View original document

The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.

April 14, 1967
9 A.M., EST


Remarks of
Board of Governors
of the
Federal Reserve System
at the
Annual Convention
of the
California Mortgage Bankers Association

Palm Springs, California
April 14, 1967

I am pleased to address this meeting of the California Mortgage

We have a great deal in common.

Willingly or unwillingly, we

share the fact that this past year mortgages, the Federal Reserve Board,
and their mutual relationships have been at the forefront of everyone's
lips and minds.
Both of us would probably prefer a return to the quieter conditions
of two years ago.

Then, when I, as a Californian, was appointed to the

Federal Reserve Board, I had to explain the functioning of the Federal
Reserve to the majority of people I met.

Most of them had either never

heard of the Federal Reserve or, if they had, they assumed its primary
function was to engrave our money.

Let me summarize briefly what I want to say today.
Last year underscored three well-known weaknesses of the mortgage

All could be reduced or removed if we had a sound, well-operating

secondary mortgage market.

I conclude that each one involved in the mortgage,

housing, and real estate fields should now increase his determination to
help develop the practices and institutions necessary if mortgages are to
compete more successfully with other investment securities.
The problems are clear.


We would like mortgages to cost less to borrowers. The
costs which are primarily at issue are relative costs--the
spread of mortgage yields above the Government bond rate.
This is the problem of operating an efficient mortgage market
and industry.



*** We must be concerned over whether or not there is and
will be sufficient mortgage money to finance the growing and
tremendous housing and related needs of the future. This is
the secular problem.
*** We have experienced another period when the mortgage
market followed feast by famine. The availability of mortgage
financing oscillates too much above and below real needs.
This is the problem of fluctuations in the mortgage market.
Finally, as an aside, I might note another matter of temporary or
immediate concern— when in modern terminology is known as a "mini-problem."
Haven't interest rates on mortgages fallen less rapidly than we might have
expected, given the tremendous inflow of funds to financial institutions
in the past four months?

Mortgage interest rates must decline sharply, if

the spread and relationship of these Government-insured loans to Government
bond yields is to return to that experienced in 1964 and 1965.
There are as always even more answers than questions.


I find four ideas that have been discussed recently attractive on an initial

They seem worthy of development and debate.

If they can be

worked out, they seem to offer hopes for considerable improvement in each
problem area.
An improved secondary market— in which existing mortgages are
traded without prior commitments— should increase the efficiency of the
mortgage market and decrease its costs.

The existence of a true secondary market with traders and
dealers should cut marketing expenses. The Federal National
Mortgage Association (FNMA) should investigate the feasibility
of establishing a real trading desk making a market in
accordance with current demand and supply.
The Federal Housing Administration (FHA) should re-examine
the possibilities of making the FHA mortgage completely insured
to the ultimate investor (not an originator). The objective
would be to have mortgages trade more like bonds with their far
smaller costs and spreads.


For the secular problem, securities should be developed
based on mortgages but tailored more closely to the experiences
and needs of traditional bond investors. Further developments
of participation certificates and debentures backed by mortgages
seem to hold promise.
The fluctuations problem of feast and famine would be aided
by each of the above steps. More importantly, however, progress
in this sphere requires some hard further thought and decisions
as to the proper relationship of the Government to the mortgage
and housing market. Are the tremendous pleas to expand
Government aid to most purchasers of houses legitimate or not?
At what point do--and at what point should--various programs
become subsidies to families regardless of income or need?
If such programs are expanded, how should the public make certain
that governmental programs reflect the needs and desires of all?
The careful re-examination I have suggested in the past of
the Federal programs of loans, guarantees, and agency issues may
shed some light in this sphere.
Trading in Secondary Markets Cuts Costs
and Improves the Supply of Funds
In talking about the advantages of a secondary mortgage market to
this audience, I feel like Moliere's gentleman who suddenly discovered he
was speaking and writing prose.
second nature.

Most things I can say you know almost as a

Perhaps, however, there is some point in expressing them in

a somewhat different perspective.
Why does a wel1-operating secondary market decrease the costs of
borrowing while increasing the available supply of funds?

