The Unbundling of Residential Mortgage Finance · 2020-01-03 · The Unbundling of Residential...

Journal of Housing Research • Volume 1, Issue 1 63

The Unbundling ofResidential Mortgage Finance

James R. Follain and Peter M. Zorn*

Introduction

Until the 1980s, the traditional buy-and-hold thrift dominated the deliveryof residential mortgage financial services. From the perspective of a par-ticipant in the market for residential mortgages, the traditional thrift wasan institution that earned its profits in varied activities. It collecteddeposits, originated loans, and serviced them; furthermore, the holding offixed-rate mortgages (FRMs) for its own portfolio generated returns abovethe risk-free rate because such a position exposed thrifts to interest rateand credit risk. In this sense, the traditional thrift can be seen as a finan-cial intermediary that “bundles” four basic activities: deposit collection,origination, servicing, and holding.

In theory, there is no reason why the four activities might not be conductedseparately. Indeed, experience indicates that more specialized institutionscan deliver residential mortgage finance. For example, mortgage bankershave for many years undertaken the origination function without holdingthe loans for their own portfolios or operating a deposit collection system.The originator not equipped for or interested in servicing can divest it. Ofcourse, the enormous growth in the secondary mortgage market has madeit easier for a wide variety of investors, who do no deposit collection atall, to hold mortgages. The introduction of adjustable-rate mortgages(ARMs) and new types of securities like the collateralized mortgage obliga-tions (CMOs) even allows the traditional thrift to divest itself of much ofthe interest rate risk formerly associated with holding FRMs.

The traditional operation seems much more specialized if viewed from theperspective of institutions that offer a wide range of financial services. Formany years, the traditional thrift did not offer checking accounts, and onlya limited number of deposit types were available. Indeed, the rates paidon these deposits were fixed by regulation (Regulation Q) for a long time;

* James R. Follain is professor of economics and department chair in the Maxwell School ofCitizenship and Public Affairs at Syracuse University; Peter M. Zom is professor of consumereconomics and housing in the School of Human Ecology at Cornell University. The helpfulcomments of Michael Lea, David Olson, Ellen Roche, and two anonymous reviewers areacknowledged and appreciated.

64 James R. Follain and Peter M. Zorn

these limits were not removed until the 1980s. Thrifts did not offer con-sumer loans, ARMs, business loans, opportunities to purchase stocks ormutual funds, insurance, or any of varied financial services available inthe market today. Their principal loan instrument—the FRM—was asimple one. Once originated, loans typically resided in the thrift’s portfoliountil termination; trading and hedging were rare, as were variations inthe composition of portfolios.

We believe this latter perspective, that of a specialized financial servicesinstitution, is broadly consistent with the intent of the regulatory structureof the past 30 years or so. The regulatory structure was designed to fostera specialized institution that would channel household savings into theresidential mortgage market; the system served to “protect” the deliveryof residential mortgage finance. Regulations such as Regulation Q, usurylaws, deposit insurance, and the Federal Home Loan Bank system’s ad-vance policy were all designed to ensure that the residential real estatesector received financing. This regulatory structure served as a “prop” tostrengthen the thrift institution and preserve what many in the broaderfinancial services industry would consider a highly specialized financialinstitution.

Recently, regulatory policy has changed in ways that greatly reduce andpossibly eliminate any comparative advantage to the thrift charter. Theelimination of the props that artificially bundled mortgage services in theform provided by the traditional thrift will now allow the marketplace toplay a greater role in determining the institutional form that will deliverresidential mortgage finance. In this sense, we say that the form in whichresidential finance is delivered in future years will converge toward itsmore “natural” state, which, in theory, may be more or less bundled thanthe traditional thrift.

One possibility is that residential mortgage finance will be provided byincreasingly specialized types of institutions responsible for one or moreof the traditional thrift’s activities. Institutions that collect deposits maynot be related to institutions that originate loans, service them, or evenhold them for investment purposes. According to this view, the traditionalthrift industry will become “unbundled” in much the way we have wit-nessed some large conglomerates divesting after mergers.

A rather different possibility is that residential mortgage finance will be-come more integrated with the broader array of financial services thatconsumers demand. At a minimum, the distinction between a bank and athrift would disappear. More radical change might even see residentialfinance delivered by nonbank institutions, as some of the large retailbrokerage houses have sought to do Consumers would be able to shop for

The Unbundling of Residential Mortgage Finance 65

all of their loans and make all of their investments at one institution. Thisoutcome implicitly assumes that regulation has effectively protected andsegmented mortgage finance from the rest of the capital markets. Withthis regulatory protection reduced, the residential finance functions maybecome better integrated with other financial services.

Of course, some combination of these two extremes is also possible. Someactivities of the traditional thrift might be integrated into less specializedinstitutions. For example, firms that offer the saver a wide variety ofchoices might collect deposits, while servicing and origination might be-come more specialized, depending on the underlying economics of the func-tion. Interest rate risk and credit risk might also be divided among avariety of investors.

The purpose of this paper is to explore the various possibilities and toforecast how residential mortgage finance may be delivered in the future.At the heart of our forecast is the view that regulatory policy has playeda major role in developing the residential finance industry. All may notshare this view. An important alternative view is that the regulatory struc-ture is itself endogenous and constantly adapting to the ebbs and flows ofthe economic and political forces that affect financial markets.1 We offersupport for our view in the next section; however, we recognize that it isdifficult to prove either point of view definitively. Furthermore, this is notthe place for a comprehensive debate of the premise; therefore, we chooseto identify our view (bias) explicitly, offer some support for it in the nextsection, and proceed with a discussion of some future possibilities thatflow from it.

Even if one accepts our view regarding the role of regulatory policy, it isdifficult to forecast how residential finance will be delivered in the future.One source of the difficulty is detecting precisely what the more naturalstate of the industry would have been absent a strong regulatory influence.Adding to the difficulty is the revolution in computers and telecommunica-tions, the internationalization of financial services, and the growingdominance of securitization as an alternative to direct financial inter-mediation.2 These changes might be so dominant as to make historical

1 Edward Kane discusses what he labels the “regulatory dialectic” in several papers, see Kane(1982).2 In very general terms, mortgage securitization refers to the process in which mortgageassets are used as collateral for a particular type of security known as mortgage-backedsecurities (MBS). MBS are traded in the secondary mortgage market.


models of residential mortgage finance irrelevant, even if one knew howmortgage finance would have been provided in the past absent a strongregulatory policy.3

The next section expands upon the conceptual framework underlying ourforecasts and discusses other factors, besides regulatory policy, that affectthe delivery of residential finance. The third section discusses how thesefactors will affect future trends in the delivery of residential mortgagefinance. The final section summarizes our forecasts and addresses thequestion of whether the typical consumer will fare any better or worseunder the new regime.

