In the depths of the Great Depression, the U.S. government decided to intervene heavily in the private sector to stimulate economic growth. A favored mechanism was to restructure an industry, through the use of subsidies.

The technique worked so well that the concept of subsidy expanded to the point where it is being used to aid much of American industry. Subsidies can take the form of tax abatements, loan guarantees, and direct investments by the government.

Unfortunately, most subsidy programs have outlived the problems they were created to solve. These days, most subsidies are siphoned off to benefit well-organized groups, often to the detriment of the industries that the subsidies were designed to assist.

In essence, the government is gratuitously handing over tens of billions of taxpayer dollars to companies and individuals in the private sector and receiving nothing in return.

Huge Subsidy Misses Its Target

Subsidies to the housing industry man run to as much as $50 billion a year. These funds are concentrated in the mortgage end of the market, where they are not needed. Relatively few dollars are available for construction lending, where they would actually do some good by stimulating production, jobs and general economic activity.

Before the 1930, there were very few self-amortizing mortgages. Therefore, individuals generally sought balloon mortgages. The most popular residential version carried a loan with a five-year term.

Since few homeowners could make the end-of-term balloon payments, it was standard practice to roll over the loan at maturity into a new five-year loan with similar terms. With the onset of the Depression, few lenders would refinance, and more than a million foreclosures occurred.

Debut of Home Subsidies

Public opinion, swayed by John Steinbeck's "The Grapes of Wrath," caused Congress to reassess the nature of home mortgages.

First came the 20-year self-amortizing mortgage, with the loan fully paid at end of term. But few would take the risk of making such a revolutionary loan. Congress created the Federal Housing Administration, which guaranteed payments on a self-amortizing loan if the homeowner defaulted.

When there was still no interest in generating these credits, the government went a step further and created the Federal National Mortgage Association -- Fannie Mae -- to buy FHA-guaranteed loans underwritten by banks or anyone else. The anyone else was the mortgage banking industry, which was virtually recreated just to make the new type of mortgages.

The system worked. By 1950, housing starts reached a record 2 million.

It became common during the next 30 years for Fannie Mae to buy sizable numbers of mortgages at biweekly auctions in recessionary periods. By the late 1960s however, the very success of the new system was creating a problem for the federal government. Every time Fannie Mae borrowed money to buy a new mortgage, the government deficit rose.

The Great Society

Despite the deficit problem, housing-related subsidies were increased dramatically by Great Society programs. Legislation in 1968 committed the nation to build 26 million housing units.

The Omnibus Housing Act of 1968 and the Financial Institutions Act of 1970 provided for the creation of new mortgage-backed instruments and a major increase in direct subsidies.

Fannie Mae was spun off to public stockholders so that it could increase its funding independent of the federal budget. In addition, the Government National Mortgage Association and the Federal Home Loan Mortgage Corp. were created to expand the flow of funds to the housing industry.

The money was used to purchase mortgages with below-market interest rates created under the new housing programs. In 1972,3 million units of housing or mobile homes were started or manufactured. This record may not be equaled for another half century.

The new programs also generated a level of fraud, deceit, and thievery that was almost wondrous to behold. After billions were stolen, the Nixon administration shut down the two programs with the most flagrant abuses. They had provided below-market interests rates for single-and multi-family housing.

Thus began a long-lasting retrenchment in programs to stimulate housing production. But there were no such cutbacks in the mortgage subsidies. Housing activity held its own for another 10 years, up to 1986. The government still utilized a modified subsidy program, designated Section 8, to stimulate housing production.

Moreover, Wall Street and pension funds heartily embraced the new mortgage-backed securities created by the 1968 and 1970 legislation. These instruments were believed to carry explicit U.S. government guarantees.

This was true for loans guaranteed by the government National Mortgage Association, but not for Fannie Mae. It also did not apply to the Federal Home Loan Mortgage Corp., or Freddie Mac.

The new mortgage securities were appealing for reasons beyond the supposed full-faith-and-credit guarantee of the U.S. government and their above-average, risk-free yield.

The securities were extremely flexible. They could be stripped to create interest-only or principal-only instruments. Their maturities could be adjusted to meet buyer's needs, and residual instruments could be created with equity-like characteristics.

In the Tax Reform Act of 1986, Congress continued the subsidies to the mortgage sector but virtually eliminated those tied to the construction sector.

This step dealt a severe blow to the ability of the housing industry to generate new units for the mortgage industry to finance. The coup de grace to housing was then administered by the hysteria in Congress and among the bank regulators in 1989. Moved by failures in the thrift industry, Washington used its weight to prevent banks and thrifts from funding construction loans.

