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For release on delivery
Expected at 2:00 p.m. EST
March 14, 1984

Statement by

Preston Martin

Vice Chairman, Board of Governors of the Federal Reserve System

before the

Subcommittee on Telecommunications, Consumer Protection, and Finance

United States House of Representatives

March 14, 1984

Mr. Chairman, I appreciate the opportunity to appear before
this Subcommittee on behalf of the Federal Reserve Board to discuss Title I
of H.R. 4557— the Secondary Mortgage Market Enhancement Act of 1983.


legislation is intended to encourage and facilitate wider participation by
private institutions in the markets for mortgage-backed securities, primarily
by amending federal securities laws and by preempting certain state securities
and investment statutes.
You have indicated that your Subcommittee is concerned primarily
about the implications of such measures for investor protection.

You also

have raised questions about the impact of the proposed legislation on the
sectoral allocation of capital and on the performance of the economy as a

After briefly reviewing the status of the markets for private mortgage-

backed securities, I will turn to the issues of investor protection and
economic impact raised by the legislation under consideration. Let me say at
the outset, however, that your emphasis on investor protection is well placed.
It is a vital public policy concern that the emerging market for private mortagebacked securities be subject to adequate degrees of federal supervision and

Abuses early in the game not only could compromise the interests

of individual investors but also could seriously undermine the process of
development of this market.
Mortgage securities markets, of course, have been an important
component of the housing finance system during the past decade.


the need for such markets is likely to increase in the future, particularly
if thrift institutions utilize the expanded asset powers recently provided to
them by law and regulation.

To better match the duration and interest rate

sensitivity of assets with liabilities, thrifts and other mortgage originators
w i t h predominantly short-term debts may move more and more long-term mortgages




to investors through the secondary markets.

Mortgage pass-through securities,

which represent ownership interests in pools of residential loans, can be the
most efficient secondary market instruments to accomplish this type of shift.
Since the early 1970s, the thrust of public policy has been to
encourage development and growth of markets for mortgage pass-through securi­
ties guaranteed by federal agencies and federally sponsored enterprises.


the end of last year, outstanding pass-through securities guaranteed by the
Government National Mortgage Association (GNMA), the Federal Home Loan Mortgage
Corporation (FHLMC), or the Federal National Mortgage Association (FNMA) totaled
$243 billion— equivalent to nearly a fifth of all residential mortgage debt
By contrast, development of markets for fully private mortgage pass­
through securities— that is, securities without federal sponsorship issued
against pools of conventional loans— has been quite modest.

While a fair

number of banks, thrift institutions, mortgage companies, insurance companies
and so-called conduit organizations have issued private pass-throughs, avail­
able estimates suggest that the total amount outstanding is only about $10

To date, private institutions have been successful mainly in the mar­

ket space left by FNMA and FHLMC.

Most issues have been private placements

tailored to the needs or preferences of individual investors or public offerings
issued against pools of those mortgage loans that are individually larger in
amount than those which may be purchased by the federally sponsored enterprises
under limits established by Congress.
Private pass-through securities generally have been unable to compete,
head to head, against those issued and/or guaranteed by federal agencies and
federally sponsored enterprises, largely because of the market benefits enjoyed
by these federally related entities.

But development of the private market

also has been hampered by state and federal laws and regulations that have




increased the cost of issuing private securities or have constrained invest­
ment in private pass-throughs by various types of institutions.

The President1s

Commission on Housing, on which I served as a member before being appointed to
the Federal Reserve Board, identified a host of legal and regulatory impedi­
ments in its 1982 report.
The Federal Reserve Board traditionally supports measures that
promise to improve the efficiency of private financial markets.

In this case,

we believe that changes in laws and regulations that encourage a broadening
of the mortgage pass-through securities markets through more extensive involve­
ment of the private sector would constitute sound public policy, so long as
other legitimate public policy objectives are not compromised in the process.
It certainly seems appropriate to adjust laws and regulations that have
disadvantaged the competitive position of private mortgage securities in our
financial markets with inadvertent or unintended constraints and obstacles.
Indeed, some technical problems have been caused by state or federal statutes
or regulations written long before mortgage-backed securities were a signifi­
cant market factor, and some impediments have arisen because of inadequate
understanding of the unique nature of these securities.
Some of these types of technical constraints recently have been
alleviated by regulatory changes at the federal level.