Conceptual Framework

This section expands upon our discussion of how regulatory policy hasshaped the delivery of residential mortgage finance. Three factors otherthan the regulatory structure are also discussed: (1) securitization, an al-ternative to the traditional financial intermediary approach that has longdominated the delivery of this country’s residential mortgage finance;(2) the potential economies of scope associated with the delivery of variousfinancial services, of which residential mortgages are but one part; and,(3) changes in technology, especially computers and telecommunications.

Regulatory Policy toward Thrifts

Regulatory policy toward thrifts since the 1930s has sought to ensure thatthe residential sector of the economy received a stable and sufficient flowof funds. Policies included those to limit the cost of borrowing fromdepositors (Regulation Q), lower tax rates for those who invested substan-tially in mortgages, underpriced deposit insurance, the implicit guaranteeassociated with debt assumed by the federal agencies—Fannie Mae,Freddie Mac, and Government National Mortgage Association (GNMA)—that allowed them to purchase mortgages from the thrift at top dollar, andmany more policies. When some regulations were altered in the deregula-

3 One reviewer suggested that an examination of the pre-1930 era may provide insights asto the natural state of banking because much of the regulatory structure to which we referwas put in place in the 1930s. Similarly, one might look to the experiences of other countrieswith different regulatory structures. Although both approaches yield insights about thenatural state, we doubt that the pre-1930 era is likely to provide an accurate picture of the1990 natural state because so many other parts of the economic landscape have changed,that is, computerization and internationalization.


tion legislation of 1980 and 1982, thrifts received some offsetting ad-vantages not permitted to banks. Arguably, the value of the thrift charterwas actually at its peak in the late 1980s.

Underlying these advantages was a national commitment to treat residen-tial mortgage finance favorably. This special treatment resulted not somuch from a love for the thrift industry, as from the country’s devotion tohomeownership. As long as the thrift industry was able to provide housingfinance in a stable manner and at a price most considered reasonable, itreceived favored treatment. Unfortunately for the thrift industry, the 1980shave seen the beginning of a break between America’s love of homeowner-ship and the need to support the traditional thrift industry. Other typesof institutions, such as mortgage bankers and commercial banks, havebeen successful in providing such funds, and the American taxpayer hasreceived a very expensive bill for the savings and loan (S&L) debacle ofthe 1980s.

The culmination of this break so far is the Financial Institutions Reform,Recovery and Enforcement Act (FIRREA), an omnibus piece of legislationpassed in the summer of 1989. FIRREA has reduced many of the ad-vantages previously associated with the charter granted to the traditionalthrift by the federal and state governments. Capital requirements wereincreased relative to the lenient practices allowed in the 1980s. Also, thenew risk-adjusted capital requirements explicitly link the amount of capitalrequired to both the interest rate and default risk of the thrift’s assets;indeed, thrifts will be forbidden to hold some types of assets, includingjunk bonds. Deposit insurance premiums were increased and will be ac-tually higher than those for commercial banks. Federal Home Loan Bankadvances are likely to be more difficult to obtain, and these regional quasi-public banks themselves are much less powerful. Overall supervision isexpected to be tighter and more thorough, making it more difficult for thethrift to delve into nontraditional, risky assets such as direct real estateinvestment.

These changes reduce the regulatory advantages granted thrifts and createa relatively level playing field for the various institutional structures thatmight deliver residential mortgage finance. Consequently, the degree offuture specialization in residential mortgage finance will depend more onthe fundamental economics of the delivery of residential mortgage financeand less on regulatory influences. Some factors that will affect the move-ment of residential mortgage finance to its more natural state are dis-cussed next.


Nonregulatory Factors that Influence Specialization

Absent the strong role of regulation, the pressures for change in the degreeof specialization will be influenced by three major factors: (1) economiesof scope; (2) changes in technology; and (3) the impact of securitization.Other factors or other approaches exist for considering whether thedelivery of residential mortgage finance will become more or less special-ized, but our approach captures many such factors without the need foran elaborate theoretical structure. For example, one might rely oneconometric estimates of the production function for mortgage finance ordiscuss the potential for further change within a political framework.4

Securitization. The securitization of mortgages and their trading on thesecondary mortgage market began in the 1930s with the creation of FannieMae. Other major milestones included the establishment of GNMA in 1968and of Freddie Mac in 1970. In each case, the secondary mortgage marketwas developed or enhanced to supplement the existing thrift industry’sability to deliver residential mortgage finance. Securitization opportunitiesavailable through the secondary mortgage market improved the geographicmatch between the demand for mortgages and the supply of funds formortgages, provided a more stable supply of funds over the business cycle,and allowed thrifts to manage better their interest rate risk.

The three federal agencies—Fannie Mae, Freddie Mac, and GNMA—arethe dominant players in the secondary mortgage market, but their rolewas not always so strong or as certain. Indeed, many asked in the early1980s whether a secondary mortgage market would be necessary in thefuture. After all, the argument went, moves to national banking, ARMs,and the elimination of Regulation Q all offered many advantages offeredby the secondary mortgage market; in addition, some placed the marketvalue of Fannie Mae’s portfolio in the red. Many also launched vigorousattacks against the strongest single asset of the federal mortgage creditagencies—the implicit guarantee of the federal government.5

Despite the attacks, the discussions in the early 198Os, and the earlyproblems of Fannie Mae, the federal credit agencies have entered the 1990sstronger than ever. Their dominant influence continues; in fact, it seemsthat FIRREA and the focus on the thrift industry’s problems have silenced,at least temporarily, those who favor a reduced role for the agencies. Dis-

4 For an example of the technical production function approach, see Evanoff et al. (1989).Derthick and Quirk (1985) is an excellent example of how one might approach the issuefrom a political economy point of view.5 Follain (1987) summarizes some of this discussion and reasons why some forecasts of theearly 1980s proved incorrect.


cussion still persists regarding the capital adequacy of the agencies, butwe think it is unlikely that either Congress or the president will hinderthe performance of the agencies while the primary mortgage market is insuch disarray.

From the consumer’s standpoint, the development of the secondarymortgage market has been an unqualified success. Funds to purchase hous-ing are provided on a more stable basis than in the past. Also, it appearsthat the combination of the secondary mortgage market and the federalcredit guarantees generates mortgages at a lower price than traditionalthrift mortgages. For example, Hendershott and Shilling (1989) presentevidence that the mortgage interest rate in the mortgage market segmentin which the federal agencies operate is about 30 basis points less thanin the market segment in which they are prohibited (such as high-pricedhousing).

From the standpoint of the thrift industry, development of the secondarymortgage market might better be viewed as a disaster. The secondarymortgage market has worked too well and has become, therefore, a lowercost alternative to the traditional thrift to provide residential mortgagefinance. Thrifts have learned, like the rest of us, that mortgage financecan be delivered without an elaborate deposit collection system andwithout originators who choose to hold mortgages in their own portfolios.

Economies of Scope. Economies of scope are realized if the cost of providingtwo or more services simultaneously is less than the cost of providing themseparately. Economies of scope are related to the cost of information. Ifthe cost of collecting or providing information about similar activities islarge relative to the cost of the activity itself, then savings may be achievedby providing information about all the activities at the same time orthrough the same medium.

