Full text of Economic Policy Review (Federal Reserve Bank of New York) : August 1971, Vol. 53, No. 8

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166

MONTHLY REVIEW, AUGUST 1971

The Problem of Securities Thefts*
S t a t e m e n t b y R ic h a r d A. D e b s

Vice President, Federal Reserve Bank of New York
We at the Federal Reserve welcome the study by the
Permanent Subcommittee on Investigations of the prob­
lem of securities thefts. We share its concern about the
gravity of the problem, and we’re most hopeful that the
present study will focus attention on the problem and
result in constructive measures toward its resolution.
The Federal Reserve Bank of New York has an interest
in this problem in three respects. In the first place, as a
Federal Reserve Bank we have a direct interest in the
safety and security of banks and the banking system, and
in sound banking practices. Second, as the Federal R e­
serve Bank responsible for implementing monetary policy
by means of open market operations in the Government
securities market, we have a direct interest in the effec­
tive functioning of that market. Finally, as fiscal agent of
the United States, we have an overall interest in all Gov­
ernment securities transactions, particularly with respect
to Government financing and the management of the
public debt.
As a reflection of our particular interests in these
matters, our principal concern— and our experience—
relates primarily to United States Government securities
and the Government securities market— which means,
in effect, m arketable Treasury and Federal agency in­
struments— and my statement today focuses mainly on
such securities. However, the Federal Reserve is also con-

cemed with the problem of securities thefts as it relates
to other types of securities and securities markets— cor­
porate and municipal securities— and references will also
be made to those securities to the extent that we have
become involved.
It may also be useful to note at this point that the
main problem in the area of Government securities is the
theft of bearer instruments, reflecting the fact that prac­
tically all of the marketable public debt is in bearer form.
This is not the case, of course, with respect to corporate
securities; nor does it apply to United States savings bonds,
which are not considered marketable instruments and
which do not constitute part of the Government securities
market.
As a general indication of the kind of volume and
velocity of transactions that we are concerned with in
the Government securities market, attached is a table
setting forth some statistics that should serve to illustrate
the overall dimensions of our operations in Government
securities.
GOVERNMENT SECURITIES

The problem of thefts of bearer Government securities
did not become acute until the latter half of 1969, when
there was a dramatic increase in the incidence and magni­
tude of such thefts. Within a couple of weeks of each
other, one New York City bank reported a loss of $2.1
million in Government securities, and another reported
a loss of $1.6 million. Shortly thereafter, a third bank
reported
a loss of $13.2 million. That made a grand total
*
Statem ent before the Permanent Subcom m ittee on Investi­
gations o f the Com m ittee on G overnm ent Operations o f the
of about $17 million reported missing in a period of little
United States Senate, June 25, 1971. Mr. D ebs has responsibility
over a month, and in New York City alone. By the end
for the Bank’s G overnm ent Bond and Safekeeping Operations.
H e is also chairman o f a Federal Reserve System Subcom m ittee
of 1969 the total value of Government securities reported
on F iscal A gency Operations, which acts as liaison between the
to us as missing in New York City— including reports
Federal Reserve Banks and the Treasury Departm ent with respect
from brokerage houses as well as banks— was about $20
to Reserve Bank operations conducted as agent for the Government.




FEDERAL RESERVE BANK OF NEW YORK
ANALYSIS OF UNITED STATES GOVERNMENT
SECURITIES ACTIVITY AT THE
FEDERAL RESERVE BANK OF NEW YORK IN 1970

Marketable debt obligations

Pieces
(in thousands)

Amount
(in millions
of dollars)

Original issues ............................................
Servicing* ......................................................
Redemptions ................................................

1,917
6,195
2,883

209,558
782,727
169,781

Total transactions handled ...............
Average daily activity ........................
Telegraphic transfers .................................
Coupons paid ..............................................
Safekeeping accounts!
Deposits and withdrawals .....................

10,995
44

1,162,066
4,648

312
3,155

269,000
1,633

763

182,366

* Includes such transactions as denominational exchanges, wire transfers,
exchanges of coupons for registered securities, etc.
t Includes various corporate and municipal securities.

million, and the total for the country as a whole, as re­
ported to the Treasury, exceeded $30 million.
It was obvious that we all had a serious new problem
on our hands. As we saw it, there were two basic ways to
approach the problem. The first— which required imme­
diate action— was how to recover the securities already
stolen. The second— of longer term application and im­
portance— was how to prevent securities being stolen in
the first place.
MEASURES FOR RECOVERY

In reviewing the first question— measures for the re­
covery of stolen securities— it appeared to us that there
was then no centrally coordinated system for distributing
current information on missing Government securities
within the financial community. Lists of stolen securities
were distributed from time to time, depending on the
efforts of the institutions suffering the loss, but for the
most part the lists were not distributed widely through­
out the country and, since they could not be kept up to
date, they soon became obsolete.
As for the Reserve Banks, traditionally their role with
respect to Government securities had been limited to
their responsibilities as fiscal agents of the United States,
carrying out the instructions of the Treasury Department.
Prior to 1958, the Treasury had maintained various lists
of certain Government securities reported as missing or
stolen by individuals throughout the country, and it dis­
tributed such lists to the Reserve Banks. Over the years,
however, the maintenance of the lists presented difficult
operating problems— particularly as the volume of Trea­




167

sury securities increased— and it also involved compli­
cated legal questions for the Treasury as the issuer of the
securities. In view of these problems, in 1958 the Treasufy
discontinued the distribution of the list and instructed the
Reserve Banks to terminate the maintenance of the list.
When we reviewed the situation with the Treasury in
the fall of 1969, it appeared that it would be impracticable
for the Treasury to try to reinstitute the former proce­
dures to meet the acute problem that had developed as
of that time. In view of the magnitude of that problem,
however, it was clear that the Reserve Banks had a direct
and immediate interest in the matter, apart from their
responsibilities as fiscal agents of the United States; they
had a concern in the problem as it affected the banking
system, and also as it affected the Government securities
market, through which monetary policy is implemented.
Accordingly, with those interests in mind, we began to
develop a new kind of procedure— we call it a “checklist
procedure”— for maintaining a surveillance for Govern­
ment and agency securities reported as stolen or missing
from the financial community.
The procedure was first initiated at the Federal Reserve
Bank of New York in December 1969, and was gradu­
ally coordinated with similar procedures established at
other Reserve Banks. By the summer of 1970, a uniform
system had been developed for use by all thirty-six Fed­
eral Reserve Banks and Branches throughout the country.
The operation of the national system is described in detail
in a circular letter issued by the Federal Reserve Bank
of New York dated October 23, 1970. Similar letters were
issued by the other eleven Reserve Banks.
The object of the checklist procedure is to maintain
a current list of stolen securities at all Reserve Bank
offices, based on reports received from banks and other
financial institutions throughout the country. Up-to-date
information is promptly circulated to all Federal Reserve
offices, by wire, through the Federal Reserve Bank of
New York, which acts as the coordinating bank for the
System. With the list, each Reserve Bank office is able
to check securities received at the office. Each office also
serves as a clearing house for information on stolen secu­
rities within its own territory. It is prepared to answer
legitimate inquiries regarding stolen securities, and is
also prepared to facilitate prom pt contact with the ap­
propriate law-enforcement authorities, including the local
police as well as the Federal Bureau of Investigation (FBI).
The basic aim of the checklist procedure is to discover
securities on the checklist; in the words of our circular
letter, “whenever a listed security is discovered, the Fed­
eral Reserve office will inform the appropriate lawenforcement agency, as well as the Treasury and other

168

MONTHLY REVIEW, AUGUST 1971

interested parties, of the discovery so that they may act
promptly in taking whatever steps they may deem nec­
essary. The Federal Reserve’s primary function is to
inform the appropriate parties of the discovery of a listed
security as promptly as possible” .
In general, the checklist is intended to supplement ex­
isting procedures. It is no substitute for the normal re­
porting of crimes to the appropriate law-enforcement
agencies. The procedure was established within the frame­
work of existing Treasury regulations and is based on full
cooperation with the FBI and the local police.
Experience with the checklist to date indicates that it
has been fairly successful in achieving its limited objec­
tives. At the New York Reserve Bank alone, we have had
hundreds of inquiries involving stolen securities, and we
have been involved in about thirty cases in which the
checklist procedure was instrumental in the discovery of
stolen securities. At least seven other Federal Reserve
offices have been involved in similar cases.
A part from the fact that the checklist procedure has
led to the recovery of securities, we believe that one of
its principal benefits is simply the fact that it exists. The
fact that the community is aware that the Federal Reserve
Banks are now checking for missing securities, and that
they serve as a central clearing house for information, in­
suring the prompt relay of such information to the authori­
ties, should serve as a deterrent to the criminal elements
dealing in such securities.
I might note at this point that there have been other
developments during the last year or so that should also
serve to discourage Government securities thefts, and
hopefully help to continue the recent decrease in the inci­
dence of such thefts. Such developments— most of which
have already been referred to in these hearings— include
(1) cooperative efforts among the various sectors of the
financial community to cope with the problem— reflecting
in general an increased awareness and concern within the
community— including for example, the work done by
the Banking and Securities Industry Committee (BASIC)
and related groups, such as the Joint Industry Control
Group and the Joint Bank-Securities Industry Committee
on Securities Protection; (2) as a result of such coopera­
tive efforts, the development of the Securities Validation
System, the data bank on stolen securities recently put into
operation as a commercial venture by Sci-Tek, Inc.; (3)
better utilization of the F B I’s National Crime Information
Center (N C IC ); (4) changes in Treasury administrative
procedures designed to speed up the processing of Gov­
ernment securities; and (5) the good record of recovery
of stolen Government securities, in large part as a result
of the efforts of the banks suffering the losses, in co­




operation with the insurance companies and the lawenforcement agencies; an outstanding example is the
record of recovery in the Morgan Guaranty case.
LONGER TERM SOLUTIONS

The checklist procedure, and similar measures for re­
porting stolen securities, are designed to recover missing
securities. Much more important, of course, are measures
designed to prevent or minimize the loss of securities in
the first place. At the Federal Reserve Bank of New York,
we have been working on such measures in two areas.
The first is the B ank’s Government Securities Clearing
Arrangement; the second is the book-entry procedure for
Government securities, in use at all Reserve Banks.
Securities Clearing Arrangement. The Government Se­
curities Clearing Arrangement was developed by the New
York Reserve Bank several years ago as a means of reduc­
ing to a minimum the need for the physical handling of
securities in transactions involving the major New York
City banks active in the Government securities market. In
brief, the Clearing Arrangement permits each of the par­
ticipants to send and receive Government securities to and
from any other participant, and to and from any other
Federal Reserve District throughout the country, by means
of transfer messages entered into terminals in its premises,
with only a single net settlement of the physical securities
involved at the end of the day. Instead of requiring the
banks to make deliveries of the physical securities under­
lying each transaction— to or from the New York Reserve
Bank or to or from any other participating bank— the
Clearing Arrangement’s net settlement procedure requires
only one delivery, and only of the net amount of securities
due to or from a bank at the end of the day. Obviously,
such a procedure greatly reduces the need to handle phys­
ical securities, and thus the exposure to loss. As an indi­
cation of the volume involved, during the last twelve
months, there was a total of 300,000 transfers, represent­
ing about $390 billion, processed through the Clearing
Arrangement; as a result of the offsetting of transactions
through the clearing process, about 75 percent of this
amount, or $290 billion, did not involve any physical
securities.
Until recently, the Clearing Arrangement was based on
low-speed teletype equipment. A t the present time, we
are completing a process of conversion to new high-speed
equipment, based on a new computer switch at the New
York Reserve Bank, which is integrated with the Federal
Reserve System’s new national communications network.
With the new equipment, we expect to increase greatly the
volume and velocity of securities transfers processed
through the Clearing Arrangement, and that in itself

FEDERAL RESERVE BANK OF NEW YORK

should reduce further the need to handle physical securi­
ties. More important, however, is the capability we will
have for integrating the Clearing Arrangement with the
book-entry procedure, thereby achieving almost complete
automation in Government securities operations and re­
ducing to a minimum the need for any handling of physical
securities.
Book-entry procedure. Several references have been
made to the book-entry procedure during the course of
these hearings. In brief, the book-entry procedure is a
system under which a definitive Government security— the
piece of paper representing a Government obligation— is
eliminated, and the obligation is recorded on the com­
puterized books of a Federal Reserve Bank. In this re­
spect, the book-entry procedure is the optimal solution
to the problem of thefts of Government securities— as well
as the problem of counterfeiting such securities— for it
eliminates the security. Beyond that, however, it provides
the key to the ultimate automation of all Government
securities operations.
The creation of the book-entry system has not been
easy. Nor is the system completed. It has been a gradual
process of conversion, with much more to do. Without
going into detail, it is enough to say that the conversion
of each class of security account has presented new and
different legal problems, tax questions, and operational
complications. These are a reflection of the fact that for
centuries the law, commercial practices, and traditions
governing transactions in securities— including, for exam­
ple, sale, purchase, assignment, negotiation, endorsement,
hypothecation, delivery, taxation, and creditors’ rights—
have all been based on the existence of a piece of paper
having intrinsic value. Under the book-entry procedure,
that piece of paper no longer exists. In this respect, the
book-entry procedure is indeed a revolutionary concept,
and it should be no wonder that its continuing develop­
ment must be a gradual process.
The first phase of the process began on January 1,
1968, after several years of study by the Federal Reserve
and the Treasury. At that time, the procedure was applied
to the securities owned by member banks and held in
custody at their Federal Reserve Banks. The procedure
was then gradually extended to cover other types of ac­
counts held at the Reserve Banks. By 1970, most of these
accounts had been converted; the next step in the program
was to go beyond the securities already held at the Reserve
Banks, and to convert the securities held in custody by
the member banks themselves for account of third parties.
It was recognized that this step in the program marked
an entirely new direction in the further expansion of the
book-entry procedure, and it was expected that it would




169

take the banks a considerable amount of time to complete
the process of conversion.
INSURANCE CRISIS

