"I work for a 12-month S&L," one executive said recently meaning that his savings and loan association will become insolvent in one year if it doesn't get some help. The coming crisis in the real estate finance industry may present the Reagan administration with its first major decision as to who will bear the costs of reducing inflation.
Real estate finance is becoming the first casualty in the war against inflation because a single policy makes it unusually vulnerable. That policy, which the federal government encouraged, is to use short-term deposits to make long-term mortgages.
The interest paid on short-term deposits goes along with inflation, but the interest received on traditional mortgages does not. Today savings and loan associations must pay up to 15 percent to attract deposits, but over half of their existing mortgages carry interest rates under 10 percent. When the rising cost of short-term deposits collides with the static returns on mortgages, the result is a tide of red ink for real estate lenders.
Real estate lenders have come in last in the great national game to secure the benefits of inflation while passing the costs on to someone else. The clear winner in the inflation game has been the borrower. Every homeowner who has enjoyed double-digit appreciation in the price of his home, while paying a single-digit interest rate on his mortgage, knows he is a winner.
Until the late 1970s, the clear loser in the inflation game was the depositor. Federal regulations limited the interest paid to depositors to levels well below the inflation rate. Savings institutions simply passed the benefits of inflation on to borrowers and the costs to the depositors.
As depositors became unhappy with bearing the costs of inflation, they departed for the higher returns of money market mutual funds, whose assets have mushroomed to $100 billion. To prevent further outflow of funds from savings institutions, federal authorities in the late 1970s created new savings instruments that carry competitive interest rates.
Paying competitive interest rates turned out to be a two-edged sword. Savings institutions prevented a massive departure of depositors to higher-yielding investments, known in the trade as disintermediation. At the same time they lost the ability to pass the costs of inflation on to the depositors because competitive rates of interest reflect the level of inflation.
Competitive interest rates soared in response to the Federal Reserve's new policy of reducing inflation through more effective control of the money supply. If today's high interest rates are the price of controlling inflation, then depositors are the clear beneficiaries, and saving institutions are clear losers.
Like poker, the inflation game requires a loser for every winner. Borrowers with single-digit mortgages are still winners. Depositors with competitive interest rates have moved from the loser's position to a neutral one, at least on a pretax basis. Now savings institutions have assumed the unwanted and unaccustomed role as loser in the inflation game. They are struggling to develop a new kind of mortgage that passes the costs of inflation to new borrowers, but they can do nothing about their enormous portfolios of mortgages with below-market rates of interest.
Savings institutions are the current losers in the inflation game, but they may not be the ultimate losers if they succeed in passing the costs on to the nation's taxpayers. Already pressure is building for federal aid to desperate real estate lenders. Proposals such as a federal purchase of mortgages with below-market interest rates effectively make the federal government the ultimate loser in the inflation game.
Pressure for more federal aid to savings institutions is coming despite the presence of heavy federal assistance already. Tax laws permit deduction of mortgage interest and the deferral of capital-gains taxes on property if another property is purchased. Federal agencies guarantee most savings deposits and provide liquidity for mortgages in the resale market. When savings institutions get in liquidity trouble, they often can secure loans from federal agencies as well.
When an industry gets in trouble, that trouble is seldom evenly distributed. Just as Chrysler is in more trouble than the other two major auto makers, some savings institutions are in worse shape than others.
Savings banks in the Northeast have the worst problems. The legacy of usury limits on their mortgage rates, a step that passed more benefits of inflation on to borrowers, leaves them most exposed. California savings and loan associations have a much milder case of the malady they share with their eastern counterparts.
Banks and insurance companies also have similar, but smaller, problems caused by making long-term mortgages with short-term deposits. These mortgages are now unprofitable, so they are curtailing future mortgage lending. A few banks such as Wells Fargo virtually have abandoned the mortgage business altogether.
The uneven distribution of financial trouble in real estate finance is a microcosm of what the entire economy faces in curtailing inflation. A significant amount of financial pain will be borne as a cost of lowering inflation, but everyone wants someone else to bear it. It is like the Frenchman during World War II who said he had lost a nephew and a cousin in this terrible conflict and then declared his willingness to sacrifice his brother-in-law to achieve victory.
The distribution of the financial pain caused in curing inflation poses a difficult issue for economists. Normally they think of income distribution as the pleasant task of sharing the output of a bountiful economy, rather than as the unpleasant task of parceling out financial pain.
Deciding who will bear the financial pain is more a political question than an economic one. As the pain becomes intense, the Reagan administration will be deluged with demands for aid, just as Margaret Thatcher's administration in Britain has been besieged by demands for government bailouts. The worsening plight of the real estate finance industry may present the Reagan administration with its first major decision of how to respond to those demands and how to distribute the financial pain inherent in ending inflation.