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of the Research Department for Review and Comment.

SM84-4

THE ROLE OF TRADITIONAL MORTGAGE
LENDERS IN FUTURE MORTGAGE LENDING:
PROBLEMS AND PROSPECTS
George G. Kaufman

SM-84-4

The Role of Traditional Mortgage Lenders
In Future Mortgage Lending: Problems and Prospects

George G. Kaufman
(Loyola University of Chicago and
Federal Reserve Bank of Chicago)

A Paper prepared for a Conference on Housing Finance in the 1980Ts
Sponsored by the U.S. Department of Housing and Urban Development
Washington, D.C.
March 30, 1984




THE ROLE OF TRADITIONAL MORTGAGE LENDERS
IN FUTURE MORTGAGE LENDING:

PROBLEMS AND PROSPECTS

George G. Kaufman*
(Loyola University of Chicago and
Federal Reserve Bank of Chicago)
A Paper Prepared for a Conference on Housing Finance in the 1980's
Sponsored by the U.S. Department of Housing and Urban Development
Washington, D.C.
March 30, 1984
One of the major concerns in current housing finance is what role will
the traditional mortgage lending institutions, in particular the thrift insti­
tutions, have in future residential mortgage financing.

This concern is real

because, until the late 1970s, savings and loan associations and mutual sav­
ings banks together generally accounted for at least one-half of the new
mortgages made directly to home buyers in any year.

In contrast, in 1980,

they accounted for only 29 percent of such mortgage lending, in 1981 for only
22 percent, and in 1982, they actually decreased their direct residential
mortgage commitments before bouncing back to 25 percent in 1983 (Table 1).
However, as may also be seen from Table 1, these figures overstate the
decline in mortgage lending by these institutions because they have in part
replaced their direct mortgage lending to home buyers with indirect mortgage
lending by purchasing participations in mortgage pools put together by them­
selves or others.

That is, for reasons that will be analyzed later, thrift

institutions have shifted some of their home mortgage lending activities from
primary securities made directly to home buyers to secondary securities made
indirectly to home buyers.

Thus, their market share of total new mortgage

investment did not fall as sharply.

However, until 1983, the increase in

mortgage pool investments did not offset totally the decline in direct mort­
gage loans, although the purchases of such investments in 1982 did prevent an
overall net disinvestment in mortgages.




In 1983, thrift acquisitions

2

of mortgage pools increased their total mortgage investments to near their
market share figures of better years.

And 1984 appears to be starting off

well, at least in terms of the volume of mortgage acquisitions.

Thus, the

decline in mortgage lending by thrift institutions from 1978 to 1982, while
substantial and long, may primarily have reflected transition problems as the
institutions got out from under restrictive regulations and the market devel­
oped new instruments and techniques to deal with the new economic environment.
This paper will discuss 1) the reasons for the relative decline in the
importance of thrift institutions as direct mortgage lenders to households in
the early 1980s, 2) the implications of deregulation in the financial sector
for thrift institutions and their mortgage lending, 3) the problems confront­
ing thrift institutions, in particular, interest rate risk management,
4) innovations in mortgage financing on both the primary and secondary mar­
kets, and 5) the prospects for thrift institutions as important direct and
indirect home mortgage lenders for the remainder of the 1980s.
Reasons for the Decline in Mortgage Lending by Thrifts

The reasons for the decline in the relative importance of savings and
loan associations and savings banks as mortgage lenders in the late 1970s
and early 1980s are well known and need only be summarized here.

Their

difficulties stemmed primarily from the prolonged and mostly unexpected rise
in interest rates since the mid-1960s.
effects.

This had a number of unfavorable

Most directly, it increased the cost of short-term funds, the tradi­

tional source of funding for these institutions, relative to revenues from
long-term fixed-rate mortgage loans, the traditional use of funds.

To miti­

gate the impact of this effect on the institutions, legislators and bank
regulators imposed two regulations that, although well intentioned, proved
very costly in the long-run and served importantly to emphasize the short-term




3
horizon and political nature of most regulatory actions.

In the mid-1960s,

the regulators extended deposit rate ceilings from commercial banks to thrift
institutions to hold down their interest costs and maintain their profitabil­
ity.

The ceilings acted much like a maximum wage law would have in, say, the

automobile industry to protect it from competition, with just as predictable
results.

Although the ceilings may have succeeded in holding down the inter­

est costs of the affected institutions, they caused difficulties every time
market rates rose above the ceiling rates, which, as may be seen from Figure 1,
was often.

Just as labor would drift from the automobile firms to firms not

subject to a maximum wage ceiling, savers redirected their new and occasionally
even their old funds to institutions not subject to these ceilings.

These

shifts were made easier by dramatic technical advances in transferring funds
quickly and cheaply.

In periods of disintermediation, the thrift institutions

expanded more slowly and their mortgage lending slowed despite more generous
advances from the Federal Home Loan Banks.

To the extent the latter offsets

private disintermediation, it represented a shell game with the losers being
the small savers who could not afford the transactions costs of shifting their
funds elsewhere.
In an attempt to reduce disintermediation from these institutions, the
regulators raised the ceilings on six month deposits (MMCs) in 1978 by tying the
ceiling rate to the six month Treasury bill rate.

This succeeded in stimulating

a large inflow of such funds, but significantly increased the interest rate
risk exposure of the institutions by shortening the maturity (duration) of
their deposits and enlarging the mismatch relative to the maturity (duration)
of their primarily long-term fixed-rate mortgages.
However, the legislators and regulators were concerned not only with the
impact of the higher interest rates on mortgage lending institutions, but also
on mortgage borrowers.

Residential housing has traditionally been the beneficiary

of special government concern.1

Thus, they prevented most institutions from

offering variable or adjustable rate mortgages (VRMs or ARMs), which would



4

shift the risk of future interest rate increases from the institutions to the
borrowers and may reduce demand.

This, too, had desired immediate effects,

but undesirable longer-term effects as the weakened thrifts were increasingly
unable to extend additional mortgage loans of any type.
Of course, the unfortunate state of the thrift institutions in this
period was not the fault of the government alone.
must accept a good share of the blame.

The institutions themselves

They, on the whole, supported the

extension of the deposit rate ceilings to them in 1966 and fought vigorously
to maintain them —
1973 —

most visibly during the so-called ’’Wildcard Experiment" in

and, with the major exception of California associations, fought only

half-heartedly for ARM authorization and additional lending powers.

2

Until

the very end, they opposed any major liberalization of the system of deposit
rate ceilings.

The industry was no more farsighted than the regulators or

Congress.
Deregulation

Finally in 1980 it became evident to even the most pro-regulation
legislator and regulator that the housing finance system not only was not
working efficiently but was both producing increasingly unfair results in that
income was being redistributed from lower to middle and upper income households
and in imminent danger of financial collapse.

In that year, Congress enacted

the Depository Institutions Deregulation and Monetary Control Act (DIDMCA)
which provided 1) the thrifts with additional lending powers and 2) for the sched­
uled removal of deposit ceilings.

Also in 1980, the Federal Home Loan Bank

Board authorized adjustable rate-type mortgages for federal associations, and
most states followed suit.

Two years later, in response to further deteriora­

tion in the financial condition of the thrift institutions, Congress accelerated
the process of deregulation in the Depository Institutions (Garn-St. Germain)
Act to provide 1) the thrifts with still further new lending powers and 2) all
depository institutions with greater ability to compete for funds with money



5

market funds.

3

In addition, after a belated start, the bank regulators, opera­

ting as the Depository Institutions Deregulation Committee established by
DIDMCA, began to remove the last vestiges of Regulation Q and permitted new
types of deposits, including the payment of interest on most household checking
accounts.

Arguments Against Deregulation
Thus, by 1984 the regulations that were the major constraints to thrift
institution operations were pretty well removed.
less free to operate as they pleased.

The thrifts were more or

But all were not happy.

Voices were

raised that deregulation would reduce, not increase, either thrift institution
participation in the mortgage market or total sources of housing finance.
This argument was not too surprising.

It has been heard in other industries

that have undergone deregulation, such as the airlines, telephone, and trucking.
While regulation hampered economically efficient operation in these industries
and maintained average prices higher than otherwise, it did protect management
from interindustry competition and provided all consumers with greater price
stability and uniformity among sellers and some consumers with lower prices
than otherwise.^

Regulation had permitted many types of cross-subsidizations.

Long-haul air passengers and cargo subsidized short-haul passengers and cargo,
particularly on less frequently traveled routes; long-distance telephone users
subsidized local calls; users of rental telephone equipment (the only equipment
permissible) subsidized other telephone operations; medium-size checking
account users subsidized small checking account users; and small savers subsi­
dized mortgage borrowers.

The beneficiaries of the quieter management, the

reduced search time associated with the more uniform prices among sellers, and
the lower, subsidized prices are harmed by deregulation and, not unexpectedly,
cried out, shouting unfair.