That was the situation that existed as of December 1,
1970, when the so-called “insurance crisis” emerged in
the Government securities market. The Subcommittee has
already heard testimony on that problem, but I would
like to review it for a moment from the point of view of
the Federal Reserve and as an example of the serious
consequences that can result from the underlying problem
of securities thefts.
Beginning in 1969, particularly with the sharp increase
in Government securities thefts in the latter half of that
year, the insurance companies active in this field became
more reluctant to continue their coverage of such secu­
rities. Unfortunately, despite some of the measures devel­
oped during 1970, the dollar amounts of the thefts con­
tinued at a relatively high level during most of the }rear.
For 1970 as a whole, losses of marketable Government
securities reported to the Treasury amounted to over $30
million.
The insurance companies were obviously concerned
about the amount of those thefts. They were just as con­
cerned, however, by the fact that they could not recover
on claims filed with the Treasury until after the maturity
date of the missing securities, even in cases where it ap­
peared that the securities would never be presented for
redemption and even where the company was willing to
sign a bond of indemnity. The reason for this was that
the Treasury did not have the legal authority to provide
relief on such claims before the maturity of the missing
security.
As the Subcommittee has heard, as a result of this
situation, a major insurance company announced plans
in December 1970 to exclude all bearer Government secu­
rities from its blanket bond coverage for dealers and
brokers and to limit severely its coverage on such securi­
ties held by money center banks in New York City. Since
the company was a predominant carrier in this field, it
became immediately obvious that, if it were to proceed
with its plans, which were to become effective early in
January— and even if no other insurance companies fol­
lowed suit, which at that time was doubtful— there would
be most severe consequences for the Government securi­
ties market. Many of the major institutions which consti­
tute the market— including the nonbank primary dealers,
the bank dealers, and the clearing banks— carried cover­
age by that company. Without adequate coverage, it was
entirely possible that the banks and dealers affected would
terminate their handling of Government securities. If they

170

MONTHLY REVIEW, AUGUST 1971

were to do so, the market would cease to function effec­
tively.
These developments served to dramatize a very funda­
mental fact that is usually taken for granted— the fact that
an effective and efficient Government securities m arket is
essential to the national economy. From the point of view
of Government, it is essential for Government financing
and the general management of the public debt. From the
point of view of the Federal Reserve, it is essential as the
means through which monetary policy is implemented,
the tool that is used to affect the level of money and credit
in the economy. To perform effectively, the Government
securities market must have depth and breadth; it was
obvious that the market could not perform effectively
without the participation of many of the major institutions
that comprise the market.
It was in the light of these considerations that the New
York Reserve Bank undertook a program in December
1970 designed (1 ) to provide for contingency planning
to ensure the continued functioning of the Government
securities market in the event that m ajor participants
terminated their securities operations because of inade­
quate insurance coverage and (2) to reduce the risk of
thefts of Government securities by accelerating the further
expansion of the book-entry program, thereby encour­
aging the insurance companies to continue their coverage.
A t the same time, the Treasury undertook a complemen­
tary program (1 ) to facilitate the further expansion of the
book-entry procedure, including the resolution of certain
tax questions by the Internal Revenue Service and (2 ) to
accelerate the time within which relief on stolen securities
could be granted.
In the light of such a program, a decision was made by
the insurance company to continue coverage for the banks
affected, on a curtailed basis, for a period of ninety days,
at the conclusion of which the situation would again be
reviewed. Coverage was not extended, however, for bearer
Government securities held by dealers and brokerage firms.
During the ninety-day period, the Treasury proposed
legislation in the Congress to permit it to accelerate the
granting of relief on stolen securities— such legislation
was subsequently enacted as Public Law 92-19, approved
May 27, 1971— and substantial progress was made in im­
plementing the program for further extending the bookentry procedure. It was against the background of these
developments that the insurance company, as the Sub­
committee knows, decided to negotiate with the banks
concerned to continue coverage beyond the ninety-day
period.
As for the brokerage firms, it appears that there has
been a general trend, by most of the insurance companies




active in the field, to exclude coverage on bearer Govern­
ment securities while they are in the premises of the firm.
The net effect of such a development has been that the
brokerage firms affected either enter into arrangements
with banks for the custody and handling of their Gov­
ernment securities or else they decide to terminate their
business in such securities. Hopefully, as the problem of
Government securities thefts is brought under control,
insurance coverage on bearer Government securities will
again be generally available to those brokerage firms that
wish to handle such securities for their customers.
As the Subcommittee knows, there are indications that
the measures thus far taken may have had an effect of
containing the problem of Government securities thefts.
Treasury records indicate that the level of such thefts has
been relatively low so far this year— about $3 million in
the first five months, with less than $500,000 from finan­
cial institutions in New York City. While it is too early to
draw any optimistic conclusions from these figures, we are
all hopeful that the trend will continue.
Over the long run, of course, the best solution is the
book-entry procedure. A t this point, we are in the process
of extending the procedure to securities owned by cus­
tomers of banks. The current status of the program is
described in our circular letter of April 26, 1971. As in­
dicated in that letter, we have started with the large New
York City banks— those that have been most exposed to
the problem of insurance coverage— and we expect the
program to be available for all member banks throughout
the country within a m atter of months. At the present time,
over $125 billion in Treasury securities is in book-entry
form, with $110 billion of that amount at the Federal
Reserve Bank of New York. Thus, well over one half of
the $230 billion of Treasury securities outstanding in
bearer form— those most vulnerable to theft— is in bookentry accounts. Gradually, as the banks bring in their
customer securities, we expect that a m ajor portion of
the remainder of the $230 billion will be converted to
book-entry form and that ultimately there will be relatively
few pieces of paper in existence evidencing a Government
debt obligation.
In New York City, we can foresee the day— not too
long distant— when virtually all transactions in the central
Government securities m arket will be effected through the
Government Securities Clearing Arrangement by means
of entries on computer terminals in the premises of the
participating banks, with little need ever to handle— or
even issue— a piece of paper representing a Government
security. The transmission and accounting will be done by
computer, and billions of dollars in Government securities
will flow to and from all sectors of the m arket through our

FEDERAL RESERVE BANK OF NEW YORK

computer switches. Obviously, this will greatly assist in
eliminating the present problem of thefts in the Govern­
ment securities market.
OTHER SECURITIES
BOOK-ENTRY SYSTEMS

It is just as obvious that some kind of book-entry com­
puter system or systems for corporate and municipal se­
curities would also help solve the problem of thefts of
those securities as well. However, the obstacles to be over­
come in the corporate and municipal area are quite com­
plex and require considerably more study. In the case of
Government securities, we have been working on the
problem for many years and have been fortunate in having
to deal with only one issuer— the United States Govern­
ment— and only one body of applicable law— Federal law.
In the case of corporate and municipal securities, there
are thousands of issuers, and the laws of fifty states to
contend with. Nevertheless, despite the obstacles, it would
appear that this is the direction in which the financial com­
munity must go, and indeed there has been significant
progress in moving forward in this direction. The estab­
lishment of the Central Certificate Service is clearly a step
in this direction and, as the Subcommittee knows, there
have been many studies of proposals for the further immo­
bilization or ultimate elimination of stock certificates.
While we are not in a position to judge the relative
merits of the various proposals under consideration, it
seems to us that the ultimate objective should be the re­
duction to a minimum of transactions requiring the pro­
cessing and exchange of pieces of paper having intrinsic
value. Based on our experience with the book-entry pro­
cedure, we do not expect that the financial community
can achieve this objective overnight; much more work and
time is required. As a Federal Reserve Bank, we of course
have an interest in the effective functioning of all financial
markets, and we are prepared to offer whatever assistance
we can in moving forward in this direction.
MEMBER BANK PRACTICES

In addition to our general interest in the long-term
possibilities of developing some kind of book-entry sys­
tems for the corporate and municipal securities markets,
we also have a specific interest in the problem of stolen
corporate and municipal securities— and that is the ex­
tent to which banks subject to our supervision may be­
come involved with such securities.
In general, a bank may become involved in a stolen
security case where (1) the security is stolen from its
custody or (2 ) the bank receives a stolen security in the




171

course of its business, such as collateral for a loan. The
Federal Reserve has developed rules and standards appli­
cable in such cases to state member banks, and the Fed­
eral Reserve Bank examiners review compliance with such
rules and standards during the course of their examina­
tions.
One of the basic rules requires that every bank subject
to Federal Reserve supervision should report any apparent
violation of the Federal banking laws to its Federal R e­
serve Bank. Such reports are then forwarded to the local
United States Attorney and to the Departm ent of Justice.
An example of the standards applicable to cases in which
securities are offered to a bank as collateral is set forth
in a Federal Reserve System letter on the subject dated
M arch 3, 1971. During their examinations, the Federal
Reserve Bank examiners determine whether such stan­
dards are being applied by the member banks.
We are continuing to study this question, particularly
in the light of the valuable information produced as a
result of these hearings, with a view to determining how
our standards may be improved to ensure that banks
maintain adequate safeguards against the risk of loss of
securities as well as the risk of accepting stolen securities
in the course of their business.
In this connection, the Federal Reserve has for some
time been of the view that it would be desirable to have
some kind of coordinated, centralized, and current check­
list and information system on corporate and municipal
securities available for direct and immediate access by the
financial community. As one possibility for such a system,
we have worked with the Joint Bank-Securities Industry
Committee on Securities Protection in its project for a
data bank on stolen securities. As the Subcommittee
knows, this is the project that has been developed by
Sci-Tek, Inc., as the Securities Validation System. Follow­
ing a pilot program, the system began on-line operations
last month. We are continuing to watch its progress, and
are hopeful that the basic concept can be developed into
a useful tool for the financial community.
LEGISLATIVE RECOMMENDATIONS

In response to the Subcommittee’s offer, we have re­
viewed, in the light of our experience and responsibilities,
the possible need for legislation to assist in dealing with
the problem of securities thefts. On the basis of our re­
view, we do not believe that legislation is necessary in
more than one or two areas at this point in time.
With respect to the Reserve Bank checklist procedure
for Government securities, no legislation appears neces­
sary for its continued operation or future development.

MONTHLY REVIEW, AUGUST 1971

172

However, our experience with the procedure has indicated
that it might be helpful, primarily to clarify the jurisdiction
of the FBI, to enact Federal legislation to make the theft
of a Government security a crime in itself, rather than
limit Federal jurisdiction to cases involving thefts from
banks or cases in which stolen securities having a value
of $5,000 or more are transported in interstate or foreign
commerce. Such a proposal has already been discussed
in the course of these hearings, and we would support its
further consideration.
With respect to a data bank or centralized information
system on stolen corporate or municipal securities avail­
able to the financial community, we would favor the devel­
opment of such a system. It does not appear, however,
that Federal legislation is necessary to facilitate such de­
velopment. If it should appear that at some future date
such legislation would be helpful, we would trust that it
would be given favorable consideration.
With respect to commercial bank practices in connec­
tion with stolen securities, we believe that the present
banking laws are adequate and permit the Federal bank
supervisory agencies sufficient authority and flexibility to
deal with the problem of securities thefts. The Federal
Reserve will continue to study the matter with a view to
determining the extent to which further administrative
action may be desirable.

With respect to the corporate and municipal securities
markets, we would favor in principle any proposal that
would reduce to a minimum— whether by immobilization
or elimination of the securities— the need to process and
exchange pieces of paper having intrinsic value. At this
point, it does not appear that Federal legislation is neces­
sary to move forward in the development of such a pro­
gram. In any case, much more study of this question is
essential before legislative action— whether on a Federal
level or a state level— can be taken. Depending on the
ultimate outcome of the Subcommittee’s present investiga­
tion, perhaps the Subcommittee may wish to consider
means of facilitating such a study, whether by legislation
or otherwise.
With respect to the book-entry procedure, it does not
appear that legislation is necessary at this point to pro­
ceed further with our program. Nor do we see the need for
legislation to extend the program to Federal agency secu­
rities, a step which is planned for the near future by means
of administrative action. However, in view of the rather
revolutionary nature of the book-entry concept, it may
well be that at some point in time legal questions may
arise that might best be resolved by Federal legislation.
In such event, we hope we would be able to seek the
assistance of this Subcommittee in support of such legisla­
tion and in support of the book-entry concept in general.

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FEDERAL RESERVE BANK OF NEW YORK

173

The Business Situation
Business activity continues to recover at a rather slow
pace in a highly inflationary atmosphere. Gross national
product (G N P ), after adjustment for price inflation, ad­
vanced at a seasonally adjusted annual rate of 3.7 percent
in the second quarter, well below the growth rate registered
at the similar stage of each of the three other post-Korean
war business recoveries. The most recent monthly data,
moreover, do not suggest any immediate change in the rate
of recovery. In June, new orders for durable goods declined,
industrial production remained virtually stable, and the
rise in personal income (net of the increase in social se­
curity benefit payments) was smaller than in May. On the
other hand, retail sales in June showed another sizable
improvement according to the advance report, thus sus­
taining the strength that had emerged earlier in the
quarter. Housing starts also rose further in June, and the
continued high level of newly issued building permits
implies that some additional upward movement in starts
may be forthcoming. The underlying inventory situation
seems conducive to a more expansionary pace of inventory
spending, inasmuch as inventory-sales ratios in most sectors
are at comfortable levels. However, the rundown of strikehedge steel inventories is likely to limit the overall rate of
inventory investment during the coming months.
Recent price developments continue to be thoroughly
disappointing. Aside from some temporary moderating
influences, there is little, if any, evidence of a slowing in
the rate of inflation. In fact, during the most recent
months, both consumer and wholesale industrial prices
have been climbing more rapidly than they did earlier in
the year. Cost pressures, moreover, remain very strong.
GROSS NATIONAL PRODUCT

According to preliminary estimates by the Department
of Commerce, the market value of the nation’s output of
goods and services rose by $19.7 billion during the second
quarter to a seasonally adjusted annual rate of $1,040.5
billion. This gain was a shade higher than the average
advance over the previous two quarters, the first of which




was depressed by the automobile strike and the second
considerably swollen by the subsequent rebound in auto
production. Slightly more than half of the GNP growth in
the April-June period took the form of higher prices,
leaving the rise in real GNP at a 3.7 percent annual rate.
Since the fourth quarter of last year, which has been
tentatively identified by the National Bureau of Economic
Research as the trough quarter of the contraction, real
output has grown at a 5.8 percent annual rate. However,
the magnitude of the rise in real GNP over this period
is biased upward because economic activity in the fourth
quarter was, as noted above, temporarily depressed by
the automobile strike. With certain allowances for the
effects of the strike, the growth rate in real GNP since the
cyclical trough has been about 1x/ i percent, or 3 percent in
annual rate terms. Whatever the precise impact of the auto
strike, it is clear that the upswing in real GNP in the two
quarters since the cyclical trough has been very modest by
comparison with the experience in the three other postKorean war recovery periods. For example, over the two
quarters following the troughs of the 1953-54 and the
1957-58 recessions, real GNP expanded by about 5 per­
cent, or at an annual rate of 10 percent. Similarly, two
quarters after the 1960-61 recession bottomed out, ad­
vances in real GNP amounted to a substantial 4 percent,
or an 8 percent annual rate (see Chart I).
Recent movements in the Federal Reserve Board’s in­
dex of industrial production (which has been substantially
restructured and revised)1 also attest to the slow tempo
of recovery. After having risen 0.7 percent in April and
again in May, it edged upward in June by only 0.1 percent.
Despite the added thrust provided by strike-related gains
in automobile and steel production, the overall rise in in­
dustrial output since last November has been a modest
4.3 percent, thus leaving the index in June 4.4 percent

1See “Industrial Production— Revised and N ew M easures”, F ed­
eral R eserve Bulletin (July 1971), pages 551-76.

