentence were changed so that instead the FDIC would not make available for public inspection ? D r . OBERG. Y e s , s i r . Mr. BROWN. Just onefinalquestion, if I may. Where would you turn, Mr. Swift, to find the competency, experience, expertise, et cetera, for your directors, trustees, officers and employees, if practically everybody within your geographic area would have a conflict insofar as this legislation is concerned ? Mr. SWIFT. Well, this is one of our concerns, that it does coyer too many—this is why we would like it limited to at least competing depository type institutions, and not mortgage bankers and real estate men, realtors, securities dealers, and so on. When it does get extended out to that point, I guess we are down to college professors and doctors and dentists. It would be an extremely difficult job to get the kind of competence and the kind of talent that is experienced in money management and investment. This would be hard to find. Mr. BROWN. Onefinalquestion Mr. ROUSSELOT. I had one additional question. I think it will require a very simple answer. Are the mutual savings banks allowed to act as trustees? Mr. SWIFT. N O — I should modify that. In two States, New Jersey and the State of Washington. But they are modestly sized trusts, I believe, in experience. The C H A I R M A N . Your time has expired. Mr. Chappell. Mr. CHAPPELL. Mr. Swift, I just wanted to ask you a question with reference to your remarks on page 18, where you say that, speaking of participation loans: "Even though savings banks have little direct stake in participation loans, we urge that they not be prohibited. Such prohibition would be largely self-defeating, resulting in reduced lender willingness to make mortgage loans, including those on rental residential structures now in great demand, with consequent increases in interest rates to borrowers and in rental costs to apartment dwellers." Are you talking about actual equity participation, the ownership of stock kickers, and so forth ? Mr. SWIFT. T O my knowledge, our industry has not been involved to any significant degree in actual equity ownership or partial equity ownership. Such participation loans as have been made have usually involved a participation in income from the property. Mr. CHAPPELL. I see, then do I take it that you would not object if it was talking about actual stock ownership or this sort of thing as kickers for the making of a loan, that you would have no objection to that? Mr. S W I F T . In principle I think perhaps I would object, because I do not see any real distinction. As a matter of practice, it would not be material to our industry's operations today. Mr. CHAPPELL. Don't you think in any of the banking institutions it 60-299—71—pt. 2 18 714 is a dangerous proposition to get into this idea, particularly when a man really needs money pretty badly, to hit him up with a part of the ownership or an equity position in the business just for the purpose of making a loan ? Mr. SWIFT. Well, Mr. Chappell, on the other side of the coin, this has been in many respects the only way a businessman could get the money. In other words, this has provided the protection, if you will, or the hedges to the bank, particularly in recent years, during a period of rapidly increasing interest rates, when lenders were hesitant to make large housing—apartment house loans, and so on, unless they had some sort of protection over a long term, and this certainly goes to the term of the loan. Without that hedge, and without that protection against rising future interest rates, lenders might be reluctant to make the loan at all. It is not a matter of sharing the profits with any distasteful or greedy attitude at all, it is purely a matter of trying to protect against a possibly poor investment in a very stringent economic climate. Mr. CHAPPELL. Don't you think, though, that there ought to be some length as it relates specifically, we will say, to deposit institutions? Mr. SWIFT. NO, I really do not, Mr. Chappell. Mr. CHAPPELL. YOU would put these institutions in the same category with insurance companies, I assume, and other lenders? Mr. SWIFT. In this respect, yes. Mr. CHAPPELL. I am sorry I cannot share your view on that. Thank you very much. The CHAIRMAN. It is now time for me to ask some questions and I would like to do it. Dr. Hinrich, you have a very interesting table right after your page 11,1 believe. That is about premiums, net cost and usage among commercial banks. And of course that will be in the record. Will you also place in the record the statistics about the mutual savings banks by States and size and so forth. Would it be proper to ask you that? Are you familiar with it, or do you have the correct information ? Dr. HINRICHS. A S far as I know these are not available, but maybe some of the mutual savings bankers might be able to help us. I should mention as well that the gentlemen with me also have statements which I assume the chairman would like to be placed in the record. The CHAIRMAN. Identify them individually. Dr. HINRICHS. Mr. John F. Daly, Mr. Neil Kanney, and Mr. William M. Dalton have statements. I have brought with me the statement of Mr. Larry Edwards of the Lincoln Rochester Trust Co., Rochester, N. Y. The CHAIRMAN. It will be perfectly all right for them to insert their statements. (The statements referred to appear on pp. 723-731.) Dr. HINRICHS. A S far as I know these data are not available. The CHAIRMAN. I will ask Mr. Swift. Mr. SWIFT. I am not certain it is available. We may be able to obtain such information. The CHAIRMAN. It is in your publications, isn't it ? 715 Mr. SWIFT. I think as far as I know we do have available the total market cost, but whether it is broken down or not I do not know. (The following information was submitted for the record by Mr. Swift:) SAVINGS BANK ACTIVITY IN PREMIUM CAMPAIGNS IN 1970 Size of bank by deposits (millions of dollars) Total 1. Number of banks 2. Total deposits (billions of dollars) 3. Total advertising expenditures allocated for 1970 (thousands of dollars). 4. Premium advertising expenditures as percent of total advertising expenditures 5. Cost of premiums (thousands of dollars) 6. Percentage of banks conducting premium campaigns, 1st 9 months of 1970. Under $10 $10 to 24.9 $25 to 49.9 $50 to 99.9 $100 to 199.9 $200 to 499.9 $500 and over 353 27 74 82 77 34 36 23 48.5 .2 1.5 3.1 5.7 4.9 11.1 22.0 32,352 108 756 1,616 3,008 2,402 8,134 16,328 22 2 1 1 4 5 21 31 5,295 11 13 33 254 147 1,543 3,294 30 22 12 17 29 35 64 87 NOTES 1. Sample banks represent 72 percent of the total number of savings banks. 2. Total deposits of sample banks represent 68 percent of total savings bank industry deposits. 3. Refers to total advertising and promotional expenditures allocated For calendar 1970. Excludes salaries and contributions to State savings banks association advertising programs and to any formal group advertising programs. 4. Ratio of premium advertising expenditures to total advertising expenditures. 5. Cost of premiums used during the 1st 9 months of 1970. Excludes advertising expenses, salaries and other expenses associated with the campaign. 6. Based on the banks in the 353 bank sample which reported having conducted premium campaigns during the 1st 9 months of 1970. Source: National Association of Mutual Savings Banks. The CHAIRMAN. My impression is that two or three States have most of the mutual savings, don't they? How much does Massachusetts have? Mr. RIORDAN. Massachusetts, Connecticut and New York. The CHAIRMAN. Massachusetts, Connecticut and New York. Massachusetts has the most of them, I believe. Mr. RIORDAN. It has the most banks. The CHAIRMAN. And then New York and Connecticut. That would constitute a large percentage of the total number, wouldn't it? Mr. SWIFT. About 70 percent of assets, I believe. The CHAIRMAN. Seventy percent of the assets. Now, then, Mr. Swift, you mentioned about conversion of savings and loan and mutuals into stock companies. We had a bill a few years ago that affected your savings banks, didn't it, and it came within one vote of passing? Mr. SWIFT. That was our Federal chartering bill, which provided for mutual institutions. The CHAIRMAN. That is right. That came within one vote of passing here on the committee. Mr. SWIFT. That is correct. The CHAIRMAN. I do not think it has been brought up since. 