The recent experiences in restructuring prices in

wake of the AT&T breakup illustrate this dramatically.




6

Implications of Deregulation
Their arguments are not entirely without merit.

Deregulation produces

structural change, at times quite abruptly, that tends to be accompanied by
uncertainty.

Most of us operate more comfortably, if not better, in an envir­

onment of structural stability and certainty.

Change and uncertainty require

greater effort and, while they may also produce greater gains for some, they
produce losses for others.

Losers, who experience actual out-of-pocket reduc­

tions in wealth, are pained more and are more vocal than are winners, who
experience a windfall and would not suffer an out-of-pocket loss if they lost
increases in wealth they never had.

Moreover, the regulations benefited most

noticeably those in place when they were first imposed; the benefits are capi­
talized in the value of the activity at that time.

Subsequent beneficiaries

paid a higher price than otherwise for the activity and operated as if the
subsidy was an ongoing state of affairs.

Removal of the subsidy at a later

date, as some aspects of deregulation would bring about, is unlikely to affect
those who benefited, but it is likely to harm current operators.^
Another reason for the dissatisfaction expressed by some is that the
deregulation catches the thrifts at a time of financial weakness, not strength.
Thus, even with the additional powers, many will not be in a good position to
use them vigorously and compete effectively, and the higher interest cost of
their deposits will only weaken them further.
A third argument is that, although the new adjustable rate mortgage
instruments reduce the interest rate risk exposure of thrift institutions,
they will also reduce the demand for mortgages as they shift the risk to the
borrower who is less able to assume it.

As we will discuss later in this

paper, the validity of this prediction depends on the pricing policies used by
the thrifts and their abilities to manage interest rate risk.

Risk must be

viewed together with its price or expected return; the higher the risk, the




7
higher the expected return.

Thus, to shift the risk to borrowers, the insti­

tutions must offer a rate concession, and at the proper concession, they will
find customers.

Of course, the institution must be careful not to offer too

large a concession so that its own income declines by more than the value of
the reduced risk.
not easy.

The proper determination of the size of this concession is

Recent surveys indicate that ARMs have become a major mortgage

instrument for many thrifts.

In December 1983, more than 50 percent of new

mortgage loans extended were ARMs and were being made by some 80 percent of
all savings and loan associations.^

Most institutions indicated that they

made these loans at some concession from fixed rate mortgages and that there
were constraints on the magnitude and timing of the rate adjustments.

As will

be discussed later, how profitable these instruments are to the thrifts awaits
observation over a longer time span.
Lastly, many believe that the broader lending powers authorized thrifts
will encourage them to cut back on their mortgage lending, and the higher
costs of deposits will force them to raise their mortgage rates to compensate.
Thus, housing finance is hit with a double whammy.

Although appealing

intuitively, neither of these arguments stands up well to analytical examina­
tion and is unlikely to be true.

Market segmentation is one of the oldest and

more misused theories in financial markets.

Indeed, this theory underlies all

attempts at credit allocation and controls.

Unless prevented by barriers,

investors will place their funds where they expect the returns to be highest
for a given level of risk.
varying degrees of success.

Barriers can interfere with such an allocation to
Restricting thrift lending primarily to residen­

tial real estate did not prevent a slowdown in mortgage lending when they were
unable to attract deposits because of deposit rate ceilings or considered the
expected return not worth the risk.




The attempts at credit controls, including

8

the most recent experience in 1980, were widely considered ineffective and
counterproductive after a brief initial period before ways of circumventing
the regulations were discovered.
Moreover, even when apparently effective in directing credit to the
targeted sectors, there is little guaranty that the funds will be used by the
recipients in the desired way.

The rapid rise in the ratio of mortgage debt to

new home values in the late 1970s is shown in Table 2.

It is evident that much

of the mortgage credit was not used to finance the purchase of new housing.
Rather, it was used to finance other expenditures, such as education, stocks,
consumer durables, etc.^

Recent history has made amply clear, particularly to

the thrift institutions, that money is fungible; if blocked one way from find­
ing the highest return, it will find other, somewhat less efficient paths.

As

long as the barriers remain in place, the new paths will be made more effi­
cient and reduce the incentive to return to the old paths when the barriers
are finally lifted.

The most effective barriers are those that explicitly

alter the price or interest rate structure, such as explicit subsidies or pen­
alties as the qualification of assets for the maximum bad debt reserve at
thrift institutions.

Of course, even the latter barrier is ineffective when

the thrifts have little, if any, taxable income.
But the financial system was not always as heavily regulated as it has
been in recent years.

Many of the regulations were imposed after the finan­

cial debacle of the 1930s, when concern for safety was the highest and concern
g

for efficiency was substantially lower.
no regulations or constraints whatsoever.

This is not to argue that there were
The charters of thrift institutions

generally emphasized mortgage lending, and commercial banks, particularly
national banks, were restricted in their mortgage lending.

Nevertheless, how

did housing finance and the thrifts do in this relatively unregulated period?




9
The proportion of residential mortgage loans held by major types of
lending institutions every 10 years since 1900 is shown in Table 3.

Through

1930, savings and loan associations and mutual savings banks held between 65
and 75 percent of total residential mortgages made by institutions, although a
very large percentage was made by noninstitutional lenders.

Commercial banks

and life insurance companies evenly split most of the institutional remainder.
From 1930 to 1950, the institutional market share of thrifts declined below
50 percent, but part of this falloff reflected a pickup by the newly created
Home Owners Loan Corporation which assumed mortgages in default.
it increased again to its previous levels through 1976.

Thereafter

Thus, history sug­

gests that thrifts have provided the major share of housing finance in
relatively deregulated as well as relatively regulated environments.

Despite

the new problems, I see no reason why thrifts cannot and will not continue to
perform the same role in the 1980s.

Thus, housing overall should not be dis­

advantaged by deregulation once the transition problems pass, as may already
have occurred.
Impact on Mortgage Rates of Removing Deposit Ceilings
The impact on mortgage rates of freeing deposit rates may be analyzed
with the help of Figure 2.

Interest rates are measured on the vertical axis

and the dollar amount of savings and mortgage lending on the horizontal axis.
The amount of funds supplied to all mortgage lending institutions and indivi­
duals at each nominal interest rate (including thrift institution operating
costs and a competitive profit markup) is shown along schedule S.
up to the right.

The amount of funds demanded by these institutions and

individuals for mortgage lending is shown along schedule D.
the right.

It slopes

It slopes down to

Assuming no restrictions, the equilibrium mortgage rate is i

volume of lending is OA.

Now impose a ceiling on deposit rates at thrift

institutions only at i^.

They are now able to attract only OB amount of




and

10

savings and supply the same quantity of mortgage loans.

(In reality, it is

likely that the institutions will find ways of paying implicit interest pay­
ments that will raise the effective rates offered and mitigate the cutbacks.)
Because at OB the demand for mortgage funds is greater than the supply of sav­
ings, there is excess demand and the mortgage rate (i^) will exceed both the
deposit rate (iQ) and the unconstrained equilibrium rate (iQ) .

How will

thrift institutions price their mortgage loans in such an environment?
A number of scenarios are possible.
profits and charge i^.

The thrifts could maximize their

But some existing or potential mortgage lenders not

covered by the deposit ceilings would be willing to offer a higher deposit
rate than ic and thereby attract additional funds that they are willing to
lend at less than i^.

(In the short-run, after the initial imposition of the

deposit rate ceilings, there are likely to be some delays in the appearance of
relatively efficient alternative mortgage lenders, but the experience of the
1970s suggested that sooner or later they appear.)

Either the thrifts are

forced to reduce their mortgage rates or they will be restricted to lending to
the least creditworthy borrowers.

Alternatively, the thrifts could charge i^.

This would be below the equilibrium rate i
mortgage loans.

and create an excess demand for

The thrifts would either raise their rates to i

or accomo­

date only their own customers or the most creditworthy borrowers through
nonprice credit rationing.

The unsatisfied demand would be shifted to the

nonthrift lenders who would charge a higher rate.

Lastly, the thrifts could

charge the estimated equilibrium rate, iQ .
In the first two scenarios —

where thrifts charge i^ or iQ —

borrowers may be charged different interest rates.

different

In the second scenario,

those borrowers fortunate enough to obtain mortgage loans at below the equili­
brium interest rate would be harmed by removal of the deposit ceilings.




11

Nevertheless, it is evident that, given time, the removal of the ceilings will
neither raise either the average or marginal mortgage rate nor reduce the
overall quantity of mortgage lending.

The existence and level of the deposit

ceiling will affect primarily the market share of the thrifts —

the lower the

ceiling rate, the smaller the thrift’s market share, ceteris paribus.
Similarly, as the thrifts receive additional lending powers, any
reductions in their mortgage lending without an offsetting reduction in mortgage
demand will generate initially higher mortgage rates that, in turn, will
induce other lenders to shift from other loans to mortgage loans, unless the
initial mortgage rates were lower than their long-term equilibrium rate, which is an
unlikely scenario for any length of time.