For example, last year

the Securities and Exchange Commission tailored some of its registration and
disclosure requirements to the special characteristics of private mortgage
pass-through securities, recognizing the need for both shelf registration
procedures and sales of these securities on a "blind pool” basis.

At the

Federal Reserve Board, we have amended Regulation T— which governs margin
credit extended by brokers and dealers for the purpose of purchasing or
carrying securities— to specify that private mortgage-backed securities are

-4eligible collateral for such credit.

We also have tailored the Regulation T

criterion to fit special features of the mortgage instruments— that is, the
amortizing or depreciating nature of mortgage securities.
Some components of Title I of H.R. 4557 also constitute technical
amendments designed to accommodate properly private mortgage securities.
Sec. 108, which would require the Securities and Exchange Commission to provide
a permanent procedure for the delayed or continuous registration of private
mortgage-backed securities, falls into this category.

These types of registra­

tion procedures, which are vital to the success of a public market in mortgage
securities, currently are available under an administrative rule of the Com­

A legislative mandate to the SEC would remove any market uncertainty

over the future of these flexible registration procedures.
The removal of statutory limitations on investment in mortgage pass­
through securities by federally chartered financial institutions, leaving it
up to the regulators to specify investment limits as well as factors relating
to the diversity of underlying mortgage pools, is another appropriate techni­
cal adjustment (Sec. 106).

The current law for national banks, for example,

limits investment in the securities of any one issuer to a percentage of un­
impaired capital stock and surplus and, in effect, treats private mortgage
pass-through securities as obligations of the issuer rather than as shares
in pools of loans constituting the obligations of many mortgage borrowers.
The current treatment for banks is a good example of law that does not properly
accommodate the true nature of mortgage pass-through securities.
I understand that this Subcommittee is concerned that some of the
provisions of Title I of H.R. 4557 may go beyond technical adjustments to law
and regulation.

Any provisions that involve tradeoffs of policy objectives,

of course, need to be considered carefully.

As a general principle, caution



should be exercised whenever federal or state laws that were intended to protect
savers, investors or financial institutions are amended, or preempted, in
order to further the development of a particular market.

Several provisions

of the proposed legislation raise issues along these lines:

the exemption of

public offerings of private mortgage-backed securities from federal registration
and disclosure requirements; the federal preemption of state legal-investment
and blue-sky laws applicable to private mortgage-backed securities; and the
provisions that seek to facilitate development of forward-delivery markets
for such securities by amending federal laws relating to the extension of
margin credit by securities brokers or dealers.
The proposed exemption from securities registration requirements
(Sec. 101)— applicable only to large sales (those over $250,000) of
"investment grade" mortgage-backed securities (those rated in one of the top
four categories by a nationally recognized statistical rating organization)
by financial institutions to investors for their own accounts— generally
appears to be a desirable extension of the current transactional exemption
for mortgages and mortgage participations contained in federal securities law.
Such large transactions presumably involve investors with a high level of
sophistication and thus do not require all of the normal investor protections
provided by the 1933 Act.
The Congress, however, should recognize the implications of several
aspects of the proposed exemption.

First, reliance would be placed upon

private rating organizations to set market standards.

There is no assurance

that these organizations will retain their current rating schemes or will not
adjust their rating categories in a manner inconsistent with the risk levels
anticipated by Congress.

Second, the exemption would be extended to all

HUD-approved mortgagees, including mortgage companies that are not subject to


the same levels of supervision, regulation and examination applicable to
depository institutions.

These factors raise questions about two important

aspects of consumer protection in the private market for pass-through securi­
ties: adequate information about the quality of mortgages in the underlying
pools, and adequate assurance of performance by the issuer/servicer over the
life of the pass-through security.