716 I think a very distinguished gentleman by the name of Grover Ensley had a lot to do with that. Isn't he your Mr. SWIFT. He is the executive vice president of the association. The CHAIRMAN. He wanted to be here today, but he had to go to Geneva in connection with an important conference that he is chairman of. M r . SWIFT. Y e s , s i r . The CHAIRMAN. Mr. Ensley is held in very high regard here too, on the Hill. He was director of the staff at the Joint Economic Committee for many years. And I know he was the one, I think, that suggested that particular bill. And I know he had a lot to do with getting consideration of it. And it came within one vote of passing. i ou mentioned about the depository type of institutions that you have referred to in your testimony. M r . SWIFT. Y e s . The CHAIRMAN. Of course commercial banks would come under that category. Mr. SWIFT. Correct. The CHAIRMAN. Would savings and loans ? Mr. SWIFT. Yes, sir, in our view, they should be included. The CHAIRMAN. They do not have checking accounts ? Mr. SWIFT. NO. Nor do we, Mr. Chairman, in most States where we do business. The CHAIRMAN. Would you be included ? M r . SWIFT. O h , y e s . The CHAIRMAN. The savings and loans would be included and the credit unions would not be included ? Mr. SWIFT. I think we should include the credit unions too, although I do not know that we have mentioned them specifically. The CHAIRMAN. They were mentioned yesterday, and I asked specifically about it. The ones at the table said they did not have in mind credit unions. 'The one who had it in his statement said he would strike it out, that he would not consider that a credit union was a depository institution. Of course, it is a matter of opinion, I guess. It has not been passed on. Dr. Hinrichs, I thought only the small banks were engaging in this premium business. But your statement here indicates that tne large banks are, also. Dr. HINRICHS. I say all banks are engaged in this. But as I mentioned, the small banks use a larger share of their advertising budgets in the premium use. Likewise the increase in the use of these premiums is much greater by the small banks than by the large banks, primarily catching up. I think the large banksfirststarted using these extensively and the small banks in order to compete have attempted to catch up, because they do not have the prestige or the buildings or the other advantages that the large banks have. So the small banks have now caught on and found it to be very efficient for their purposes as a means of competition. The CHAIRMAN. I notice here the billion dollar banks had been engaged in using premiums at one time or another, 71 percent of them. Dr. HINRICHS. Quite true, yes. 717 The CHAIRMAN. The percentage of banks using customer premiums, according to the 1970 ABA survey, was 46 percent of the billion dollar banks, and only say 4 percent of the banks $4 million and under. Now, of course there is no direct relationship between the premium that is received—say it is a wi«* or an alarm clock, a blender, something like that—there it is no relationship between that premium and the amount of interest that the person receives, if you were to try to relate it to interest rates? Dr. HINRICHS. Except for the ceiling in terms of $5. The CHAIRMAN. The ceiling fixed by the regulatory agency? Dr. HINRICHS. That is right. The CHAIRMAN. They did not have any ratio of costs, did they? Dr. HINRICHS. Up to $ 5 . So that one bank might only give away maybe a one-dollar piggybank and another bank might give away a $5 wig, it is wholesale cost, and therefore the wig might represent maybe $10 or $15 if it were purchased at a retail store. The CHAIRMAN. Isn't it your understanding that the banks generally objected to that because they were just not in that kind of a business, they just hated to do it, and at the same time they wanted to meet competition if it were required or permitted or tolerated? Dr. HINRICHS. Actually quite a few banks now, I think, view the banking industry as one in which they are prevented from competing for funds with insurance companies, mutual funds and so forth. And quite a few of the leaders of the bank industry have argued that for the banks to really compete effectively they must engage in twentieth century marketing practices as do other organizations. The CHAIRMAN. May I ask a question of you gentlemen at the table there. How many of you believe that we should continue allowing these premiums to be paid? Would you indicate by holding up your hands ? I am not trying to put you on the spot, I would not even put your names in the record the way you vote, out I just want to get the sentiment. How many would favor continuing the premium giveaways? Mr. SWIFT. Would you rephrase the question ? The CHAIRMAN. I am not trying to phrase it accurately, and I am not trying to get any persuasive arguments either way from you gentlemen. But how many of you would favor continuing the method of premium giveaways byfinancialinstitutions? Any of you? (No response.) The CHAIRMAN. All right, we will keep that in mind. But if you are going to continue it why don't you relate it in value some way ? Even green stamps are related to the value of the merchandise you buy. Would you be in favor of relating it the same way? In other words, if you would give a person a value not exceeding a certain percent of interest annually, would you be in favor of that, rather than the premiums if you wanted to dispense with the premiums? That would be more equitable, I would think. I do not feel strongly about this. And really the pressure that I have gotten from different organizations has been from the people who are selling these wigs and different things, they did not want to be stopped. Mr. BROWN. Will the gentleman yield ? The CHAIRMAN. Let me finish. 718 Mr. BROWN. I was just going to comment that I heard over the radio that a filling station here in town is giving out postage stamps instead of trading stamps. The CHAIRMAN. They could give out pennies or anything else or some of these new Kennedy dollars that just came out a few days ago. Mr. Clark, may I ask you a question? As for checking account privileges for the mutual savings banks in Massachusetts, what has been the position of the large Boston commercial banks in which mutual savings banks hold substantial stocks ? Mr. CLARK. They have participated in the opposition as members of the Massachusetts ^Bankers Association. The CHAIRMAN. They did participate? Mr. CLARK. In the organized opposition. I think they have taken no public position as individual institutions. The CHAIRMAN. N O public position that they were against it? Mr. CLARK. That is right. The CHAIRMAN. I think the bill was put on the back burner or something. It did not come to a test, did it? Mr. CLARK. It is still, I believe, before the legislature, and before the Committee on Banks and Banking. I have not heard that it has been reported. I must admit, the issue is in very great doubt. T h e CHAIRMAN. Y e s , s i r . I will get back to these premiums. I noticed an advertisement in the New York Times one time where some bank was offering, I believe, a Cadillac car if a certain amount were deposited in the bank. Didn't that relate to an exact time that it would have to remain on deposit? And wasn't it related to a certain amount of interest on the amount of money that was required to be on deposit? Dr. HINRICHS. Right. This actually is not the type of premium that I have been referring to. We have tried to distinguish the prepaid interest in terms of merchandise as separate from the promotional Sremium for the small savings account that you have. And the Federal oes require that, under regulation Q if you give away a Cadillac it must, in fact, really represent the legal rate of interest the customer would have received over this period of time. We think this is somewhat misleading advertising, and too confusing since we want to have truth in lending^ truth in borrowing, et cetera. The CHAIRMAN. I am very much in favor of thrift, of course. In fact, I have been trying to ^et the credit unions to have sort of