Moreover, as is argued in the next

section, the primary reason for the new thrift powers was to provide them with
shorter maturity assets in order to permit them to reduce their maturity
(duration) mismatch.

But, as noted, the concurrent authorization to make

adjustable rate mortgage achieves the same objective of reducing the mismatch
and interest rate risk exposure without incurring startup costs in new areas
or accepting the credits traditional lenders in the new areas reject.

Thrifts

have a comparative advantage in continuing to do what they do best —

make

home mortgage loans.
But will they?

Perhaps the most important implication of deregulation is

that it shifts and greatly complicates the functions of management.

In a

regulated environment, government pretty well delineated the product lines,
geographical market areas, and prices charged and paid.
of freedom and independence were small.

Management’s degrees

The rewards for innovativeness and

aggressiveness in marketing were relatively small, but so also were the penal­
ties for failure.

The battlefield was not economic, but political.

Management

spent much of its energies lobbying legislators, regulators and the public
rather than on economic decisions.




Donald Rumsfeld noted, when he was

12
president of Searle in the regulated drug industry, that "when I get up in the
morning as a businessman, I think a lot more about government than I do about
our competitors, because government is that much involved."

9

In 1984, management of thrift institutions, similar to management of
airlines, telephone companies, and trucking firms, must choose their product
lines, geographical market areas, and prices without government assistance.
In addition, the barriers to entry for both new thrifts and nonthrifts are
greatly reduced, intensifying competition.

Wrong decisions or bad luck are

more painful, although public concern for safety is unlikely to produce overnight
Braniff Airlines.

Probably as a result, thrifts appear to have been cau­

tious in using their new lending powers.^

Even in states in which state

chartered institutions were able to make limited consumer and/or commercial
loans for some time, they have remained primarily residential mortgage lenders.
Some may have observed the unfortunate results of a few large East Coast mutual
savings banks that diversified by shifting out of mortgage loans to longer-term
corporate bonds in the 1970s only to suffer worse losses as interest rates
increased than their less adventurous neighbors.

Others may have been deterred

by the high startup costs of developing a commercial lending group and fears
of getting stuck with the credits no one else wanted.
return on mortgages has improved.

At the same time, the

According to Salomon Brothers, mortgage

securities had the highest return of any type of debt security in 1983, and
Table 4 shows that mortgage yields appear to have favorable spreads over
10 year Treasury securities even after adjustment for call (prepayment) premi­
ums, which, of course, vary directly with the level of interest rates.^
In 1983, thrift institutions sharply increased their overall home
mortgage lending to near their 1970s market share.
fer slightly.

Projections for 1984 dif­

Bankers Trust sees a continuation of the regained high level,

while Salomon Brothers sees a small decrease in market share.

Neither, how­

ever, expects a significant increase in the allocation of thrift funds to
consumer lending relative to the period just before deregulation.




If I am

13

correct in my argument that most thrift institutions will not expand greatly
into new nonmortgage powers and will remain primarily home mortgage lenders
and if deregulation results in a larger proportion of funds raised through
short-term interest sensitive deposits, such as MMDAs, interest rate risk man­
agement will be among the most important problems confronting management in
the next decade.

13

Managing Interest Rate Risk

As noted, an institution exposes itself to interest rate risk in the
process of engaging in interest rate intermediation when it mismatches the
interest and price sensitivities of its assets and deposits.
accurately, it is first necessary to measure it accurately.

To manage risk
Recent advances

in economic and finance theory have demonstrated that the degree of interest
rate risk exposure is proportionate to and can be reasonably accurately mea­
sured by a one number (single factor) duration "gap", or the difference between
the weighted duration of the institution’s assets and the weighted duration of
its deposits, where the weights depend on the account on the thrift institu­
tion’s balance sheet or income statement that is of major concern to management.
Such "target" accounts can include capital, the capital-asset ratio, or net
income.

Different target accounts are associated with different measures of

duration gap.

Durations have the pleasant property that the prices of any

security or portfolio of securities having the same duration are equally sen­
sitive to interest rate changes.

Although duration is a relatively simple

concept in theory, it is more difficult to apply.

However, although strenuous,

the information required is no more strenuous than that required by any other
procedure that purports to measure interest rate risk accurately, e.g., maturity
gapping.

The details of duration and the advantages and disadvantages of

using duration gaps over alternative techniques have been discussed at length




14

in the recent literature and will not be repeated in this paper.^

But it is

important to emphasize some of the implications for management.
Interest rate risk management does not imply eliminating interest rate
risk or "immunizing," so that changes in interest rates do not have any effect
on the target aocount selected.

Rather, it implies controlling risk so that

the expected rewards in the target account are at least sufficient to compen­
sate for any losses consistent with the assumed degree of risk exposure.
Thrift institutions receive a return on their successful interest rate inter­
mediation activities, and this return would be lost if they discontinued this
activity and became pure brokers.

On the other hand, as most thrifts have

learned the hard way in recent years, unexpected increases in the degree of
risk assumed from unexpected increases in the level and volatility of interest
rates can turn expected rewards into realized losses.

Having been badly

burned, many believe that thrifts should withdraw from this activity altogether
and concentrate on credit quality intermediation and nonintermediation or bro­
kerage services.

It is unlikely that many thrifts could in the near future

restructure their balance sheets to be able to eliminate the large duration
gaps or mismatches they currently have from much longer duration assets than
deposits, even if they wanted to do so.

Thus, they must live with interest

rate risk and learn to manage it successfully.
It

is frequently argued that as long as the yield curve is upward sloping

so that long-term rates are higher than short-term rates, lending long at
fixed rates and funding short-term is profitable.

Conversely, such a strategy

is not considered profitable when yield curves are downward sloping.

Both

statements are not only incorrect, but are dangerous to the health and welfare
of thrift institutions.

Economic theory and much empirical research has

clearly demonstrated that the yield curve contains important information on
the consensus of market opinion about the future course of interest rates.
the absence of any persuasive evidence that one can consistently predict



In

15
interest rates better than the market can, an upward sloping yield curve indi­
cates that short-term interest rates are expected to increase above current
long-term rates.

Thus, the positive spread from borrowing short today and

lending long may be expected to narrow and, in time, turn negative.

And the

steeper the yield curve, the larger will be the expected losses in the future.
Today’s revenues from such a strategy are not really net income but reserves
to be used to offset tomorrow’s expected losses.

The relevant period for

evaluating the success of a borrow short-lend long strategy is the overall
life of the long asset.
ing and borders on fraud.

The use of any shorter accounting period is mislead­
(Similar myopia may exist for upfront loan fees.)

Indeed, it is precisely the failure to use the long period in the 1960s and
1970s that contributed greatly to the current financial difficulties of the
thrifts.
But human nature being what it is, it is tempting to view the current
spread under upward sloping yield curves as permanent income and to take the
credit and rewards.

This is particularly true for thrift institutions, as

noted by Edward Kane, as long as federal deposit insurance is not priced on
the basis of risk to discourage such behavior.^

Many a reputation for pro­

fitable management in the ’’golden years” of the thrift industry were based on
this confusion.

And many of today’s next generation managers are picking up

the pieces of this strategy and bearing the burden of the penalties, while
their predecessors bask in the warm glow of their promotions or higher incomes
and bonuses derived from their earlier ’’successes.”

The latter may even won­

der aloud why their successors are not as successful as they were.
likely that history will repeat.

And it is

There is a great deal of truth in the adage

that the spread a thrift institution will charge between the rate on a 30 year
fixed-rate mortgage and the rate it pays on short deposits is proportionately




16

related to the number of years to retirement of the chief executive officer.
The nearer to retirement, the smaller is the spread as he or she will not be
in the saddle when the negative spread occurs.

The longer to retirement, the

larger is the spread as the CEO expects to be around when the bad news hits.
This analysis also demonstrates that it may be profitable to borrow at a
higher rate than one lends, if the higher rate is short-term and the lower
rate is long-term.

The yield curve is thus downward sloping, and the short­

term rate is expected to decline below the current long-term rate so that
today’s losses will be offset by tomorrow’s gains.

Thus, ARMs, whose rates are

tied to short-term rates, should not always be priced at the same discount
yield or concession from fixed rate mortgages and, at times, may even need to
be priced at a premium yield.

(Holding the yield curve constant, ARMs should

be priced to yield somewhat less than comparable FRMs to reflect the smaller
degree of interest rate risk assumed by the issuer and the better call protec­
tion.)

Otherwise, if short-term interest rates decline below current long­

term rates, as expected in a downward-sloping yield curve, the rate on the ARM
will only decline further and the mortgage will not only yield less than a FRM
but may lock-in a loss.

