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In the Mortgage Subsidy Bond Tax Act of 1980, the Congress sharply restricted the issuance of tax-exempt bonds for housing. Because a large number of bond issues was marketed under these restrictions in November and December 1981, the Congressional Budget Office (CBO) has been able to prepare this preliminary assessment of experience under the act. This paper, prepared at the request of Charles Rangel, Chairman of the Oversight Subcommittee of the House Committee on Ways and Means, examines these bond issues and describes the experience to date under the act. It also discusses the liberalizations of some of the act's provisions adopted December 16, 1981 by the Senate in the Miscellaneous Tax Bill (H.R. 4717).
Cynthia Francis Gensheimer of the CBO's Tax Analysis Division prepared the report, with the assistance of Martha J. Smith and under the direction of James M. Verdier. Bruce Davie of the Committee on Ways and Means reviewed and provided suggestions on the report. Patricia H. Johnston edited the manuscript and Linda B. Brockman typed it for publication.
Dozens of investment bankers, lawyers, housing agency officials, and
rating agency and insurance company personnel gave generously of their
time in relating their experiences with the act's provisions and providing
information to CBO. A preliminary list of the bond issues discussed in
this report was provided by The Bond Buyer in mid-December.
Alice M. Rivlin
Director
March 1982
SUMMARY
CHAPTER I. INTRODUCTION
CHAPTER II. IMPACT OF ADVERSE MARKET CONDITIONS
CHAPTER III. ARBITRAGE RULES FOR BONDS FOR OWNER-OCCUPIED HOUSING
CHAPTER IV. EFFECTS OF OTHER PROVISIONS ON BONDS FOR OWNER-OCCUPIED HOUSING
CHAPTER V. BONDS FOR RENTAL HOUSING
APPENDIX INDEX OF FOOTNOTES TO INDIVIDUAL BOND ISSUES
APPENDIX A. BONDS ISSUED IN 1981 FOR MORTGAGES ON OWNER-OCCUPIED HOUSING UNDER THE PERMANENT RULES OF THE ACT
APPENDIX B. TITLE 1 HOME-IMPROVEMENT BONDS ISSUED UNDER THE PERMANENT RULES IN 1981
APPENDIX C. SAMPLE OF BONDS ISSUED FOR RENTAL HOUSING IN LATE 1981
| TABLES | |
| 1. | CASH CONTRIBUTIONS TO BONDS ISSUED FOR OWNER-OCCUPIED HOUSING UNDER THE ACT'S PERMANENT RULES |
| 2. | 1981 LIMITS ON BOND VOLUME BY STATE |
| 3. | PERCENTAGE OF MORTGAGE FUNDS THE TEN LARGEST 1981 ISSUERS EXPECT TO USE FOR NEWLY CONSTRUCTED HOUSING |
In December 1980, the Congress sharply limited
the use of tax-exempt bonds for housing in response to a surge in the issuance
of these bonds and in an attempt to target the assistance more efficiently.
A year later, enough bonds have been issued under the new rules to enable
the Congressional Budget Office to make a preliminary assessment of the
effects of the act and to discuss the potential effects of some less restrictive
amendments adopted by the Senate in the Miscellaneous Tax Bill.
BACKGROUND
Tax-exempt bonds have been issued for housing since just after World War I, but not until the early 1970s were the bonds issued in any great quantity. At that time, many state housing agencies started to issue tax-exempt bonds for mortgages on apartment buildings and on owner-occupied houses, and in 1978 local governments began to issue bonds for mortgages on owner-occupied houses.
State and local governments issue bonds at relatively low, tax-exempt interest rates and relend the proceeds at slightly higher rates for mortgages. In the case of bonds issued for owner-occupied housing, people apply for the mortgages at private lending institutions that are hired by the bond issuers to process the mortgage applications to check both for general creditworthiness and to ensure that borrowers meet all restrictions imposed by federal and state law and by the issuer.
The federal government subsidizes the bond issues because interest on the bonds is exempt from federal income tax. Most of the subsidy is passed on to homeowners who get below-market-rate mortgages and to bondholders who do not have to pay tax on their investment income (they pay a lower, implicit tax, however, in that the bonds carry a lower interest rate than taxable bonds do). Some of the subsidy also goes to the various intermediaries in the process.