An example of potential economies of scope in financial services is theconcept of “one-stop” banking, which gives consumers access to a broadarray of financial services, all at the same location or institution. If, forexample, the cost of providing or collecting information about bothmortgage and consumer loans is large relative to the cost of the loan itselfand if some of the fixed costs of providing or collecting such informationcan be allocated between the two loan types, then the cost of providingboth types of loans simultaneously may be less than the cost of providingthem separately. Similar possibilities exist for the consumer’s choicesamong types of deposit accounts; institutions that can provide a broadarray of investment alternatives may have an edge over those that offerlimited choices.


It is easy to find examples of firms that believe such economies exist. Manyretail brokerage firms offer consumers a diverse array of investment al-ternatives, as well as certain types of loans, such as home equity loans.Hoping to benefit from potential economies of scope, some large firms suchas Sears have purchased brokerage firms. Since 1980, thrifts have alsomoved in this direction by expanding their loan offerings to include carloans, consumer loans, insurance, various types of deposits, and even stockpurchases.

It is not as easy to find hardcore evidence of substantial economies ofscope. Although some studies have been undertaken, those conducted whileregulatory policy determined institutional structure are unlikely to be ac-curate guides to the future (Kolari and Zardkoohi 1987). Furthermore,some experiments of the 1980s, like the Sears purchase of Dean Witter,have not proved to be great successes. Nonetheless, we offer some specula-tion about the potential for economies of scope and how they might affectthe degree of specialization in the future delivery of residential finance.

Changes in Technology. Changes in technology may play a major role indetermining the future of institutional change. Numerous examplesdemonstrate how new technology can affect the delivery of financial ser-vices. Examples include the electronic transfer of funds and computerizedaccess to accounts. Residential mortgage finance has also been affectedfundamentally. Witness the massive amounts of dollars and paperworkprocessed by computers in the secondary mortgage market and the oppor-tunities to apply for mortgages through national computer networks.

Although technology will continue to affect the future delivery of residen-tial mortgage finance, its effect on the unbundling process is not as obvious.Historically, investments by firms in mainframe-dominated data processingsystems have required large initial costs that generated benefits to a widearray of users within the firm. If this continues to be true, then largeconglomerates that bundle a variety of financial services may hold an ad-vantage over more specialized firms. However, the continued developmentof the personal computer and stand-alone workstations may have the op-posite effect. The initial purchase and learning costs associated with thesemachines are far less than the traditional mainframe approach to dataprocessing. It is already possible and relatively inexpensive for very spe-cialized firms to become established and linked to complex national datanetworks. If the revolution in personal workstations continues, then thepast advantages of large and bundled firms may decline. Unfortunately,we find little in the academic literature to guide our forecasts in thisarea. Consequently, for our discussion of the impact of technology on the


unbundling of the traditional thrift industry, we rely on the few studieswe have found, casual empiricism, anecdotes, and experiences within theuniversity environment.6

Pressures and Opportunities for Change

Concepts discussed in the preceding section help to assess how the ac-tivities of the traditional thrift institution may be reorganized in the fu-ture. We focus on activities related to the delivery of residential mortgagefinance: deposit collection, mortgage origination, servicing, and investmentin mortgages, which involves holding both interest rate and credit risk.For each activity, we identify recent trends and ask whether regulatorypolicy, securitization, economies of scope, or technological change are likelyto encourage or discourage specialization in the delivery of residentialmortgage finance.7

Deposit Collection

The link between the amount of deposits collected by the thrift industryand the flow of funds into residential mortgages has seriously eroded inrecent years. This may seem a bit surprising given that the ratio of thriftdeposits to the value of residential mortgage debt held by all sectors isonly 10 percent below its value in 1970, 45 percent versus 50 percent(col. 1, table 1); however, this ratio has declined by over 17 percentagepoints since 1976. A better indication of the link’s erosion is the ratio ofnet new thrift deposits (net of interest credited) to net new holdings ofmortgages; this ratio has declined dramatically during the 1980s (col. 2,table 1). In 1988, this ratio was only 17 percent. Obviously, residentialhousing has relied on sources of funds other than thrift deposits for quitesome time. Even thrift deposits do not lead the thrifts to invest inmortgages to the extent they formerly did (col. 3, table 1).

Recent changes in regulatory policy increase the likelihood that thefunds for residential mortgage finance will be collected outside the tradi-tional thrift structure. Higher deposit insurance premiums and capital

6 Salomon Brothers (1987) presents results of a survey of 35 large banks that focus on theinvestments of these banks in technology expenditures. Although the survey gives littleattention to the mortgage business, it does reveal the enormous amount of money being spenton technology by large banks and the potential profitability of such expenditures.7 For an excellent overview and discussion of many important trends of the past 20 years,see Barth and Freund (1989).


Table 1. The Relationship of Thrift Deposits to Home Mortgages

Year

Net New ThriftThrift Deposits/ Deposits/ Thrift Deposits/Total Mortgages Net New Mortgages Thrift Mortgages

1970 .498451971 .543701972 .575331973 .563491974 .555361975 .599801976 .622851977 .611471978 .580251979 .546081980 .534311981 .507431982 .524351983 .559121984 .587281985 .566321986 .517151987 .479991988 .44683

1.04634.83294.46428.45924

1.09187.79851.54555.40085.33132.42800.17399.90119.87100.83579.38447.19940.19232.16804

.97461.00051.0045.9593.9499.9931

1.0068.9821.9588.9473.9636.9503

1.03841.09611.10961.10961.09371.05761.0320

Sources: Board of Governors of the Federal Reserve System, Washington, D.C., FederalReserve flow of funds accounts (Year-end summaries); U.S. League of Savings Institutions, Savings institutions sourcebook, Chicago, (selected annual issues).

requirements increase the cost of funds to the thrift industry and reduceits advantage in collecting deposits. In fact, deposit insurance premiumswill be higher for thrifts than for banks until 1998.

Whether these policies will produce a completely level playing field for allpotential collectors of deposits is not clear. Regulators will have to adjustdeposit insurance premiums to changes in the economic environment inorder to guarantee a level field. If, for example, the volatility of interestrates increases, all else being equal, then insurance premiums to banksand thrifts should be increased to take account of the higher interest raterisk associated with a thrift portfolio; otherwise, thrifts and banks wouldmaintain an advantage over other collectors of household deposits. Thelarger financial institutions with federally insured deposits, bank or thrift,may also enjoy an advantage until regulators indicate a willingness toclose large institutions as quickly and completely as they do smaller ones.Another factor affecting the terrain of the playing field is the imple-mentation of the risk-based capital requirements. If new requirements


accurately reflect the risk associated with the assets and liabilities of athrift or bank, then this policy will help level the playing field; otherwise,thrifts and banks may still hold a sizeable advantage relative to uninsuredfinancial institutions. More time and analysis is needed to assess thesepolicies.