Yet, surveys of ARM yields indicate little, if any,

awareness of this and other long-term pricing implications on the part of ARM
lenders.^

Regardless of how it may appear at the time, the shape of the

yield curve does not permit a thrift institution to escape interest rate risk
when it temporally mismatches the interest sensitivity of its borrowing and
lending.
Unfortunately, when thrift institution managers and regulators belatedly
became sensitive to interest rate intermediation and risk in the late 1970s,
they found little help from academics and other researchers.
had been caught napping.




The latter also

As late as the early 1970s, popular models of thrift

17

institutions tended to specify the long-term fixed mortgage rate as a markup on the
short-term deposit rate so that they effectively excluded interest rate intermediation.

18

The earliest interest rate risk models were based more on

intuition and casual theorizing than on rigorous development on theoretical
constructs.

These models divided the institution’s assets and liabilities

into maturity buckets or gaps according to the maturity or first date of
repricing of each item.

This provided the institution with a rough picture of

their balance sheet imbalance and interest rate exposure.

Although simple to

understand and almost as simple to implement, maturity gap models were only a
first step and possess serious limitations relative to duration models.

They

do not consider all the cash flows, they equate different interest sensitive
securities, they cannot aggregate the imbalance into a single number, they
require simultaneous management of numerous maturity sectors, and many more
limitations that I have described elsewhere.

Whatever the technique used to

measure risk exposure, a tremendous amount of information about every account
on the balance sheet is required.

Interest rate risk management, in effect,

requires a new generation of management information systems.

Because changes

in any management information system are costly, it is important that institu­
tions do not commit major resources to developing systems that will quickly be
outmoded.

This is equally true for the regulators.

While the new bank

(Schedule J) and thrift (Section H) reporting forms requiring maturity break­
downs are a major step forward, they are insufficient for accurate measurement
or management of interest rate risk.

Regulators could make an important con­

tribution to the industry by being in the forefront in developing accurate
interest rate measurement techniques.
Duration Analysis
One significant advantage of using duration gap analysis for managing
interest rate risk is that it permits an institution to assume almost any




18

degree of interest risk it wishes without sacrificing the large variety of
different maturity products demanded by its customers.

The duration of a

portfolio is the weighted average of the durations of the individual composite
securities.

Thus, any value of duration for a portfolio is consistent with an

almost infinite combination of securities with differing durations.

Likewise,

any value of a particular duration gap is consistent with an almost infinite
combination of asset and deposit accounts with different securities.

For

example, in today’s interest rate environment, a zero duration gap using the
dollar value of net worth as the target account can be structured using fixedrate 30 year mortgages and a fixed-rate seven and one-half year zero coupon
CD.

If not prepaid, this mortgage has a duration of about seven years.

The

duration of any zero coupon, single payment instrument is its term to maturity.
The duration gap equation for capital as the target account is-.^O
DGAPk = (Da - wDp),
where:
= duration
Dp =duration

of assets
of deposits

P

= market value of deposits

A

= market value of assets

w

*P/A

K

=capital

If the institution’s capital-asset ratio is 5 percent, the duration gap will
be approximately zero (7 - .95 x 7.5), the durations are ’’matched’* and the
institution will be protected or ’’immunized” against changes in interest
rates.

The market value of its capital will remain constant regardless of

changes in interest rates.

Of course, in actuality, some prepayment will be

assigned to the mortgage, and its duration will be shorter and can be funded
without interest rate risk by even shorter-term CDs.




19

If an institution believed that interest rates were going to decline by
more than the market consensus, it may wish to gamble and assume some risk.
It can do so by structuring its balance sheet to produce a positive duration
gap of, say, one year.

This may be achieved by funding the 30 year maturity,

seven year duration mortgage with a six and one-third year zero coupon CD.
For purposes of price sensitivity, the institution effectively behaves like a
one-year bond.

For every 100 basis point decline in interest rates, the mar­

ket value of the institution’s capital account will increase by an amount
equal to some 1 percent of its assets.

Of course, if it predicts incorrectly

and interest rates rise, its capital account will decline by about 1 percent
of assets for every 100 basis point increase in rates.

It is important to

note that if an institution wishes to assume interest rate risk, it must pre­
dict at least the direction of interest rate changes, and for it to win its
gamble, it must be right on its prediction.

The relationship among duration

gap, interest rate change, and the market value of capital is, at first
approximation, shown by the following equations:
= -DGAPk (Ai)
and

f

- -KAP k ( ! ') M

where:
A

= market value of assets

K

= market value of capital (net worth)

A

= change from previous value

i

= yield to maturity

DGAP^ = duration gap for capital
Similar equations exist for other target accounts.

Thus, the institution can

predict the change in the target account for any expected change in interest
rates.

The more certain it is of that interest rates will decline or the




20

greater the degree of interest rate risk it wishes to assume, the greater will
be the value of the duration gap it selects.
If the institution believes interest rates are going to rise more than
the consensus of the market expects, it would produce a negative duration gap
by, say, funding the 30 year maturity, seven year duration mortgage with an
eight and one-half year zero coupon CD.

It would then expect capital to

increase by 1 percent of assets for every 100 basis point increase in interest
rates.

Of course, if rates change in the direction opposite to that expected,

net worth will decline.
It can be seen in the above examples that, because duration is a single
number, the institution can achieve its desired macro risk exposure levels,
including immunization, without sacrificing its abilities to accommodate a
wide range of the maturity preferences of its customers on the micro level.
This flexibility in meeting customer demand is considerably smaller when using
maturity gaps to measure risk exposure as the institution is then constrained
to cash flow matching or mismatching in each of the many gaps.
It is worthwhile to devote additional attention to some of the
complexities of measuring risk exposure under any fairly accurate technique.
It has already been noted that the institution must predict mortgage prepay­
ments.

But it must also estimate the use of all other option features on its

assets and deposits, such as repricing of variable or floating rate securities
and due-on-sale, early deposit withdrawals, and other put provisions.

Even

more troublesome is the correct classification of deposit accounts that are
always and immediately available at their par value, such as demand deposits,
MMDAs, NOWs, SNOWs, and passbooks.

Deregulation has increased the importance

of these accounts to the total deposit base of most thrifts.

Duration analysis,

as well as any other procedure that attempts to derive an economically accurate




21

measure of the financial condition, requires mark to market or present value
accounting, even for hard to market and nonmarketable securities.

Thus, as

interest rates rise, the market value of securities declines, and the longer is the
duration, the larger the decline.

If deposits are available at par at all

times, both their maturity and duration are one day and an increase in inter­
est rates will not lower their market value.
But what if all deposits are not withdrawn if, when market rates of
interest rise, a particular thrift institution does not increase its deposit
rate commensurately, either in cash or in services?
"core” deposits.

Some deposits remain as

It is likely that the amount of core deposits will vary

according to the size of the gap between the interest rate paid on the par­
ticular type of deposit by the thrift and that paid by its competitors and to
the length of time the gap exists.

Nevertheless, it is possible to statis­

tically estimate the average amount and length of core deposits and treat them
as an equivalent CD whose market value does fluctuate with interest rates.
Thus, as market rates rise above the deposit rate offered by the thrift insti­
tution, the market value of its core deposits declines below their par value.
Nevertheless, deposits are likely to remain short duration securities that are
unlikely to reduce the positive gap produced by longer duration assets signi­
ficantly.

To assist thrifts in doing so and reducing their interest rate risk

exposure, the financial markets have developed new securities.

Innovation of New Mortgage Securities

Financial intermediaries are like tailors.

They take financial

instruments that do not fit the characteristics of investors or borrowers and
reshape them, in terms of denomination, maturity, repricing periods, credit
quality risk, cash flow characteristics, and so on, so that they do.




Of

22

course, banker sounds much classier than tailor.

Because the number of

investors and borrowers is large and their needs vary and change as both the
economic and financial environment and the regulations and legislation change,
the number of securities custom tailored to supplement the standard securities
available on the rack is large.

Because of the unusually rapid pace of change

in the financial sector over the past 10 years, financial tailors have been
particularly busy designing and redesigning new instruments.

Like clothing

designers, however, the imaginations of financial designers tend to outrun the
permanent or mass demand, and more new instruments are designed than eventually
survive.

Again like clothing designers, financial designers appear to have

little trouble finding customers who are willing to be the first to try a new
design before all the advantages or disadvantages of the material, cut, color,
etc. are fully known.

There appears to be a certain prestige in being the

first in the world, country, or community to be seen using a new financial
security, just as there is in being the first to be seen wearing a new outfit.
Moreover, the price of the first-of-a-kind security like that of a first-of-akind outfit is high.

But many of the financial designs, like clothing designs,

do not last long enough to move into mass production, even at much lower
prices.

The December 1981 issue of the Institutional Investor features its

choices for the leading new financial security innovations of 1981.
have survived.