MONTHLY REVIEW, AUGUST 1971

174

C hart I

REAL G R O S S N A T IO N A L PRODUCT IN
FOUR E C O N O M IC CO NTRACTIO NS A N D RECOVERIES
P ercent

P ercent

A

BUSINESS-CYCLE T R O U G H

/'A
s f X
\

\

\\

-

1

V

—

_

1 9 5 7 -5 9

y / / \

1 9 6 0 -6 2

/r
_■—

----------X. _ _ __

■
_

*

1
1969-71

1 9 5 3 -5 5

—

Q u a rte rs b e fo re tro u g h
.
-

*

4

N o te :

.
-

1

..
3

!
-

2

......
-

1
1

Q u a rte rs a fte r tro u g h
0

...

1.
1

____ L
2

...

__

3

4

The b u s in e s s -c y c le tr o u g h s , as id e n tifie d b y th e N a tio n a l B u re a u o f

E c o n o m ic R e s e a rc h , a re A u g u s t 19 54 , A p r il 1958, F e b ru a ry 1961, a n d
N o v e m b e r 19 70 ( te n ta tiv e ).
* A d ju s te d a t th e F e d e ra l R e s e rv e B a n k o f N e w Y o rk fo r th e im p a c t o f th e
a u to m o b ile s trik e .
S o u rc e :

U n ite d S ta te s D e p a r tm e n t o f C o m m e rc e .

below the pre-recession peak attained in September 1969.
Sharply reduced levels of steel production will retard the
growth of the overall index in the near future, as con­
sumers work off their strike-hedge inventories of raw or
semifinished materials.
During the second quarter, current-dollar final expendi­
tures, i.e., GNP net of inventory investment, climbed
$18.2 billion, about equal to the average of the two pre­
ceding quarters. This second-quarter rise in final expendi­
tures was paced by a large $15.5 billion advance in con­
sumer spending, as outlays for services and in particular
nondurable goods posted considerable increases. The
second-quarter gain of $2.4 billion in consumer spending
on durables stemmed partly from an advance of $1.4 billion
in outlays on automobiles and parts. The latter, in turn,
reflected to a large extent the continued strength in sales
of imported cars.
Over the first six months of 1971, sales of new domestic
passenger cars were running at a seasonally adjusted
annual rate of 8.3 million units (see Chart II). This
figure, although well ahead of the total for 1970, was
somewhat below the 8.5 million units averaged over 1968
and 1969. In contrast, total auto sales, at just under 10
million units during the first six months of this year, have
surpassed the 1968-69 average of 9.6 million units. The




difference is accounted for, of course, by the dramatic
increase in sales of imported cars. Imports were selling
at a 1.8 million unit annual rate in June and at a 1.7
million rate in the second quarter as a whole. This brought
their share of the new car market to approximately 18
percent in June, the highest on record except for the
strike-distorted final months of last year. D ata for July
show the rate of sales of domestic autos the same as dur­
ing the first half of the year, with imports selling at a
1.6 million unit pace.
The large second-quarter rise in consumer spending
recorded in the GNP accounts had been suggested by
developments in retail sales over the quarter. The pre­
liminary data for June— which could be sharply revised—
indicate considerable further strengthening in retail pur­
chasing at the end of the quarter. Indeed, these statistics
show that total retail sales advanced by a hefty 1.6 per­
cent in the month, with all major categories sharing in
the gain. The June increase followed large upward revi­
sions in the data for each of the three preceding months.
Even with the sizable advance in personal consumption
outlays in the second quarter, consumers stepped up
their rate of savings. As a consequence, the ratio of
personal savings to disposable or after-tax income climbed
to 8.3 percent from 8.1 percent.2 Much, if not all, of this
second-quarter rise can be traced to the increase in social
security benefit payments that occurred in June. Since the
new benefits were retroactive to January 1, the June
payments included lump-sum payments for the earlier
months of the year as well as the permanent increase in
benefits. In the aggregate, this added about %5Vi billion
(at an annual rate) to second-quarter disposable income.
However, the checks probably were received too late
in the quarter to affect consumer spending appreciably,
with the consequence that the savings rate increased
significantly. Nevertheless, the rate was very high even
aside from this factor. Indeed, over the six quarters ended
in the April-June period, the savings rate averaged 8 per­
cent in contrast to an average of about 6 lA percent over
the post-Korean war period as a whole.

2
A long with the preliminary G N P data for the second quarter,
the Departm ent o f Com m erce released its annual revisions o f the
G N P and related data for the last three years. In terms of the
spending aggregates, m ost o f the revisions were small. H owever,
reflecting an upward revision in personal incom e and a downward
revision in consum er spending, both the level o f personal savings
and the savings ratio were revised upward by significant amounts.
For exam ple, on the basis o f the earlier estimates, the savings rate
for 1970 was 7.3 percent whereas the revised data show the rate at
7.8 percent.

175

FEDERAL RESERVE BANK OF NEW YORK

Spending on residential construction registered another
strong advance in the second quarter, rising by $2.9
billion to a record seasonally adjusted annual rate of
$39.3 billion; this was 37 percent above the recent low
registered during the third quarter of 1970. The prospects
for continued gains in home building seem good despite
some firming of mortgage market conditions. In June,
housing starts totaled 1.98 million units at a seasonally
adjusted annual rate. This was the largest volume in any
single month of this year and raised housing starts for the
second quarter as a whole to a 1.95 million rate, the
highest since the third quarter of 1950. Although building
permits issued in June backed off somewhat from their
very high May reading, the volume of permits for the
second quarter as a whole points to the likelihood of a
further increase in housing starts in coming months.
In contrast to the thrust provided by residential con­
struction, business fixed investment in the second quarter
advanced only at a slim $1.8 billion annual rate as a result
of a $2.0 billion gain in outlays on producers’ durable
equipment and a small decline in outlays on structures.
This served to confirm the rather sluggish outlook for
capital spending suggested by various surveys, such as the
2.7 percent gain for 1971 indicated by the most recent
Department of Commerce-Securities and Exchange Com­
mission survey. Moreover, the already remote possibility
that business fixed investment spending would strengthen
in the coming months has been further diminished by
other recent developments. As measured by the Federal
Reserve Board’s index of industrial production, output of
business equipment slipped in June in continuation of a
long decline dating from September 1969. The Federal
Reserve also disclosed that manufacturing firms were oper­
ating at a low, seasonally adjusted 73.2 percent of their
capacity during the April-June period, down from the 78
percent averaged over the first three quarters of 1970 which
were relatively free from the effects of the automotive strike.
Inventory accumulation amounted to an estimated $4.7
billion (annual rate) in the second quarter. However, this
figure is still quite preliminary, being based on partial re­
turns for the months of April and May. Analysis of inven­
tory movements in recent quarters is complicated by actual
and potential labor disputes, but it appears that stockpiling
in anticipation of a steel strike accounted for a sizable por­
tion of the second-quarter accumulation. The runoff of
these steel stocks in the coming months will, of course,
act as a drag on overall inventory spending. Apart from
the steel inventory situation, however, the inventory picture
is good, with the inventory-sales ratios for all businesses
and for most major sectors at comfortable levels. This
contrasts with the situation at the turn of the year, when




stocks were somewhat high relative to sales.
Government purchases of goods and services contributed
$2 billion (annual rate) to the second-quarter GNP ad­
vance. Federal outlays dropped by $0.7 billion, as a $1.0
billion contraction in defense outlays was only partially off­
set by a small gain in the nondefense categories. Since peak­
ing in the third quarter of 1969, Federal defense expendi­
tures have fallen by an average of $1 billion per quarter,
so that even a leveling-off would serve to bolster GNP
growth. In this regard, there are some tentative indications
that the prolonged contraction in defense outlays may
have run its course. For example, based on the Federal
Reserve Board’s index of industrial production, defense
and space equipment output increased for the second con­
secutive month in June, although it was still 29 percent
below the peak reached in August 1968.
State and local government spending rose at an annual
rate of $2.7 billion in the second quarter, as the overall
advance was held down by an apparent decline in outlays
on structures and capital-type goods. This latter drop was

C h a rt II

NEW CAR SALES
S e a s o n a lly a d ju s te d a n n u a l rates
M illio n s of cars

P ercent

M illio n s of cars

P ercent

S o u rc e s : S e a s o n a lly a d ju s te d im p o r te d c a r sale s d a ta a r e fro m th e U n ite d State s
D e p a r tm e n t o f C o m m e rc e . D o m e s tic c a r sale s d a ta a re g a th e r e d fro m in d u s tr y
s o u rc e s a n d a re s e a s o n a lly a d ju s te d a t th e F e d e ra l R e se rve B a n k o f N e w Y o rk.

MONTHLY REVIEW, AUGUST 1971

176

probably a statistical fluke, since the very heavy volume
of state and local borrowing in recent quarters is almost
certainly providing an impetus to outlays on structures.
Moreover, the Emergency Employment Act of 1971, which
was signed into law during July, will increase Federal
grants to state and local governments by an additional $1
billion during the current fiscal year. In turn, state and
local spending will rise as these funds are used to provide
public service jobs for the unemployed. Thus, state and
local outlays could show larger gains over the coming
quarters.
Net exports of goods and services, according to still
incomplete data, plummeted from a $4.2 billion annual
rate in the first quarter to a scant $0.1 billion in the
April-June period as a result of a large spurt in imports
and some slippage in exports. This sharp decline in net
exports produced a $4.1 billion drag on the overall rise in
GNP. The Commerce Department noted that imports of
raw materials had increased, partly in anticipation of a steel
strike. Observers point out that steel imports could subside
substantially in the second half of this year, since foreign
steel sellers may already have exhausted their voluntary
quotas on 1971 shipments to the United States.
PRICES, WAGES, AND PRODUCTIVITY

Price developments during the second quarter reflect a
combination of some major setbacks in the struggle
against inflation and a few very tentative and isolated
gains. On balance, there are virtually no signs of a signifi­
cant lessening in the pace of inflation. The most compre­
hensive available measure of price movements, the GNP
deflator, slowed to a 4.2 percent annual rate of increase
in the second quarter, down from the 5.3 percent rate of
the January-M arch period. This deceleration is an over­
statement, however, since the first-quarter deflator was
given a temporary boost by the Federal pay raise, which
accounted for roughly 1 percentage point of the increase
in that period. Moreover, since the deflator is a weighted
average of many component price indexes, with the
weights being determined by output in each current
quarter, shifts in the composition of output c a o obscure
underlying price trends. Both the final quarter of last year
and the first period of 1971 were substantially affected by
the huge swings in the durable consumption goods com­
ponent, which exaggerated the pace of inflation in the
fourth quarter and may have understated it in the first
quarter. In the second quarter of 1971, a continuing shift
in the composition of output toward relatively low-priced
items may have resulted in a further overstatement of the
extent to which inflation moderated. Using the output




weights from the year 1958— the only full-year period for
which such data are available— in an attempt to abstract
from these compositional movements indicates that the an­
nual rate of increase in the deflator during the April-June
period was 5 percent rather than the 4.2 percent indicated
by the current weights scheme. Although somewhat of an
improvement from the 5.8 percent change (1958 weights)
in the first quarter (after excluding the Federal pay raise),
the 5 percent figure is not much lower than the 5 V2 percent
advance averaged over the four quarters of last year. A
similar deflator that uses weights from the fourth quarter
of 1965 leads to essentially the same results.
Wholesale price changes must be interpreted as ex­
tremely discouraging. Movements in the overall index have
been dominated by the erratic behavior of agricultural
prices. Despite a July decrease, prices in the farm products,
processed foods, and feeds category have advanced at a
seasonally adjusted annual rate of 4.2 percent thus far this
year, in contrast to their 1.2 percent decline during all of
1970. More significant, however, are the movements in
prices of wholesale industrial commodities. These increased
at an annual rate of 2.8 percent in the first quarter and 5.2
percent in the second quarter, and soared upward at an
8.4 percent rate in July. During 1970, such prices had risen
by 3.6 percent.
Consumer prices made a poor showing in June, when
the seasonally adjusted index spurted ahead at a 5.5 percent
annual rate. This was somewhat below M ay’s very high 6.7
percent upsurge, but considerably above the 3 percent ad­
vance registered over the first four months of this year. The
Bureau of Labor Statistics’ mortgage interest rate index
declined for the sixth consecutive month in June and again
retarded the rise in total consumer prices. Over the first
half of 1971, the total consumer price index rose at a 4
percent annual rate, but without the benefit of declining
mortgage rates it would have advanced at a rate of about
5 percent.
Movements in wages and salaries have provided little
or no relief from inflationary pressures. Measured from
a year earlier, the index of seasonally adjusted compensa­
tion per man-hour for the private nonfarm economy grew
by a rapid 7.9 percent in the second quarter of 1971, the
largest increase since the closing quarter of 1968. Output
per man-hour rose by 3.5 percent from the second quarter
of 1970 to the second quarter of 1971, a gain somewhat
more modest than was experienced at similar stages of
previous economic recoveries since the Korean war. As a
consequence, labor costs per unit of output rose 4.2 per­
cent, representing a definite slowdown from the peak yearto-year increase registered in the first quarter of 1970.
Nevertheless, unit labor costs are still rising at an excep­

FEDERAL RESERVE BANK OF NEW YORK

tionally rapid rate. This upward movement, moreover,
contrasts with declines in parallel periods of previous cycles.
By the second quarter after the cyclical trough, unit labor
costs had fallen 2.7 percent following the 1953-54 reces­
sion, 0.4 percent after the 1957-58 contraction, and 1.2
percent subsequent to the 1960-61 downturn. These earlier
declines resulted from somewhat more rapid rates of pro­
ductivity growth than we have had this time and substan­
tially smaller advances in compensation per man-hour.
The latest Bureau of Labor Statistics survey shows that
the rate of increase in wages and benefits under major
collective bargaining agreements was smaller during the
first half of 1971 than for the full year 1970. The mean
life-of-contract wage and benefit changes negotiated from
January through June was 8.3 percent per year for all
industries, in contrast to 1970’s 9.1 percent. However,
these data, which exclude possible cost-of-living wage
increases, do not warrant the conclusion that there has
been a slowdown in the pace of the advances. M anufac­
turing contracts signed during the first six months of this
year provided for slightly larger average wage rate increases
than last year. Moreover, very few construction labor agree­
ments were included in the first six months’ data, even
though a large number normally occur during the April-




177

June quarter. These construction settlements may well
show up in the surveys covering the latter half of this
year, giving an upward push to the figures for that period.
In addition, the hefty settlements recently reached in pri­
mary metals, transportation, and communications will
leave their imprint on the figures gathered for the third
quarter of this year.
The rapid rise in labor costs has occurred despite the
continuing generally soft condition of labor markets. A
mixed picture emerges from the most recent data. Accord­
ing to the July survey of nonagricultural establishments, sea­
sonally adjusted payroll employment declined by 200,000
workers, the second consecutive monthly decrease. Only
about one fourth of this drop can be traced to the increase
in the number of persons involved in work stoppages for
the entire survey week. The July household survey, on the
other hand, which counts striking workers as employed
and further differs from the payroll survey in terms of
coverage and seasonal adjustment techniques, indicated a
rise in employment of 500,000. Since the seasonally ad­
justed labor force grew by 700,000 persons, the unemploy­
ment rate rose to 5.8 percent, up from the June figure of
5.6 percent which is believed to have been artificially de­
pressed by seasonal adjustment problems.