an economic education in the high schools over the country to set up credit unions so they could handle actual money and draw on it, and also get interest on it. And they have started it down at Fort Knox, Kv., in the high school. It has a good credit union, and encourages thrift. It teaches children how to handle money. Very few school teachers who first start out know anything about handling money. They do not know how to make a deposit, they do not know how to apply for a loan, and just the normal things that a person should know when they become of age, they do not all know them. And if the banks or mutual savings banks, the savings and loans, credit unions, would engage in that activity to encourage thrift I think it would be fine. It teaches the boys and girls something when they should know it. They grow up with it, and they would have knowledge of it, and they would certainly be more sophisticated in many ways. 719 Don't you think that would be a good idea, Dr. Hinrichs? Dr. HINRICHS. Absolutely. And that is why, as I have pointed out, these customer premiums in a sense are designed to encourage thrift in more people, members of the family—two of my children, for example, opened up small savings accounts. And they were induced by the fact that they could get—as an example, a free football, they see the free football, and they say, "Dad, take us down to the bank. We want to open up a savings account and get a football." In a sense they ask this. When I go to the bank, my tiny daughter 3 years old, goes in with me. She likes the lollipops that the bank gives away; so she comes along. I think this is fine, bring them into the banks so they learn. I explain then about opening up a savings account and how the system works. I think these devices are designed for human psychological needs and do provide some incentives to encourage more members of the same family, and especially young people to open up their own savings accounts. The CHAIRMAN. Under these supervisory agency rules, if they allow $5 for a $100 deposit, how long must that deposit remain in the bank? Dr. HINRICHS. Let me refer to Mr. Edwards here. I would like to have him speak, since he came down from New York, and he knows more about banking than I do. There is no legal time limit as such, but the actual retention rates have been 90 percent for 3 months, and 75 percent for 1 year, so in fact most of the customers do keep their funds in the bank. The continuity programs have a great advantage, because then it induces the customer to return. So he comes back maybe once a month to put in a little money and then buy a dish at half the price. The CHAIRMAN. In other words, when a depositor was given a premium for putting in $5 or $10 he could draw it out the next day if he wanted to, couldn't he? Dr. HINRICHS. That is true, sir. Although basically the evidence is that people do not act in that fashion. The CHAIRMAN. But generally 7 5 percent of them keep it for 9 0 days and a large percentage up to a year ? Dr. HINRICHS. As a matter of fact, there is a higher retention rate for premium programs than simply walk-in accounts. The CHAIRMAN. I think it is very persuasive from the thrift side and is encouraging thrift. Mr. Bryan, you brought out a good point on the Federal Reserve. You said that a mistake was made in 1927 in the McFadden Act when the charter was renewed and made perpetual. If my recollection is correct, and I believe it is, the original charter of the Federal Reserve was 25 years? Mr. BRYAN. Wasn't it 20, sir? T h e CHAIRMAN. I t w a s 2 0 , s i r . M r . BRYAN. Y e s , s i r . The CHAIRMAN. I thought it was right in there. I had not looked at the act for a long time, but I knew it was a shorter period than perpetual, and I was opposed to that too. I was not in Congress then. I was elected to Congress the next year. But I knew all about that 720 McFadden Act. I felt that was a terrible mistake, because if they had left the Federal Reserve Act for near the 20 years, they would have had a lot more experience, and probably have made some good additions to the act. I agree with you that a mistake was made at that time. In fact, it is not a bad idea to have these important and very lucrative as well as exclusive franchises to expire now and then anyway, so that people can show that they are rendering public service in order to get them renewed. Now, the trust accounts, I would like to make one comment on that. Our reports have been revealing; on the trust accounts. Now, a bank within 50 miles of Washington, D.C. was about 285th in size as banks are ranked by deposits. It had trust accounts aggregating $2.3 billion, and for decades that bank was never examined. It was not insured. It was never examined by any Federal banking authority. But in the Holding Company Act at the end of last year, the 91st Congress, under that Holding Company Act of course they are now—they must be insured, and of course they are examined. But there are a lot of things that are sort of laws in the monetary system as well as all other systems involving Federal law that we find out in these different investigations. But I think something should be done about the trust accounts. I do not want to unduly restrict them or unduly harm them, I want to encourage them. But I think that full accounting and auditing should be required at certain times. That is the reason I have always been in favor of the Federal Reserve being audited. The Federal Reserve has never been audited by the General Accounting Office. It has always gotten an exemption. Of course, they carefully audit the Defense Department and the Atomic Energy Commission and all other departments of the Government. But the Federal Reserve has never been audited by the General Accounting Office. The things that have happened under that of course would require too much detail. But I believe in these audits myself, and I think .they should be done at certain intervals and reports made at certain times. # The regulatory agencies have gotten rather careless in their reporting. I know over the years we have had difficulty and problems getting a report from the Federal Reserve. It is due at the end of the year, such as at the end of 1970, we should have had the report in 10 days. We have not gotten it yet. We have got a little bobtailed report that does not mean too much, and the other report will come in later. But the other agencies are the same way, I mean the Comptroller of the Currency and the FDIC and the Federal Loan Board as well as the Federal Reserve, they are late in getting in their reports. Now, the importance of that is that if the Congressmen got their reports immediately soon after a session of Congress starts, why if there is anything in there that is shocking or astounding or bad or wrong, something can be done about <*ettinsr a correction made. But if the report is not filed until the end of that Congress, like near the end of this Congress, the 92d Congress, why it would be next year before consideration could be given to it, and there would not be as much interest in ijb at that time. And therefore I look with great disfavor on these agencies delaying their reports. 