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In this regard we do suggest one modification to S. 1147 in order to make such programs truly attractive from a marketing standpoint. As presently drafted, S. 1147 would require the taxpayer to reduce the cost basis of the principal residence in accordance with the discounted amount of the prepayment. This is still too complicated and thus we believe that the

preferable approach is to provide complete forgiveness. This approach has the critical advantage of being simple for the lender to explain, the borrower to understand, and the IRS to administer.

Any revenue loss to the Treasury is more apparent than real because the prepayments would not take place or would be minimal if the discounts are taxed. The potential revenues would be in meaningful volume only if they are tax exempt. In other words, any tax would destroy the revenue base. On the other side of the equation, such prepayments will, in the future, reduce the single largest individual tax deduction, that of mortgage interest. Furthermore, such a program will hasten the day when thrift institutions will again pay taxes to the Treasury; it would reduce the possibility that federal assistance would have to be provided to thrift institutions if interest rates turn up again; and, it will enhance our industry's ability to finance new


In conclusion, the savings bank industry greatly appreciates the efforts of Senators Danforth, Tsongas and others to address the present tax obstacle to mortgage prepayment plans. We applaud the initiative of the Subcommittee in calling this hearing, and we strongly support the prompt enactment of legislation such as S. 1147.

Senator DANFORTH. Let me see if we can just spell out for the record what this transaction is and why it has existed. The typical person has a house with a $24,000 mortgage, and that mortgage has an interest rate of 72 percent. Is that the typical case?

Mr. CRAMER. That is right.

Senator DANFORTH. The financial institution says that if the individual will pay off the mortgage, if they would pay it off at $18,000, that is the end of it. Is that what happens?

Mr. CRAMER. Correct.

Senator DANFORTH. Now then as far as the financial institutions are concerned-I don't know who wants to answer the question— but why would a savings and loan, or a savings bank, want to do that? Why would you want to receive $18,000 on a $24,000 debt?

Mr. WILLOUGHBY. In the hope that the reinvestment of that $18,000 would recover the $6,000 discount. In other words, we could put it to work at current rates, and those rates would be sufficiently higher to recover the loss over a relatively short period of time, and in the meantime put us into a black earnings position.

Senator DANFORTH. So what has happened to the savings and loans and the savings banks in recent years is that they were caught in the squeeze. They had portfolios of mortgages which paid low interest; that they, in turn, had to pay high rates for their money, and they were losing on that transaction. The idea is to be able to get rid of these low interest rate mortgages in order to provide a more profitable portfolio. Is that the nub of it?

Mr. WILLOUGHBY. Yes, sir.

Mr. PITT. That is essentially it, yes, sir.

Senator DANFORTH. So given that desire to get rid of those low interest paying mortgages, a program was put into effect, Mr. Cramer, that your organization was arranging and promoting to provide for just this kind of repayment. Is that right?

Mr. CRAMER. That is correct. Our program itself is one for lenders who don't want to mount the marketing campaign and don't have the staff available to do all the follow up with the borrowers. But this type of promotion, of getting borrowers to pay off loans at discounts, is something that our company has done and lenders on their own have done, commercial banks, savings and loans, savings banks.

Senator DANFORTH. When did this occur? Is this a fairly recent development?

Mr. CRAMER. I think discounting, per se, to the borrowers is not something new. In the past it used to be in vogue during periods of high interest rates. In the mid-seventies, lenders went back to their borrowers with the 5-percent mortgages and offered them discounts to prepay.

Mr. WILLOUGHBY. It is a very difficult thing for most borrowers, most laymen, to understand, Senator. And one of the advantages of David's company's campaign was that it makes it more comprehensible, and it is more effectively marketed.

Senator DANFORTH. It has occurred in the past, you say.

'Mr. CRAMER. Right.

Senator DANFORTH. But at a time when the S&Ls were in such difficult straights, wasn't there a renewed campaign or a new effort to try to do this?

Mr. CRAMER. I think, very clearly, in the last several years, in 1981 and 1982, discounting is something that the industry as a whole embraced, just because the outflow of funds into the mutual money market funds was so severe, that as the rates went up, the lenders had to look to the mortgages for the first time as a real source of generating funds. They saw that while one alternative existed to sell these loans off into an established secondary market, which Wall Street and other lenders, and pension funds really run, one would be able to go to a borrower and offer a slightly lower discount than the secondary market would take.