178

MONTHLY REVIEW, AUGUST 1971

Recent Monetary and Bank Credit Developments
During the second quarter of 1971, the growth rate in
the narrow money supply, M ^ 1 accelerated while the
rates of expansion of most other major monetary ag­
gregates became more moderate. The quickened growth
of Mi reflected a step-up in demand deposit growth, al­
though this may have been exaggerated somewhat by datareporting and seasonal adjustment problems. On the other
hand, time and savings deposit growth at both commercial
banks and thrift institutions tailed off from the recordshattering pace of the first quarter, partly because rising
market interest rates induced investors to channel funds
into— or not to switch out of— alternative investments. As
a consequence, the rate of growth of the broader money
supply measures, M 2 and M 3, slowed somewhat. On bal­
ance, however, the rates of growth in all the money supply
measures remained relatively high by historical standards.
The adjusted bank credit proxy and total bank credit,
like Mo and M 3, advanced more moderately in the second
quarter, with the slowdown in the proxy resulting prin­
cipally from the deceleration in both CDs and other time
and savings deposits. The growth rate of the proxy, how­
ever, was considerably less than the growth rates of the
money supply measures. This was attributable primarily
to the fact that the proxy— unlike the other measures—
includes nondeposit sources of funds and Government
deposits, both of which declined during the quarter. As in
earlier quarters, most of the strength in total bank credit
reflected increases in bank holdings of securities, although
bank purchases of tax-exempt securities slowed consid­
erably. Business loan demand remained sluggish, as cor­
porate borrowers continued to raise large amounts of funds
in the capital markets.

justed annual rate of 11.3 percent (see Chart I) . This ad­
vance, coming on the heels of the 8.9 percent gain regis­
tered in the first quarter, pushed the rate of growth in M x
for the first six months of the year to 10.3 percent. The
rise in the money supply over the first half of this year has
been extraordinarily rapid. As a comparison, over the
decade of the 1960’s the narrow money supply expanded
at a compound rate of only 3.6 percent per year. Of
course, some acceleration in the growth of the money
stock may be desirable in the early stages of business re­
coveries, but the rise in
since November has been
much stronger than that experienced in similar intervals
following the three previous recessions. On the other
hand, the income velocity of money has not increased so
much in this recovery as it did in the early stages of the

C h a rt I

C H A N G ES IN M O N E T A R Y A N D CREDIT A G G REG A TES
S e a s o n a lly a d ju s te d a n n u a l rates
P ercent

P erce nt

THE MONEY SUPPLY MEASURES

During the second quarter of 1971, the narrowly de­
fined money supply, M 1? expanded at a seasonally ad­

1st q u a r te r
1971

I 2 n d q u a rte r
1971

M l = C urrency plus dem and deposits held by the public.
M 2 = M l plus com m ercial bank savings and time deposits held by the p ublic, less
negotia b le certificates o f d e p o sit in denom inations o f $100,000 or more.
A dju ste d bank c re d it proxy = Total member bqnk deposits subject to reserve
requirements plus nondeposit sources o f funds, such as E uro-d o llar b orrow ings

1
For definitions o f M i, M 2, and the adjusted bank credit proxy,
see Chart I. M 3 equals M 2 plus mutual savings bank deposits and
savings and loan association shares.




and the proceeds o f commercial paper issued by bank holding com panies or
other affiliates.
Source.- Board of G overnors of the Federal Reserve System.

FEDERAL RESERVE BANK OF NEW YORK

reserves expanded by 11.1 percent and 10.0 percent,
respectively, little changed from the rates of growth that
prevailed in the first quarter. The growth of reserves was
particularly strong in May in the face of the uneasy finan­
cial market conditions that emerged at the time of the
Treasury’s May refunding. The international financial
crisis and investor concern about the size of upcoming
Government and corporate financing needs, along with
renewed worries about inflation, amplified the pressures
in the financial markets. In June, however, member
bank nonborrowed reserves declined at a seasonally
adjusted annual rate of 6.2 percent, as the Federal Re­
serve sought to counteract the unexpectedly rapid increase
in the money supply in the preceding months. Conse­
quently, for the quarter as a whole the growth rates in
nonborrowed reserves and total reserves were 5.3 percent
and 6.7 percent, well below the first-quarter rates of 11.0
percent and 10.9 percent.
The acceleration in the rate of growth of the narrow
money supply, and particularly its demand deposit com­
ponent, at the same time that the growth of member bank
reserves was slowing down can be explained in part by the
concentration of the increase in demand deposits at coun­
try banks. Required reserve rates are almost always lower
at country banks than at reserve city banks, so that a
given input of reserves can support a larger volume of
demand deposits at country banks than at reserve city
banks. A second factor explaining the development was
a shift in the mix of new deposits in the second quarter
relative to the first quarter (see Chart II ). In the Januaryto-M arch period, the demand deposit component of M 1
expanded by 8.9 percent while time and savings deposits
other than large CDs grew by 27.0 percent. Thus, a
relatively large share of the growth in reserves was used
to support the huge increase in time deposits. In the sec­
ond quarter, the growth of time deposits tailed off sharply
to 13.5 percent while demand deposit growth accelerated
somewhat to 11.8 percent. As a consequence, in the three
months ended June, a substantially larger share of the
additional reserves was supporting demand deposit growth
than in the previous period.
Because of the slowdown in the rate of growth of time
and savings deposits, there was also some reduction in
the rate of expansion of M 2. This measure posted a 12.6
percent seasonally adjusted annual rate advance during
the three months ended June. In the first quarter, M 2 had
advanced 17.8 percent. Although the increase in time
and savings deposits other than CDs remained strong by
historical standards, the second-quarter 13.9 percent sea­
sonally adjusted annual rate of growth was significantly
B ulle­
below the rates of gain experienced in the first quarter.

three preceding recoveries. Part of the advance in M 1
can be explained by policy actions during the first quarter,
which were designed to bring about a more rapid growth
in the money stock in order to compensate for the short­
fall in growth that occurred during the fourth quarter of
1970 in the wake of the General Motors strike. While
this factor may explain part or all of the acceleration in
the growth in M x during the first quarter, the reasons for
the further step-up in growth over the April-June interval
are not so apparent.
The complexities involved in the measurement of the
money supply are such that a clear explanation of the
reasons for the rapid growth of M x in the second quarter
is difficult to establish, even in retrospect. There is some
evidence that much of the growth in demand deposits
materialized at “country” member banks and at non­
member banks. Data-reporting problems are particularly
troublesome at nonmember banks, since complete reports
of deposit levels are made only twice a year. Compli­
cations arising from the removal of seasonal variations
from the money stock data may be another source of error.
The new Federal Reserve Board survey of demand
deposit ownership2 sheds some additional light on the
recent behavior of the money supply. Data from this
survey report levels of gross demand deposits held by
financial businesses, nonfinancial businesses, consumers,
foreigners, and all others. Since these data are not sea­
sonally adjusted, and are available only for one year,
meaningful analysis of quarterly changes in the pattern
of deposit ownership is quite difficult. Over the full year
ended June, the data do indicate that demand deposits
held by consumers rose considerably faster than total
deposits, accounting for more than 50 percent of the
aggregate deposit increase. The more rapid rise in con­
sumer demand deposit holdings is consistent with the
stepped-up pace of consumer transactions that emerged
over this period. However, the rapid increase in these
deposits may also reflect some precautionary deposit
building, as consumers reacted to the uncertainties of
rising unemployment and inflation.
Whatever the role of these various factors in contrib­
uting to the advance in the money supply, it must be rec­
ognized that the growth of member bank reserves— at
least through May— was also rapid, thereby facilitating a
sharp rise in the money stock. For example, in the period
between March and May, nonborrowed reserves and total

2
Details of this survey are reported in the Federal R eserve
tin (June 1971), pages 456-67.




179

180

MONTHLY REVIEW, AUGUST 1971

C h a rt II

C H A N G ES IN DEPOSITS A N D RESERVES
S e a s o n a lly a d ju s te d a n n u a l ra te s

O th e r tim e a n d
s a v in g s d e p o s its

P riv a te d e m a n d
d e p o s its *

|

11 st q u a r te r

jjj|

1971
* Deposits at a ll com m ercial banks.
^ E x cluding negotiable certificates o f deposit in denom inations o f $100,000 or more.
Source: Board of G overnors o f the Federal Reserve System.

This more moderate growth probably in part reflected
increases in market interest rates during the quarter that
induced investors to channel savings into other instru­
ments. In response to these developments, a number of
major commercial banks increased the rates paid on pass­
book and term savings to the maximum permitted under
Regulation Q ceilings.
Deposit inflows to the thrift institutions were also less
strong during the second quarter relative to the first quar­
ter. According to the preliminary estimates, deposit in­
flows at savings and loan associations and mutual savings
banks during the three months ended June expanded at a
17.6 percent seasonally adjusted annual rate. While this
growth rate was very strong compared with past years, it
represented a considerable slowing from the first quarter
when thrift institution deposits rose by 24.0 percent. R e­
flecting the slower growth of time deposits, M 3 posted a
14.8 percent gain in the quarter, compared with a rise of
19.0 percent in the first three months of the year.
ADJUSTED BANK CREDIT PROXY
AND NONDEPOSIT LIABILITIES

The adjusted bank credit proxy grew moderately in the
second quarter, rising at a seasonally adjusted annual rate
of 6.5 percent. This followed a gain of 10.9 percent dur­




ing the first three months of the year. Thus, for the six
months ended June the growth rate in the proxy was a
shade under 9 percent. In light of the very rapid growth
in Mi and M2 over this same period, the slower growth
rate in the proxy may appear inconsistent. However,
virtually all of the disparity can be explained by the be­
havior of United States Government deposits and of non­
deposit sources of funds, primarily commercial bank
liabilities to foreign branches and bank-related commer­
cial paper. In total, these items declined by $9 billion on a
seasonally adjusted annual rate basis over the first six
months of the year. Since they are included in the proxy
but excluded from M x and M 2, the declines in these
components retarded the growth of the proxy relative to
the money supply measures.
The deceleration in the rate of growth of the proxy in
the second quarter from its pace in the first quarter can
be traced in part to the previously noted slowdown in the
growth rate of commercial bank time and savings de­
posits other than large CDs. Beyond this, however, the
growth of large CDs continued to slacken, Government
deposits declined, and the runoff of nondeposit liabilities
persisted. Over the quarter as a whole, CD growth at
weekly reporting banks totaled $800 million, seasonally
adjusted, the smallest such quarterly gain since Regulation
Q ceilings on these deposits were suspended last sum­
mer (see Chart III). The overall growth in CDs for the
quarter was held down as a result of their absolute
decline in April, when many corporations apparently used
maturing CDs to meet their tax obligations. Rising market
interest rates forced banks to raise their CD offering rates
substantially in order to attract such funds. The rate most
often quoted for maturities of sixty to eighty-nine days
increased by 175 basis points over the quarter.
Reflecting in part the strength in private deposit flows,
bank reliance on nondeposit sources of funds continued
to diminish (see Chart III). Liabilities to foreign
branches, the major nondeposit source of funds, fell in
April and May by $1,858 million and $735 million, re­
spectively.3 The decline in April was, to a large extent,

3
The data on liabilities to foreign branches reported here differ
from the data printed in the Federal R eserve Bulletin in several ways.
The series used in this article is based on weekly averages o f daily
figures rather than W ednesday levels. M oreover, it includes liabilities
to branches in United States possessions, territories, Puerto Rico,
and overseas military installations. These and other minor adjust­
m ents yield a series of liabilities that are subject to the reserve
provisions o f Regulation M. The series in the B ulletin, on the other
hand, is directed toward the balance-of-paym ents im pact o f the
liabilities.