21

Not all

Nineteen eighty-one was the year of the low and zero coupon

original issue discount bonds.

It was also the year of the more forgettable,

original issue discount convertible bonds and commodity linked Eurodollar
bonds.

The moral of this analogy is that, although flashy, all new financial

instruments are not necessarily successful in solving the problem they were
designed to solve, and they must be examined and priced carefully.
We have already discussed the variable rate mortgage instruments that
were designed in recent years to reduce the durations of thrift institution




23
assets.

(The maturity of an unconstrained variable rate instrument is only to

the first estimated date of repricing back to par value.)

Over these years, a

large number of alternative VRMs were designed differing in length of time
between permissible changes in contract interest rates, the maximum permissible
interest rate change per time and/or over the life of the mortgage, the market
index to which the rate changes are tied, the maximum amount of negative amortization if any, prepayment provisions, and due-on-sale provisions.

22

Although

many were introduced, the high degree of confusion sown among both lenders and
borrowers suggests that only some will survive.

23

But even this large number of VRMs did not satisfy every thrift
institution’s or other mortgage lender’s need.

While VRMs reduced durations,

they did not change the high costs of credit evaluation, the odd and small
denominations, the unique tailoring to the particular needs of the home buyer
—

all of which reduced the marketability of the mortgage and increased the

operating costs —

or the reluctance of potential borrowers to use VRMs.

Indeed, VRMs increased servicing costs.

Where there is a perceived need, fin­

ancial tailors will attempt to design a newer, if not a better, security.

The

first new securities were the pass-throughs and mortgage bonds designed by
GNMA and FNMA in the early 1970s.
problems —

While these securities reduced many of the

such as the odd denominations, high credit evaluation costs and

servicing costs —

except for mortgage bonds, they did not alter the cash flow

pattern of the underlying individual mortgages.

And mortgage bonds were tail­

ored more for life insurance companies and pension funds by lengthening the
duration.

Thrifts wanted shorter durations.

In 1983, FHLMC tailored a new instrument to satisfy the needs of investors
with different maturity preferences.

The first issue of its collateralized

mortgage obligations (CMOs) basically divided the overall cash flow from a
pool of mortgages, which collateralize the securities, into three maturity
classes or series of securities.



The first (short-term) group receives all

24

principal payments until the total principal amount of this series is repaid.
The second (intermediate term) group receives all subsequent principal pay­
ments until its principal amount is repaid, and the third (long-term) group
receives all remaining principal payments.

All three series receive regular

semi-annual coupon interest payments, but not necessarily at the same rate.
The FHLMC guaranteed a minimum cash flow in each period based on historical
prepayment experience.

Larger than historical prepayments are passed-through.

The protection from reduced prepayments increases the certainty of the instru­
ment, particularly for the first two tranches which do not have a call provision.
The risk has been assumed by the FHLMC.

Later issues modified these charac­

teristics somewhat to custom-tailor the cash flow patterns even further.
Similar securities have also been developed by private firms, differing
slightly in the types of mortgages included in the pools, the guaranty or
insurance against default losses, the number of maturity classes —
ple, four classes have become popular —
maximum cash flow patterns.

for exam­

and the guaranty in minimum and

The securities made it easier for investors, who

found the cash flow characteristics of the previous mortgage-backed securities
undesirable, to invest in mortgages.

From the sale of the first CMO by FHLMC

in June 1983 through year-end 1983, 12 issues totaling almost $5 billion had
been sold by eight different issuers.
the dollar volume.
amount.

Freddie Mac accounted for 36 percent of

The 1984 volume promises to be far in excess of this

Some $4 billion of CMOs were issued in the first two months alone.

Data from the first two Freddie Mac CMO sales indicate that thrift
institutions were the largest buyers of the short-term series, purchasing
almost one-third of the dollar amount, followed by commercial banks and, sur­
prisingly, life insurance firms.

Pension funds were the largest single buyers

of both the intermediate and long-term series.

Surprisingly, commercial banks

purchased only slightly smaller proportions of the intermediate and long-term




25

series than the short, and, although thrifts purchased only 13 percent of the
long-term series, these purchases amounted to almost the same dollar total as
their short-term series purchases.

A more recent survey by Salomon Brothers,

shown in Figure 3, reported that thrifts purchased 27 percent of the shortestterm class —

which had an average maturity of under four years —

3 percent of the longest —

which had a maturity of over 10 years.

banks followed a similar strategy.

and only
Commercial

Insurance companies were the heaviest pur­

chasers of intermediate-term CMOs and pension funds by far the largest
purchasers of longer-term maturities, accounting for almost one-half of the
purchases of seven to ten year issues and two-thirds of those with average
maturities longer than 10 years.^
To date, CMOs have been highly successful judging both from the volume and
from the lower interest yield on the average of the three series than on a com­
parable GNMA pass-through security.

The first CMOs sold by FHLMC in 1983

yielded almost 100 basis points less than comparable GNMAs. J

Although the

spread has narrowed with subsequent sales, it still exists currently.

Some,

but far from all, of the spread must be attributed to the reduced call risk
and increased stability in the cash flows.
One may ask why, after adjusting for structural differences, the average
of the parts of a CMO should yield more or less than a comparable whole security.
Why did investors not find it profitable previously to buy the entire issue and
sell off the higher priced subparts or for issuers to sell only securities with
cash flows limited to the higher priced maturity sectors?

Of course, something

comparable has been tailored for Treasury securities, where a number of major
security dealers were effectively able to strip the coupons off Treasury bonds
and to repackage and sell off each cash flow (coupon as well as principal at
maturity) in zero coupon security form at a lower average yield than the yield
on the Treasury bond used as collateral.




26

With respect to the last, one can

26
legitimately question why the Treasury itself has not taken advantage of the
lower yields possible.

After all, it supposedly is operating in the public

interest in a period of extraordinarily high and controversial deficits.

The

evidence does appear to suggest that, at least for now, there are some yield dif­
ferentials in segmenting —

an apparently unsatisfied demand has been located.

The above instruments are all on the cash market, but as everyone except
those living on Mars for the last decade know full well, there has been a lit­
eral explosion of innovation on the futures and options markets.

These have

greatly increased the menu available to thrifts for structuring their balance
sheets to obtain the desired interest rate risk exposure.

Although instruments on

these markets were developed primarily to ease interest rate hedging, they
involve considerable risk.

They are also considerably more complex to under­

stand and use correctly than are cash securities.
cause much larger losses than on the cash market.

Errors in use or judgment can
27

They are also tempting

instruments to use to increase interest rate risk at little if any current
cash outlays —

bet-the-bank at times current income is low —

and their use

must be monitored carefully.
Futures and options are quite different securities.

Futures permit one

to offset the interest rate implications of a cash position by mirroring it on
the futures market.

If one buys on the cash market, one sells on the futures

market and conversely.

It follows that the closer the instruments used on

both markets, the better is the offset or hedge.

But one need not hedge.

Futures contracts can be mixed with cash positions to obtain any desired duration gap and interest rate exposure.

7 ft

Their primary advantage here is that

they are relatively cheap and give a big duration bang for the out-of-pocket
buck.
—

Their primary disadvantage is that they introduce other types of risk

cash flow (liquidity) risk from daily mark-to-market and basis risk from

dissimilar securities.




In addition, particularly with non-duration analysis

27
based systems, there is a tendency to use futures to hedge individual opera­
tions or gaps (microhedging) rather than only the overall bank or gap
(macrohedging).

This introduces excess costs.

Options permit the hedging of option features on outstanding cash
securities, such as prepayment (call) provisions on mortgages, upside or down­
side caps on variable rate loans, and early withdrawal (put) provisions on
deposits.

In contrast to futures, option hedges are placed by mimicking the

exposed option, so that if there are prepayment (call) provisions on outstand­
ing mortgages, the thrift buys call options.

If interest rates decline and

mortgage borrowers exercise their options to call or prepay all or part of
their loans, the thrift can exercise or sell its call option on similar
securities and offset losses.

Generally, the liquidity risks are somewhat

smaller than for futures, but it is possible to lever up to higher risk levels.
Similar to futures contracts, the hedge is better the more similar the securi­
ties to which the options apply.

Also similar to futures contracts, options

are more complex than most cash instruments and require greater skills on the
part of the users and are tempting to use for hedging individual transactions.
Indeed, centralization of all futures and options trading with overall asset
and liability management is a prerequisite for efficient interest rate risk
management.

The institution needs one interest rate risk manager, not many,

to manage one interest rate gap, not many.
More recently, financial tailors have designed even more complex
instruments, such as options on futures contracts.

While dazzling in their

design, their staying power and usefulness to thrift institutions are still in
question.

Thrift managers should be cautious about accepting these new­

fangled securities too quickly, particularly at the very high prices at which
they are currently marketed.