The most important factor affecting the unbundling of deposit collectionis securitization. It has clearly broken the link between deposit collectionand origination. The 1980s have shown, without a doubt, that steadydeposit flows into the thrift industry are unnecessary to deliver ap-propriately priced and stable supplies of funds for residential mortgagefinance. The implicit guarantee granted to the federal credit agencies hashelped develop the role of securitization, but even if this guarantee isremoved or priced more properly, the developments in the secondarymortgage market over the past two decades are unlikely to be reversedsoon.

Economies of scope probably exist in collecting savings from the householdsector, An institution that offers many investment alternatives will likelydominate an institution that offers only one, if all else is equal. It is lessclear whether the cost savings are substantial for many typical savers whoinvest in a limited number of assets other than their homes. Nonetheless,economies of scope probably provide a modest incentive to incorporatedeposit collection into the operations of an organization that offershouseholds, especially upper-income households, a wide array of invest-ment vehicles.

The primary effect of technological change in deposit collection is thatcomputers have greatly reduced the importance of “bricks and mortar.”Numerous easily accessible branches were important to the strategy ofmany thrifts in collecting deposits when interest rate ceilings limited theamounts thrifts could pay to depositors. Such locational advantages aremuch less important in today’s computerized and less regulated environ-ment, and, to the extent that branch networks are costly to operate, in-stitutions that rely heavily on branches will be at a competitivedisadvantage.

In summary, we believe that the erosion of the link between thrifts’ depositcollection and residential mortgage finance is likely to continue. We alsothink that economies of scope will generate advantages to institutions thatoffer a wide variety of investment vehicles; this will help retail brokeragefirms relative to the traditional thrift.


Origination

Thrifts continue to be the dominant originator of one- to four-familymortgage loans. In 1988, thrifts originated $180 billion in mortgages; allother lenders provided about $150 billion. The trends in originations indi-cate that the traditional thrift (S&Ls and mutual savings banks) has been the dominant originator since 1970, although its share of originations hasdeclined since the mid-seventies (see table 2). Following a decline in themid-seventies mortgage bankers are originating around 25 percent ofresidential mortgages, just as they were in 1970. Commercial banks arebecoming increasingly important; indeed, their share in the third quarterof 1989, the most recent quarter for which we have data, indicates thatcommercial banks originated nearly as many mortgages as the thriftindustry.

Table 2. Percentage Originations of One- to Four-Family Home Mortgages by Institution Type

YearCommercial

Banks

Mutual Savings & FederalSavings Loan Mortgage CreditBanks Associations Companies Agencies

1970 .2191 .0603 .4163 .2503 .03841971 .2180 .0613 .4604 .2161 .03111972 .2334 .0666 .4843 .1757 .02691973 .2374 .0747 .4858 .1600 .02971974 .2389 .0582 .4582 .1930 .03651975 .1855 .0556 .5293 .1796 .03681976 .2172 .0570 .5488 .1396 .02351977 .2264 .0535 .5328 .1584 .01911978 .2374 .0507 .4861 .1862 .02621979 .2214 .0479 .4427 .2419 .02381980 .2151 .0406 .4567 .2199 .03271981 .2208 .0410 .4274 .2439 .04551982 .2598 .0413 .3588 .2888 .03611983 .2221 .0534 .4039 .2961 .01581984 .2059 .0623 .4722 .2336 .01581985 .2346 .0308 .4500 .2604 .01301986 .2387 .0684 .3869 .2893 .00591987 .2766 .0760 .3877 .2445 .00641988 .2656 .0741 .4183 .2224 .0075

Sources: U.S. Department of Housing and Urban Development, Office of Financial Manage-ment, Survey of mortgage lending actiuity (Annuals, 1970–88).


The fact that thrifts still originate most mortgages does not necessarilymean all such lenders conform to the traditional thrift model; indeed, wesuspect the aggregate numbers mask the specialization that has occurredamong many thrifts that have become, for all practical purposes, mortgagebankers that originate and sell mortgages. Ideally, one would like to assessthis hypothesis by examining the ratio of originations to purchases amongindividual thrifts in order to get a sense of the variation within the thriftindustry. Our guess is that this ratio varies considerably, indicating thatmany thrifts have already made the transition to pure mortgage bankers.

Absent such a precise test, we compute the ratio of the net change inmortgage holdings to net originations (originations/repayments) for S&Ls.This ratio declined from 1.45 in 1971 to 1.11 (1976), to 0.86 (1981), and,essentially, to zero in 1986. We also compute the ratio of mortgage-backedsecurities (MBS) sales to purchases and find a rise from 0.25 in 1971 to0.69 (1976), to 1.24 (1981), and 4.89 (1986). Both series indicate the trans-formation of the S&L industry from one that invests heavily in themortgages it originates to one dominated by originators.

The development of the secondary mortgage market has had, and willcontinue to have, a profound effect on the origination function. Asmortgages have become easier to securitize and sell in the secondarymortgage market, origination has probably become much easier and morecompetitive. Standard forms are available, and time spent in the inventoryof the originator can be kept to a minimum because of the market forMBS. Securitization thus encouraged the expansion of the potential fororiginators to operate as pure mortgage bankers and, consequently, theunbundling of the origination and holding functions of mortgage finance.

Securitization’s primary impact has been on the FRM market; indeed,securitization of ARMs has lagged growth in the origination of ARMs. Forexample, ARMs represented about 60 percent of conventional mortgageoriginations in 1988, but less than 20 percent of the pass-through MBSissued that year. Some may interpret this as a sign that securitization willbecome less important if ARMs continue to be the mortgage instrumentmost in demand. We do not share this opinion. One reason ARMs havenot been as heavily securitized is that in recent years regulators stronglyencouraged thrifts to hold ARMs in their portfolios, securitized or not, inorder to limit their exposure to interest rate risk. The new risk-adjustedcapital requirements will replace such regulatory lobbying and provide anincentive for banks and thrifts to hold securitized ARMs. Furthermore,development of ARMs tied to alternative interest rate indexes (e.g., Londoninterbank offered rate), will probably increase their attractiveness to thebroader capital markets.


Economies of scope do seem to offer potential advantages to firms thatoffer one-stop shopping for loans, but this service’s value is likely to varyamong consumers. Consider the high end of the market, characterized byborrowers who desire low loan-to-value loans, and who have large amountsof financial assets other than housing equity, and who are likely to usebrokerage services, obtain second mortgages, and have home equity linesof credit. Such borrowers can probably benefit from the cost savingsgenerated by the economies of scope that a broad financial services firmcan provide.

At the other end of the market are borrowers who have little wealth outsideof their housing equity. Such borrowers are unlikely to benefit greatly froman institution that offers a wide variety of financial assets. However, suchborrowers are likely to demand mortgages with high loan-to-value andpayment-to-income ratios, loans that are more difficult to securitize thanloans that satisfy the underwriting criteria of the federal mortgage agen-cies. As a consequence, thrifts (or other lenders) may have an opportunityto serve this segment of the mortgage market. Similarly, the diversity ofthe housing market and the difficulty of accurate underwriting in all partsof the market suggest profit opportunities for those who specialize inoriginating mortgages in these areas. This will tend to create “boutique”thrifts that must hold the difficult-to-securitize mortgages they originate.