721 This morning I received a report from the Credit Union National Board. General Nickerson is in charge of it, a very fine man, and he has gotten the report out. Even though it is not as early as it should be according to my feeling about it, it is at least in. But the others are not in. Ana I hope that they will be inspired to make those reports more quickly and more carefully, and at certainly the right time. Does anyone else want to ask any questions ? Mr. WIDNALL. Yes; Mr. Chairman. The CHAIRMAN. Mr. Widnall. Thank you, Mr. Chairman. Mr. Swift, I would iust like to ask you this one question. With the changes made in regulations by the regulator agencies, so that $10 today is the top that can be spent for a premium, as I understand it, don't you admit that this is a reasonable amount, and it is not going to be anything that is going to affect adversely the operation of an institution? Mr. SWIFT. I think the way the regulation was drawn it did have some serious adverse effects, not necessarily because of the amount set as the limit, but because of the two-tiered effect. In other words, the $5 limit on amounts under $5,000 and the $10 limit on amounts over $5,000. I think these premiums, the $10 premiums for the large amounts over $5,000, is what really created the churning of money from bank to bank. This was not really thrift promotion, because anybody who has got $5,000 or more dollars has already presumably learned thrift. It wound up in a situation where people were taking money out of one bank and putting it in to another for the sake of this premium. And the $10 amount gift was apparently attractive enough to make this all worthwhile, even though it may have caused this person to leave a bank with which he had a long association and had developed a loyalty and satisfaction with. But it was enough to cause him to make that switch. And this, then, forced other banks into running similar campaigns, and before long it was just moving around in circles. Mr. WIDNALL. Mr. Swift, it is my understanding that this moving around took place when they are offering more than $10 gifts, where there were television sets offered, and toasters, and the Cadillac by the New York bank. All that is out the window now. Mr. SWIFT. I cannot remember the date that that regulation was effective—but all of the excesses of the last half—I guess it was most of 1970—were all under that regulation with the $10 limit. There were millions of dollars that were moving around from bank to bank. Mr. WIDNALL. Then what we should do is ban any kind of premium in connection with any kind of business so that you can't go to a gas station and accumulate glasses or dishes or things like that by adding a few pennies, or by direct gifts originally and everything like that? You are against the premium business itself? You would like to see the price of gas reduced and no premiums ? Mr. SWIFT. There are many bankers, of course—you have different views on this. But I think the consensus of our industry—and our statement so States—is that we feel that a moderate priced giveaway for opening new branches or celebrating particular events for the bank does in effect have some beneficial results in terms of starting people 722 on the road to thrift and as an initiation to a new office. It does not have an adverse impact on another bank, because the amounts involved are not sufficient to create that problem. So we are not opposing necessarily premiums in all cases, but we do feel that some regulation and restriction is almost essential if we are to avoid the excesses that develop. Mr. WIDNALL. The banks that I have just named, primarily thrift institutions, have been offering blankets, electrical equipment and everything else at the opening of a new branch or in connection with some special event at the institution. I do not quite see how you distinguish between that and the general offering of premiums. Mr. SWIFT. It depends really on how it is offered. You see, this regulation permits you to offer a $10 gift if the deposit is more than $5,000. Now, this is going to be the most attractive one. And this is the one that creates the problem. If it was a $10 limit on all deposit amounts, and the bank could set their own amount, this, I think, through competition would bring it down to where it would not have this adverse impact. If you want to spend the money, give a $10 gift for opening a $25 account, fine, if that is what they want to do. The CHAIRMAN. Would you yield ? The gentleman keeps referring to a $10 limit. Didn't you say that it was wholesale? Mr. SWIFT. That is right. The $10 limit on the bank is wholesale, that is right. The CHAIRMAN. Well, there are certain articles in the jewelry line— sometimes a $10 wholesale could be a $20 or $25 item, couldn't it? Mr. SWIFT. I think so, based on the testimony we have here this morning. The CHAIRMAN. Mr. Brown. Mr. BROWN. Just one question. Your statement, Mr. Swift, is replete with suggestions that interlocks, insofar as they apply to mutual savings banks, are really in the public interest and the Ibank and customer interest, rather than detrimental. Of course, Dr. Burns has said that he thinks there is nothing inherently wrong. Mr. SWIFT. That is right. Mr. BROWN. The specific reference in your statement to which I wish to direct a question involves the interlocks which have the bank participating or someone associated with the bank participating in a title company transaction, real estate closing, and things of this nature. I think m your statement you indicate that you think this kind of relationship is not anticompetitive, but rather is in the public interest, because it benefits the customer ana the depositors of the bank, is that not correct? Mr. SWIFT. This is correct. Mr. BROWN. Wouldn't the testimony that you have given, although you have related it only to mutual savings banks, wouldn't you say it could be equally applicable to other depository institutions? Mr. SWIFT. Yes, I believe so. Mr. BROWN. Thank you very much. The CHAIRMAN. We appreciate the testimony that you gentlemen have presented. It will be very helpful to us. 723 I do not know of any member that feels strongly about this, certainly to the extent that he would be biased or prejudiced on any of these issues. These issues have arisen from time to time. We have been asked to have hearings on them. So we just put as many of them a& possible in this whole bill. When the committee meets—we expect to have the first meeting just as an informal session as soon as we complete the hearings. We expect to finish on Tuesday when Mr. McLaren of the Department of Justice will be our witness. Mr. David Rockefeller will be here on Monday, and then we will attempt to find out how the committee feels about these different issues and act accordingly sometime, and get up a bill and present it or not get up a bill. We do not know how it will come out. but anyway we thank each and * ittendance here, and for the committee I lk you very much. __ ^ We will continue our hearings on H.R. 5700 on Monday, May 3, 1971, at 10 o'clock a.m. (The statements referred to by Dr. Harley H. Hinrichs on p. 714 of John F. Daly, International Silver Co.; William M. Dalton, W. M. Dalton & Associates; Larry O. Edwards, Lincoln Rochester Trust Co.; and Neil Kanney, Grace China Co. follow:) STATEMENT OF JOHN F . D A L Y , INTERNATIONAL SILVER COMPANY The International Silver Company has been in the bank premium business for 23 years. The company pioneered in the continuity premium field beginning about 1955. I personally have had the immediate responsibility for the improvement and expansion of the company's business in this area for 14 years and feel I can speak with some expertise. Incidentally, in that period the company has participated in continuity and one-time programs with literally thousands of banks and savings and loan associations. We are opposed to the anti-premium portion of H.R. 5700. Obviously, it would eliminate a very necessary merchandising tool for small and medium financial institutions. A merchandising tool that already has real and realistic dollar limitations imposed by the various regulatory agencies. (I think we must be careful not to be confused by so-called abuses such as prepaid interest. An example would be an automobile "free" with a large interest-free deposit for a period of several years.) This is not a premium offer, but rather a manipulation of the payment of interest. As such, we feel it must come within the purview of the regulatory agencies. We at International are concerned seriously with the precedent anti-premium legislation would certainly set. The premium industry is a four to five billion dollar business. Premiums are used by grocery stores, by gasoline stations, by industry broadly * * * to move their products. The abolition of premiums would have an appalling impact on our entire economy. Low-cost premiums in good taste can be an effective merchandising tool in the financial field. Continuity programs are self-liquidating to the financial institutions. The savings accounts opened during these programs will still be retained a year later by 80-86% of the savers. We can prove that a saver being given the first place setting and purchasing additional place settings with additional deposits, will have his or her money in there a year after signing up as a club member. We have surveyed this time after time and found that the percentage ranges from 80-86% of the savers. Therefore, the allegation that money deposited because of premium offers flows from bank to bank is simply not supported by fact. I challenge anyone to prove the allegation that such money does flow from bank to bank. We can conclude from the above that premium programs by banking institutions are good for the supplier. They are just as obviously good for the bank using the premium. But there is good to the saver or consumer, if you will, that many tend to overlook. 