Banks that wanted to lend for new construction -- residential or commercial -- were advised to sharply increase their reserves against these loans and add more equity. In essence, the regulators created disincentives.

A Metamorphosis for Subsidies

Lacking available financing or subsidies, the value of new projects plummeted and carried existing home values with them. One might argue that a credit-driven recession then began. Housing starts in 1991 hit a 45-year low.

Yet the mortgage-subsidy programs remained in force. They could not be used to stimulate housing production any longer because of the construction disincentives. The subsidies could be used, however, to generate profits through mortgage and house swapping. This is exactly what occurred.

Fannie Mae and Freddie Mac cranked up their operations, generating stockholder profits with the subsidies they received.

According to Arthur Hill, the federal housing commissioner, the "implicit" subsidies include:

* Lower borrowing costs because the market perceives an implicit government guarantee.

* Lower regulatory capital requirements relative to other regulated financial institutions.

* Exemption from state and local income taxes.

* Exemption from Securities and Exchange Commission and state and local registration requirements for regulated financial institutions.

* Higher demand for Fannie Mae and Freddie Mac securities, which are qualified investments for regulated financial institutions.

* A potential $2.5 billion line of credit from the Treasury.

These subsidies may be worth $1 billion to $3 billion a year to each of the publicly held, secondary mortgage companies -- Fannie Mae and Freddie Mac.

Higher Returns on Equity

In a letter to me, Mr. Hill explained that these subsidies are translated into lower interest rates for homeowners that may be worth $2.2 billion to $4.4 billion a year. He noted:

"In recent years, FNMA and FHLMC have consistently earned returns on equity much higher than other financial institutions and higher than U.S. corporations generally. FNMA's return on equity averaged 30% during the last three years and was 27.7% in 1991.

"FHLMC's return on equity averaged 23% during the last three years and was 23.6% in 1991. FNMA had over $2 billion in pretax income in 1991 and increased its outstanding [mortgage-backed securities program] by 24%, from $300 billion to $372 billion.

"During the four years ending at yearend 1991, the price of FNMA common stock rose from $10.17 to $69 per share and dividends per share increased from 12 cents to $1.04. FHLMC common stock rose from $4.04 to $45.83 per share and dividends increased 37 cents, to $2.00. In both cases adjustments were made for stock splits."

While I do not wish to misrepresent Mr. Hill's thinking, the point should be reiterated that in the last year of his analysis, housing starts were lower than in 1946. The subsidy money flowed straight from taxpayers' pockets into those of the stockholders and management of Fannie Mae and Freddie Mac.

Bigger Fish to Fry

This was not the biggest taxpayer giveaway to housing in 1991, however. It may be painful for every American homeowner to note, but the tax deduction on mortgage interest for single-family homes may have cost the government $40 billion last year.

There is a mistaken assumption that the tax subsidy lowers the cost of home ownership. Since people will pay what they can afford to buy housing, all the subsidy does is increase the price of homes so that the seller can achieve a higher profit on the sale.

A simple example will explain how this works. A home buyer generally will pay 25% to 33% of income to own a home. With no tax subsidy on mortgage interest, this allows the buyer to pay X for a house. With the tax subsidy, the homeowner, still paying 25% to 33% of income, can buy a house for Y, a higher price that reflects the tax benefit.

Where Banks Fit In

Thus, the real impact of the subsidy is to increase the price of the home. This benefits the seller and, therefore, the mortgage tax subsidy takes money from taxpayers to pay for higher-cost houses, directly benefiting existing homeowners (of which I am one). What this tax subsidy does not do is stimulate housing production or cause homes to be sold.

If the U.S. government really wanted to assist the new-housing industry, and use its subsidies for more than lining the pockets of certain privileged groups, it would refocus on the banking industry. Subsidies would be provided for construction loans and reduced on mortgage loans, encouraging new units to go into the pipeline.

The taxpayer giveaway to Fannie Mae and Freddie Mac would be in part directed to the banking industry, where it would result in housing being built. The government would actually get something for its money.

The same abuses that occurred in the past would undoubtedly reappear, since it is unlikely that systematic corruption can be eliminated. However, bank construction subsidies stimulate the economy.

If Washington could swallow its hatred for the banking industry and realize how banking stimulates economic activity, not only would the subsidy be better directed. Bank capital would grow, too, which is something the government seems to think is important. Mr. Bove is a banking consultant with the Bove Group in Chatman, N.J.

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