It improves the

liquidity of each instrument.

It allows more

rapid adjustments.

It lowers marketing costs.

It may make a better market possible for forward commit­


Mortgages are relatively expensive to turn over.

No simple market

exists where an investor can find a bid or offer for some or all of his

The spread between bid and asked prices for a mortgage tends to

be fairly large.

Costs of a transaction may be heavy.

Compared to issues

of bonds or other securities, mortgages are small in amount and extremely
and structure.

Each mortgage differs according to the borrower, location,
A buyer finds it costly to value each loan.

more expensive and more personal than in other markets.

Trading is both

Most sales depend

upon established relationships or/and Government insurance and guarantees.
Clearly, despite the segmented and localized nature of the
primary market for mortgages, some secondary marketing does exist.
why you are here, and also FNMA and the Home Loan Bank system.
sales are for permanent additions to a lender's portfolio.

That is

Still most

If I want to sell

a mortgage today, there is no place to call and get a good bid or even
estimate of the price a buyer would pay.
These high marketing costs must be paid for by the borrower over
and above pure interest.

Lenders must also add a risk premium because they

cannot be certain that they can turn over a mortgage in time of need.
Finally, individuals and pension and retirement funds or small commercial
banks or other financial institutions find it costly and difficult to
invest in one or a few mortgages.

This limits the supply of funds.


Making FNMA an Active Dealer in Mortgages
When FNMA was established, it was seen as a possible prototype
for many private secondary market firms.

This may still be possible.

is the most likely place for a true secondary operation to develop.


successful, the type of operation could spread.
I am impressed with three suggested experimental operations for
FNMA which could probe the feasibility and problems involved in trying to
operate a true secondary market.
existing hybrid operations.

This would be in some contrast to its

At the moment, FNMA in its secondary market

operations serves to furnish a great deal of market support and also holds
loans as they season.
only with long lags.

On the other hand, its prices adjust to market changes
As a result it may be on one side or the other of the

market at any one time for considerable periods.

Its prices and purchases

reflect Government policy as much as the underlying forces in the market.
One idea is for FNMA to establish a separate section or subsidiary
that would be ready to make a market on both the buying and selling side at
any time for insured and guaranteed mortgages.
similar to the trading of bond dealers.

This unit would operate

It would adjust its prices on a

daily or even an hourly basis as the size of its inventory increased or

Such a trading unit would be a constant source of needed

information for all mortgage brokers and investors.
A second suggestion would have FNMA buy or sell a share of its
commitments through an auction similar to the existing auction of U.S. Treasury

Even without daily trading, a monthly auction would still give a

better and more rapid adjustment of the market to the current economy.


The final idea is related to the next suggestion and also to
developments among mortgage banks and the Farmers Home Administration.
This concept would have FNMA sell some mortgages with full recourse against
FNMA while making the necessary charges for this service.

This would

enable lenders to buy mortgages from FNMA secure in the knowledge that they
had a security guaranteed by an agency of the U.S. Government.

They would

not have to check each individual loan.
Improving the Operation of
FHA Mortgage Insurance
Many observers have always been concerned about the wide spread
between yields on FHA insured mortgages and Government bonds or the
certificates of Government agencies such as FNMA.

In recent markets, this

spread over similar length Governments has been as much as 200 basis points
or a full 2 per cent.
There are well-known reasons for the spread.

The cost of

servicing by the servicing agent and the lender is not minor.
is not universal.
are high.

The market

If one wants to liquidate, marketing or turnover costs

Finally, an unknown risk exists which may be high on an

individual mortgage even though very low on a statistical basis.
If only the first type of cost existed, a spread of 50 to 75
basis points would probably be more than adequate.

The other costs arise

because the holder of an insured mortgage does not have an 100 per cent
ironclad claim against the FHA.
must fulfill.

He has certain responsibilities which he

In addition he may lose money or goodwill (in the event of

default) on a loan because of accidents, acts of God, or other factors


against which he cannot insure.