724 For example, a savings bank with $100-million in assets will generate literally thousands of new accounts in a year-long program. Old savers, also, will have a much larger savings account. In many instances, the new savers will have a savings account for the first time. The immediate social implications for good in a bank incentive program are enormous. The community has hundreds, if not thousands, of new savers for the first time. The banking institution has more money for home building, etc. Savings help the overall economy by being an anti-inflationary influence. In summary, the saver, the bank, the community and the nation all benefit from low cost premiums. This bill, if passed with provisions banning premiums* would do irreparable harm to International Silver Company and to a countless number of other consumer goods manufacturers. It would mean the immediate lay-off of hundreds in the Meriden-Wallingford area • • • already an acutely depressed employment center. It would mean the immediate lay-off of thousands in other consumer goods industries and related industries, such as transportation. It would have a devastating effect on that segment of our economy * * • consumer goods manufacturing • * * which must be emphasized as we de-emphasize defense oriented production. STATEMENT OF W I L L I A M M . DALTON, PRESIDENT, W . M . DALTON & ASSOCIATES, I N C . ; B A N K AND SAVING & LOAN CUSTOMER P R E M I U M S INTRODUCTION This paper is a recapitulation of the effect and benefit of continuity savings account promotions utilizing such merchandise as place settings of china, stainless steel flatware and leaded crystal in which our Company has specialized for the past 11 plus years. CONTINUITY PROMOTIONS What are continuity promotions.—Continuity promotions are cost promotions where a place setting of merchandise such as china, stainless steel, leaded crystal, etc. is given away free to a new account opened for twenty-five dollars or more; or with the first twenty-five dollars added to an existing account. Additional units of the same merchandise are sold to the customer at a special low price such as $2.95 with each twenty-five dollars added to the account. This type of promotion makes it easy and inexpensive for the customer to acquire a set of excellent quality merchandise at his own pace, easily, inexpensively and tends to encourage and build a steady savings habit among large numbers of bank and savings and loan customers. Deposit requirements for the free gift are deliberately kept low ($25) so as to make it possible for almost all income groups to participate. If a customer can only add one dollar to his account, he is allowed to accumulate these deposits and when he reaches a total of twenty-five dollars he can get his free gift. The major beneficiary.—The major beneficiary is the small passbook saver. The average customer opening a new account opens with an average deposit running between three hundred to four hundred dollars. The average existing account will add two hundred to three hundred dollars to his account to get the free gift. For units sold the average deposit runs between fifty and one hundred dollars. Benefits of.—These programs offer the benefit of: A. A free gift to the consumer. B. Additional units being sold at a very low price while the customer builds a steady savings habit. C. Lower income families enjoy some of the better things of life easily and inexpensively. D. Make saving more enjoyable rather than being a task. Sources of savings gained.—The greatest savings gains traditionally come from existing accounts. These gains over normal deposits represent 2/3 to 70% of total gains during the campaign. The balance of gains largely come from uncommitted customers and the dissatisfied customer who is looking to change. Marketing benefit.—Continuity promotions give the small banks and savings & loans an effective marketing tool against major competition. Philadelphia is an excellent case in point—we currently have four savings & loans with assets of IS million, 61 million, 72 million and 115 million all running continuity promotions. 725 These four associations have as competition five banks with total assets of 10 billion dollars total—plus four savings banks with assets from 450 million to over 2 billion dollars. Additionally, there are other banks and many savings & loans in the Philadelphia market. All of these four savings & loan associations are using continuity as a marketing tool to off-set huge competitive ad budgets. Since their budgets are of necessity smaller than much of their competition, it is critical for them to receive the maximum amount of new business from each dollar expended. Therefore all of them have turned to continuity. Our Company sold about 150 new promotions last year and in almost every single instance our new customer was one of the small banks or savings & loans in town. Retention benefits.—Continuity promotions show a greater customer retention factor than regular walk-in business. Many banks and savings & loans have done studies on retention of continuity premium generated accounts and I know of no instance where retention of these accounts was as low as or lower than regular walk-in business. In every case, retention of continuity premium accounts was higher. Cost.—Continuity promotions cost the bank $2.00 to $2.50 on each free unit given away. On units sold, the bank makes a small profit usually 30 to 400 to help cover the freight and handling cost. Banks and savings & loans do not recover cost of free units—full and unliquidated costs are generally charged to the ad budget. An excellent case in point is a 20 million dollar savings & loan in North Carolina. In a period of 5 months they reported 814 new accounts, savings increases of $702,000 at a net cost to the bank of $1,957.90. These programs are deliberately tailored to keep prices to the consumer low, to make the program a real inducement and keep bank and saving & loan margins on units sold low so that banks and savings & loans do not enter into the china or stainless business but really look on these items as strictly a marketing tool to induce new business with net costs applied to the ad budget. This concept has been especially appealing and useful to small institutions. Deposit churning.—A number of banks and savings & loans have made studies of competitors deposits while a continuity promotion is at work. Conclusions reached have been that the competitor not using promotions tends to continue to gain deposits at the same pace as before the promotion started, but the bank and saving & loan running the promotion gains deposits at an accelerated pace. This is a further indicator that the bank or saving & loan running a promotion is getting his major benefit from inducing a better share of his customers' income into savings with new business coming from the uncommitted customer or dissatisfied customer looking to make a change. Difficult marketing situation applications.