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By JOHN N. COLLINS Why is it getting harder and harder to obtain a mortgage? Financial institutions and government are in a state of flux, trying to come to terms with the volatile money market of the 1980's. But even if they do succeed in freeing up money for mortgages, it appears the interest rates will not go down to affordable levels for many Americans. [This article and the accompanying article by Dona Gerson conclude the series on Illinois housing problems published since January 1980. The series has been supported by a grant from the Ford Foundation. The complete series will be reprinted by Illinois Issues in a single volume through the generous support of the Ford Foundation. — Editor.] THE CURRENT Housing recession brings to the surface once again underlying issues about the way home purchases are financed. Since World War II, there have been seven identifiable housing recessions, and in each, mortgage rates have inched higher than in the previous one. Although mortgage rates in Illinois have slipped down 5 to 6 percentage points from the wintertime highs of around 17 percent, this short-term improvement should not obscure long-term trends in the home-financing system and the need for changes. The present system was established during the Great Depression and is based on long-term fixed rate mortgages, issued principally by local savings institutions. Before that, homes were typically financed by short-term "balloon notes" in which the full principal would be due and payable at the end of the 5- to 10-year note period with no incremental schedule of payments. Usually a new balloon note would then have to be written, providing only for interest payments until that note would once again expire and the full principal would be due again. Mortgage funds The present home-financing system is now squeaking badly, and permanent changes are underway. The housing industry now depends on mortgage loans for financing almost all new housing. The problem is that investing in mortgages has become less profitable than other investments, such as stocks and bonds. In order to compete for investment funds with these other financial sectors, home mortgage financing must be able to offer investors competitive rates of return, equal risk, and similar ease of liquidity. Community-based savings associations handle most home mortgages and serve as an intermediary between mort- December 1980/Illinois Issues/17
In 1966, a measure referred to as "Regulation Q" was enacted by the federal government to forestall disintermediation in order to protect home financing. Intended as a temporary measure but subsequently retained through numerous amendments, it established a rate differential allowing savings associations to pay their savers more in ordinary passbook savings than what commercial banks can pay. Currently these rate ceilings are 5.5 percent for savings associations and 5.25 percent for banks. Unfortunately, with other investment possibilities available, the rate ceiling differential has proven to be ineffective in keeping savings associations competitive for investment dollars. Starting in 1978, the Federal Home Loan Bank Board, the regulatory agency for federally chartered savings and loan associations, opened the door for savings associations to raise capital by offering their savers special short-term, high interest-rate saving certificates. These 6-month and 30-month certificates have now become significant sources of investment funds for savings associations and have helped to moderate the worst effects of disintermediation during the recent tight money period. As a result, it is estimated that in Illinois less than 30 percent of savings associations investment funds come from passbook savings accounts. Another problem for mortgage lenders has been statutory usury limits that no longer conform to the real cost of money. Illinois' usury limit was increased in 1974 by the General Assembly when savings and loans virtually shut down their mortgage business because the allowable state interest rate would not cover their money costs in the tight market. The situation was repeated last year, and in November the General Assembly temporarily lifted the usury limits. The state usury limit was scheduled for automatic resumption in January 1981, but the state statute has now been preempted by the federal Depository Institutions Deregulation Act of 1980, enacted by the federal government on March 31. This act allows states to reestablish their usury limits by April 1982, but it requires new statutory authority. Thus the Illinois General Assembly will be faced with the usury issue during its next session, and the outcome of that debate is quite unclear at this time. Secondary markets Another recent change in the source of investment funds for local savings associations is the secondary market. Secondary markets provide an additional level of intermediation between mortgage borrowers and investors. Secondary market institutions buy packages of mortgages from mortgage lenders — usually savings associations — thus converting mortgage loans into liquid assets for the local savings association. Investors from outside the local community can buy into the mortgage packages through the secondary institutions just like they can buy bonds and other financial investments. This brings new investment funds into the mortgage market from national investment pools (such as pension funds) and allows a flow of investment funds within the nation from capital-surplus areas to capital-short areas. The original secondary market agency for housing was the Federal National Mortgage Association, referred to as Fannie Mae. Established in 1938 to buy federally insured mortgages with government funds, Fannie Mae was transformed in 1970 into a privately financed corporation, which is free to raise investment funds on the private market. At that time, the Government National Mortgage Association, or Ginnie Mae, was established to assume the primary role in financing housing subsidy programs using U.S. Treasury loans and mortgage backed securities. A third mortgage secondary market institution, also established in 1970, is the Federal Home Loan Mortgage Corporation or Freddie Mac. Now the most important secondary market institution for savings associations, Freddie Mac was specifically created to provide a secondary market for conventional or non-federally insured mortgage loans. Although the specific features of these secondary market transactions are constantly changing and are quite complex, their common purpose is to convert individual mortgages into investments which are marketable in the private capital markets in order to bring more funds into local housing intermediaries, principally savings associations. These three secondary market institutions have opened up access to investment capital through an expanded secondary market and through short-term market rate investment certificates and have helped curb the disintermediation problem. As the money sources for savings associations shift to the higher priced competitive sources of money, however, mortgage rates must also increase. Already the spread between the average effective yield on mortgage portfolios and the average effective cost of savings for Chicago area savings associations has dropped from 1.51 percentage points in March 1978 to a meager .18 percentage points in March 1980. It is clear that for the immediate future, mortgage rates will remain in the double digit zone while lenders search for ways to match their rate of return on mortgage loans