181

FEDERAL RESERVE BANK OF NEW YORK

a reflection of the Treasury’s $1.5 billion issue of threemonth certificates of indebtedness to foreign branches of
United States banks. These instruments, like the two spe­
cial note issues sold earlier by the Export-Import Bank,
were designed to absorb Euro-dollars in order to reduce
any adverse international developments resulting from
the rundown of liabilities to foreign branches. Holdings of
these securities issues can be counted in the calculation of
the reserve-free base. This allows the banks to run down
their liabilities to foreign branches by the amount of the
securities purchased without incurring a future reserve
penalty should they start to rebuild such liabilities. Since
April 9, the outstanding volume of special securities has
remained at $3 billion, as the first Export-Im port Bank
note issue of $1.0 billion was rolled over on April 26 and
the second $0.5 billion Export-Import Bank note issue was
replaced by a Treasury certificate of indebtedness on June 1.
In June, liabilities to foreign branches reversed direc­
tion, growing by $782 million during the month to $3,870
million. This represented the first monthly increase since
the middle of 1970. The reversal presumably occurred
because Euro-dollar rates declined over the month, as
foreign exchange speculative pressures eased and some
dollars flowed from foreign official coffers back into the
market, while at the same time domestic short-term rates
continued to rise. This eliminated much of the rate dis-

C h a rt III

LARGE CERTIFICATES OF DEPOSIT A N D
NO ND EPO SIT SOURCES OF FU N DS
B illio n s o f d o lla rs

W e e k ly re p o rtin g b a n k s

1 97 0

B illio n s o f d o lla rs

1971

Sources: Board o f G overnors o f the Federal Reserve System,- Federal Reserve




advantage of Euro-dollars; indeed, at times Federal funds
rates exceeded Euro-dollar overnight rates by a substantial
amount. In most cases, banks were able to increase their
borrowings of Euro-dollars without being subject to the
20 percent marginal reserve requirement, inasmuch as they
were permitted to use the cushion provided by their hold­
ings of special note issues. The second major nondeposit
source of funds, bank-related commercial paper, showed
little change over the quarter. A t the end of June, the total
amount of bank-related paper outstanding was $1,733
million, $616 million below the 1970 year-end level.
BANK CREDIT

The total volume of all commercial bank credit out­
standing posted a moderate gain over the three months
ended June, advancing at a 7.4 percent seasonally ad­
justed annual rate after adjustment for loan transactions
with affiliates (see Chart IV ). Although this increase was
not so rapid as the 12.2 percent rate of the first quarter,
it was roughly in line with the behavior of bank credit in
1970 as a whole, when an 8.0 percent expansion was
recorded. Following the pattern of other recent quarters,
much of the overall strength in bank credit reflected a
rise in securities holdings by the commercial banks, the
latest expansion amounting to 13.6 percent. On the other
hand, total loans remained decidedly on the sluggish side.
Indeed, total commercial bank loans adjusted for net sales
to affiliates from banks’ loan portfolios rose at a seasonally
adjusted annual rate of about 4 percent (see Chart IV ).
The dominant factor holding down the rate of advance
of overall bank lending has been the continued weakness
in business loans. Over the three months ended June,
business loans adjusted for net loan sales grew by slightly
less than 3 percent. Moreover, in the seven months follow­
ing the November 1970 business-cycle trough, the rise in
business loans was only 1.8 percent, and even this growth
rate may be overstated since the level of loans in November
was probably artificially depressed by the automobile
strike. Sluggishness in the behavior of business loans in
the early months of a recovery is not, however, unusual.
F or example, over the seven months following the
business-cycle troughs of April 1958 and February 1961,
business loans expanded at seasonally adjusted annual
rates of 2.0 percent and 2.8 percent, respectively.
The recent weakness in business loans has several
causes. On the one hand, the recovery in business activity
to date has been of modest proportions. Beyond this,
corporate tax liabilities have been depressed by the low
levels of corporate profits. Perhaps more importantly, it
appears that the cash flows provided by maturing CDs

182

MONTHLY REVIEW, AUGUST 1971

C h a rt IV

C H A N G ES IN B A N K CREDIT A N D ITS C O M PO N EN T S
ALL C O M M ER C IAL BANKS
P ercenf

S e a so n a lly a d ju s te d a n n u a l ra te s

P ercent

A djusted to include net sales to a ffilia te s from banks' loan p o rtfo lio s.
Source: Board o f G overnors of the Federal Reserve System.

and maturing tax anticipation bills, especially in the month
of April, were large enough relative to tax liabilities to
reduce business dependence on bank loans for funds to
pay taxes. The single most important consideration, how­
ever, has been the continued corporate preference for
bond financing. While the volume of new corporate bond
flotations in the second quarter dropped below the record-




shattering pace of the first three months of the year, the
$7.2 billion (seasonally adjusted) of new corporate offer­
ings was still very high by past standards.
Aside from business loans, most other major categories
of bank lending showed some strengthening in the second
quarter. Indeed, consumer, real estate, and agricultural
loans all advanced more rapidly than in either of the two
preceding quarters. The only absolute decline was posted
in the usually volatile securities loan category.
Investment holdings of the commercial banks continued
to advance in the second quarter, but at a substantially
slower pace than was experienced in the preceding several
quarters. For the three months ended June, investment
holdings grew at a 13.6 percent seasonally adjusted annual
rate, whereas the rate of gain over the preceding three
months had been 24.6 percent. United States Government
securities holdings advanced by 10.4 percent over the
quarter (see Chart IV ). However, this advance was pri­
marily a reflection of their strong rise during the last
statement week in June, when the Treasury sold %2Va bil­
lion of 6 percent notes with full Tax and Loan Account
privileges.
The reduction in the pace at which banks acquired
“other securities”, primarily tax-exempt state and local
government issues, was particularly dramatic. From the
end of July 1970 to March 1971, these securities holdings
had advanced at a seasonally adjusted annual rate in ex­
cess of 30 percent as banks absorbed a major share of the
massive volume of new issues of tax-exempt state and
local securities. In contrast, during the second quarter of
1971 the increase in bank holdings of other securities tailed
off to 15.7 percent, and the 8.9 percent June advance was
the smallest monthly increase in almost a year.

FEDERAL RESERVE BANK OF NEW YORK

183

The Money and Bond Markets in July
Uneasiness over the persistence of inflationary pressures
in the economy and the further rapid growth of the
money supply pervaded the financial markets during July.
Short-term interest rates rose over the month, as the
Treasury embarked on heavy seasonal borrowing and
the Federal Reserve reduced the provision of nonborrowed
reserves. Long-term corporate interest rates edged higher,
too, despite a tapering-off in sales of new issues. Municipal
bond yields, however, receded until late in the month,
when they worked higher.
On July 15 the Board of Governors of the Federal Re­
serve System approved a Vi percentage point increase to
5 percent in the discount rate at four Federal Reserve
Banks, and the remainder followed shortly thereafter.
The increase in the discount rate was intended to bring
it into better alignment with short-term interest rates—
commercial banks had raised their prime lending rate by
V2 percentage point about two weeks earlier— and also
to signal the Board’s continuing concern over substantial
cost-push inflation. The widely anticipated changes in the
discount and prime rates had only a minor impact on the
financial markets in July, given the sharp climb in market
rates during the preceding months. Despite the restraint
imposed by the System on nonborrowed reserves, the
narrow money supply, Mi, continued to expand very
rapidly in July. The broad money supply, M L>— which
includes the public’s holdings of commercial bank time
and savings deposits other than large certificates of de­
posit (C D s)— posted only a moderate gain, and growth
of the adjusted bank credit proxy was also moderate.
In the Government securities market, much of the
attention during the month centered on the Treasury’s
refunding of $5.06 billion in notes and bonds maturing
in August. On July 21, the Treasury announced that it
would offer a four-year three-month note priced to yield
7.06 percent and a ten-year bond priced to yield 7.11
percent in exchange for the maturing issues. The Treasury
also indicated that it would accept cash subscriptions up
to a maximum of $10,000 from private individuals for
the ten-year bond. Preliminary results of the refunding,




announced on July 30, indicated an attrition of $1.4
billion or 33.6 percent. At the conclusion of the financing,
the Treasury disclosed that it would cover the attrition
and raise additional cash by auctioning $2.5 billion of a
new eighteen-month 6 V2 percent note.
THE MONEY MARKET

The money market firmed significantly in July, as
the System provided reserves more reluctantly. Non­
borrowed reserves rose by only $102 million (not sea­
sonally adjusted)— which is but a small fraction of the
normal seasonal rise in July— following the $553 million
decline in June. On a seasonally adjusted basis, non­
borrowed reserves dropped by $325 million in July, after
a $160 million decline in June. At the same time, mem­
ber banks relied more heavily on the discount window to
obtain reserves. Indeed, during the second and third
statement weeks in July, when reserve city banks were
heavy borrowers over each weekend, borrowings ap­
proached or exceeded $1 billion. For the month as a
whole, borrowings averaged $830 million (see Table I) ,
up sharply from the June level of $514 million. Reflecting
this rise, net borrowed reserves rose by $354 million to
$658 million, the largest reserve deficit in about a year,.
As bank reserve positions tightened during the month,
banks continued to bid more aggressively for Federal
funds, putting upward pressure on the rate in this market.
Thus, the average effective rate on Federal funds during
July rose by 40 basis points to 5.31 percent. Among other
market rate changes, major commercial banks lifted their
prime lending rates to 6 percent, up from the 5Vi percent
level that had prevailed since late April. This action, which
followed the Independence Day holiday, had been widely
anticipated in the markets and was the culmination of
the broadly based uptrend in money market rates that had
occurred during June. Also in July, dealers increased their
offering rates on prime four- to six-month commercial pa­
per by 13 basis points, while dealers’ secondary market
offering rates on three-month CDs rose by about 20 basis

MONTHLY REVIEW, AUGUST 1971

184

points. No net changes occurred in the rates on bankers’
acceptances or on ninety-day sales finance company paper
(see Chart I) . Three-month Euro-dollar rates rose by
about 19 basis points from June 30 to July 30.

Table I
FACTORS TENDING TO INCREASE OR DECREASE MEMBER
BANK RESERVES, JULY 1971
In millions of dollars; ( + ) denotes increase
(—) decrease in excess reserves
Changes in daily averages—
week ended

Net
changes

Factors
July
7

July
14

July
21

Member bank required reserves ..................
Operating transactions (subtotal) ..............
Federal Reserve float ................................
Treasury operations* ................................
Gold and foreign account ......................
Currency outside banks ..........................
Other Federal Reserve liabilities
and capital ................................................

+ 24
— 386

— 213
— 476
4- 213
— 244

— 391
— 40
+ 24
+ 176
— 4
— 336

— 427
+ 204
+ 29
+ 811

— 466
— 340
+ 188
+ 82
+ 29
— 624

— 90

4- 30

4 - ioo

— 56

— 16

Total “ market” factors ........................

— 362

— 689

— 431

+ 676

— 806

+ 451

4- 34

4 613

— 381

+ 717

+ 166

4 - 208

+ 25
— 4

+

27

+

1

+ 426
— 5

4 537

+ 47
+
8
+ 131
+ 11

—
—
—
+

July
28

“ Market” factors

-f- 378
— 54
— 4
— 616

+
8
— 483

+ 114

+ 562

Direct Federal Reserve credit
transactions

Open market operations (subtotal)............
Outright holdings:
Treasury securities ................................
Bankers’ acceptances ............................
Repurchase agreements:
Treasury securities ................................
Bankers’ acceptances ............................
Federal agency obligations ..................
Member bank borrowings ............................
Other Federal Reserve assetsf ....................
Total

.........................................................

Excess reserves

.................................................

+
+
4+
—
+

1

207
30
47
89
45

—

3

— 134
— 17
— 20
4- 330
4- 53

386
2
21

577
31

+
+
+
—
+

224
58
14
205
140

4 - 407

4- 417

+ 755

— 929

+ 650

+

— 272

+ 324

— 253

— 156

45

Monthly
averages

Daily average levels

Member bank:

Total reserves, including vault c a s h ..........
Required reserves ............................................
Excess reserves ...............................................
Borrowings .......................................................
Free, or net borrowed (—), reserves........
Nonborrowed reserves ..................................
Net carry-over, excess or deficit ( —) § ----

30,313
30,036
277
661
— 384
29,652
160

30,254
30,249
5
991
— 986
29,263
165

30,969
30,640
329
1,122
— 79^

29,847
3

Note: Because of rounding, figures do not necessarily add to totals.
* Includes changes in Treasury currency and cash.
| Includes assets denominated in foreign currencies.
$ Average for four weeks ended July 28.
§ Not reflected in data above.




30,602
30,526
76
545
— 469
30,057
116

30,535+
30,363$
172J
830 $
— 658t
29,705+
111+

Market observers continued to scrutinize the published
statistics on the monetary aggregates during July, although
weekly and even monthly movements of these series are
often erratic and are generally known to be very difficult
to interpret. On July 16, published statistics indicated an
unusually large $3.2 billion rise in the money supply for
the statement week ended July 7. Although the money
supply dropped by $1.3 billion in the subsequent week,
growth for the month was nonetheless strong. The daily
average money supply (M x) rose in July at an 11.2 percent
seasonally adjusted annual rate, following the 11.3 per­
cent rise in the money supply over the second quarter.
Commenting on these developments in his July 23 testi­
mony before the Joint Economic Committee, Chairman
Arthur Burns indicated that these rates of growth are
higher than is necessary or desirable over any length of
time to sustain healthy economic expansion. He also
noted that the Federal Reserve has already taken some
steps to promote a more moderate rate of monetary ex­
pansion.
Following the pattern that emerged in the second
quarter, most of the other monetary aggregates grew at
markedly more moderate rates in July than did M l The
broader measure of the money supply, M 2— defined to
include Mi plus commercial bank savings and time de­
posits other than large CDs— continued to slacken, with
July growth estimated at an 8.5 percent seasonally ad­
justed rate as compared with the 11.0 percent rise in
June. The slower expansion of M 2 in July resulted largely
from the weaker inflows of savings and time deposits
other than large CDs. Time deposit growth in July was
roughly half that occurring in the second quarter of 1971
The adjusted bank credit proxy— member bank deposits
subject to reserve requirements plus certain nondeposit
sources of funds— rose at a 7.6 percent seasonally ad­
justed annual rate in July, slightly above the expansion
rate that occurred in the second quarter. One factor tending
to retard the growth of the proxy relative to M i and M 2
has been a steep rundown in Government deposits, which
are not included in M x or M 2. Large CDs, which are
included in the adjusted proxy but not in M 2, rose by
about $737 million at the twelve weekly reporting banks
in New York City, as some banks continued to bid ag­
gressively for funds from this source.

.

