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Housing --- Finance

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This paper examines the portfolio choice of savings and loan associations (SLAS) between mortgages and bonds, first in a certainty world and then under uncertainty. Differences in servicing and transactions costs, in default losses, in tax treatment and in the timing of payments are accounted for in a certain world. SLAs are seen as investing in bonds only if the demand for mortgage funds is sufficiently weak that more profitable SLAs compete away some of the value of their tax preference by bidding down mortgage rates; in this case less profitable SLAs would find corporate debt attractive. In an uncertain world, mortgages will command a premium over bonds to compensate for the prepayment option extended mortgage borrowers. The appropriate value of this premium depends on uncertainty regarding future interest rates and aversion to this uncertainty. SLAs that view future interest rates as more uncertain than the market does generally, or who are more averse to this uncertainty, will require an options premium greater than that determined in the market. Thus they will find corporate debt to be attractive relative to bonds, even when the demand for mortgage funds is strong and their mortgage tax preference is not competed away.

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This paper proceeds as follows. We first identify the essential services provided by a financial system and then derive the characteristics of the system that would exist in a technologically advanced society unfettered by nonneutral taxes and regulations. Next we consider how taxes and regulations have shaped the existing American financial structure. Finally, we posit likely tax and regulatory changes and conjecture as to how technological innovation will further interact with these changes to alter the American financial system. Our basic contentions are that the tax and regulatory influences are eroding and that the system will eventually move toward the unfettered financial system described in the first section.