Regulatory policy probably played a modest role in assigning the origina-tion function to thrifts, so changes in regulatory policy are unlikely toaffect the issue of unbundling. Neither is technology likely to have muchof an impact. If anything, it seems that technological improvements incommunicating information will make it even easier for firms to enter theorigination sector. If so, then mortgage origination will become even lessclosely linked to the other functions of the traditional thrift.

In sum, the origination function is slipping away from the traditional thriftoperation, and there seems little incentive to restore a strong or uniquelinkage. This does not necessarily mean that more specialized institutionswill provide mortgage lending. There will likely be some lending by firmsthat offer a full array of financial services; this segment will probably caterto the high end of the market. In nonstandard markets, primarily thesegment of the market associated with larger amounts of default risk,boutique thrifts will probably predominate and maintain the traditionalspecialization in mortgage originations.


Servicing

The top 15 mortgage servicers (see table 3) serviced over $325 billion inmortgages in 1989. This sum represents nearly one-sixth of the total one-to four-family residential mortgages outstanding in 1989. When one con-siders that there are thousands of mortgage originators, the concentrationof mortgage servicing is even more striking.

In fact, servicing appears to have become increasingly concentrated andunbundled from the origination function, according to the limited amountof data publicly available. The American Banker, May 12, 1989, reportsthat the percentage of total outstanding mortgage debt serviced by the top100 servicers increased from 10.7 percent in 1974 to 19.8 percent in 1988.This percentage remained virtually constant through the 1970s andfinished at 11.3 percent; thus the ratio has nearly doubled during the1980s. The question relevant to this analysis is whether the trend towardconcentration is short term or whether it is driven by more fundamentalchanges in the industry. If it is driven by long-term factors we emphasize—regulatory policy, securitization, economies of scope or scale, and technol-ogy—then even more concentration and separation of the originationfunction from other traditional thrift functions seem certain. We discussthe views of other authors on this point and present some of our ownspeculations.

Indeed, several short-term factors have affected recent trends, several ofwhich are discussed in two recent articles in Mortgage Banking. Hinkleet al. (1990) suggest that increased concentration is due to several factors,one of the most important being an attempt by many mortgage bankersto cover some operating losses from their other lines of business, loanproduction and warehousing. They also indicate that trading is stimulatedby increased interest in servicing by banks and the enormous amounts ofassets being controlled by the Resolution Trust Corporation (RTC). Inanother article, Rosenblatt (1990) presents evidence, based on the 1988Survey of Mortgage Bankers, which also indicates an enormous amountof trading of loan servicing contracts. Most sales tend to be from smallerfirms to larger firms. Companies with servicing portfolios of less than $1billion were net sellers of over half of their servicing contracts. Companieswith servicing portfolios in excess of $4 billion, on the other hand, werelarge net purchasers. Rosenblatt also presents evidence that many smallerfirms may have sold their servicing contracts to generate additional incometo offset losses in their other lines of business.

Another short-term factor may be the need for income by lenders in thethrift industry. Historically, such lenders did not include the value of aservicing contract on the balance sheet; instead, they recorded origination


fees as current income. Because a portion of the origination fees repre-sented an initial payment fee for future servicing, this practice allowedlenders to inflate current income statements above their “true” value.Recent changes in the accounting rules relating to thrifts and mortgagebankers (Statement of Financial Accounting Standards No. 91 1986) nolonger permit this. Under current rules, origination fees are to be amor-tized over the expected life of the mortgage contract. As a result,originators can improve the book value of their institutions by selling theservicing contract and recording the sale as current income. To the extentthat these originators continue to experience financial difficulties and focusattention on the firm’s accounting value, rather than its true economicvalue, they have an incentive to unbundle servicing from their otheractivities.

Among the long-term factors that affect the specialization of the servicingfunction, securitization must rank at the top; indeed, it has probably beenthe dominant factor in the unbundling of servicing from the traditionalthrift’s other activities, especially the investment function. To the extentthat the secondary mortgage market distributes the holdings of mortgagesto a wide variety of investors, most of whom have no interest or expertisein servicing, the secondary mortgage market provides a powerful incentiveto unbundle servicing.

No obvious economies of scope are associated with servicing unless theservicers can take advantage of the list of borrowers to market otherproducts such as financial services. Indeed, some of the top servicers seemto have such potential, including Citicorp, Bank America Corp, ShearsonLehman Hutton Mortgage, and a few others (see table 3). Other than theaccess to the mailing list, servicing does not seem to offer substantialeconomies of scope because contact between the mortgage servicer and theborrower is unusual. Indeed, consumer complaints have been leviedagainst some servicers, and legislation has been proposed to hold servicersresponsible for neglect in paying property taxes and insurance premiums.Such unpopular views of mortgage servicers suggest the servicer specialistmay not have an easy time persuading the borrowers on its list to purchaseother financial services.

Although economies of scope are probably not too important in unbundlingmortgage servicing, economies of scale may be. Indeed, concentration num-bers are consistent with economies of scale. Our conversations with someindustry specialists indicate that many believe this is a primary reasonfor the recent increase in concentration. Hoping to realize cost savingsfrom economies of scale, several major firms have moved to centralized


Table 3. Top 15 Mortgage Services in 1989(dollars in billions)

Servicer1989

Volume

PercentChange1988–89

1988 1987Volume Volume

5

6

7

8

9

10

11

12

13

1415

Citicorp Mortgage, Inc.Fleet/NorstarFinancial GroupFireman’s FundMortgage CorporationGMAC MortgageCorporationLomas FinancialCorporationBankAmericaCorporationShearson LehmanHutton MortgageBancBoston MortgageCorporationMetmor (MetropolitanLife Insurance)Chase HomeMortgage CorporationCity Savings Bank(formerly CityFed) First Union MortgageCorporationa

Home Savings ofAmericaMarine Midland BankCountrywide FundingCorporation

Total volume fortop 15 servicers:

Percent market sharefor top 15 servicers:

Total outstandingmortgage holdingsfor all servicers:

$60.0

$35.0

$29.7

$29.7

$22.0

$20.3

$17.6

$16.1

$15.3

$14.7

$14.2

$13.8

$13.1$12.8

$12.5

$326.8

16.3%

14.9

15.1

30.3

$52.2 $44.4

$30.4 $27.7

$22.8 $17.9

15.6

0.9

13.4

$24.5

$21.7

$17.8

24.8 n.a.

22.0

–15.9

21.5

$25.7

$21.8

$17.9

$14.1

$13.2

$18.2

$12.1

$12.0

$19.0

$5.4

–9.0 $19.7

27.8

13.980.3

5.0

14.5%

$15.6

$10.8

$11.5$7.1

$11.9

$285.3

$10.2

$11.0$3.3

$8.6

$243.2

8.7% 15.0% 14.2%

$2,000.0 5.4% $1,897.8 $1,712.3

Source: Inside mortgage finance, February 16, 1990, p. 6. a1988 figure is as of June 1988; 1987 figure is as of June 1987.