The use of tax-exempt bonds for owner-occupied housing increased dramatically in the late 1970s. In 1976, according to the Department of Housing and Urban Development, a total of $1.3 billion in these bonds was issued, compared to $12 billion in 1980.
During this expansionary period, federal law imposed basically no restrictions
on these bonds, as long as they were issued under the auspices of a state
or local government. The Congress was concerned both about the large federal
revenue losses associated with the growing bond volume and about the possibility
that the volume of housing bonds would push up interest rates on tax-exempt
bonds issued for more traditional public purposes. Moreover, the Congress
wanted to target the assistance as efficiently as possible.
THE MORTGAGE SUBSIDY BOND TAX ACT OF 1980
In response to these concerns, the Congress enacted the Mortgage Subsidy Bond Tax Act of 1980. This act sharply limits tax-exempt bonds for owner-occupied housing and denies tax-exemption on nearly all bonds for owner-occupied housing issued after December 31, 1983. It also restricts somewhat tax-exempt bonds for rental housing.
In order to limit the dollar amount of bonds issued for owner-occupied
housing, the act imposes limits on the amount of bonds that each state
may issue. The act imposes several restrictions to target the assistance:
issuers can charge homebuyers interest rates no more than 1 percentage
point above the interest rate on the bonds; all borrowers must be first-time
homebuyers; price limits are imposed on bond-financed houses; and a portion
of each bond issue is reserved for mortgages in targeted areas. Bonds can
be issued for rental housing only if at least 20 percent of apartment units
(15 percent in targeted areas) are rented to low- or moderate-income tenants.
EXPERIENCE UNDER THE ACT
Lenient transitional rules exempted bond issues in the pipeline from the act's restrictions. Therefore, most of the bonds subject to the permanent rules of the legislation were not issued until the last two months of 1981, after workable temporary regulations were published. Thirty-eight bond issues for mortgages on owner-occupied housing were issued under the new restrictions in 1981, totaling $1.68 billion. Eight bond issues for home-improvement loans were issued under the permanent rules in 1981, totaling $155 million. A total of $1.1 billion in bonds for rental housing was issued in 1981, only a small portion of which was affected by the act's restrictions, because most of these bonds have traditionally financed apartments in which all tenants are low income.
Adverse Market Conditions
While the act's restrictions created difficulties for bond issuers in late 1981, mortgage revenue bonds faced other problems unrelated to the act. Tax-exempt interest rates reached their highest historical levels in late 1981, both in absolute terms and as a percentage of comparable taxable rates. Consequently, since high interest rates on bonds necessitate high interest rates on the mortgages financed with bond proceeds, the mortgage interest rates offered by these programs had to be higher than those previously charged. Only a small group of borrowers both could (or would) pay the higher rates and had incomes high enough to meet the lenders' qualifications for the high-rate mortgages but low enough to meet the programs' income limits.
In response to the high interest rates on long-term, tax-exempt bonds, many issuers devised ways to shorten bond maturities and thereby achieve lower bond interest rates that enabled them to set lower mortgage interest rates. Usually this was done by shortening the maturities on the mortgages. Some programs offer level-payment mortgages that will be paid off at the end of 20 or 25 years instead of the usual 30 years or mortgages in which the monthly payments increase each year, so that the entire mortgage is paid fully at the end of about 16 years.
Arbitrage Rules
Federal law generally prohibits the issuance of tax-exempt bonds at low interest rates if the bond proceeds are invested at much higher rates. Without these so-called "arbitrage" rules, state and local governments could profit from tax-exempt bonds. As part of the Mortgage Subsidy Bond Tax Act of 1980, the Congress tightened the arbitrage rules for tax-exempt bonds for owner-occupied housing in order to channel most of the subsidy provided by the tax exemption to homeowners rather than to issuers and financial intermediaries. To this end, the act requires that mortgage interest rates be no more than 1 percentage point above bond interest rates and that any profit earned on nonmortgage investments be rebated to the homeowners or to the federal government.