THE GOVERNMENT SECURITIES MARKET

The rapid
the discount
at midmonth
sphere in the

growth of the money supply, the rise in
rate, and firming money market conditions
all contributed to a generally cautious atmo­
market for United States Government securi-

FEDERAL RESERVE BANK OF NEW YORK

185

C h a rt I

SELECTED INTEREST RATES
P e rc e n t

M O N E Y M AR KET RATES

M a y - J u l y 1971

B O N D M A R K E T YIELDS

P e rc e n t

N o te : D a ta a re show n fo r bu sin e s s d a y s o n ly .
M O N E Y MARKET RATES QUOTED: Bid ra te s fo r th re e -m o n th E u ro -d o lla rs in L o n d o n ; o ffe r in g
ra te s fo r d ir e c tly p la c e d fin a n c e c o m p a n y p a p e r; th e e ffe c tiv e ra te on F e d e ra l fu n d s (the
ra te m ost re p re s e n ta tiv e o f the tra n s a c tio n s e x e c u te d ); c lo sin g b id ra te s (q u o te d in term s
o f ra te o f d isco un t) on n e w e s t o u ts ta n d in g th re e -m o n th T re a s u ry b ills .
B O N D MARKET YIELDS QUOTED: Y ie ld s on new A a - ra te d p u b lic u tility b o n d s (a rro w s p o in t
fro m u n d e r w r itin g s y n d ic a te re o ffe rin g y ie ld on a g iv e n issue to m a rk e t y ie ld on
the sam e issue im m e d ia te ly a fte r it has been re le a se d from s y n d ic a te re s tric tio n s );

ties during July. M arket participants were also concerned
about the potential size of cash financing needs by both
the Treasury and the Federal agencies over the months
ahead. Although the long-anticipated increase in the
bank prime lending rate to 6 percent and the subse­
quent rise in the discount rate removed one element of
jncertainty, the approach of the Treasury’s August re­
funding became another restraining influence. The antici­
pation of the announcement of the financing terms on
luly 21 and the subscription period for the new offerings
vere dominant influences on market activity during much
)f July, though participants generally believed that the
efunding operation would foster a steady tone in the
noney market.




d a ily a v e ra g e s o f y ie ld s on s e a so n e d A a a -ra te d c o rp o ra te b o n d s ; d a ily a v e ra g e s o f yie ld s
on lo n g -term G o v e rn m e n t se cu ritie s (bonds d ue o r c a lla b le in ten y e a rs o r more) a n d on
G o v e rn m e n t s e c u ritie s d ue in th re e to fiv e y e a rs , co m p u te d on the b a sis o f c lo sin g b id
p ric e s ; T h u rs d a y a v e ra g e s o f y ie ld s on tw e n ty sea so n e d tw e n ty -y e a r ta x -e x e m p t b o n d s
(c a rry in g M o o d y 's ra tin g s o f A a a , A a , A , a n d B aa).
Sources: F e d e ra l R eserve B ank o f N ew Y o rk, B o a rd o f G o v e rn o rs o f th e F e d e ra l Reserve System ,
M o o d y ’ s Investors S e rv ic e , a n d The W e e k ly Bond Buy er.

In the refunding, the Treasury offered holders of $5.06
billion of 4 percent bonds and 8Va percent notes maturing
August 15 the right to exchange their holdings for a new
7 percent four-year three-month note or a ten-year 7 per­
cent bond. The new notes and bonds were priced to yield
about 7.06 percent and 7.11 percent, respectively. In addi­
tion, the Treasury accepted cash subscriptions from in­
dividuals up to a maximum amount of $10,000 for the
new bonds. This offering was the Treasury’s first attempt
to market a long-term maturity under the recent Congres­
sional authorization permitting the Treasury to sell up to
$10 billion in bonds without regard to the 4V4 percent
interest rate ceiling on these issues.
Trading in the new issues was sluggish, some sales

186

MONTHLY REVIEW, AUGUST 1971

of the “rights” issues appeared, and prices weakened,
reflecting market expectations that a large budget deficit
in the current fiscal year would result in subsequent
offerings of new issues at still higher rates. Preliminary
results of the refunding, announced on July 30, confirmed
the generally sluggish market reception of the new issues.
Of the $4.12 billion of publicly held issues, $251 million
was exchanged for the new ten-year bond and $2.48
billion for the new note, leaving $1.39 billion to be re­
deemed for cash. Individual investor cash subscriptions
for the ten-year bond totaled $192 million. The relatively
high 33.6 percent attrition in the exchange operation
appeared due in part to the wide dispersal in holdings
of maturing issues and to the absence of an “anchor”— or
relatively short-term issue— in the refunding package.
At the same time that the Treasury announced the pre­
liminary refunding results, it also scheduled an auction
of $2.5 billion of eighteen-month 6 V2 percent notes for
August 5, to be issued August 16.
Over the first half of July, yields on Government cou­
pon securities trended moderately lower. The steady tone
of the long- and intermediate-term sectors of the market
reflected in part strong technical conditions prevailing in
this interval. Over the second half of the month, however,
yields moved higher and the return on issues maturing in
three to five years reached 6.85 percent on July 30, 10
basis points above the end-of-June level, while long-term
yields declined to 5.94 percent, down 3 basis points over

Table II
AVERAGE ISSUING RATES*
AT REGULAR TREASURY BILL AUCTIONS
In percent
Weekly auction dates—July 1971
Maturities

Three-month ........................................ 1
Six-month ...........................................

July
2

July
12

July
19

July
26

5.467
5.614

5.376
5.483

5.546
5.724

5.554
5.833

Monthly auction dates—May-July 1971

Nine-month .........................................
One-year ............................................... 1

1

May
27

June
24

July
27

4.688
4.790

5.425
5.567

5.944
5.953

1Interest rates on bills are quoted in terms of a 360-day year, with the discounts from
par as the return on the face amount of the bills payable at m aturity. Bond yield
equivalents, related to the amount actually invested, would be slightly higher.




the month. The climb in intermediate- and long-term
yields after midmonth reflected, in part, market adjustment
to the refunding and reports of an acceleration in con­
sumer prices in June.
Treasury bill rates fluctuated widely over July but
closed the month at levels above those prevailing at the
end of June. Contributing to the upward pressure on bill
rates in early July was an expanded supply of bills ema­
nating from an increase in the weekly volume of bills
auctioned, from tax anticipation bills auctioned on June
30, and from a rise in foreign central bank sales. There­
fore, bidding was weak in the first weekly bill auction of
the month (advanced to Friday, July 2, because of the
Independence Day holiday), resulting in a wide range of
prices among the accepted tenders. Average issuing rates
for the new three- and six-month issues were set at 5.47
percent and 5.61 percent, respectively (see Table I I ) ,
39 and 34 basis points above the rates set in the last
auction in June. At these higher rates, stronger interest
developed in the July 12 auction, bringing average issuing
rates on the three- and six-month maturities down by 9
and 13 basis points, respectively, from the prior week’s
levels.
The announcement of the hike in the discount rate on
July 15, press reports of a sharp jump in the money supply
for the week ended July 7, and a marked tightening dis­
played in published bank reserve statistics resulted in re­
newed concern over the future course of interest rates,
and a cautious tone once again pervaded the market.
Bidding in the July 19 auction established average issuing
rates for the new three- and six-month bills at 5.55 per­
cent and 5.72 percent, respectively, up 17 and 24 basis
points from the levels of the week earlier. Subsequently,
overall activity grew quiet and rates eased lower, as par­
ticipants awaited the Treasury’s refunding announcement
on July 21. With the approach of the refunding, prospects
for the bill sector were brightened by the possibility of
some reinvestment demand stemming from the attrition.
Furthermore, the absence of a short note issue in the re­
funding package was a source of some encouragement,
and relatively strong interest developed in the bill auction
on July 26. Fairly aggressive bidding reflected considerable
bank interest, and tenders were accepted within a verj
narrow range of prices. Average issuing rates for the new
three- and six-month bills were set at 5.55 percent anc
5.83 percent, respectively, 1 and 11 basis points above the
rates set one week earlier. Most bill rates moved lowei
in the final days of July. Over the month on balance
however, rates on bills of less than three months’ maturity
rose by 21 to 34 basis points, while most longer bill rate:
generally rose by 20 to 55 basis points.

FEDERAL RESERVE BANK OF NEW YORK

187

OTHER SECURITIES MARKETS

C h a rt II

CORPORATE A N D M U N IC IPA L B O N D OFFERINGS

Activity in the markets for corporate and tax-exempt
securities presented a contrasting picture during July.
While enthusiastic investor reception of a huge municipal
offering early in the month set the stage for subsequent
price advances in the tax-exempt sector, the disappointing
placement of a key telephone offering typified the fairly
indecisive performance in the corporate sector. The mar­
ket was characterized by the usual summer lull, and the
$3.8 billion volume of new corporate and tax-exempt
financings fell short of the average monthly flotations in
the first and second quarters of this year (see Chart II).
The calendar of new issues was nevertheless sizable by
comparison with the average monthly volume over the
first three quarters of 1970.
After yields on tax-exempt securities had advanced in
June to the highest levels of 1971, several new offerings
attracted enthusiastic investor demand in early July. On
July 7, the largest financing ever undertaken by a city set
the pace of activity when New York City sold $357 mil­
lion of lower medium-grade securities. The city incurred
a net annual interest cost of 7.58 percent, the highest in
its history. At a record return to investors for a New York
City issue, the bonds sold out by the end of the day. Fol­
lowing this event, many other state and local government
issues encountered excellent receptions at lower yields.
Reflecting the downtrend in yields during the month, The
Weekly Bond Buyer's twenty-bond yield index recorded
a drop in each of the first three weeks of July, and then
rose to 6.05 percent on July 29, still 14 basis points below
the July 1 level.
After the general increase in the bank prime lending
rate, corporate bond prices stabilized and moved higher
in moderately active trading. The discount rate advance
had been largely discounted earlier, and thus had only a
ninor effect on the market. A relatively light calendar of
lew issues buoyed prices, and participants awaited a key
elephone company offering scheduled for July 13. The
"Jew York Telephone Company sold $150 million Aaaated refunding mortgage bonds, with the yield to invesors established at 7.90 percent, 10 basis points above
he return on a comparable issue marketed three weeks
arlier. Though the terms of the financing were almost
xactly as predicted by market analysts, market reception
/as surprisingly lukewarm, as investors resisted attempts
o hold yields below 8 percent. This issue was released
rom price restrictions on July 19, when dealers sought to
educe the backlog of unsold high-grade utility bonds, and




B illio n s o f d o lla rs
B illio n s o f d o lla rs
7
T—
------------------------------------------------------------------------------------------------------------------17
M u n ic ip a l

1970 1971
Is tq u a rte r*

1970 1971
2nd q u a r te r *

1970 1971
June

1970 1971
J u ly

* A verage m onthly volum e in the quarter.
Sources: Securities and Exchange Commission; Board of Governors of the
Federal Reserve System.

the yield jumped to 8.01 percent.
In the wake of the poor investor reception given the
New York Telephone bonds, prices of outstanding issues
receded. On July 20, a key $100 million Aaa-rated utility
issue came to market, bearing a 7.95 percent return to
investors, and this offering also encountered a discourag­
ing initial investor response. These bonds were released
from price restrictions about a week later, and the yield
rose to about 8.13 percent. In contrast, on the following
day a major competitively offered utility issue was quickly
sold out but at a yield which was 10 basis points above
the return on a comparable security marketed a week
earlier.
Only two Aa-rated utility offerings came to market in
July, attesting to the slow pace of market activity during
the month. The first was offered on July 7 and carried an
8 percent yield, which was identical to the return on a
comparable issue sold two weeks earlier. The second key
utility offering was the most im portant corporate financing
in the last week of July. The new bonds met a poor in­
vestor reception, though they were priced to yield 8.20
percent. The jump of 20 basis points above yields on the
earlier offerings was an indication of the general rise in
corporate bond yields as July drew to a close.

188

MONTHLY REVIEW, AUGUST 1971

Real Estate Investment Trusts: An Appraisal
of Their Impact on Mortgage Credit
By L eon K orobow

and R ic h a r d

The rapid growth of Real Estate Investment Trusts
(R E IT s) during 1968-70 provides another illustration
of the ability of financial institutions and markets to make
adaptive changes in the face of severe liquidity pressures
and credit scarcities. These investment companies operate
under the Real Estate Investment Act of 1960, which
exempts the trusts from corporate income and capital
gains taxation, provided they pay out nearly all their
income. A fundamental objective of the legislation is to
facilitate real estate investment by granting trusts the
same tax advantages enjoyed by regulated investment
companies, such as mutual funds, which invest mainly
in corporate equities and bonds. The legislation also en­
courages REITs to seek wide ownership of their shares,
thus promoting broad-based participation in the owner­
ship of real estate assets.
Tax advantages alone, however, do not explain the
recent flurry of activity in the formation of trusts or the
blossoming interest in the sponsorship of new trusts by
banks, life insurance companies, and mortgage companies.
Why these trusts have met with such recent success in a
market in which the major financial intermediaries have
had long experience can be explained by a variety of insti­
tutional, regulatory, and economic factors.

J. G e l s o n *

markets. The intense liquidity strains of 1969 and 1970
created new opportunities for profitable intermediation
by these trusts, which face no restrictions on the interest
rates they can pay on borrowings and, therefore, are able to
compete more effectively for funds than other institutional
lenders. Frequently, their funds have been obtained at
high cost, but the trusts have been in a position to select
the most promising investments while their favored tax
status facilitates the payment of an attractive after-tax
yield.
The R E IT s’ improved opportunities arose in part be­
cause commercial banks curtailed sharply the dollar growth
of their mortgage assets (see chart) in response to heavy
demand for business loans. In view of the increased diffi­
culties the banks faced in obtaining funds from both
deposit and nondeposit sources, it was not surprising that
many of them either shifted prospective mortgage cus­
tomers to REITs with which they had working relation­
ships or sold the trusts a part of their mortgage loans. The
sales provided the banks with new funds and helped meel
R E IT needs for portfolio assets. Bank sponsorship oi
new trusts facilitated such timely transactions. In addition
attractive fees and service charges became available
through the advisory relationship that often accompaniec
sponsorship. Such income at times may have reflectec
R
EIT profits on investments that could not have been mad<
RECENT MORTGAGE MARKET DEVELOPMENTS
by the banks directly because of various regulations.
The increasing participation of R EITs as specialized
The portfolio preferences of life insurance companies
lenders and investors in the real estate industry can best which typically hold long-term assets, also were changin
be understood in the context of the particularly adverse during this period. Investment in home mortgages wa
impact that financial stringencies have had on mortgage handicapped, in part, by state-imposed interest rate cei]
ings and by the limits specified in Federal home-loan
guarantee programs, although “points” or fees and sei
vice charges helped boost effective rates. Consequently
life
insurance companies restructured their total mortgag
* Chief, Financial Statistics Division, and economist in that divi­
assets to meet the substantial demand for convention;
sion, respectively.