with their costs of obtaining money. Maintaining a profitable rate of return is the big challenge. As a consequence of being linked to national 18/December 1980/Illinois Issues capital markets in inflationary times, the home-financing system must maintain flexibility in rates of return on mortgages so as to reflect short-term fluctuations in the national cost of money. Faced with uncertainty about future increases in the cost of money, mortgage lenders are hesitant to make a 20- or 30-year mortgage commitment at today's interest rate of return. That problem has focused attention on experiences in other countries, such as Canada. There, most mortgages are written as so-called "rollover mortgages." A rollover mortgage has a fixed rate of interest based on a long-term amortization, but is written for only five years at a time; at the end of this period, the homeowner must rollover his note into another short-term mortgage based on the current interest rate. Thus the mortgage lender is relieved of the risk of increases in the cost of obtaining money, and this risk is assumed by the mortgage borrower. Renegotiable rates While rollover mortgages are not permitted for federally chartered savings associations, the Federal Home Loan Bank Board issued regulations in early 1980 for a new type of mortgage instrument called the "renegotiable rate mortgage" or RRM. Acclaimed by the Illinois Savings and Loan League as perhaps the most significant thing that has happened in mortgage lending since 1932, the RRM allows mortgages based on the traditional long-term amortization schedule but with the provision that every three to five years the interest rate can be adjusted up or down. The rate adjustments are based on an index published by the Federal Home Loan Bank Board. Over the life of the mortgage, the interest rate can not be adjusted more than 5 percentage points above or below the initial rate. The RRM thus decreases the risk to mortgage lenders of being stuck with mortgages earning considerably less than their costs for obtaining money. It also provides some protection for home buyers against being stuck with a high mortgage rate after rates have cooled down. RRMs also carry protection against penalty charges for renegotiating the rate or terminating the mortgage if the homeowner doesn't want to continue the mortgage at an increased interest rate. At first, title companies were reluctant to stand behind RRMs in Illinois because state law prohibits changing the interest rate of a loan during its lifetime. This prohibition was lifted when the governor signed H.B. 1563 (P.A. 81-1367) this summer. Title companies are now accepting RRMs for all savings and loans, but the national secondary markets are not. That obstacle may be overcome, however, when Freddie Mac issues guidelines for RRMs. (Meanwhile, there is confusion as to whether P.A. 81-1367 applies to banks in Illinois as well as to savings and loans. Some banks and trust companies will not accept RRMs until the law is clarified by the General Assembly.)
Fundamental changes in the capacity of savings associations to raise funds for home financing are also being brought about by the Depository Institutions Deregulation Act enacted last March 31. Congress intended this act to ease the disintermediation of funds from home mortgage intermediaries by lifting regulations on the way savings associations can do business. Recognizing that the regulation Q rate differential, which was intended to favor savings associations, has not protected them against disintermediation of funds to banks, this new act will phase out over a six-year period, the interest rate ceilings and differential which can be paid by all depository institutions on passbook savings. Rate restrictions on short-term 6- and 30-month certificates are also reduced. S&L deregulation There is currently considerable confusion about rate restrictions on short-term certificates because of a May 28 ruling issued by the committee charged with implementing the deregulation act. The U.S. League of Savings Associations has filed suit against this new ruling, claiming it is a premature elimination of interest differential and will thus be disadvantageous to savings associations in raising funds for use in the housing market. This suit focuses attention on the highly interrelated character of a wide range of regulations which affect the capacity of savings associations to finance home purchases. Future changes required by the deregulation act will reduce the present $10,000 minimum deposit needed for savers to buy six-month, high interest rate certificates. That will encourage more savings from small savers. Also to be changed is an increase in the amount savings associations can invest in short-term, high-return loans such as consumer loans, commercial paper, and others. The way will also be opened for federally chartered savings associations to offer the equivalent of interest-bearing checking accounts, now available to commercial banks. Referred to as NOW accounts (negotiable order or withdrawal accounts), these allow passbook savings accounts to have withdrawal orders written against them much like a checking account. NOW accounts have previously been available to state-chartered savings associations in Illinois, and with the expansion of this authority to federally chartered associations, widespread use of NOW accounts is anticipated by the industry. December 1980/Illinois Issues/19 It is clear that the long-term effect of these changes will be to make savings associations more like banks in their capacity to raise funds and to earn market rates of return on their investments. Congress' stated intention behind this far-reaching deregulation act is to enable savings associations to become one-stop family financial centers while still remaining oriented to housing loans as their major lending activity. Before all the changes are fully implemented, however, a short-term weakening of the ability of savings associations to finance home purchases may occur — as the U.S. League of Savings Associations contends in its suit. Another approach for increasing the flow of funds available for home financing is to increase the incentives for individuals to save rather than consume. The deregulation act has some provisions designed to encourage small savers. The U.S. League of Savings Associations has suggested a tax deferment for individual savings earmarked for a home downpayment. And starting in 1982, the present deduction allowed on federal income taxes for the first $100 earned through dividends will be expanded to include the first $200 earned through dividends as well as interest. Various proposals were discussed during the recent Illinois General Assembly to include such provisions in the state income tax code. Further action in this direction is anticipated in the next General Assembly. An extended period of continual change and disruption is likely for the home-financing system. Once the changes now being implemented are completed, there should be an increase in the flow of funds available for home financing. But rates may never drop back to those of the 1960's, when almost every American family could buy a home. Even with the new changes, the price of a mortgage will continue to rise, and in the 1980's, perhaps only the middle- and high-income families will be able to buy a house. John N. Collins is director of the Center for Policy Studies and Program Evaluation at Sangamon State University and is also associate professor of administration. 20/December 1980/Illinois Issues |
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