As a result, the FHA insurance is primarily

valuable to larger lenders who can check the servicing agents' performance
and also assume the residual risks on an actuarial basis.
It has been suggested that the FHA, FNMA, or private firms could
assume these residual risks for a much smaller fee than now exists in the
spread between FHA mortgages and other Government-secured issues.


could guarantee payment of 100 per cent of the unpaid principal balance of
VA and FHA underwritten mortgages alike.

With full recourse, the final

lender could buy an FHA mortgage without concern as to the underlying
property, borrower, or uninsurable risk.

Some such arrangement seems

necessary if there is to be real trading in mortgages or sales to smaller
The idea of complete insurance has been questioned on the
assumption that it might encourage laxity in lending or servicing standards.
To avoid this possibility the existing co-insurance feature could be retained
but the responsibility be placed on the originator and the servicer of the
loan rather than the final lender.

This seems more logical and more

It would serve to improve marketability and increase the number

of possible lenders on mortgages.
Various methods can be envisaged for maintaining responsibility.
There could be direct recourse, or the holding of partial credits in a
pool to be released according to certain schedules and underwriting results.
Arrangements of this type, which are common in instalment lending, may make
sense in the mortgage field.

From the FHA's point of view the originator

and servicer would continue to have a financial interest in improving their


operations, but the second and following holders would have a loan with a
mucn improved Government guarantee.
This idea of partial or full recourse against the originator or
servicer is extremely important if we try to imagine a true secondary
market for conventional mortgages let alone the Government-underwritten

No efficient small-lot trading of conventional mortgages is likely

because of the high additional cost to each purchaser in turn of rechecking
the appraisal, the property, the papers, etc.

Such trading would be far

more likely, if the holder could claim against the originator of the loan.
We could imagine a situation where mortgages traded at different prices
depending on the credit rating of the guarantors, just as bonds now trade
at different prices depending on the credit-worthiness of their issuer.
Mortgage Bonds and
Participation Certificates
A third suggestion with great appeal is that more effort be given
to the development of securities using pools of mortgages as collateral but
aimed at smaller investors and those who purchase traditional types of bonds.
Again the operations of the FHLBB and savings and loans in issuing longer
term bonds and the issuance by FNMA of participation certificates are
cases in point.

Both types of operation could be expanded.


operations are also theoretically possible for well-financed private firms.
These proposals aim at separating the function of servicing and
handling the mortgage from the function of furnishing the funds.


participation certificates or mortgage debentures can be based upon both
the pledge of mortgages and the security of the issuing organization.



can be tailored in their terms, forms, and payments to the needs of
individual investors and the need for marketability.

In many European

countries such certificates and debentures dominate the long-term credit
The Cause of Fluctuations in the
Supply of Mortgage Money
You probably feel at this point like those watching Hamlet without
the Prince of Denmark.

Why have I said so little about the problem of

getting a greater supply of mortgage money in periods when over-all credit
demands are intense?

After recent experiences you probably feel that is

the most critical problem.
to this topic.

In actuality, everything I have said is related

A well-organized, properly functioning secondary market for

mortgage funds is one of the industry's best chances of avoiding similar
fund shortages in the primary market in the future.
What did happen last year?

The answer is simple.

surge occurred in the over-all demand for credit.

A tremendous

Credit's growth was

restrained in line with the growth in real resources.

In a fully-employed

economy, money and credit growing faster than the ability to produce goods
means higher bidding for the limited supply.

As a result prices rise and

we have inflation.
With people and firms bidding hard for credit, its price (the
interest rate) rose.

Those willing to pay the most got a larger share.

Typically in such periods, the supply increases as new lenders enter the
market, but some old borrowers may get squeezed out.


The problem for potential mortgage borrowers is that mortgages
have not remained competitive in periods of rising interest rates.


from choice, but more so because of institutional rigidities, mortgage
borrowers' share of credit falls in boom periods.
Rigidities are of two types.

In the first place most mortgages

come from financial and particularly thrift institutions.

As rates rise,

these groups tend not to stay competitive with the money and bond markets.
As a result their share of new savings falls as do their mortgage loans.
Secondly, the mortgage market does not adjust very rapidly to changing

Because marketing is expensive, time-consuming, and personal,

it tends to be cushioned against short-term interest rate movements.


interest rates move rapidly, these lags mean lenders prefer to seek the
higher rates being offered elsewhere.
Improved Markets Functioning as a
Source of Cyclical Funds
Developments of this type show why the suggestions to achieve a
more efficient secondary market also constitute a partial solution of the
fluctuations problem.

