A Death Blow To the Private Mortgage Sector

The scarcity of mortgage financing is a prime example of how frenzied action by bank regulators can have a severe impact on the economy.

Their actions are fostering the creation of an oligopoly in the mortgage sector, which can only further harm housing in the long run.

Congress does not want the burden of guaranteeing bank and thrift deposits. The regulators are therefore enforcing a new series of requirements, primarily in the capital and loan-reserve sectors, that would shrink the size of banks, their deposits, and - critically - the insurance necessary to cover those deposits.

Congress and the regulators do not seem to care about the impact of the policy on the economy. Policymakers believe that banks can be replaced by large industrial and financial conglomerates, so they are taking actions to foster the growth of these megaorganizations.

A Grim Prognosis

They are pursuing these policies even though Democrats and Republicans in Washington know that the strategies will devastate the banks and cause a flow of available assets away from midsize, entrepreneurial, nonfinancial companies to the large oligopolicies.

Consider these statistics:

* Housing starts in 1950 were approximately 2 million units. In 1972, the peak year, they reached almost 2.4 million. If mobile home shipments were added to this total, new unit construction in 1972 was almost 3 million units. In 1991, housing starts alone will be fortunate to exceed a million units.

* The population of the United States in 1950 was 150 million people, or 40% less than it is today. In 1972, there were 45 million fewer people that today.

* For 90 years, from 1890 to 1980, the number of people per housing unit in the United States declined. Evidence in the past few years suggests that this ratio is flattening - and even turning up.

Washington Knows Better

For decades, the best studies have shown that the average American could not afford the average single-family home. Housing thrives on adequate financing and dies when that financing is removed. This concept is well understood in Washington.

During the 1920s, the dominant form of housing finance was the five-year balloon mortgage. During the Depression few could either make the balloon payment or refinance. So that there were massive foreclosures.

The 20-year self-amortizing mortgage was created in the 1930s. However, no lending institution was willing to make such a radical loan in a period of economic downturn.

Therefore, Congress created the Federal Housing Administration, the Farmers Housing Administration, and the Veterans Administration to insure these new mortgage loans. In essence, the full faith and credit of the U.S. government was placed behind private mortgages.

Powerful Mechanism Created

Still there were no takers. Congress, therefore, created the Federal National Mortgage Association to buy the new 20-year guaranteed loans from any institution willing to originate them. When few depository institutions responded to even this deal, the mortgage banking industry stepped forward to facilitate the creation and sale of the new mortgages.

After World War II, it was evident that a powerful financing mechanism had been developed. In 1950, an incredible 2 million houses were built.

Households were fulfilling their loan-servicing requirements, but each new mortgage purchased by Federal National Mortgage Administration was added to the federal debt. This meant that housing was pushing other federal priorities aside and housing programs had to be restricted.

The Great Society Solution

In the mid-60s, young Americans were very angry. They wanted jobs in the domestic economy, and they did not want to fight in Vietnam. The result was the worst series of riots in this country in a century. America's largest cities were being torched in civil insurrection.

President Johnson was therefore able to persuade Congress to fund his Great Society program. Housing was a key part of this program, since people were not expected to burn down their own houses. In 1968 the nation promised to put in place 26 million new housing units in the ensuing 10 years.

Several give-away programs were developed to help lower-income families into new homes. A major effort was also made to assist middle-income families in their attempt to find home financing. The concept was to tap new sources of funding for housing by creating a series of mortgage-backed securities.

Just as in the 1930s, no one wanted these new instruments. Therefore in 1970, Congress spun Federal National Mortgage Association out to the public and created the Government National Mortgage Association and the Federal Home Loan Mortgage Corp. These new agencies, along with FNMA, were expected to buy the innovative mortgage instruments or create guaranteed pools of mortgage loans for others to buy.

Once again, the new financing mechanisms proved to be incredibly powerful. In 1972, also stimulated heavily by low-income housing programs, housing starts actually surpassed the 1950 record for the first time.

The Nixon Solution

Once again, however, the costs of the housing finance programs proved to be too high for the government to maintain. Therefore, the Nixon administration started to take the government out of housing.

The private sector continued to do surprisingly well, because the new mortgage-backed securities performed better than the most optimistic had hoped they might. Funds flooded into housing. As late as 1986, the nation was able to support the construction of 1.8 million new units.

The passage of a major tax reform act in 1886 resulted in a drastic change in the return on investment in all types of real estate. This dramatically reduced construction of multifamily and single-family homes.

By 1990, most lending to residential home builders (and builders of all other forms of real estate) was effectively curtailed by the stringent audits of banking institutions, forced write-downs of land and development loans, and the relatively high reserves demanded for all types of real estate lending.

As a result, when the current recession developed, the "pipeline" of new residential construction was at a very low level, unable to support a true contra-cyclical revival in housing activity.

Target on Private Sector

Now the Federal Reserve Board, in concert with other regulators, seems poised to deliver the coup de grace to the private mortgage sector. As explained, in the late 1960s and early 1970s a variety of mortgage-backed securities had been developed to bring new sources of funds into housing.

The amount of loss "guaranteed" was set up as a reserve on the originator/packager's balance sheet to assure that there would be adequate coverage "upfront" if the estimated loss was actualized. Through this mechanism, the mortgages could be originated and sold or removed from the first lender's balance sheet. This meant there was little capital involved in the transaction.

Now the Fed has decided to invalidate the sale treatment. It is arguing that the originator/packager must keep the whole loan package on its balance sheet and put up the requisite amount of capital to back the mortgages because this institution has risk in the mortgages.

Consequences of Risk Rule

This ruling will:

* Reduce the amount of mortgages that depository institutions can make, because they will not have the capital necessary.

* Force institutions that want to stay in the mortgage securitization business to buy outside insurance. This will increase mortgage costs and force the majority of sellers to deal through Fannie Mae and Freddie Mac.

* Increase the oligolopolistic control of the industry held by these two insurer/packagers. The growth in housing activity will once again be tied to the ability of these institutions to grow their capital bases - which of course Washington is attempting to slow.

* Raise the cost of nonstandard mortgages (those not meeting the FNMA or FHLMC parameters) so that the private sector can sell them economically. This will further increase the price of housing.

Everyone but a favored few will have been harmed. Nero will keep fiddling as . . . .

Mr. Bove is a banking consultant with the Bove Group in Chatham, N.J.

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