They may be trading a reduction in a known risk

for an increase in an unknown risk. 30




28
One cannot help but be somewhat disturbed by the reported extraordinarily
high fees that appear to be earned by both private and quasi-public creators
of the new mortgage instruments, as well as of interest rate swaps and other
innovations which are not discussed in this paper.

The "Street” is awash with

stories of investment bankers selling thrifts a package of new mortgage securi­
ties for their old securities to reduce their interest rate risk and then
reselling the securities within the next few days at substantial markups.

The

American Banker of February 13, 1984 reported that some 40 percent of Salomon
Brothers* 1983 profits were derived from mortgage-related securities activi31
ties.
Freddie Mac has sponsored numerous full-page advertisements in the
Wall Street Journal and other major newspapers publicizing their operations•or
most recent sale in particular, as has Fannie May.
to drum up business.
firms.

32

These appear to be designed

In this they are competing vigorously with private

Although it is likely, as in clothing design, that the prices and

profits from these innovative tailoring activities will decline if the pro­
ducts find a lasting demand, as I suspect many will, and are produced in mass
quantities in a limited number of styles for sale off the rack, why were pro­
fits so high to start with?
At least part of the reason may be the asymmetry in financial sophistication
between the financial tailors at investment banking firms and governmentsponsored mortgage agencies, many of whom are not long out of school with
their MBAs and Ph.D.’s in financial design, and the financial officers at most
thrift institutions, whose professional training has been largely in direct
mortgage lending.

The latter are relatively unschooled in the high-powered

financial mathematics that are required to understand many of the newer securi­
ties, such as stochastic calculus, matrix algebra, linear programming, option
pricing theory, and optimization theory.

We appear to have moved into an era

of super-finance, which requires super-math to understand.




Charged with the

29

objective to reduce interest rate risk almost without regard to cost, finance
officers at thrifts are literally at the mercies of the investment bankers for
quantifying costs.

And many investment bankers appear to take the phrase

f,without regard to cost" quite literally.

Thrift institutions have jumped almost

overnight from the world of ordinary finance to the world of high finance with
its heavy hitters, sophisticated dressers, and fast operators.
prepared for the change.

They were not

To play winning ball, if not just remain afloat, in

the big leagues of high finance, thrifts need to quickly acquire the necessary
expertise to put them on an even footing with their "advisors."

Although

there are many advantages to training one’s own personnel, time may be so
short that many institutions may be best off by raiding the advisors.

The Secondary Market

The great emphasis in current housing finance is on the secondary market.
Indeed, the Federal Home Loan Mortgage Corporation has just published the
first issue of a journal devoted solely to this market —
Markets.

Secondary Mortgage

The reason for the emphasis on the secondary market is simple; it

increases the breadth and liquidity of the entire housing finance system.

It

permits both nontraditional mortgage lenders, who are not positioned to origi­
nate new mortgages themselves, and traditional mortgage lenders, who are
positioned to originate mortgages but are in capital surplus areas and thus do
not have sufficient opportunities to do so, to participate in the mortgage
market.

That is, secondary markets expedite mortgage fund transfers across

both industry and geographical boundaries.

Moreover, the secondary market

encourages mortgage originators to originate more such loans in the knowledge
that they can sell off any "surplus” loans quickly and without great cost.
But, unlike many other types of securities, individual residential mortgage
loans do not readily lend themselves to trading after origination.




As noted

30

earlier, they have small and odd denominations, unique and optional cash flow
patterns, costly credit valuations, and so on.

Thus, the financial tailors

tailored new instruments that attempt to overcome these barriers.
As noted, the first secondary securities —

securities issued by someone

other than the ultimate borrower who uses the funds to purchase housing or
some other nonfinancial asset —

were participation certificates pioneered by

GNMA that standardized the denominations by pooling individual mortgages,
reduced the credit checks and risk by using first FHA-VA and then privately
insured mortgages as collateral, and increased cash flow certainty through the
law of large numbers.

They did not restyle the cash flows, however.

The

first attempt at this was the mortgage bond pioneered by FHLMC and more
recently and on a much larger scale the CMOs, again pioneered by FHLMC.
By year-end 1983, tailored mortgage-related securities (MRSs) out­
standing totaled about $243 billion and accounted for about 15 percent of
total mortgage debt outstanding and 20 percent of all home mortgage debt.

In

1983 alone, more than $85 billion of these securities were issued, up from
$50 billion in 1982.

(There appear to be rather significant inconsistencies

among the data sources on MRSs.

I believe that Freddie Mac can make a major

contribution by collecting and publishing accurate primary data as well as
secondary data in its Secondary Mortgage Markets journal.)
By their very creation, these secondary securities increase the size of
the mortgage market, just as the introduction of financial intermediaries such
as commercial banks and thrift institutions and their secondary securities —
deposits —

increased the size of the overall financial market.

Of course,

the dollar amount of mortgage-related securities issued greatly overstates the
net contribution to housing finance.

Even if the securities were all pur­

chased by nontraditional mortgage lenders, which as was shown in Table 1 is
not the case, some of the purchases are likely to be at the expense of tradi­
tional lenders who found that the increased competition had reduced risk-adjusted



31
yields below their minimum acceptable levels and invested in other securities.
But MRSs would increase the market even more if they traded after their initial
placement on a true secondary market.
Preliminary evidence from the new data published in Secondary Mortgage
Markets and elsewhere indicates that these instruments have in their short
lifespans become relatively major trading vehicles.

33

MRS daily average

trading volume in 1983 was estimated to be $2.1 billion, up from $0.9 billion
in 1982.

(Indeed, there is some evidence that MRSs are traded proportionately

more heavily than other securities by regional dealers who do not report to
the Federal Reserve, which collects the trading data, so that their activity
is likely to be underestimated.

This is another area in which Freddie Mac can

make a major contribution by improving data quality.)

As can be seen from

Table 5, which lists the reported trading volume of major marketable securi­
ties, MRS trading volume is beginning to look respectable relative to other
securities.

In terms of turnover, MRSs are already 40 percent as active as

federal agency securities and 23 percent as active as intermediate-term
Treasury securities, both veteran trading vehicles.

The heavy trading volume

is particularly remarkable in light of the widespread belief of only a few
years back that once placed, these instruments did not trade again.

This

bodes well for the future efficiency of the mortgage market and the continued
ability of the market both to shift mortgage funds from surplus to deficit
areas and to attract nontraditional mortgage lenders at low interest rates.

Conclusions

Deregulation has and will continue to change the structure of the
residential mortgage market.

But deregulation is only the surface reason.

The real forces directing the changes are the higher levels and increased
volatility in interest rates that both decreased the profits of traditional




32

mortgage lending institutions and increased uncertainty and risk and the
advances in telecommunication technology that caused the deregulation.

If

these forces had not developed, the regulations in force would have continued
to work or not work as before and deregulation would most likely not have
occurred, certainly to the extent that it has.
Although deregulation has caused transition problems, it has appeared to
solve the more severe problems caused by the old regulations.

The cure was

not worse than the disease, and the patient has survived with the help of siz­
able blood transfusions in the form of paper capital and deposit insurance
subsidies.

This is not to say that the thrifts are permanently out of the

woods, but any future problems are more likely to be caused by their old acti­
vities or the low coupon, fixed-rate mortgages on their books rather than
their "legitimate11 (nonfraudulent) current activities.

34

Public policy to

deal with this problem if interest rates again rise sharply should be sep­
arated from public policy to strengthen the housing finance system.

This

system should now be in pretty good shape.
Traditional residential mortgage lenders, particularly the thrift
institutions, may be expected to remain the primary source of funding in the
market, but the type of financing they will provide will change, and there is
likely to be some decrease in the importance of their commitment.

Direct

lending, particularly through fixed rate loans, will decline but will in large
part be offset by increases in indirect lending and the development of new
mortgage securities that will come closer to being just what the doctor ordered
for most parties.

Any decrease in the commitment of thrifts to the mortgage

market will be offset by the entry of nontraditional lenders.
The housing finance delivery system will become more complex, and losses
stemming from errors will be larger in magnitude and more serious in conse­
quence.

Thrift institution management will have to increase its abilities to




33

deal with this new environment.

Financial tailors can be counted on to make

managers’ jobs both easier by permitting them to be able to incur only the degree
of risk they wish and more difficult by making the instruments that produce these
results more complex.

A return to the old simpler ways of financing housing

can only occur with a return to greater financial stability.
hands of the government.

This is in the

The private sector can only make the best of any

given environment, and, if history is a guide, in case of problems, regulators
are likely to provide short-term gains at the expense of later, larger losses.
As Henry Sidgwick noted in his Principles of Political Economy nearly 100 years
ago:
It does not follow that whenever laissez faire falls short government
interference is expedient; since the drawbacks of the latter may, in
any particular case, be worse than the shortcomings of private enter­
prise.^
Thus, it is better for the industry to work out problems as efficiently and
fairly as possible rather than to invite in the government either directly or
indirectly through its failure to solve its problems adequately.




