3 LEARNING OBJECTIVES At the conclusion of this chapter, students will be able to: Understand the development of the monetary system in the United States. Explain the importance of the Federal Reserve Bank, including its role in establishing monetary policy within the monetary system of the United States. Understand the general workings of the U.S. Treasury and the economic effects of borrowing by the government versus those of other sectors of credit users. Describe the interest rates in several sectors of the investment marketplace. Define usury and explain how it has been regulated over time.
4 Introduction The system of barter does not always work very well. No commodity is more widely used and less understood than money. Precious metals, gems, furs, and spices have been used as money. Modern money is supported by the intangible qualities of trust and confidence. In the early years of this country’s growth the control of money was considered a right belonging to each state. It was not until the Civil War that the federal government actually took over the issuance and control of currency.
5 Federal Reserve Bank System Federal control over the nation’s money supply was established by the creation of the Fed in 1913 which acts as the nation’s central bank. Seven governors (including a chair) are appointed by the U.S. president Members serve terms of 14 years, thus shielding them from politics. The chair serves a four-year term not concurrent with the president. The chair has the authority to influence the selection of the 12 Federal Reserve District presidents adds to the power of that office. The chair also influences the selection of which of the five out of 12 district presidents will sit on the powerful Open Market Committee. The Fed oversees the T-i-L, ECOA and other national credit policies. The Fed’s monetary policies most influence the cost and availability of mortgage money.
6 Resource – The Federal Reserve www.federalreserve.gov
7 Monetary Policies 1. Controlling the amount of money in circulation (the money supply). 2. Adjusting the amount of funds available within the commercial banking network through its “open market operations”. 3. Signaling interest rate movements through changes in its discount rate or in the federal funds rate. 4. Setting cash reserve requirements for depository institutions. The Fed uses four basic tools to influence the economy through the nation’s monetary system, as follows.
8 Money Supply The difficult task faced by the Fed is to create a balance so that growth in the nation’s money supply is commensurate with growth in its population and productivity. Too much money in circulation can cause destructive inflation, and too little can create damaging recessions. But true measures of the amount of money in this country are difficult to determine, which in turn makes sound decisions difficult. The size of our total money supply and the enormous economy it serves make the problem appear almost beyond comprehension. We will use a simple example. Remember that the value of money is represented by the amount of goods and services that it can buy.
9 EXAMPLE If we have 10,000 units of goods and money available to purchase these products totaling $1 million, each unit of goods is worth $100. We could increasing productivity and produce more goods. Assume that the growth has created 20,000 units of goods and services for sale but no increase has been made in the available money. With twice as much to buy for the same amount of money, the price of each unit of goods and services would drop to $50. If the money supply was increased to $3 million, then each unit would be worth $150. With so much more money available the dollar becomes less valuable. A careful balance must be maintained between the nation’s money supply and increases in productivity.
10 Definition of Money Money consists of those assets that have immediate purchasing power. In this definition, bank deposits are a key factor. A problem arises in that recent banking regs have altered the way bank accounts can be used. The line between time deposits and demand deposits is no longer clear. One challenge is the declining role of commercial banks. Mutual fund assets now exceed the total money in the banking system. Thus decisions on money supply must be made using only a partial measure of the total market. The Fed considers “money supply” to be currency in circulation plus both demand and time deposits within the banking system.
11 www.moneyfactory.gov More than half of all U.S. currency is printed in Fort Worth!
12 M1 Currency in circulation, nonbank travelers’ checks, demand deposits in commercial banks, and other checkable deposits at commercial banks and thrift institutions including credit union share drafts accounts. M2 The total of M1 plus savings and small-denomination time deposits at all commercial banks and thrift institutions, retail money funds, and institutional money funds. M3 The total of M2 plus large-denomination ($100,000 and over) time deposits at all depository institutions, term Eurodollars held by U.S. residents at foreign and U.S. banks, term repurchase agreements at commercial banks and savings associations, and balances of institutional money market mutual funds. MZM The total of M3 plus other liquid assets such as all other money market funds that can be redeemable at par on demand. The Money Supply
13 Management of the Money Supply The amount of money available in the US is controlled by the Fed. It operates through a system of 12 districts (Texas is in the 11 th ). 8,800 commercial banks handle most of the cash transfers in the country. The Open Market Committee decides on whether or not to increase the money supply. To increase the supply of money, the Fed simply creates additional money and uses it to purchase U.S. Treasury securities on the open market. This authority to create money gives the Fed tremendous influence in financial markets. An influx of new money creates an increase in the money supply, which is expected to lower interest rates and thus give the economy a lift.