—A number of states such as Florida, Texas, Illinois have "unit bank" laws which do not permit bank and savings & loan branches. As communities change and customers move away, it becomes more difficult for many banks and savings & loans to hold old customers. Continuity promotions have been effectively used to retain old accounts and have provided the added incentive to old accounts to add to savings by mail. An excellent case in point is one of our oldest customers, a commercial bank in Jacksonville, Florida. This bank started a china promotion in June 1961. This bank is out of the downtown district in a residential area, is blocked off from the downtown district by a river and has a high number of military personnel in its marketing area. This bank is faced with a changing neighborhood, constant turnover of military personnel and since Florida does not permit branch banking, this bank has a difficult marketing problem. In 1961 when the deposits of the bank were $28 million, savings account balances were not growing. They were in fact stagnant. The bank turned to fine china for a promotion and in the first 9 months of the promotion, increased savings by almost one million dollars. The campaign is still active today because it has worked effectively in producing repeat savers, has kept customers coming back from all over the area and has even produced deposits from military personnel in different parts of the world. This bank is today about $82 million in assets and is still running a fine china continuity savings account campaign. Retail sales.—Each customer by acquiring a new set of china or stainless steel or crystal helps to popularize that item in his residential area and among his friends and neighbors. A number of retailers have found that this popularization promotes new sales for retailers since most banks use only one or two patterns and many consumers do not want the same thing as their neighbors. Additionally, 726 customers with new sets provide the stimulus for neighbors to add to incomplete sets and unmatched sets. Aggressive retailers have found that a customer getting a new set of china for instance becomes a prospect for other table-top accessories such as center pieces, candlestick holders, linens, crystal, etc. and some retailers have taken this opportunity to promote sales of related items. An acknowledgment of the accuracy of new markets being created by the sale of one item is the simple fact that there is a tendency for America's china manufacturers and sterling manufacturers to acquire manufacturers in a related field so that today manufacturers such as Lenox China and Gorham silver have become complete table-top conglomerates. Almost all, if not all, suppliers in bank and saving & loan continuity promotions use special trade-marks and patterns which are not sold in retail stores to avoid interference with regular retail distribution and price structures. We have found that most of this merchandise goes into latent or untapped markets and does not in any way interfere with retail distribution. SUMMARY The bank and saving & loan savings account promotion business using continuity merchandise such as fine china, stainless steel flatware and leaded crystal has been a tremendous force for good in this country. The customers like it, and respond to it; banks and savings & loans like and use it and premium suppliers such as ourselves have built highly successful businesses with i t Therefore, the benefits to aU concerned far out-weigh any disadvantages and the bank continuity business should be allowed to continue. STATEMENT OF LARRY O . EDWARDS, V I C E PRESIDENT I N CHARGE OF MARKETING LINCOLN ROCHESTER TRUST CO., ROCHESTER, N . Y . My purpose, hopefully, is to give you a better understanding of the role of premium and giveaway promotions in banking from a banker's point-of-view. So that my remarks may be put in perspective, it is appropriate to give you a frame of reference by describing who I am and something about the bank I represent. I am the vice president in charge of the Marketing Department of Lincoln Rochester Trust Company, Rochester, New York. Lincoln Rochester, as of December 31, m o , had total assets of $929,332,000 and total deposits of $S1S,770,000. At year end, we had 39 branch offices located in the six counties of New York's Eighth Banking District. We are the largest bank in our banking district and a part of an almost two-billion dollar multi-bank holding company with principal banks in the cities of White Plains, Syracuse, Jamestown, Binghamton and Rochester, New York. While our bank's premium promotions have been successful, by the measures we place on them, we also recognize that there have been some difficulties and abuses in the use of premiums and giveaways by banks. As a result, we believe that bank use of premiums and giveaway items needs more definitive regulation— but certainly not prohibition. While I cannot presume to identify for the Committee, all positive and negative aspects of banks' premium involvement, I am hopeful that awareness of our experience with premiums can be helpful to you, the Committee, in determining the legislative issues involved. In 1966, when our bank first conceived of using a premium as an inducement to opening new savings or checking accounts or adding to existing ones, there was a natural reluctance on the part of our senior management to be the first bank to engage in such activities in our market. Specifically, there was a fear that depositors we would gain through such a promotion, would switch their accounts from another bank, and later, other banks could similarly entice the same customers away from us just as easily as we got them. Attendant to this fear was the disturbing thought that the basis for customer loyalty might shift from that which was related to giving good financial service to a temporary allegiance based only upon a customer's fleeting impression of which bank was offering the best merchandise deal. In the spirit of trying new marketing techniques, and despite our fears, we tried a so-called "self-liquidating premium promotion on a bankwide basis." The essence of our consumer offer was this: If you make a deposit to an existing savings account or open a new deposit account at Lincoln Rochester, you can buy this Kodak Hawkeye Instamatic 727 Camera for less than you would expect. We promoted this offer with an amount of advertising and promotion dollars which were the same as we would normally spend for advertising over the period of promotion. Additionally, the purchase arrangement we made on the cameras was in sufficient volume so that we could arrange delivery of a good comparable value to the customer by simply charging him "our cost" for the merchandise including handling and transportation. The results were not startling by today's premium standards, but we did open almost 5,700 new accounts. The number of new accounts is not what is important here, but rather, how long the savers we got from this promotion have stayed with us since 1966. Normally, without the benefit of special inducements, we find that three out of four, or 75%, of the accounts we open will still be open one year later. Three months after we opened new savings accounts with the camera promotion, we still had 96.1% of those savers with us. Nine months after account opening, 86% were still maintaining the premium opened account. One year after account opening, we had 75.7% retention of those same accounts. These retention rates are very nearly equal to the retention rates of regular walk-in savings accounts opened without the benefit of special premium inducement. And, this retention rate for premium induced accounts occurred despite the fact that a number of other banks ran premium programs after we announced our first one. Our bank has run a premium program in all one of the succeeding years, with similar analysis of account retention. The figures for each of these successive campaigns do not differ materially from the ones quoted. We continue to run these campaigns because we have proved to ourselves that savings accounts induced by the use of premiums create customers with just as much loyalty to our bank as we experienced without premiums. We also find that such customers are not prone to switch their accounts easily to other banks, just because a better premium offer is being promoted elsewhere. Throughout our five year experience with bank premium and giveaway promotions, there has been another element of concern—the role of banks as financial institutions in the "merchandise business". In other words, is the proper role of banking served when banks become purveyors of merchandise in addition to the traditional function of supplying financial service? Here again, our own senior management was the first to bring this question up, in our case. They wondered if many