The act so limits the yield on investments made with bond proceeds that the yields are not high enough to cover interest due on the bonds and other expenses and still leave a cushion for unexpected contingencies. In effect, therefore, the act implicitly requires state and local governments to subsidize tax-exempt bonds for owner-occupied housing. The Administration has just proposed explicitly requiring state or local subsidization for all tax-exempt bonds issued for private purposes.
For the most part, subsidies on housing bonds were provided by cash contributions from state housing agencies or state or local governments. The yield on investments made with these cash contributions was then available, along with the yield on investments made with bond proceeds, to cover expenses and debt payments on the bonds and to provide additional security for the issue. The amount of cash conributions varied widely from issue to issue but was about 8.7 percent of the total amount of bonds issued for mortgages on owner-occupied houses in 1981.
The ability and willingness of state and local governments to subsidize bond issues also varies widely. Some state housing agencies have large net worths and were able to contribute to issues,, but others have smaller net worths or funds that are committed to other purposes. If surplus funds remain after all bonds have been retired and expenses met, they usually revert to the housing agencies' general funds. A portion of the agencies' contributions, therefore, might be thought of as loans, rather than grants, although the amount of funds returned could be small and not recovered for many years.
Some issues did not receive cash contributions but were issued as housing agencies' general obligations or were backed by other agency assets in addition to the bond proceeds. Several issues were self-supporting, however. These included bonds of which at least a portion were unrated and privately placed with investors rather than publicly marketed. Investors who purchased these bonds probably were willing to accept a level of risk unacceptable to the rating agencies.
Under another approach, homebuyers were charged interest rates exceeding those normally allowed, on the assumption that large amounts of their mortgage debt would be forgiven once all bonds are retired. This later forgiveness would reduce the effective interest rate. Compliance with the arbitrage rules requires only that the issuer demonstrate, under reasonable assumptions, that it expects to forgive a large amount of indebtedness. If events turn out otherwise, no violation of the rules would occur, but homeowners would pay higher interest rates than the Congress intended in the 1980 act.
As discussed above, the intent of the new arbitrage rules was to channel as much of the subsidy as possible to homebuyers and thereby offer them the lowest possible interest rate on their mortgages. The success of the rules in achieving low mortgage interest rates is uncertain, for no one knows what the interest rates would have been in the absence of the rules.
The lower are the costs of a bond program--bond interest and fees to financial intermediaries--the lower are the mortgage interest rates that need be charged. In the aggregate, fees for financial services have probably decreased a little or stayed the same, even though the act increased the responsibilities of many financial intermediaries. Because the act's yield restrictions reduce the security of the bonds (even with sizable cash contributions), bond interest rates may be somewhat higher than they otherwise would be, however. The net effect of the act, therefore, may have been to increase mortgage rates somewhat.
The act requires that any profit on nonmortgage investments made with bond proceeds be rebated to the homeowners or to the federal government. By design many of the issuers do not expect to rebate much, if any, money. Their reserves are either funded wholly with outside cash contributions, or invested pursuant to long-term contracts with banks at interest rates below the rates on the bonds.
Volume Limits
The act limits the annual volume of bonds that can be issued in any state to $200 million or to 9 percent of the state's annual mortgage originations averaged over the past three years, whichever is greater. The formula favors sparsely populated states; in 1981, bonding authority per capita was $500 in Alaska but only $24 in New York State. The volume limits imposed by the act were not a constraint in 1981, however, since only two states issued their full allotments in that year.
Targeted Area Provisions
The targeted area provisions of the act require that at least 20 percent of mortgage funds be reserved for targeted areas, designate certain census tracts automatically as targeted areas, and allow states to nominate other areas for designation. Less than the full 20 percent can be reserved if the jurisdiction contains no targeted areas, if the targeted areas are sparsely populated, or if they are areas in which few mortgages have been made in the past. Because of these exceptions, the majority of 1981 issuers set aside little or no funds for mortgages in targeted areas.
Although federal lax offers incentives to set aside funds for targeted areas by allowing the purchase of higher priced houses and purchase by other than first-time homebuyers in those areas, the value of these incentives is small compared to the added costs of setting aside funds for mortgages in targeted areas. The market, therefore, places at a disadvantage issuers that are required by law to set aside the full 20 percent of funds for targeted areas, namely those with many qualified census tracts.