Rank

1

2

3

4


processing centers. Hinkle et al. (1990) acknowledge the industry’s con-tinuing debate about such scale economies, but they admit the recenttrends are consistent with such economies.

If such economies do exist and are just now being fully appreciated, thenfurther concentration and specialization will probably occur in mortgageservicing; however, we remain a bit skeptical. One reason is that we findno econometric studies to confirm the existence of such economies; absenta careful study of this type, it is difficult to be sure that all factors affectingthe cost of production are properly considered. Furthermore, electronicdata processing (EDP) costs represent less than 10 percent, on average,of the direct costs of servicing a mortgage contract, according toRosenblatt’s numbers (1990). Even if EDP costs are reduced by half, onlya modest cost savings would be realized unless EDP can produce substan-tial reductions in labor costs, foreclosure expenses, and loan loss provisions.These three categories account for the bulk of servicing costs.

Although not determined, regulatory policy regarding the measurement ofinterest rate risk may also be an important factor in the unbundling ofservicing because servicing is an interest-rate-sensitive asset. The valueof the servicing asset is derived from the future stream of net income itprovides. Because prepayment may end these payments before thematurity date, the value of the servicing asset is sensitive to changes ininterest rates. In addition, a portfolio that includes both mortgages andtheir servicing contracts (assuming the duration of the portfolio is positive)is less interest rate sensitive than an otherwise identical portfolio ofmortgages that does not include servicing. To the extent that new regula-tions will focus attention on the interest rate exposure of a thrift’s portfolio,the regulations will provide lenders with an incentive (or disincentive) tocontinue (or reverse) the unbundling trend. Until we can evaluate thespecific models the regulators will use to assess interest rate risk, it isdifficult to know which trend will dominate.

In summary, mortgage servicing is the most specialized activity of theresidential mortgage finance industry, and we believe securitization is themost important factor affecting its unbundling. Whether recent trendstoward rapid concentration of servicing activity among large firms are like-ly to continue is more difficult to assess. Clearly, mortgage servicers maybe about to reap substantial benefits from scale economies in servicing; ifso, then mortgage servicing may become even more specialized andseparate from other functions of the traditional thrift. However, the recenttrends are also affected by a variety of short-run factors that are unlikelyto be as important in the year 2000 as they are today.


Holding: Portfolio Investment

To clarify trends in mortgage investment, we must introduce a differentconceptual framework than that used to analyze the specialization ofdeposit collection, origination, and servicing. Instead of thinking of holdingas a production activity like the other three functions, consider it an in-vestment decision. As such, investors consider the returns to mortgageinvestment, their volatility, and their correlation with other assets in theirportfolio. In fact, mortgages in the 1980s generated returns exceeding long-term U.S. treasury bonds by 125 to 300 or more basis points. The extraor-dinary returns are earned because mortgage investments are subject toboth default and interest rate risk, the latter compounded by the possibilityof early prepayment.

Many years ago, thrifts held most of the mortgages they originated in theirown portfolios, but this has become less true during the past 20 years. In1971, the ratio of net acquisitions to originations of one- to four-familymortgages (net of repayments and purchases and sales of securities) amongS&Ls was about 60 percent; purchases represented about one-fourth oforiginations; and sales less than 7 percent. In 1986, net acquisitions wereactually negative even though S&Ls originated over $176 billion in one-to four-family mortgages; purchases were about one-third of originations;and sales were nearly 80 percent. Although 1986 was an unusual yearbecause so many mortgages were used to refinance existing mortgages(about half), it still emphasizes the point that the origination and theinvestment functions have become quite separate among thrifts.

Some broader trends in mortgage investment are also discernible. Thedirect holdings of mortgages by savings institutions remained relativelyconstant at 56 percent through the 1970s and then declined steadilythrough the 1980s to a low of 33 percent (see table 4). Commercial banks’holdings of mortgages remained relatively constant at approximately16 percent throughout this period. Direct holdings by households remainedrelatively stable at 5.6 percent through the mid-1980s and have since ex-perienced a decline. Direct holdings by insurance and pensions havedeclined consistently through the past two decades, from a high of10.7 percent in 1970 to a low of 0.9 percent in 1988. This decline wasaccompanied by an increased percentage of mortgages guaranteed or in-sured by federal agencies—from 17 percent in 1980 to 41 percent in 1988.

These numbers probably overstate the decline in the amount of mortgageinvestment by thrifts because thrifts are large purchasers of the mortgagesguaranteed and insured by federal agencies, GNMA, Fannie Mae, andFreddie Mac. Unfortunately, it is difficult to determine exactly the valueof the MBS purchased by thrifts. Nothaft (1989) provides a careful analysis


Table 4. Percentage of Home Mortgages Held by Investors

Pools Commercial Savings InsuranceYear Households and Agencies Banks Institutions and Pensions

1970 7.643 6.824 14.368 55.978 10.6661971 6.949 7.759 14.958 56.373 9.0681972 5.939 8.632 15.820 57.563 7.3271973 5.281 9.348 16.861 57.699 6.0501974 5.556 10.608 17.101 56.813 5.2811975 5.515 11.784 16.146 56.783 4.4241976 5.134 12.734 15.978 57.368 3.6331977 4.742 13.419 16.611 57.152 2.8921978 4.766 14.311 17.394 55.466 2.4371979 5.017 16.086 17.364 52.834 2.3691980 6.065 17.244 16.773 50.518 2.3951981 6.880 18.289 16.480 48.326 2.1771982 7.511 23.023 16.096 42.665 2.2131983 6.766 26.929 15.206 40.860 1.7581984 6.414 28.282 14.683 40.443 1.5341985 5.818 31.412 14.320 38.525 1.2281986 4.213 38.157 13.703 34.147 1.0631987 3.474 41.429 14.220 32.397 .9061988 3.390 41.487 14.456 32.702 .901

Source: Board of Governors of the Federal Reserve System, Washington, D.C., Federal Reserve flow of funds accounts (Year-end summaries).

of this problem with 1988 data and finds that thrifts held less than 30 per-cent of the outstanding federal MBS.8 Taking this adjustment into accountincreases the share of mortgages held by thrifts from 32 percent to about44 percent in 1988, still well below their share in the early 1970s.