14 Open Market Operations The Fed has access to a large supply of both government bonds and cash, and can move these assets in and out of the banking system. If the Fed decides the economy needs slowing down, it can issue an order to sell some of the Fed’s supply of government bonds. These bonds are purchased by investors and the money to buy them is locked away in the Federal Reserve. The cash is no longer available for banks to use in making loans. If the Fed decides it is necessary to speed up the economy, it can buy government bonds, thus increasing the cash available to banks.
15 Discount Rate of Interest The rate charged by the Fed to depository institutions. The Fed’s most widely publicized means of economic influence. Yet in practice it is the least effective because it does not represent a cost of funds. This money cannot be used as a source of capital. It is to provide a cushion when unanticipated needs for cash arise. Thus the Fed’s discount rate of interest is more of a signal to the banking community than a true cost of funds. The prime rate of interest—the rate on which a bank bases its charges to borrowers, tends to move up or down with the discount rate.
16 The Fed Funds Rate More recently the Fed has been acting to change the federal funds rate rather than to change the discount rate of interest. While any such change is widely reported in the media as an increase, or decrease, in interest rates, it is not a mandatory change. The federal funds rate is a constantly changing rate, different in all parts of the country. It is what banks charge each other for short-term loans that enable a bank to meet its liquidity requirements under federal rules. Thus it has picked up the name of “federal funds rate.” Between banks, it is a negotiated rate.
17 Reserve Requirements The Fed controls the reserves that must be set aside by all federally insured depository institutions. These institutions must maintain certain cash reserves on deposit with the Fed, reserves that pay no interest. This practice allows the banking system to borrow its own noninterest- bearing deposits from the Fed at the discount rate of interest. The Federal Reserve can be a very profitable operation for the government. The reserve requirement in place as of December 31, 2010, for those defined financial depository institutions was 10 percent for liabilities in excess of $58.8 million, 3 percent for those liabilities from $10.7 million to $58.8 million, and 0 percent on the balance below $10.7 million.
18 The United States Treasury Responsible for raising the cash to pay the government’s bills. The money to pay the government’s obligations comes from three sources: tax revenues, borrowed funds, and printing money. If the government lives within its income, tax revenues are sufficient. When it spends more than it raises in taxes, the additional money must either be borrowed or printed. This crucial decision (borrow or print) rests primarily with the Treasury. Printing money requires consent of the Fed’s Board of Governors. Treasury borrowing is accomplished through periodic sales of government bonds, notes, and bills to the general public. The only limit is the national debt ceiling established by Congress.
19 Resource – The United States Treasury www.treasury.gov
20 Interest Rates Interest is the cost of using another’s money, and that cost reflects supply and demand factors similar to the way commodity prices do except that demand does not always respond to a change in price.
21 Implications for the Real Estate Market Imagine someone desiring to buy a home priced at $200,000. The buyer will make a 20% down payment and borrow $160,000. If the interest rate is 6%, her monthly payment will be $959.28 and her monthly income required to qualify for the loan will be $7,118.47. If the interest rate goes to 7% she will need to have a monthly income of $7,410.70. If interest rates climb to 8%, an increase in income to $7,714.97 will be required, the equivalent of a raise of almost $600 per month. For a 90% LTV loan, the variations are even more dramatic. The monthly income requirement at 6% would be $8,706.30 while at 8% it would be $9,511.59, a difference of over $800 per month.
23 Source – The Real Estate Center Resource – The Real Estate Center – www.recenter.tamu.edu
24 Supply of Money Thirty years ago, dependence on savings accounts as a source of mortgage money caused periodic shortages in the availability of funds. These shortages were caused when savings were withdrawn from depository institutions and placed in higher yielding investments. As real estate financing shifted to the use of mortgage-backed securities, the capacity to tap huge financial markets for funds accelerated, bringing ample cash into the mortgage market. Just prior to the recent Financial Crisis it seemed that a shortage of mortgage money had become a thing of the past. Now the supply of money derives from a much broader base of sources including pension funds, money market funds, and mutual funds, all in addition to savings deposits in the banking system.