First-Time Homebuyer and Purchase Price Provisions
With a few exceptions, the act requires potential purchasers to be first-time homebuyers. Because many state and local governments had previously imposed low-income limits on borrowers under their tax-exempt bond programs, a majority of the borrowers has always been first-time homebuyers. Many of the issuers have not been much affected by this provision, therefore, other than to be faced with the additional administrative burden of demonstrating compliance. Although not bound to do so by federal law, nearly all issuers impose income limits on borrowers.
The act limits the purchase prices of bond-financed houses to 90 percent of the area median purchase price (110 percent in targeted areas). The limits vary widely according to area, ranging from $33,000 for existing houses in northeast Pennsylvania to $144,000 for existing houses in San Jose, California.
Registration Requirement
All tax-exempt bonds for housing must be issued in registered form after January 1, 1982, meaning that names of all bondholders must be on file with the trustee bank. This requirement was imposed so that the Internal Revenue Service (IRS) could locate bondholders to collect gift and estate taxes and tax on bond interest if the bonds were found to violate any of the act's requirements. Housing bonds are currently the only major group of tax-exempt bonds that must be issued in registered form. Many investment analysts fear that this requirement has narrowed the market for the bonds and that interest rates on them may initially rise by at least one-fourth of a percentage point as a consequence.
Bonds for Veterans' Housing
Bonds for veterans' housing may be issued free of nearly all of the act's requirements, as long as the bonds are general obligations of the state. California and Oregon were the only states that issued general obligation bonds for veterans' housing in 1981, but these bonds totaled 20 percent of the tax-exempt bonds issued for owner-occupied housing in that year.
Bonds for Home-Improvement Loans
Eight issues of bonds for home-improvement loans were marketed in 1981 under the act's permanent rules. Bond proceeds may be used for home-improvement loans up to $15,000 each. In 1981 most of these bonds financed Title 1 home-improvement loans insured by the Federal Housing Administration. Title 1 loans can be used for general home improvements and repairs, but not for recreational facilities, such as swimming pools.
The home-improvement loan bonds were more heavily subsidized with cash contributions (often with Community Development Block Grant funds) than were the bonds for mortgages on owner-occupied houses. In several cases, interest rates were set lower on loans for low-income people or for people buying houses in designated neighborhoods than for other borrowers.
Bonds for Rental Housing
The act allows tax-exempt bonds to finance rental housing only if at least 20 percent of the units (15 percent in targeted areas) are rented to low- or moderate-income tenants for at least 20 years. Since most apartments financed with tax-exempt bonds have been 100 percent low-income projects, this requirement only affects a small share of the rental-housing bonds.
At the high interest rates now prevailing in the tax-exempt bond market, most developers do not find rental housing projects profitable, even without the requirement that 20 percent of the units be reserved for low-income tenants. The targeting requirement probably worsens the profit outlook somewhat, but is not the primary factor impeding bond issuance.
Enforcement of the targeting requirement could prove to be a problem, since many of the bonds are being issued with maturities shorter than 20 years. Bond counsels have required that the 20-year targeting requirement be filed as a deed restriction or covenant running with the land, so that it binds current and future owners of the project. If abrogated, low-income tenants, or the bond issuing agencies, would possibly sue for enforcement of the restriction.
Very little is known about the quality of the units that have been set
aside for low- or moderate-income tenants (whether they are less desirable
than or separated from the other units, for instance).
PROPOSED AMENDMENTS TO THE ACT
The Miscellaneous Tax Bill (H.R. 4717) passed by the Senate on December 16, 1981, contains provisions easing the restrictions on bonds for owner-occupied and rental housing. The House bill contains no provisions dealing with housing bonds.
The Senate version of the bill would allow slightly higher yields on mortgages financed with bond proceeds. Most issuers feel that these higher yields would enable them to issue bonds with smaller cash contributions, but that some contribution would probably still be needed in most cases. The Senate bill would also shorten the length of time during which the targeting requirement for rental housing bonds would be in effect. The Joint Committee on Taxation estimates that the federal revenue loss of the amendments would be $4 million in fiscal year 1983 and $22 million in fiscal year 1986, for a total revenue loss over 1983-1986 of $50 million.
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