A particularly interesting development in the 1980s is that mortgage in-vestors were allowed to unbundle much of the interest rate and credit riskassociated with mortgages. ARM originations became as important as FRMoriginations; lenders were able, therefore, to allocate much of the interestrate risk to borrowers. The multiclass securities, the CMO and the realestate mortgage investment conduit (REMIC)9 , did essentially the same

8 Even this adjustment omits the allocation of the multiclass security. Unfortunately,systematic information about the allocation of these securities is unavailable, but it is believedthat thrifts own a small portion of them. 9 CMOs and REMICs are multiclass securities introduced in the 1980s. They are backed byMBS, but the cash flows, especially prepayments, from the MBS are allocated to differentclasses of security holders in a well-defined way. The holders of the lowest maturity classesreceive all prepayments until they have received all of their initial investment, thenprepayments are used to pay off the holder of the second lowest maturity class, and so forth.


thing for the FRM; mortgage investors could accept as much interest raterisk as they desired. Credit guarantees offered by federal agencies for theirsecurities and the growth in the private mortgage insurance industry alsoallowed lenders to unload much of the credit risk associated withmortgages.

When holding mortgages is seen as an investment decision, the key factorresponsible for the unbundling of mortgage investment from the traditionalthrift is rather simple to identify: securitization. The secondary mortgagemarket has allowed a wide variety of investors to include mortgages andmortgage-related securities in their portfolios, as evidenced by the decreas-ing percentage of mortgages held as whole loans by ultimate investors.Because of these advances in securitizing mortgages, the investmentamounts can be as small as the price of a share in a mutual fund or asexpensive as a multibillion-dollar position in REMICs.

It is also through the secondary mortgage market that regulatory policyhas had its most direct effect on the specialization of holding mortgages.By granting implicit or explicit guarantees to debt issued by Fannie Mae,GNMA, and Freddie Mac, the federal government gave these agencies anadvantage that allowed them to funnel funds to the mortgage market atrates competitive with those that thrifts could offer because of their depositinsurance advantage. As noted above, the secondary mortgage market alsogave thrifts an incentive to securitize their mortgage assets through federalagencies in order to reduce their default risk.

Within the investment framework, it is easy to see that economies of scopehave little effect on the degree to which investors specialize in mortgageinvestment. Economies of scope pertain to the benefits of jointly producingtwo or more goods, not to the diversification of benefits associated withincluding mortgage assets in a diversified portfolio. Similarly, technologicaladvances only indirectly affect the decision to invest in mortgages, andonly to the extent that technological advances reduce the transaction costsof obtaining and maintaining a well-diversified portfolio that includesmortgage-related assets. Although technological advances have beendramatic during the 1980s and will probably continue, transaction costsassociated with mortgage investment are probably low enough already toallow a wide variety of investors to hold mortgages in their portfolios.

What will happen to the specialization of mortgage investment in the fu-ture? It seems to us that the trends of the 1980s will probably acceleratein the 1990s as the traditional thrift industry continues its decline. Anincreasing percentage of mortgages will be securitized, thrifts will becomeless and less prominent in the market and, as a result, mortgage assetswill become more diversely held.


Who will hold the mortgages formerly held by the thrift industry? Com-mercial banks will probably increase their share considerably, especiallywith the elimination of the tax advantage of investing in tax-exempt bonds.Absent this advantage, banks already have shown signs of replacing theirholdings of tax-exempt bonds with mortgages and MBS. Furthermore, risk-adjusted capital requirements will probably favor the holding of more MBSby banks. Pension funds may also increase their holdings of mortgagesbecause of the large growth expected of these funds in the future. Theirlonger lived assets also make pension funds prime candidates for certaintypes of multiclass securities.

Our guess is that the household sector is likely to increase its share themost. The household sector should be able to do so through mutual funds.We already see the ease with which mutual funds can offer householdsthe opportunity to invest in mortgages, and future developments shouldmake investment even easier. Too, if federal policy can increase the savingsrates of households, this alone should increase the household sector’s in-vestment in mortgages.

What kinds of new mortgage-related securities will be invented? Therewill certainly be continued development and further improvement of ex-isting multiclass securities that allocate interest rate risk, especially forARMs. Improvement is probably needed in the area of credit risk. Cur-rently, credit risk is allocated among lenders—the federal agencies,mortgage insurers, and the household sector—but the nightmares of the1980s in many parts of the country will probably result in a higher pricefor default risk. We have seen this recently in the junk-bond market. Per-haps we will see the home mortgage divided into parts much as commercialMBS are. For example, we might see the first 50 to 60 percent sold as aseparate security and the next 10 to 20 percent sold as another “junkmortgage.” This may happen if the appraisal industry proves able to im-plement many FIRREA provisions that aim to improve the accuracy andreliability of real estate appraisals. Improvements in this area might leadto more reliable ratings of various MBS. If so, then we might see Moody’sratings for various classes of MBS in the year 2000.

Last, we must wonder whether lenders will continue to be able to unloadinterest rate risk on the household sector through ARMs. One scenariosuggests that ARM demand will decline dramatically in the 1990s for tworeasons. First, the interest rate differential between the ARM and FRMrate and the level of nominal interest rates will both decline in the 1990sbecause “teaser” rates will be eliminated, especially if inflation in the 1990sis less than in the 1980s. Such declines would reduce the demand forARMs (Brueckner and Follain 1989). Second, lenders will be less interestedin unloading interest rate risk onto consumers because this can be so easily


done in the secondary mortgage market by issuing multiclass securitiessuch as REMICs. Furthermore, lenders will probably not receive the samefavorable consideration from regulators for issuing ARMS as they did inthe 1980s. We find this scenario quite reasonable, although it might besomewhat offset if inflation returns or if the market for ARM securitiesimproves dramatically.

Summary

The delivery of residential mortgage finance has for years been providedby the traditional thrift, which we define as an institution involved in fourmajor activities: deposit collection, origination, servicing, and investment.We argue that the traditional thrift will not dominate in the year 2000 asit has in the past 30 years. The past ten years have seen the start of thisinstitution’s demise. The key to its success is also the key to its downfall—regulatory policy. The changes noted above, especially those associatedwith FIRREA, have greatly reduced the traditional thrift’s formeradvantages.

Regulatory policy is not the only factor that will lead to the demise of thetraditional thrift institution. The enormous success of the secondarymortgage market was probably sufficient to supplant the role of the tradi-tional thrift, even without the regulatory factor, although the change mightnot have been as rapid. This is especially true if the powerful advantagegranted the federal credit agencies continues unabated. Old-fashionedfinancial intermediation simply cannot compete with the combination ofsecuritization and an active mortgage banking industry.

We also discuss the possible role of economies of scope and of technologyin unbundling. Unfortunately, little hard evidence is available to allowprecise views of the future; nonetheless, we discuss several ways in whichthese factors influence the allocation of the traditional thrift’s activities.The effects of these forces are most likely to appear in deposit collectionand servicing. We see servicing as the most specialized area; the potentialexists for it to become even more specialized.

Despite our view that the many functions of traditional thrift activitieswill become less bundled, all aspects of the delivery of residential mortgagefinance will not necessarily become more specialized. Some functions willbe assumed by institutions offering a broad array of services. For example,we expect that certain types of originations and much of the deposit col-lection function will be undertaken by banks and retail brokerage houses.Interest rate risk will be assumed by institutions with broader portfoliosthan the typical thrift, as well as by those with portfolios more suited to


interest rate risk. Credit risk will be distributed among households,mortgage insurance firms, the federal credit agencies, and institutions thatcan more easily hedge default risk.