34

Footnotes
*1 am indebted to David Andrakonis, Gillian Garcia, Edward Kane, Alden Toevs,
James Van Horne, Robert Van Order, and Kevin Villani for helpful comments and
suggestions on an earlier draft.
1.

U.S. Congress, House of Representatives, Subcommittee on Housing and
Community Development of the Committee on Banking, Currency, and Housing,
Evolution of Role of the Federal Government in Housing and Community
Development: A Chronology of Legislative and Selected Executive Action,
1892-1974 (Committee Print), 94 Cong., 1 Sess., October 1975; The Report
of the Presidents Commission on Housing (Washington, D.C.; Government
Printing Office), 1982. Some viewed the regulation of thrifts to assist
in housing finance as a "social contract" between them and the government.
See Kenneth J. Thygerson, "Financial Restructuring: Impact on Housing,"
Contemporary Policy Issues, The Financial Services Industry: A Decade of
Change (Western Economic Association), January 1983, pp. 18-32.

2.

Edward J. Kane, "Getting Along Without Regulation Q: Testing the
Standard View of Deposit-Rate Competition During the fWild-Cardf
Experience," Journal of Finance, June 1978.

3.

Leveling the Playing Field: A Review of the DIDMCA of 1980 and the GarnSt. Germain Act of 1982 (Federal Reserve Bank of Chicago), December 1983.

4.

Roger G. Noll and Bruce M. Owen, eds., The Political Economy of
Deregulation: Interest Groups in the Regulatory Process (Washington,
D.C.; American Enterprise Institute), 1983; Thomas Gale Moore, "Rail and
Truck Reform - The Record So Far," Regulation, November/December 1983,
pp. 33-41; "Deregulating America: The Benefits Begin to Show - In
Productivity, Innovation and Prices," Business Week, November 28, 1983,
pp. 80-96; "The Burden of Economic Regulation," Economic Report of the
President, 1983 (Washington, D.C.), pp. 96-123; U.S. Congress, House of
Representatives, Subcommittee on Aviation, Committee on Public Works and
Transportation, Review of Airline Deregulation: Hearings, 98 Cong.,
1 Sess., May 24, June 9, 15, 1983; Douglas W. Caves, Laurits R. Christensen,
and Michael Tretheway, "Airline Productivity Under Deregulation,"
Regulation, November/December 1982; __________________ , "Productivity
Performance of U.S. Trunk and Local Service Airlines in the Era of
Deregulation," Economic Inquiry, July 1983; and Council of Economic
Advisers, "The Burden of Economic Regulation," Economic Report of the
President, 1983, pp. 96-123.

5.

A study of deregulation of the railroads concluded that " . . . deregulation
has benefited consumers, shippers and the railroad industry. It has pen­
alized past owners of licensed trucking firms, Teamsters, and some rail
workers." Moore, "Rail and Truck Reform," p. 41. A discussion of some
unforeseen problems of deregulation appears in Richard 0. Zerbe, Jr.,
"Seattle Taxis: Deregulation Hits a Pothole," Regulation, November/
December 1983.6
*

6.

Michael Lea, "Freddie Mac ARM Lender Survey: The State of the Market" in
What Makes an ARM Successful? (Washington, D.C.; Federal Home Loan
Mortgage Corporation), p. 3; and Freddie Mac Reports, February 1984, p. 5.




35

Footnotes (continued)

7.

Allan H. Meltzer, "Credit Availability and Economic Decisions: Some
Evidence From the Mortgage and Housing Markets" in Government Credit
Allocation (San Francisco, Institute for Contemporary Studies), 1975,
pp. 123-150; David F. Seiders, "Mortgage Borrowing Against Equity in
Existing Homes," Staff Economic Study, 96 (Board of Governors of the
Federal Reserve System), 1978; and "Tapping the Home-Equity Till," Morgan
Guaranty Survey (August 1979), pp. 4-7.

8.

George G. Kaufman, Larry Mote and Harvey Rosenblum, Implications of
Deregulation for Product Lines and Geographical Markets of Financial
Institutions, Staff Memorandum 82-2 (Federal Reserve Bank of Chicago),
April 1982; and __________________ , The Future of Commercial Banks in the
Financial Services Industry, Staff Memorandum 83-5 (Federal Reserve Bank
of Chicago), 1983.

9.

Donald Rumsfeld, "A Politician-Turned-Executive Surveys Both Worlds,"
Fortune Magazine, September 10, 1979, p. 94. Deregulation has not yet
stopped political lobbying for housing support. In 1983, the National
Association of Realtors and the National Association of Home Builders
were the second and third largest donors through political action commit­
tees (PACs). Brooks Jackson, "PAC Funds Flow to Congress," Wall Street
Journal, February 23, 1984, p. 50.1
0

10.

Constance Dunham and Margeret Guerin-Calvert, "How Quickly Can Thrifts
Move Into Commercial Lending," New England Economic Review, November/
December 1983; "Determinants of Thrift Institutions’ Commercial Lending .
Activity," Proceedings of a Conference on Bank Structure and Competition,
1983 (Chicago; Federal Reserve Bank of Chicago), pp. 129-150; Brian Maris,
"Consumer Lending by S&Ls: The Prospects," Federal Home Loan Bank Board
Journal, May 1980, pp. 20-25; Robert A. Eisenbeis and Myron L. Kwast,
"The Implications of Expanded Portfolio Powers on S&L Institution
Performance" (Working Paper; Board of Governors of the Federal Reserve
System), 1982; Eric I. Hemel, "The Financial Outlook for the Savings and
Loan Industry," Federal Home Loan Bank Board Journal, January 1984,
pp. 2-5; John Crockett and A. Thomas King, "The Contribution of New Asset
Powers to S&L Earnings: A Comparison of Federal- and State-Chartered
Associations in Texas," Working Paper, 110 (Federal Home Loan Bank Board),
1982; and Lisa J. McCue, "Commercial Lending: No Mad Rush," American
Banker, February 28, 1984, pp. 13, 14, 42. For an early study, see Ray C.
Fair and Dwight M. Jaffee, "The Implications of the Proposals of the Hunt
Commission for the Mortgage and Housing Markets: An Empirical Study" in
Policies for a More Competitive Financial System, Conference Series No. 8
(Boston; Federal Reserve Bank of Boston), 1972, pp. 99-148. A number of
other studies modeling the lending patterns of thrift institutions under
deregulation are reviewed in Willard McIntosh, Arthur E. Warner, and
James Gaines, "The Garn-St. Germain Act and the Availability of Funds to
the Real Estate Industry," Federal Home Loan Bank Board Journal, May/June
1983.

11.

Salomon Brothers, Comments on Credit, January 6, 1984, p. 2.




36

Footnotes (cpntinued)

12.

Henry Kaufman, James McKeon, and Steven Blitz, 1984 Prospects for
Financial Markets (New York; Salomon Brothers), December 14, 1983;
Donald E. Woolley and Beverly Lowen, Credit and Capital Markets for 1984
(New York; Bankers Trust Company), 1984.

13.

Credit quality will also remain an important risk, particularly if
thrifts enter into consumer and commercial lending and real estate
investment and development. Some institutions may attempt to offset
reductions in revenues from reduced interest rate risk activities with
revenues from lower credit quality investments. Moreover, risk-taking of
any type is encouraged as long as federal deposit insurance remains
underpriced to risky institutions. The underpricing of deposit insurance
may also encourage fraudulent activities, particularly in states that
have authorized additional powers to their state-chartered thrift insti­
tutions, such investments as real estate development and equities. In a
world in which technology permits almost instantaneous deposit and fund
transfers, accurate current monitoring of investments by deposit insur­
ance agencies becomes almost impossible. This raises important questions
about the appropriate uses of federal deposit insurance and the types of
investments to be financed with an effective government guaranty.
G. 0. Bierwag and George G. Kaufman, "A Proposal for Federal Deposit
Insurance with Risk Sensitive Premiums,11 Bank Structure and Competition:
Proceedings (Federal Reserve Bank of Chicago), 1983, pp. 223-242.

14.

George G. Kaufman, Measuring and Managing Interest Rate Risk: A Primer,"
Economic Perspectives (Federal Reserve Bank of Chicago), January/February
1984; and G. 0. Bierwag, George G. Kaufman and Alden Toevs, ’’Duration:
Its Development and Use in Bond Portfolio Management,” Financial Analysts
Journal, July/August 1983.

15.

George G. Kaufman, ”The Thrift Institution Problem Reconsidered,” Journal
of Bank Research, Spring 1972; __________________ , ”The Case for Mortgage
Rate Insurance,” Journal of Money, Credit and Banking, November 1973; and
Hemel, pp. 2-3.

16.