It may be appropriate to design a simpli­

fied, special-purpose set of SEC registration requirements for the types of
transactions envisioned in Sec. 101, specifying pertinent characteristics
of the pooled mortgages as well as the responsibilities of the issuer/servicer.
Federal preemption of state blue-sky and legal-investment laws for
investment grade mortgage-backed securities (Sec. 107) raises further ques­
tions about investor protection as well as about the interests of savers in
state-chartered depository institutions, life insurance companies and pension

"Investment grade" is not a particularly strict standard and, in fact,

most public offerings of private mortgage pass-through securities have been
rated in the top two categories.

It may be questionable public policy to

require the states to treat all mortgage-backed securities rated in the top
four categories by any nationally recognized rating organization as if they
were Treasury or federal agency securities, even though the proposed legisla­
tion would give the states three years to opt out of the federal preemption.
Some states eventually may feel that it is appropriate to apply more stringent
legal investment standards than federal law would permit or to require more
complete disclosure with respect to the character of the underlying mortgage

Thus, it may be preferable to allow the states an unlimited amount of

time to override federal preemption of their blue-sky and legal-investment
statutes rather than to incorporate private rating service standards in
federal law and to set a time limit on the state override.


The provisions that would facilitate development of forwarddelivery markets in private mortgage-backed securities, by specifying that
contracts made by brokers and dealers for delayed delivery of such securities
(within 180 days) do not involve extensions of credit subject to margin
limitations (Sec. 103-105), appear to constitute sound public policy.


delivery arrangements currently are an integral part of the markets for federally
related mortgage pass-through securities, and such arrangements clearly are
essential to the success of private markets.

Furthermore, under these

provisions both the Federal Reserve Board and the Securities and Exchange
Commission would have the authority to institute remedial measures if the
need should arise, by shortening the forward-delivery period.

The SEC also

would retain its regulatory authority over self-regulatory broker-dealer
organizations to ensure that these organizations maintain adequate margin
deposit rules for forward contracts in private mortgage-backed securities.
And, of course, the SEC would retain authority to establish minimum net
capital requirements that reflect a broker-dealer1s exposure in the forward
trading market.

These types of controls should prevent repetition of some of

the problems that arose in the unregulated forward market for GNMA-guaranteed
securities several years ago.
The potential impact of the package of measures contained in Title I
on the allocation of capital between the housing sector and other sectors of
the economy, and on the growth of the economy as a whole, is difficult to
judge in quantitative terms.

It seems safe to say, however, that changes in

law that reduce the costs of issuing private mortgage pass-through securities
or enhance the attractiveness of these securities to investors should translate
into lower costs of mortgage credit for the ultimate borrowers whose loans
are in the pools behind the securities.

Thus, enactment of Title I should




encourage more capital to flow into the housing sector and less to flow to
other private sectors.

If this process altered capital allocation away from

plant and equipment, there could be some impact on business productivity
growth over time.
These types of conclusions assume, of course, that the provisions
in the proposed legislation are the only adjustments that are made to the
structure of the secondary mortgage markets.

If the measures designed to

enhance the development of the private secondary markets were coupled with
measures designed to limit the secondary market activities of the federally
sponsored enterprises, any potential impacts of the legislation currently
ucier consideration o . capital allocation and economic growth could be altered.
A shift of secondary market functions from the public to the private
sector may now be a proper course for public policy, following more than a
decade of valuable demonstration and market development by the federally
related entities.

Both FNMA and FHLMC have done pathbreaking work by helping

to standardize the conventional home mortgage instrument and by moving large
amounts of pass-through securities issued against pools of such loans into
a capital market that had been unaccustomed to conventional pass-throughs.
We have now reached a point where conventional mortgage documents are
standardized nationally, where mortgage pass-through securities are a
familiar instrument in national financial markets, and where the private
mortgage insurance industry is capable of providing mortgage pool insurance
necessary to secure high ratings for a large volume of conventional pass­

These foundations, coupled with the types of legal adjustments

contained in Title I of H.R. 4557— and perhaps with the creation of more
flexible mortgage investment trusts under federal tax law— can provide the
basis for a viable private secondary mortgage market that can serve the needs
of the.housing

industry during the years ahead.

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