Although the traditional thrift’s dominance of residential mortgage financewill be over, certain niches will exist for firms that wish to originate loansto certain sectors of the residential mortgage market. These niches willinclude difficult-to-standardize or -securitize loans; lenders that specializein these loans may be able to obtain extraordinary returns because of theinformation they possess. For example, those that specialize in marketswith unusual amounts of default risk may have an advantage if they be-come experts in that marketplace. Their knowledge may allow lenders tohold for investment purposes loans that are undervalued by the market;that is, these lenders may be able to obtain for their portfolio loans theyfeel are not properly priced in the larger market for mortgage securities.

Of course, a potential risk to taxpayers from a smaller thrift industry stillexists if the thrift industry becomes more focused on nonstandard loansand loans that are difficult to securitize. In particular, thrifts may incurhigher amounts of default risk, and the taxpayer, by virtue of our nation’scommitment to deposit insurance, may have to rescue the thrift industryonce again. Unless deposit insurance premiums adjust to changingeconomic conditions and variations in the riskiness of thrift portfolios,another S&L debacle may yet occur in the future. Regulators must main-tain a close watch.

Will the changes we predict improve the delivery of residential mortgagefinance? Can residential mortgage finance be delivered at a reasonableprice and in a stable manner without a dominant institution like the tradi-tional thrift? This was not the question given us, but it is relevant andcrucial. Indeed, an answer follows from our analysis. To the extent thatchanges are driven by competitive pressures, changes can only be construc-tive. In particular, technological improvements and the increased liquidityof mortgage assets must result in a lower cost of mortgage debt. Regulatorychanges, such as higher deposit insurance and capital requirements, mayoffset some of these cost reductions slightly, but the major effect of theregulatory changes is to reduce the thrift industry’s role in the delivery ofmortgage finance, not to increase the cost of mortgage finance. Indeed, aslong as the implicit guarantees granted the federal credit agencies areunderpriced, mortgage finance should remain cheaper than it would be ina more neutral setting.

What major changes might lead to radical departures from the scenariosdepicted in this paper? One possibility is a serious default crisis imposingsubstantial losses directly on the federal agencies. If such a crisis does


arise in the 1990s, then the federal government may withdraw its com-mitment to the federal credit agencies, much as it has done with the thriftindustry in the 1980s. Our guess is that the federal credit agencies arewell aware of this possibility and are paying more attention to credit riskthan ever before.

Another possible change might be a major inflationary spiral like that inthe 1970s and early 1980s that increases nominal interest rates and makeshousing less affordable, especially to first-time home buyers. Such a situa-tion might produce requests for assistance to the housing sector. Our guessand hope is that such requests will be met, not with assistance to thesuppliers of residential mortgage finance, but rather with assistance tar-geted directly to home buyers. Furthermore, as long as local governmentpolicies for land use are not too onerous and demographic projections proveaccurate, pressure on the relative price of housing should not be too greatin most parts of the country over the next decade.

Radical change may also occur if the country’s regulatory structure forcommercial banks and investment banks changes drastically. Specifically,competitive pressures from international banks and the investment bank-ing industry are already leading many to argue in favor of repealing theGlass-Steagall Act that prohibits substantial interactions between commer-cial banks and investment bankers. Although top regulators still maintainstrong beliefs that the current regulatory structure, with modest adjust-ments, is necessary for stable and well-functioning financial markets, weare not as sure. The complexity of financial markets and the enormousamounts of resources devoted to them may simply be too much for thecountry’s regulatory structure, or any modest modification of it, to handle.Regulators may always be one step behind industry advancements andsomeday may find themselves faced with a bill they cannot handle. If thisoccurs, then massive deregulation of financial institutions may result, inthe form of 100 percent reserve banking or the limiting of deposit in-surance to demand deposits in highly capitalized institutions. How residen-tial finance would fare under such a system is hard to predict, but it seemsunlikely that it would be better. Such a revolution would probably increase,perhaps substantially, the cost of residential mortgage finance.

Such dreary scenarios may lead one to ask whether it would be better togo back to the “old days.” This was a frequently touted theme among S&Lexecutives during the early 1980s. Looking back is always dangerous, butin this case it is especially so. We simply do not have that option. Pressurefrom technological forces, international competition, and innovations in thebroader financial services preclude a return to the old days. Modern ex-ecutives should recognize this and adapt as quickly as possible. Regulators


should remain vigilant and be ready and able to adjust more rapidly thanthey did in the 1980s. To do otherwise will lead to darker days for residen-tial mortgage finance.

References

Barth, James R., and James L. Freund. 1989. The evolving financial services sector:1970–1988. Office of Thrift Supervision. Washington, D.C.

Board of Governors of the Federal Reserve System, Federal Reserve flow of fundsaccount (year-end summaries). Washington, D.C. (various issues).

Brueckner, Jan K., and James R. Follain. 1989. ARMs and the demand for housing.Regional Science and Urban Economics 19:164–87.

Derthick, Martha, and Paul J. Quirk. 1985. The politics of deregulation.Washington, D.C.: The Brookings Institution.

Evanoff, Douglas D., Phillip R. Israilevich, and Randall C. Merris. 1989. Technicalchange, regulation, and economies of scale for large commercial banks: Anapplication of a modified version of Shephard’s lemma. Working Paper SeriesWP-89-11. Federal Reserve Bank of Chicago.

Follain, James R. 1987. The U.S. secondary mortgage market: Born in a regulatedenvironment but flourishing in a competitive one. Illinois Business Review 44(October):2–5.

Hendershott, Patric H., and James D. Shilling. 1989. The impact of the agencieson conventional fixed-rate mortgage yields. Journal of Real Estate Finance andEconomics 2:101–15.

Hinkle, Hal, Steve Harris, and Dick Loggins. 1990. Mortgage servicing: Supplyand demand trends. Mortgage Banking (January):57–60.

Inside mortgage finance. 1990. Financial World Publications, Washington, D.C.(February 16), p. 6.

Kane, Edward. 1982. Metamorphosis in financial services. Strategic planning foreconomic and technological change in the financial services industry. Proceedingsof the Eighth Annual Federal Home Loan Bank of San Francisco Conference(December):49–66.

Kolari, James, and Asghar Zardkoohi. 1987. Bank costs, structure, and performance.Lexington, Mass.: Lexington Books.

Nothaft, Frank. 1989. Changes in housing’s depth chart. Secondary MortgageMarket (Fall):7–9.

Rosenblatt, Robert M. 1990. The 1988 servicing profit picture. Mortgage Banking(February):51–6.


Salomon Brothers. 1987. Technology and banking: The implications of strategicexpenditures. New York: McKinsey and Company.

U.S. Department of Housing and Urban Development, Office of FinancialManagement, Survey of mortgage lending activity. Washington, D.C. (Annuals,1970–88).

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