FEDERAL RESERVE BANK OF NEW YORK

B illio n s

A N N U A L INCREM ENTS IN M O R T G A G E DEBT
HELD BY SELECTED INSTITUTIONS
o f d o lla r s
1965-70
B illio n s o f d o lla rs

189

amounts of existing mortgage debt from other lenders.
Consequently, it is impossible to regard the entire increase
in R E IT holdings of mortgages as a net addition to the
overall increase in such outstanding debt. Moreover, it is
argued below that the trusts’ use of market borrowings
to finance the acquisition of debt on commercial and
multifamily properties, on balance, probably contributed
to a diversion of funds away from home mortgages.
LEGAL AND REGULATORY STATUS OF REITS

* D a ta not a v a ila b le fo r e arlie r years.
Sources: B oard o f G o vern ors o f the Federal Reserve System, F low -of-Funds Accounts.Peter A. Schulkin, "Real Estate Investm ent Trusts: A New Financial In te rm e d ia ry",
N ew Eng la nd Economic Review (Federal Reserve Bank o f Boston: N ovem berD ecem ber 1970); A u d it Investm ent Research, Inc.; and com pilations p repared by
the Federal Reserve Bank o f New York.

nortgages on multifamily and commercial properties,
"hese types of mortgages generally represent borrowing
>y business firms, and in many states such borrowing is
ubject to less severe regulation of interest charges comared with regulation of rates on home mortgages. Morever, life insurance companies, like the banks, were alert
> the possibility of expanding profitable operations withut financial strain through sponsorship of R EITs. Thrift
Lstitutions have also evidenced some interest in trusts,
tgarding them as a potential device for improving their
>mpetitive position in the mortgage market.
During 1968-70, most of the growth in R E IT assets
fleeted proliferation of new trusts that absorbed sizable




To qualify for special tax treatment, R EITs must dis­
tribute at least 90 percent of their ordinary income to their
shareholders, derive not less than 75 percent of their gross
income from real estate transactions (e.g., rents, interest
on mortgages, and sales of property) and hold at least
75 percent of their assets in the form of real estate loans
and property, cash, and Government securities. The shares
of a R E IT must be issued to no fewer than one hundred
persons, and the holdings of five or fewer individuals can­
not exceed 50 percent of the total.1 In addition, REITs
must function as investors in, rather than managers of,
real estate and they may not hold property primarily for
resale.2 When the trusts so qualify, the income and capital
gains they distribute are taxed only when received by
their shareholders. These provisions permit the trusts to
offer returns that are attractive to investors in the low to
moderate income-tax brackets.
R EITs face relatively few restrictions by Federal reg­
ulatory authorities. In fact, the Board of Governors of
the Federal Reserve System has included the advising of
R EITs among those activities which are appropriate for a
bank holding company.3 Thus, commercial bank sponsor­
ship of a R E IT appears to be on firm ground.
The REITs have wide latitude in the issuance of equity

1 See Public Law 86-779, Section 10, September 14, 1960, which
added Sections 856-58 to Chapter 1, Subchapter M, of the Internal
Revenue Code o f 1954.
2 For a detailed description o f the operations o f various types o f
trusts, see Peter A . Schulkin, “Real Estate Investm ent Trusts: A N ew
Financial Intermediary”, N e w England E conom ic R eview (Federal
Reserve Bank o f Boston: N ovem ber-D ecem ber 1 9 7 0 ).
3 Acting under the authority of the Bank H olding Com pany A ct
Amendments of 1970, the Board o f G overnors has amended Reg­
ulation Y (applicable to bank holding com panies’ interests in non­
banking activities) and has determined that it is proper for a bank
holding company to act as, or to retain or acquire an interest in
a com pany which acts as, an investm ent or financial adviser to a
REIT. See Board o f G overnors o f the Federal Reserve System,
Bank H olding Com panies, A m en dm en ts to R egulation Y , Section
222.4 (N onbanking A ctivities).

190

MONTHLY REVIEW, AUGUST 1971

or debt instruments (except, of course, that they cannot
accept deposits). Moreover, the existence of an advisory
relationship between a commercial bank and a R E IT has
not constituted affiliation for purposes of Regulation D.
Consequently, borrowing by R EITs through the commer­
cial paper market has not been subject to reserve require­
ments even when the proceeds are used to purchase an
asset from the bank adviser (see appendix). The trusts
must observe local usury laws, but they are not in­
hibited by regulations concerning the geographic areas
in which they may operate, the size of the loan to a par­
ticular borrower, or its quality. However, some states have
imposed very tight restrictions on the sale of shares by a
R EIT. These regulations appear to have discouraged the
marketing of R E IT shares in these areas, although it is
not clear that they are an effective hindrance to R E IT
lending.
The conditional tax exemption granted R EITs by the
1960 legislation has tended to inspire caution on the part
of trust managers to avoid transactions that might lead
to an adverse Treasury ruling on a trust’s tax status. The
proliferation of new trusts suggests, however, that the
legal qualifications are not a significant roadblock. On the
other hand, the rapid growth of R E IT activity has led
interested observers to express concern over the price a
trust might pay should it fail to qualify for tax exemption
in a particular year. The question has arisen, for example,
whether a R E IT ’s tax-exempt status might be jeopardized
by sales of participations in mortgage loans originated
by the trust or by sales of property received through fore­
closure. Critics of the R E IT industry cite potential con­
flicts of interest between trust and sponsor, especially
where the latter is a bank, as the basis for more stringent
official regulation. It seems likely, however, that the vari­
ous doubts over the ability of R EITs to serve their share­
holders’ interests and meet the requirements and objec­
tives of the 1960 act will be resolved gradually without
the need for further legislation.4

Table I
ASSETS OF 114 REAL ESTATE INVESTMENT TRUSTS
December 31, 1970
Assets
Type of trust

Number

Independent trusts ..........................

59

Dollar volume
(in millions)

Share of total
(in percent)

1,780

41.3

Trusts sponsored or advised by:
Commercial banks ............................

22

847

19.7

Life insurance companies ..............

8

596

13.8

Mortgage companies ........................

13

415

9.6

Financial conglomerates ................

12

672

15.6

Total ...............................................

114

4,310

100.0

Source: Peter A. Schulkin, “Real Estate Investment Trusts: A New Financial
Intermediary”, New England Economic Review (Federal Reserve Bank of
Boston: November-December 1970), pages 4-5.

The newer REITs, such as the trusts sponsored or
advised by commercial banks, life insurance companies,

or mortgage companies, largely hold mortgage debt (both
short and long term ). However, many trusts have invested
a sizable amount in direct ownership of real properties.
The overwhelming preference of the newer trusts for
mortgages partly reflects the financial orientation of the
sponsors, who may wish to avoid the actual or potential
risks and problems associated with direct ownership of
real property.
The flurry of activity in REITs between 1968 and
1970 added more than one hundred new institutions to
the sixty-one trusts already operating. A t the end of
1970, the assets of a group of 114 trusts whose dollar
volume is believed to account for over 90 percent of the
industry total, amounted to $4.3 billion (see Table I ) . f
Close to $2.5 billion of this amount reflected the assets
of institutions formed during 1969 or 1970. Commercialbank-sponsored REITs bulked the largest among the
newer trusts. Such institutions held nearly $850 millioi
of assets, or almost 20 percent of the $4.3 billion total
Another $600 million, or about 14 percent, was accounte<
for by trusts sponsored by life insurance companies, an<

4 For example, the Comptroller of the Currency recently ruled
that a national bank’s trust department may not make investments
in a REIT when the bank is the investment adviser or sponsor,
or has other relationships that may possess elements of a conflict
of interest.

5 Information on the number of trusts in existence is obtaine
largely from announcements of new issues. Moreover, no tin
series is published for assets and liabilities of REITs. Data f(
a subset of 114 institutions have been compiled at the Federal R<
serve Bank of Boston by Schulkin, op. cit., pages 4-5.

PROFILE OF THE INDUSTRY




FEDERAL RESERVE BANK OF NEW YORK

a further $400 million, or around 10 percent, by R EITs
that are advised by mortgage companies. The remaining
57 percent consisted of the assets of trusts which are not
closely linked to banks, insurance companies, or mortgage
companies.
R EITs have resorted to public offerings of both debt
and equity instruments for initial capital. They have at­
tempted to appeal simultaneously to investors who may
be attracted either by a high current yield or by the pros­
pect of capital appreciation. Consequently, the offerings
frequently have taken the form of units that consist of
shares of beneficial interest coupled with either warrants
or convertible debentures. Very often the price of the
unit is low enough to attract investors holding relatively
small amounts of funds.
The success with which R EITs have been able to draw
funds from the capital markets is suggested by the upsurge
of their securities flotations during the years 1968-70 (see
Table II). Only six issues, amounting to $91 million, were
offered in the three years 1961-63 and none in the next
four years. The pace began to accelerate in 1968, how­
ever. In both the equity and longer term debt markets,
R EIT offerings absorbed increased shares of the new
issues market. By 1970, R E IT equity issues constituted
almost 11 percent of the total offered, compared with 1
percent in 1961. Debt issues accounted for 2.4 percent
in 1970, compared with none nine years earlier. This
growth was remarkable in view of the keen competition
for funds and very high borrowing costs in recent years.

191

Although capital issues remain a source of funds for
expansion, R E IT managers have been alert to the pos­
sibilities of short-term borrowing, particularly from banks.
Bank lines of credit are perhaps equally important as a
prerequisite for the issuance of commercial paper. Exami­
nation of the prospectuses of many newly formed REITs
indicated that bank credit totaling several hundred million
dollars was arranged, partly to provide coverage for pros­
pective commercial paper issues. In some cases, sponsor­
ing organizations agreed to guarantee a specific amount of
commercial paper issued by a R EIT, and it is clear that
several bank holding companies have increased their
issuance of commercial paper to finance the real estate
operations of nonbank subsidiaries or affiliates. It is likely
that the sales of such paper may well become a model for
future R E IT financing patterns.
IMPACT ON MORTGAGE DEBT

During the three years ended December 1970, when
total mortgage debt increased by about $83 billion, R EITs
added an estimated $3.2 billion to their holdings of m ort­
gage debt. This increase raised the level of the trusts’
mortgage assets to an estimated $3.8 billion (see Table
I I I ) .6 By the end of 1970, commercial-bank-sponsored
trusts held about $900 million, those sponsored by life
insurance companies about $600 million, mortgagecompany-sponsored trusts some $400 million, and other
REITs about $1.9 billion. These estimates clearly indicate
that aggregate R E IT mortgage assets holdings are very
small in relation to the total stock of mortgage debt. How­

Table II
CAPITAL ISSUES OF REAL ESTATE INVESTMENT TRUSTS*
Equity
Period

Debt

Share of public
Share of public
Dollar
offerings of all
offerings of all Number
Dollar
Number
new corporate
volume
new corporate
of
volume
of
issues
issues
issues (in millions)
issues (in millions)
(in percent)
(in percent)

961

3

39.3

1.0

0

0

0

)62

2

40.5

2.3

0

0

0

)6 3 ......

1

1L4

0.8

0

0

0

>64-67

t

t

t

t

t

t

>68

4

69.3

1.5

2

27.5

0.3

>69

30

899.9

10.7

2

70.0

0.5

>70.

29

938.8

10.8

21

611.7

2.4

Publicly underwritten issues of $10 million or more.
None issued.
airces: William B. Smith and Benjamin R. Jacobson, “Real Estate Invest­
ment Trusts: In the Money and Here to Stay”, Real Estate Forum (Oc­
tober 1970), page 27; Audit Investment Research, Inc., Realty Trust
Review (February 1971), page 11; and Federal Reserve Bulletin.




6
The lack o f com prehensive time series on REIT assets neces­
sitated a considerable amount of estimating to obtain total REIT
holdings o f real estate m ortgages and particularly the tim e pattern
o f the increments. For exam ple, the trusts frequently extend con­
struction and developm ent loans which are secured by first mort­
gages. It is also possible that occasionally other types of construction
financing m ay be provided by REITs. In the latter instance, the
credit being supplied would be more closely akin to a business loan
than to a m ortgage obligation. H owever, based on inform ation
gained from many REIT prospectuses and from m odest informal
surveys, the trust assets estim ated from data on new capital issues
were assumed to be held in the form o f m ortgages on m ultifam ily
and com mercial properties. A m oderate upward adjustment then
was incorporated to account for the growth o f such assets obviously
financed from sources other than new capital issues. This adjust­
ment was necessary to integrate the inform ation on new issues
with various data covering outstanding levels o f R EITs’ total assets
and mortgage assets. A n y upward bias introduced by these pro­
cedures m ay be partially offset by the above-noted incom plete cov­
erage o f REIT assets holdings. Thus, the estim ated totals may not
be very far from the actual amounts.

192

MONTHLY REVIEW, AUGUST 1971

ever, the trusts added increasing amounts of mortgage
debt to their portfolios during 1968-70, whereas commer­
cial banks and mutual savings banks curtailed their m ort­
gage lending and life insurance companies’ acquisitions
steadied.
By 1970, the annual growth of R E IT s’ mortgage assets

Table III
ANNUAL INCREMENTS IN PRIVATE FINANCIAL INSTITUTIONS’
HOLDINGS OF TOTAL MORTGAGE DEBT AND OF MORTGAGE
DEBT SECURED BY NONFARM MULTIFAMILY AND
COMMERCIAL PROPERTIES
In billion s o f dollars

Holdings of mortgage debt

1968

1969

1970

Amount
outstanding
December 31,
1970

Total mortgage debt in the
United States:
All types ...............................................
Multifamily and commercial .............

27.4
10.1

28.6
11.2

27.0
12.3

453.6
142.7

All private financial institutions’
holdings:
Total ........................................................
Multifamily and commercial ............

22.4
9.9

21.5
9.7

20.5
12.0

377.9
125.3

Real estate investments trusts:
Multifamily and commercial*

0.2

1.1

1.9

3.8

Trusts sponsored or advised by:
Commercial banksf .....................
Life insurance companiesf .........
Mortgage companiesf ................
Other ..............................................

....

0.0
0.0
0.0
0.2

0.1
0.1
0.2
0.7

0.8
0.5
0.2
0.4

0.9
0.6
0.4
1.9

Commercial banks:
Total ....................................................
Multifamily and commercial .........

6.7
2.9

4.8
2.0

2.5
1.1

72.5
26.2

Life insurance companies:
Total ....................................................
Multifamily and commercial .........

2.5
3.0

2.0
3.1

2.3
3.8

74.3
42.1

Savings and loan associations:
Total ....................................................
Multifamily and commercial .........

9.0
2.0

9.5
1.9

10.3
2.9

150.6
25.3

Mutual savings banks:
Total ....................................................
Multifamily and commercial .........