A well-operating market would decrease the lag

between money market rates and those on mortgages.

Lenders would not need

to shift so large a proportion of their funds to other borrowers.

As an

aside, if the techniques for marketing mortgages improve, the mortgage
banking business would become far more interesting and more productive while
demanding a higher level of analytical ability and skills.


More important, if these advances are achieved, the channels
through which mortgages can draw on the money and capital markets in times
of need will be improved.

These channels have been developing.

Both the

Federal Home Loan Banks and FNMA made a tremendous contribution to housing
this past year.

They increased their advances and mortgage holdings by

$3.3 billions.

They furnished 27 per cent of the net additional money in

the market for 1-4 family homes, or 22 per cent for all residential mortgages,
including multi-family.
These instruments require still further development.


agencies have tended to stress shorter term borrowing and a somewhat
narrower market among lenders.

With more channels, and entry to more sources

of funds, mortgages could retain a higher share of lenders' money in
periods of less ebullient credit.
Some Difficult Problems Still Ahead
It would be wrong to make it appear that the problems of
fluctuations in credit terms can be solved simply.

As last year made clear,

when the demand for credit grows too rapidly, all sectors will eventually
feel squeezed and all will find themselves faced with high rates.

Only a

more flexible fiscal policy adjusting demand for resources more directly is
likely to be a real solution to this particular problem.

Drastic changes

in demand flowing into the credit sphere are bound to create major problems
for mortgages.




Three factors influence house building's instability:
(a) Real demand fluctuates,

(b) For technical reasons, inventory fluctuations

in new and used houses cause major swings in production.

(At times a

decrease in building coming from this source may not be unwelcome.)
(c) Finally, the purchase of houses is sensitive to movements in interest
rates simply because credit inevitably plays a much larger role in housing
than in most other industries.
This relationship of credit to production is, of course, one
of the reasons so much stress has been placed on Government-aided interest
rates for housing.
Government aid.

Last year tremendous pressures built up for increased

I heard surprisingly few demands that the mortgage and

building industries be freed of both Government aid and interference and
be allowed to stand on their own feet.
In the course of last year's debates, it became apparent that
support for at least four different interest rate levels in the secondary
market could be found among the building and real estate groups.


(1) The rate set entirely by the money market with no Government

(2) The current Government agency rates paid by the FHLBB and FNMA.

Such rates depend on the Government's name and implied guarantee and result
in a rate between the private market and that of the Government's own issues.
Under last year's stresses, this rate came close to the private market rate.
(3) A third rate is the Government's own borrowing rate.

(4) During the

year many people urged that borrowers on houses be given a special subsidy
to bring their rate below even the Government rate.

Frequently these suggestions

called for the Federal Reserve to pay the subsidies with funds that otherwise
are turned over to the Treausry to increase Government revenues.


In attempting to think through means of improving the secondary
mortgage market, the question of rate is important.

Should the amounts

paid by the Government to aid average or wealthy borrowers be increased?
What will the benefits and cost of more Government aid be both with
respect to your industry and our over-all economic life?
I have suggested previously that the question of Government and
Government agency guarantees and borrowing ought to be re-examined carefully.
I hope the President's Budget Commission will be able to perform this task.
Clearly, ideas as to how to improve the secondary mortgage market must be
closely related to the sources of financing available at different rates.
Concluding Remarks
Obviously, no simple solutions exist to the mortgage industry's
complex problems.

Recently the mortgage market has turned sharply around.

More money is available.
should fall further.

Interest rates have come down and by past patterns

We should not, however, forget recent experiences.

Now is the time to reshape some of the institutional functioning of the
mortgage market in order to reduce future fluctuations.


improvements in the secondary market should increase future stability, lower
costs, and obtain more funds from a broader base of lenders.

Such potential

improvements are worth searching for and adopting, both from the point of
view of your industry and the economy as a whole.