of the good commercial customer relationships we had taken years to develop, would be jeopardized by our involvement with premium merchandise. Even if our current customers in the merchandise business didn't leave us, we wondered if they would be inclined to look upon us as new competition rather than as a financial consultant. Because of this concern, our bank has always taken steps to pre-alert our major merchandise customers to our plans to promote a premium as an incentive to gain new deposit accounts. With our very first premium promotion, we elected to work through a local photo finisher and retailer for delivery and sale of the Kodak cameras rather than purchasing and handling the cameras and the distribution of them ourselves. While our motivation was to avoid potential conflict with retailers and wholesalers by implementing such an arrangement, we found, after the fact, that by so doing we did not compromise the promotional value of our premium offer. As a result of our successful experience with our first premium, we have continued to use regular distribution channels established by the manufacturers for handling premium campaigns. Sometimes we use premium distributors and other times we use retail distributors. We have never inventoried and warehoused merchandise ourselves. In some cases, we have even avoided a direct customer-to-bank transaction for the payment of purchase price on premiums, but rather, have encouraged customers to remit directly to the premium supplier and expect delivery direct from the supplier once the customer has qualified with us and is entitled to purchase or receive the premium. Since we have established that we need not handle any merchandise on bank premises, excepting that merchandise needed for display purposes, and we can still conduct successful premium campaigns, we have concluded that there is no need for us to perform all the functions of a retailer and run the risk of being considered direct competition to him. With the above policies during the five year period of our experience with premium campaigns, we have received very few complaints from retail merchants of other businessmen concerning our premium activities. Apparently, the communication before a campaign is run and the merchandise relationship we use, have helped us avoid problems in this area. 728 A third concern which, I must say, was shared not only by our senior management but by we marketing people, was the very essence of the strategy behind premium incentive deposit campaigns. Unless the public wanted premiums from their bank, no amount of advertising, promotion or selling effort was going to result in a successful new deposit campaign. We have done research to determine what our customers and prospective customers' attitudes are towards our bank's offerings of premiums in deposit campaigns. We interviewed customers both on and off bank premises. The results show a clear majority of our customers express a positive overall reaction to this type of promotional activity. In addition, the customer response to premium campaigns also tends to support the public acceptance of our premium activities. Last year, we at Lincoln Rochester noted the emergence of a special kind of premium program in the New York City market, wherein banks were offering merchandise, such as appliances and automobiles, in lieu of interest. Typically, a depositor who qualified with a rather substantial deposit, would be delivered the merchandise before the interest was earned, but would also be required to leave his money on deposit for a stated period of time. Frankly, we looked upon this as a unique promotional scheme that clearly had some promise as an incentive, but in our view, this kind of activity violates the spirit of the New York State Banking Department Guidelines published on premium promotions by banks, and, in a sense, also violates the spirit of the Federal Reserve's Regulation Q. Merchandise in lieu of interest, we think, is simply payment of interest in a different form. In our premium activities, we generally run what is known as self-liquidating premiums, wherein we arrange for a certain volume of merchandise at a lower than suggested retail price to be offered to our customers. The essence of this is that we offer our customers an opportunity to buy an item through established distribution channels at a price which is generally below the price at which most retailers would sell the same or similar items. The price paid by the customer, who qualifies in our deposit campaign, is equal to the cost of the merchandise plus any direct handling or transportation charges associated with getting the merchandise to the customer. We choose not to make a profit on such transactions, but to pass the whole merchandise saving on to the depositor. Our premium advertising states our price and compares it to a comparable retail value, using suggested retail prices established by manufacturers, or it includes a general statement suggesting the customer will save money on the purchase. We do not use artificially inflated or unpublished prices. It is possible, and has happened, that a customer can find one retailer selling the same merchandise at or near the price we are quoting and, infrequently, we have been challenged by customers who interpret our advertisements as deceptive or misleading. Since we have familiarized ourselves with the regulations with respect to deceptive and misleading advertising, we can generally answer directly to the customer to his satisfaction. Section 217.6 of Regulation Q of the Federal Reserve Board states that "no member bank shall make any advertisement, announcement or solicitation relating to the interest paid on deposits which is incorrect or misleading." This has been interpreted by the Federal Reserve Board to apply to premium items. Furthermore, there are already laws at the state and federal level to guard the consumer against fraudulent claims by manufacturers and retailers. We assume these laws also apply to us and we comply with them. Over the course of running premium campaigns, our bank has received customer questions about whether or not the money spent on such programs is depositors money, and as such, represents an unjustified use of it. First of all, the promotional money we spend on premium campaigns is budgeted for and controlled, as part of our overall advertising and other marketing expenses. With a prudent management, the risk of depositor loss, therefore, is minimal. We've often felt that beneath the surface of this question, however, is the issue as to whether these various expenditures increase the availability of new deposit dollars. Our actual experience is that a premium promotion advertising expenditure of from $50 to $70 thousand dollars, brings in $3 to $8 million dollars in new deposit money. It does not seem logical, therefore, to focus our attention on the expenditure when the real test of appropriateness is the result measured in terms of the amount of new funds generated which can be directed back into our community in the form of mortgages, personal loans and business loans. Premium campaign expenditures are one of our most cost-efficient devices for securing new deposit flows. In the absence of such promotions, banks like ours 729 would have to spend far more in advertising and other promotion expense to get the same results. Further, at our bank, we indirectly relate the amount of our mortgage portfolio to the total amount of dollars on deposit in regular savings accounts. As we generate new savings deposit dollars, more money becomes available for mortgages. Since our experience with premium promotions has been that they are most effective in the area of regular savings deposit dollars, then it follows that our ability to make more mortgages in our communities is partially a function of our success in attracting new deposit dollars through such premium promotions. Another of our internal concerns over the period of time we have been involved in premium promotions, has been the question as to whether deposit funds resulting from such programs are not only new to our bank, but are also new to the banking system. In other words, it would be difficult for us to argue that we can