Edward J. Kane, ”S&Ls and Interest Rate Regulation: The FSLIC as an InPlace Bailout Program,” Bank Structure and Competition: Proceedings
(Federal Reserve Bank of Chicago), 1982, pp. 283-308.

17.

Some formulas for pricing ARMs as well as other complex mortgages appear
in Kevin E. Villani, Pricing Mortgage Credit (Working Paper Series, No. 1,
Federal Home Loan Mortgage Corporation), 1983. See also George G.
Kaufman, ’’Financial Intermediaries and Variable Rate Mortgages,” Invited
Research Working Paper, 16 (Federal Home Loan Bank Board), 1977; George G.
Kaufman and Eleanor Erdevig, ’’Improving Housing Finance in an Inflationary
Environment: Alternative Residential Mortgage Instruments,” Economic
Perspectives (Federal Reserve Bank of Chicago), July/August 1981; and
George G. Kaufman, ’’Impact of Deregulation on the Mortgage Market,”
Housing Finance in the Eighties: Issues and Options (Federal National
Mortgage Association), 1981.




37

Footnotes (continued)

18.

Stephen M. Goldfeld and Dwight M. Jaffee, "The Determinants of DepositRate Setting by Savings and Loan Associations," Journal of Finance,
June 1970, pp. 615-632; Patric H. Hendershott, "Financial Disintermediation
in a Macroeconomic Framework," Journal of Finance, September 1971,
pp. 843-856.

19.

George G. Kaufman, "Measuring and Managing Interest Rate

Risk."

20.

George G. Kaufman, "Measuring and Managing Interest Rate

Risk."

21.

"The Best Deals of 1981," Institutional Investor, December 1981, pp. 115—
145.

22.

Michael Lea, "Freddie Mac ARM Survey," and Dolores Lynn, "Lender
Experience with ARMs" in What Makes an ARM Successful? (Washington, D.C.;
Federal Home Loan Mortgage Corporation); Gene D. Sullivan and R. Mark
Rogers, "Time Adjustable Mortgage Loan: Benefits to the Consumer and to
the Housing Industry," Economic Review (Federal Reserve Bank of Atlanta),
January 1983, pp. 32-47; Arden R. Hall, Catherine A. Baird and Karen
Pelham, Recent Trends in Adjustable and Other Mortgage Lending: A Survey
of the Eleventh District (Federal Home Loan Bank of San Francisco),
February 1984; and Jack M. Guttentag, "Solving the Mortgage Menu Problem,"
Housing Finance Review, July 1983.

23.

Robert M. Buckley and Kevin E. Villani, "Problems with the AdjustableRate Mortgage Regulations," Housing Finance Review, July 1983, pp. 183-190.

24.

Kent W. Colton, "The Revolution in Secondary Mortgage Markets: Exhibits"
(Working Paper, Federal Home Loan Mortgage Corporation), December 30, 1983;
and Salomon Brothers, "Who Buys CMOs?" Comments on Credit, March 9, 1984,
pp. 2-3.

25.

Salomon Brothers, "Innovations in the Mortgage Market," Comments on
Credit, October 14, 1983, pp. 2-3; Colton, Exhibit 9.

26.

George G. Kaufman, "The Opportunity Cost to the U.S. Treasury of Privately
Issued, Treasury Collateralized Zero Coupon Bonds" (Memo, Federal Reserve
Bank of Chicago), October 28, 1983 and __________________ , "Financing the
National Debt: Time for Innovation," Backgrounder (Heritage Foundation),
August 9, 1982.

27.

John Morris, "New Jersey S&L Hit by Futures Bloodbath," American Banker,
November 22, 1982, pp. 1, 15.

28.

G. 0. Bierwag, et al, "Duration:

29.

Rodney L. Jacobs, "Fixed-Rate Lending and Interest Rate Futures Hedging,"
Journal of Bank Research, Autumn 1983.




Its Development and Use."

38

Footnotes (continued)

30.

Thrift managers must also be careful to distinguish the effects of the
new instruments on economic income from those on accounting income.
While some of the instruments may increase accounting income, particu­
larly in the short-term, and satisfy regulatory considerations, they may
have no, unfavorable, or hidden effects on economic income, the ultimate
test of an institution's success or failure.

31.

The same figure and profit data for other firms are reported in Linda
Sandler, "The Mortgage-Backed Securities Bonanza," Institutional Investor,
March 1984, pp. 84-92.

32.

David LaGesse, "Battle Is on for Mortgage Securities," American Banker,
January 26, 1984, pp. 1, 23.

33.

Kevin E. Villani, "The Secondary Mortgage Markets: What They Are, What
They Do, and How to Measure Them," Secondary Mortgage Markets, February
1984, pp. 24-44; Federal Home Loan Mortgage Corporation, The Secondary
Market in Residential Real Estate (Washington, D.C.), August 1983.

34.

See footnote 13 and the importance of proper pricing of federal deposit
insurance and monitoring of risky activities.

35.

Henry Sidgwick, Principals of Political Economy (London; Macmillan
Publishing Co.), 1887, p. 414.




39

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NET FINANCING OF HOME MORTGAGES BY LENDER
1950 - 1983

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40

TABLE 2

MORTGAGE FUNDS AND RESIDENTIAL CONSTRUCTION

Year

1950
1955
1960
1965
1970
1975
1979
1980
1981
1982
1983'




Net
Value of
Private
New Home
Mortgage
Residential
Construction
Loans
(Billion Dollars)
18.1
21.9
23.0
27.9
31.9
46.5
99.0
87.3

86.6
74.8

112.8

7.5
12.6

11.1
17.1
15.0
42.0
120.0

96.7
75.9
56.6
111.4

Mortgage Loans
Construction
Activity
(Percent)
41
58
48
61
47
90

121
111
88
76
99

Board of Governors of the Federal Reserve System and Economic Report
of the President, 1984.

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42

TABLE 4

MORTGAGE YIELDS
1955 - 1983

FHA Mortgage
Less 10 Year Treasury

FHA Mortgage
(Percent)
1955
1960
1965
1970
1975
1976
1977
1978
1979
1980
1981
1982
1983

4.25
5.77
5.05
8.77
9.05
8.74
8.41
9.44
10.69
13.63
16.66
16.11
13.44

1.47
1.64
0.80
1.56
1.63
1.21
1.05
1.11
1.33
2.26
2.74
2.93
2.44

Salomon Brothers, Analytical Record of Yields and
Yield Spreads. 1983.

43

TABLE 5

TRADING ACTIVITY OF MAJOR SECURITIES
1982

Security

Marketable Treasury Security
Bills
Other <1 yr.
1-5 yr.
5-10 yr.
<10 yr.
Federal Agencies*
Certificates of Deposits
Bankers Acceptances
Commercial Paper
Mortgage-Related Securities

Trading Volume
Amount
Outstanding^
(Daily Average)
(Billion Dollars)
12/31/82
1983
12/31/83
1982
1051
289
105
298
106
96
240
92
78
185
245

882
257
89
239
78
73
237
132
80
166
179

*Debt only
2
Held by private investors

Sources:

Federal Reserve System, U.S. Treasury Department.




42.1
22.4
0.7
8.7
5.3
5.0
5.5
4.3
2.7
8.0
2.1

32.3
18.4
0.8
6.3
3.6
3.2
4.1
5.0
2.5
7.6
0.9

Turnover
(Percent)
1982
1983
4.0
7.8
0.7
2.9
5.0
5.2
2.3
4.7
3.4
4.3
0.9

3.7
7.2
0.9
2.6
4.6
4.4
1.7
3.8
3.1
4.6
0.5




44

FIGURE 1
SAVINGS INFLOWS TO DEPOSITORY INSTITUTIONS
AND THE SPREAD BETWEEN MARKET
AND CEILING DEPOSIT RATES
fiiiliuns of Collars

Percentage points

-kCnange m savings deposits at commercial banks and thrift Institutions (seasonally ad|usied averages
o! daily figures)
•s Ceiling on passoook savings accounts at commercial banks leas rate on 3-month Treasury bills
(both me jsured in percent par annum).

Source:

Economic Report of the President, 1984, p. 152.

45
Figure 2
Regulation Q Deposit Rate Ceilings Reduce Savings Flow
and May or May Not Reduce Mortgage Rate

i







46

Figure 3

Profile of CMO Investors

Thrifts

Penson Funds. Investment Advisers and
Commercial Banks (Trust)

Commercial Banks (Portfolio)

Other (Securities Dealers, Federal Agencies,
Foundations, and Municipal and Corporate
Operating Funds)

Insurance Companies
Note: Weighted-average life of Class 1 or A is 4 years and less, Class 2 or B is 4, 1-7 years;
Class 3 or C is 7.1-10 years, and Class 4 or Z is more than 10 years.
Source:

Salamon Brothers, Inc. Comments on Credit, March 9, 1984.