Senator DANFORTH. So you were involved in trying to encourage this discounting of mortgages. At the time that this was begun and the promotion started, was it believed that the amount of the discount was taxable?

Mr. CRAMER. We found ourselves in a curious position with borrowers. We maintained from the beginning-and I think it is almost 3 years ago that our first promotions went out to borrowers-that the discount was taxable. We also found that we were getting into sticky legal grounds if we said to the borrower, that as a matter of fact, this is taxable. So we always included a caveat and said to make sure you check with your own counsel. Very often we would get into these almost heated arguments with borrowers, who would then come back and say, well, my accountant doesn't think it is taxable. We would say, well then believe your accountant. I did it myself where I called the 800 number at the IRS to say "Is this amount taxable?" A couple of days later a clerk called me back and said, "No, it's not taxable." I got into the same argument with the clerk at the IRS. So at least when that ruling did come out in late 1982, it helped our phone people to at least get off the phone and say, "Look, here is chapter and verse of where the ruling is."

Senator DANFORTH. What was the effect of that ruling on the practice?

Mr. CRAMER. It did not really change our results, because we had been disclosing the tax liability from the beginning. It did generate a large number of telephone calls from borrowers who had probably not taken advantage of the program anyway. There were articles all over the country. We found that our clients-and maybe Keith Willoughby can speak to that better-did receive a lot of phone calls from borrowers.

Senator DANFORTH. Other than phone calls though, was there an effect on the practice as far as you are concerned?

Mr. PITT. Mr. Chairman, I think that it did have an effect. I cannot speak for the industry, but, in general, I think that just as many institutions tried their own in-house programs. They have tried the PUMPS program and other such similar programs. But I can speak from my own personal viewpoint as to the experience we had. We offered an in-house discount program that we were meeting with some fair success with until such time as we got word of the proposed Revenue Ruling coming down that was going to provide that it was going to be taxable, at which time our results began to drop off substantially when it was a fact accomplished that it would be a taxable income to them. We were meeting with

fairly good success prior to that time in getting people to take the discount with the idea that it was perhaps not going to be taxable. Senator DANFORTH. Did you have the same experience, Mr. Willoughby?

Mr. WILLOUGHBY. We did make it as clear as we could to people that we felt that it was taxable. We had our own accountants look at it, and they said it was.

Senator DANFORTH. Did that dampen enthusiasm?

Mr. WILLOUGHBY. Unquestionably. It also made it necessary for us to offer a considerably higher rate. As I said, we were offering an effective rate of 13 percent, which made it very close to break even for us.

Senator DANFORTH. Right. It does seem to me to be an unusual tax policy in a country which we had thought was attempting to encourage savings, and which has a low rate of savings, with an Internal Revenue Code that tends to reward borrowing and encourage saving; to have a policy where somebody wants to pay off a debt, they have to pay Uncle Sam a premium in order to do so.

Mr. PITT. Mr. Chairman, we think that the public policy is already there for this purpose in the case of extinguishing a debt. We think it is just a logical extension to carry it forward in this area, which is so vital to the well-being and the welfare of this country, that being housing and homeownership.

Senator DANFORTH. Yes. Thank you all very much for your testimony. The hearing is adjourned.

[By direction of the chairman the following communications were made a part of the hearing record:]

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We are writing with respect to Senate bills which were the subject of a Senate Finance Taxation SubCommittee hearing on May 27, 1983.

We respectfully submit the attached memorandum which describes in detail our comments concerning certain aspects of Senate bills S.738, S.1194 and S.1195 and request that these comments be included in the record of the hearing.

In general, we believe that the proposed legislation contained in all three bills is appropriate and will be beneficial in encouraging research and technological education and will help the United States to enhance its position as a world leader in technological developments. However, in a few limited instances, we believe that certain provisions of the bills may not thoroughly carryout their expressed intent. In addition, we believe there are a few structural errors in one of the bills.

We appreciate your considerations of these comments and would be pleased to answer any questions you may have with respect to the specific items discussed in the enclosed memorandum or the bills in general.

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