3.0
1.4

2.6
1.2

1.8
1.0

57.9
20.5

Other private financial :$
Total ....................................................
Multifamily and commercial .........

1.0
0.4

1.5
0.4

1.7
1.3

18.8
7.4

Note: Because of rounding, figures do not necessarily add to totals.
* The figures shown are those for total trust mortgage assets, but it is believed
that virtually all trust mortgages are secured by multifamily and commer­
cial properties.
t No such trusts were believed operating in 1968.
t Includes credit unions, private pension funds, state and local government
retirement funds, nonlife insurance companies, mortgage companies, and
banks in territories and possessions.
Sources: Flow-of-Funds Accounts data, adjusted to allow fully for the esti­
mated mortgage holdings of real estate investment trusts. The latter fig­
ures were obtained from the Federal Reserve Bank of Boston’s New
England Economic Review (November-December 1970) and from unpub­
lished estimates of Audit Investment Research, Inc. Where no asset data
were available, the dollar values of capital issues were used as approxi­
mations. All data are as of the year-end.




increased to $1.9 billion. In contrast, the absolute in­
crease in commercial bank holdings of mortgage debt
slowed markedly to $2.5 billion, the growth at mutual
savings banks slipped to $1.8 billion, and life insurance
companies added a relatively stable $2.3 billion. Only
savings and loan associations increased the pace of their
mortgage investments, adding $10.3 billion. Inasmuch
as the available information strongly indicates that the
R E IT s’ mortgage assets are virtually all secured by multi­
family and commercial properties (nonhom e), it is ob­
vious that their impact was greatest in that sector. In
1970, the trusts’ estimated total acquisition of nonhome
mortgage debt far exceeded the increments in such assets
reported by commercial banks ($1.1 billion) and mutual
savings banks ($1.0 billion). However, it was well below
the amounts added by life insurance companies ($3.8
billion) and by savings and loan associations ($2.9 billion).
Although R EITs’ mortgage lending obviously was be­
coming increasingly important relative to other mortgage
lenders during the last few years, the trusts’ loans prob­
ably, at least in part, simply reallocated the existing sup­
ply of mortgage credit. A study of the behavior of private
financial institutions’ shares of mortgage obligations dur­
ing the recent period of heightened R E IT activity sheds
some light on this matter. The market share of aggregate
mortgage debt and of debt on multifamily and commercial
properties held by various types of financial institutions
is shown in Table IV for the years 1968-70.
It is significant that the portion of aggregate mortgage
debt held by private financial institutions declined from
84.4 percent at the end of 1968 to 83.3 percent two years
later, despite the increasing pace of R E IT activity. In con­
trast, the share of debt on commercial and multifamify
properties rose from 86.9 percent to 87.8 percent.7 REITs
increased their share of lending in this latter sector ever
more, from 0.7 percent at the end of 1968 to 2.7 percen
by the end of last year. The failure of private financial in­
stitutions’ share of total debt to rise suggests that the growtl
of R EIT assets did not entirely represent a net contributioi
to the growth of aggregate mortgage debt.
Although a R E IT may engage in portfolio transaction
with an institution other than its adviser, a rough approxi
mation of the impact of trust operations on each of th
major types of mortgage lenders may be obtained b

7 The cited behavior o f the share o f m ortgage debt held t
private financial institutions fully reflects the upward adjustmei
made in the F low -of-Funds data to include REIT mortgage lendir
in the debt totals held by private financial institutions.

FEDERAL RESERVE BANK OF NEW YORK
Table TV
PRIVATE FINANCIAL INSTITUTIONS* SHARES OF TOTAL
MORTGAGE DEBT AND OF MORTGAGE DEBT SECURED
BY NONFARM MULTIFAMILY AND COMMERCIAL PROPERTIES
Holdings of mortgage debt

1968

1969

1970

Amount outstanding
(in billions of dollars)
Total mortgage debt in the United States:
All types ..........................................................
Multifamily and commercial ........................

398.0
119.2

426.6
130.4

453.6
142.7

Share of totals
(in percent)
All private financial institutions’ holdings:
Total ........................................................ .........
Multifamily and commercial .......................

84.4
86.9

83.8
86.9

83.3
87.8

Real estate investment trusts:
Multifamily and commercial § ................

0.7

1.5

2.7

Trusts sponsored or advised by:
Commercial banks ..................................
Life insurance companies .....................
Mortgage companies .............................
Other ........................................................

0.0
0.0
0.0
0.7

0.1
0.1
0.2
1.1

0.6
0.4
0.3
1.3

Commercial banks:
Total ..............................................................
Multifamily and commercial .....................

16.4
19.4

16.4
19.2

16.0
18.4

Life insurance companies:
Total ..............................................................
Multifamily and commercial .....................

17.6
29.5

16.9
29.4

16.4
29.5

Savings and loan associations:
Total ..........................................................
Multifamily and commercial .....................

32.9
17.2

32.9
17.2

33.2
17.7

Mutual savings banks:
Total ..............................................................
Multifamily and commercial .....................

13.4
15.4

13.2
15.0

12.8
14.4

Other private financial:
Total .......................................... ...................
Multifamily and commercial ....................

3.9
4.8

4.0
4.7

4.1
5.2

Note: See Table III for sources and other footnote references.
§ As a share of all types of mortgage debt in the United States, the REITs’
holdings accounted for 0.2 percent in 1968, 0.4 percent in 1969, and 0.8
percent in 1970.

viewing jointly the mortgage debt held by the trust and
its sponsor or adviser. For example, pooling the mortgagelending activity of banks and bank-sponsored trusts in
the nonhome sector indicates that the combined share
declined from 19.4 percent at the end of 1968 to 19.0
percent by the end of 1970. Similarly, commercial banks’
portion of total mortgage debt decreased from 16.4 percent
to 16.2 percent if the lending by bank-sponsored trusts is
included. It is clear that commercial banks used the funds
obtained from R EITs and other nondeposit sources pri­
marily for purposes other than to finance mortgage loans.
Life insurance companies’ share of nonhome debt was




193

little changed between 1969 and 1970. Moreover, the
portion of such assets held by these companies and their
sponsored trusts rose from 29.5 percent to 29.9 percent
during that period. In contrast, the life insurance com­
panies’ share of total mortgage debt dropped from 17.6
percent to 16.4 percent, the decline resulting mainly from
a reduction in home mortgage lending.
Insufficient data preclude a similar analysis of the
effect of R E IT activities on lending by mortgage com­
panies, which function largely as mortgage brokers but
also may invest in such assets. However, mortgage com­
panies account for only a very small part of total mortgage
debt and for that reason are included in the category
“other private financial” institutions in Tables III and IV.
Not many thrift institutions have acted as sponsors to
or advisers of R EITs and, so far as is known, they have
not engaged in any significant volume of portfolio trans­
actions with REITs. The availability of funds from the
Federal Home Loan Bank Board enabled savings and
loan associations to increase their portion of nonhome
debt from 17.2 percent at the end of 1968 to 17.7 percent
two years later and to raise their share of total mortgage
debt from 32.9 percent to 33.2 percent. Without recourse
to such funds, mutual savings banks sustained a decline
in their portion of nonhome mortgages from 15.4 percent
to 14.4 percent and in total mortgage debt from 13.4 per­
cent to 12.8 percent.8 These reduced shares were sub­
stantially the result of the adverse deposit flows the mutual
savings banks experienced as rising m arket rates of inter­
est placed thrift deposits at an increasing competitive dis­
advantage, although in part the decline also reflected a
portfolio shift by these institutions in favor of higher yield­
ing corporate securities.
The data on which these various shares are based
leave much to be desired. They do suggest, however, that
R EITs probably helped to insulate the m arket for non­
home mortgages, to some extent, from the adverse impact
of the recent monetary stringency. Principally, this insula­
tion resulted from the R E IT s’ use of funds obtained in the
capital markets to acquire mortgages secured by multi­
family and commercial properties. Interest on such instru­
ments was subject, as noted earlier, to much less

8 Although mutual savings banks are eligible for membership
in the Federal Home Loan Bank System, only a small number of
such banks have chosen to be members and the amount of funds
advanced to these institutions has not been large.

194

MONTHLY REVIEW, AUGUST 1971

restriction, compared with the usury limits on conven­
tional home mortgages in many states and on debt issued
under Federal home-loan-guarantee programs. Moreover,
the R E IT s’ demand for mortgage assets enhanced the
marketability of nonhome debt held in the portfolios of
other mortgage lenders. To some degree, however, the
R E IT sales of debt and equity instruments probably con­
tributed to the diversion of funds from thrift institutions
and from mortgage markets.
FUTURE PROSPECTS

During the relatively short period of their activity,
REITs have demonstrated their skill at intermediating
profitably between mortgage borrowers and lenders of
funds in a highly strained monetary environment that
tended to discourage the participation of some of the
major mortgage lenders. It is to be expected that the
recent renewal of heavy deposit flows to thrift institutions
and the greatly improved liquidity position of other mort­
gage lenders will increase the competitive pressures on
REITs. However, the trusts, which generally tend to be
high-cost operations, will concurrently benefit from the
greatly improved availability of bank credit and market
sources of funds.
The improved liquidity situation may well delay the
implementation of any latent plans by thrift institutions to
enter the field of sponsors of REITs. Recently, only one
R E IT of substantial size was sponsored by a savings
institution. However, thrift industry spokesmen have rec­
ognized the possibilities for widening the base of their
operations through sponsorship of REITs.
Despite changing monetary conditions, the trusts are
likely to remain attractive vehicles for real estate and
mortgage investments. Commercial banks, in particular,
may well continue to regard a relationship with a R EIT
as potentially rewarding over the longer term. Not the
least of the advantages afforded by sponsorship of a trust
are the opportunities for bank portfolio adjustments to
be financed indirectly by R E IT borrowings through open
market instruments. Other substantial advantages follow
from the advisory fees a bank may earn, the possibility
of providing a customer indirectly with a larger loan
than the bank itself could extend because of regulatory
limits on the size of any one loan, and the capacity to
meet demands which the bank alone could not fill because
of restrictions on acceptable collateral or other regulatory
limitations. Bank sponsorship of trusts may be viewed,
therefore, as a further and undoubtedly viable develop­
ment in the trend toward increased activity by banking
organizations over a widening range of financial services.




APPENDIX: A NOTE ON THE EFFECT OF REITS
ON BANK CREDIT STATISTICS

The trusts’ borrowing operations and portfolio trans­
actions can present problems in the measurement of bank
credit similar to those created by commercial banks’
resort to other nondeposit sources of funds in 1969-70.
During that period, the effective impact of Regulation Q
ceilings prevented banks from competing for funds
through deposit instruments. Consequently, many banks
initially turned to the Euro-dollar m arket and then to
affiliated institutions or parent organizations that had
access to market sources of funds without being subject
to interest rate ceilings (or reserve requirements) on
borrowed funds. A foreign branch of a United States
bank thus was able to borrow in the Euro-dollar market
and pass the money to the head office, or the bank’s
affiliate could issue commercial paper, without encounter­
ing any such restrictions. The proceeds of the commercial
paper were used largely for acquiring loans from the bank;
in this way, outstanding bank credit was shifted to the
books of the affiliate while freeing bank resources to
finance new loans.
Banks’ incentives to make further use of such non­
deposit sources of funds have been reduced, following
the imposition of marginal reserve requirements on banks’
Euro-dollar borrowings in October 1969 and the plac­
ing of reserve requirements in September 1970 on
the proceeds to the bank from commercial paper issued
by bank affiliates.9 As noted earlier, transactions by
commercial-bank-sponsored R EITs are not subject to
these regulations, even though a R E IT ’s purchase of a
mortgage asset from a bank may be financed in much
the same way (i.e., through commercial paper sales) as
a purchase of a bank loan by a bank affiliate, and has
much the same effect on a bank’s lending capacity as an
affiliate’s purchase. Of course, it may be argued that a
commercial bank sale to a R E IT with which the former
has no explicit relationship is hardly different from any
market sale of an asset by a bank. However, when the
transaction involves a trust that the bank has sponsored,
or with which the latter has an advisory relationship, the

9 Board of Governors of the Federal Reserve System, Amend­
ment to Regulation M, Section 213.7 ( Reserves Against Foreign
Branch D eposits); Federal Reserve Bank of New York, Circulai
No. 6593, August 21, 1970 (Regulation D: Amendment, Supple­
ment, and Interpretation, including Part 204 on commercial papei
of bank affiliates).

FEDERAL RESERVE BANK OF NEW YORK

195

paper are used by the affiliate to purchase a loan from the
bank, and the issue of paper was for less than thirty days,
the bank must meet demand deposit reserve requirements
against these proceeds. The bank must meet time deposit
requirements against funds obtained from longer term
issues. (No reserve requirements are applicable to com­
mercial paper proceeds which are not shifted to the bank
but are used instead to finance the operations of a parent
organization’s nonbank subsidiaries.) Because the proxy
includes both reservable and nonreservable bank-related
paper, it reflects the associated outright loan sales con­
cluded between parent organization and affiliated bank
plus the credit-creating activities of the parent organiza­
tion through its nonbank affiliates.
The failure of the indicators of bank credit to blanket
those REITs that are sponsored by banks can have ad­
verse short-term effects on these indicators inasmuch as
bank sales to trusts can amount to several hundred mil­
lion dollars. In fact, data on nondeposit sources of funds
filed by weekly reporting banks with Federal Reserve
10 For a definition of the adjusted bank credit proxy, see this Banks suggest the total outstanding volume of bank sales
Review, page 178, Chart I; see also Federal Reserve Bank of Cleve­ of real estate debt to R EITs may amount to as much as
land, “Bank Credit Proxy”, Economic Review (February 1971),
$1 billion.
pages 3-10.

sale may hold more significance within a broadened defini­
tion of the banking system.
Nonetheless, because bank-sponsored trusts are not con­
sidered affiliated institutions, few attempts have been made
to gather data on their credit-creating activities. Such
credit creation is not covered by the adjustments incor­
porated in member bank data to obtain accurate current
estimates of bank credit growth. One measure used to
obtain such estimates is the “adjusted bank credit proxy”,
which encompasses the credit extended by the bank as
well as the credit generated by affiliated institutions.10
At present, the adjusted proxy estimates the total volume
of loans extended by banks and their affiliates by adding
to the original bank data the total amount of commercial
paper issued by the parent organization or affiliate of
a bank. These commercial paper issues have come to be
known as bank-related paper. If the proceeds of such