create new loans as a result of premium campaigns, if the deposits we gained represented switches from our own savings accounts, switches from other banks' savings accounts, or would have been deposited in another bank anyway if we had not run the premium campaign. Our research evidence in the following table suggests that for premium campaigns, we have less switching from either our own or other banks' savings accounts than we experience for non-premium activated accounts. The table also shows that the source of money for premium accounts is predominately cash—suggesting that there is greater probability that we are creating new deposits with premium offers, than is the case for our normal, non-premium induced account openings. Source of funds used in opening new savings accounts Cash Checking accounts from bank offering premium program Savings accounts from bank offering premium program... Checks drawn on other banks, including commercial mutual savings and savings and loans All other sources Percent of deposit dollars generated from a premium offer Percent of deposit dollars generated from nonpremium account openings 72 13 4 11 13 30 7 4 35 11 STATEMENT OF N E I L K A N N E Y , PRESIDENT, GRACE C H I N A CO., SOUTH H A C K E N S A C K , N . J . Gentlemen, my name is Neil Kanney and I'm president of the Grace China Company in South Hackensack, New Jersey. We are a small company engaged exclusively in the sale of tableware products as premiums to the banking community. My personal credentials have been developed as a result of approximately eight years in the sale of such tableware products on a retail and wholesale basis and an additional seven years experience in the development of savings account building continuity programs for financial institutions. Some of my testimony will be my own personal opinions formed by my experience in the bank marketing field, in addition to the experiences of customers, properly documented, showing the attitudes of financial institutions and their customers to the offering of a gift, along with some of the benefits derived. First of all, it might be helpful to understand who is interested in premium offers. Without exception, the small pass book saver, generally the housewife or youngster starting a new savings account, is the ultimate consumer of the premium products we offer. Usually their deposits are not large and they're very rarely intrigued by the various differences in interest rate that are so effectively used to induce deposits from the large private or commercial depositor. The housewife is often stimulated by a premium to open or add to a savings account primarily because the premium we offer appeals to her, she becomes a "saver", in order to complete her set of fine china or similar product. Probably one of the greatest advantages of premiums in general, and certainly some in particular, is that premium offers bring in pass book deposits at the lowest possible cost to the financial institution using them. A small bank in southern New York in January, 1968, Wrote me, "Our final costs, not including advertising costs, etc., was just $200.30." This $25,000,000 60-299—71—pt. 2 19 730 bank received in deposits during the campaign, over $500,000 from both new and present customers. Another medium size savings & loan association in North Carolina, in 1966, a year in which premiums were desperately needed to help stem the out-flow of savings dollars, wrote to inform me that, "During the year the savings attributable to the china program had exceeded $4,200,000. The total cost of the program to us including freight, use tax, and miscellaneous expense has been about $13,500. Thus the costs of the program is less than % of 1% of the savings generated" . . . A most significant contribution to the financial community is the fact that premiums definitely increase traffic and new accounts, stimulate business, and tend to help create a savings habit on the part of people who originally begin an account because of the premium offered. A commercial bank in Congressman WidnalFs district in northern New Jersey, wrote me, in 1964, "Without any extraordinary openings in July, we opened 1609 new accounts, an increase of some 500% which we attribute to the china program. Other benefits which seem to have come from this program were an increase in regular checking accounts of 100% above normal expectancies and an increase of 50% in our convenience checking accounts". It might be pointed out that the other benefits mentioned in this letter came as a by-product of the original campaign offered. No inducement was offered to make deposits in regular or special checking accounts at that time. A small savings & loan association in Roanoke, Virginia, at the end of a promotional campaign said, "We have had terrific results with the china program. I'm sure it brought us a lot of business when money was scarce, but there is no way to tell for sure just how much. At least we created a lot of traffic which is definitely needed in every business". And in 1969, a savings bank running it's first account building program wrote, "The results have been most gratifying. We took in over $5,000,000 in deposits that were directly attributed to the promotion. Compared to the same 30 day period last year, our new accounts increased 182%, there was a 9.5% increase in new account deposits and 13.7% increase in total deposits" . . . An advertising agency in Greensboro, North Carolina, wrote describing a promotional campaign of ours, "When one can start a savings in-flow program 12, December, 1966, and find it still going full steam 31, May, 1967, without any evidence of let up and with average deposits per set of diina, averaging almost $300 instead of the advertised $25, you've got something!" . . . Premiums are a decisive factor in the growth and development of small banks and savings & loan associations. In southern New Jersey, a small bank writes, "Without a doubt, growth from $32,00,000 in assets, November, 1966, to May, 1969, $87,000,000 is attributed in large part to premiums programs". Again, in 1966, an experience brought out during a severe "tight money situation" shows a small $10,000,000 savings & loan association commenting on one of our programs: "We have opened a total of 379 new accounts for total deposits of approximately $172,000 with activity on all of our savings accounts pertaining to china, amounting to 2300 accounts being effected for total deposits in excess of $615,000". I might like to point out that at this time there were only 4000 accounts registered with the association. It's significant to note that better than % of the people at the association were participating. Continuing on, "Our area of the state is predominately that of farming and thusly provides for income of a seasonal nature. We are at this time entering into the period of the greatest wealth and income of the county and we are looking forward to a real effected as well as deposits placed with us between now and the end of the calendar year". The most significant internal advantage to the small bank and savings & loan association is that premiums give them an opportunity to compete on an equal level with the larger and more heavily funded institutions. Competing in an age where advertising costs for production and media are high, is very difficult for the small institution in a large market. A good example was pointed out to me recently by advertising people in Dallas, Texas, in which they state that the increased cost of time and space in advertising media have in some cases risen to the point where thes mall bank is incapable of effectively bringing it's service message to the public. In the past four years, the 60 second radio commercial has increased from a price of $14 to $46. Fourteen lines of newspaper advertising has increased from 63c per line in 1966, to a current rate of 84c per line. 731 According to these specialists, "Although bank budgets for advertising have increased 25%, the new budget will pay for 20% less than the prior years' expenditures." Television 60 second commercials in prime time in the Dallas market, cost $400. This rate all but eliminates prime time television from the grasp of the would-be small bank advertise