25 Demand for Credit The demand for credit comes from four categories of borrowers. 1. Government 2. Corporate 3. Mortgage 4. Consumer
26 Monetary Policies of the Federal Reserve A substantial influence on interest rates is the ability of the Fed to increase the money available in this country at any time.
27 Fiscal Policies of the United States Government The way in which the federal government handles its tax and spending policies is called its fiscal policies. Fiscal policies represent a key factor in the competitive markets that control interest rates. If Congress and the president decide to spend more than the available income (tax revenues), the difference must be made up by either borrowing or printing money. Thus forcing the Treasury and the Fed to act almost regardless of the effect on interest rates.
28 Interest Rate Indicators There are a number of different interest rates published daily in leading business magazines and newspapers. All of these give good clues as to the direction in which money costs are moving. Following are four rates that represent important interest rate indicators for the real estate mortgage business.
29 Treasury Bill Rate The cost of short-term borrowing by the federal government is set each week at the auctions of three and six-month Treasury bills. T-bills are sold in minimum denominations of $10,000, and can be purchased from banks or through authorized security dealers. The return on this type of investment is expressed not as an interest rate but as a yield because it is determined by the difference between the purchase price and the face value of the bill. The auctions provide an accurate indication of current short-term rates and the trend, up or down, gives a clue to the future.
30 Prime Rate Defined as the interest rate charged by a commercial bank to its most creditworthy customers. Each bank sets its prime rate by any method it chooses, as the rate is not regulated. Today the prime rate is used more as a base upon which to float an interest rate for many kinds of loans than an actual lending rate. For example, a construction loan may be quoted at two points over prime; if the prime rate is 3.25%, the construction loan will be 5.25%.
31 Fannie Mae/Freddie Mac–Administered Yield Requirements During the early 1980s both Fannie Mae and Freddie Mac phased out their frequent auctions for loan commitments to their sellers/servicers. The auctions have been replaced by daily access to these secondary- market purchasers by seller/servicers through indicative pricing processes. Fannie Mae developed new technology called eCommittingONE™, an easy- to-use Web-based application that provides automated pricing information and best efforts committing processes. Fannie Mae posts a historically required net yield by day online on all currently offered loan products.
32 U.S. Treasury Security Rates Shorter-term (one- to five-year) Treasury rates have become more important as an indicator of mortgage rates. Not only do they accurately reflect the shorter-term money market rates that affect mortgage money, but they are also being used as a major index for setting ARM loan interest rates. Because the market for Treasuries is constantly changing to reflect the money markets, the rates reported are usually averages of daily rates for weekly or monthly time periods. All financial publications carry information on U.S. Treasury yields and the Fed now offers a weekly release covering selected interest rates.
33 London Interbank Offered Rate The LIBOR is based on the rates at which banks borrow unsecured funds from other banks in the London wholesale money market. LIBOR rates are a favorite referenced rate ARMs. LIBOR helped trigger problems with many ARM products during the subprime loan crisis. LIBOR rates remained higher than rates based on Treasury bills, Treasury notes, and the Eleventh District Monthly Weighted Average Cost of Funds Index (COFI) from 2004 to 2009. Therefore ARM products based on LIBOR caused higher mortgage delinquencies as borrowers struggled with higher payments.
34 Usury State laws limiting the amount of interest on different kinds of loans. Interest rates remained generally below the various state limits, and there was little concern for this particular restriction. But as interest rates continued to climb usury limits began to surface and restricted mortgage lending in some states. States with higher interest limits were able to attract the big investors. Many states were excluded from the market by restrictive usury laws. Congress preempted state usury limits for first-mortgage residential loans as of March 31, 1980. The growth of lending across state lines coupled with the big national markets for loans has made restrictive usury laws counterproductive.
35 Questions for Discussion 1. Outline the monetary system used in this country. 2. How does the Federal Reserve increase the money supply? 3. How does the Treasury raise money when it has to borrow? 4. Explain the major factors that influence interest rates and describe the effects interest rate factors have on the residential mortgage market. 5. Explain the meaning of the terms fiscal policies and monetary policies. 6. Define discount rate of interest and prime rate. 7. Identify the four major areas of demand for money. 8. How does a change in interest rates affect business borrowing? 9. Discuss the effects of the new loan commitment software applications on residential mortgage lending. 10. Suggest ways to improve our banking system.