Download Real Estate Finance - Instructor`s Manual - Ch 02

Chapter 2 Money and Interest Rates
Learning Objectives
At the conclusion of this chapter, students will be able to:
1. Understand the development of the monetary system in the United States.
2. Explain the importance of the Federal Reserve Bank, including its role in establishing
monetary policy within the monetary system of the United States.
3. 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.
4. Describe the interest rates in several sectors of the investment marketplace.
5. Define usury and explain how it has been regulated over time.
I.
Introduction
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Knowledge of the monetary system helps a student understand the pressures that influence
mortgage rates. The influences are subtle and often misinterpreted in the media. The handling of
our monetary system by the Federal Reserve Bank has a powerful influence on all interest rates.
"Money" should be distinguished from "investment capital." The latter includes such assets as
buildings, land, commodities, and securities. Money is invested in these assets. It is the growth of
mortgage pools using investable money that has helped reduce mortgage interest rates and
sustains adequate funding of mortgage loans.
Money is a commodity that represents purchasing power. Its value depends on the
confidence people have in the issuing government. Monetary policy has developed over many
years, beginning under state control, shifting to federal control during the Civil War.
II.
Federal Reserve Bank System
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The Federal Reserve Bank, established in 1913, is the national bank with many responsibilities,
one of which is managing the money supply. The bank board has 7 governors with a chair-man,
all appointed by the president of the U. S. subject to confirmation by the senate. The system
functions through 12 district offices, each with its own president, 5 of whom sit with the board as
the Open Market Committee.
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The Board is responsible for many functions such as overseeing the Truth-in-Lending Act,
monitoring the Equal Credit Opportunity Act, and implementing other national credit policies,
but determining monetary policies is most important.
A.
Monetary Policies
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The Fed's authority to set monetary policies is implemented with four tools:
1.
2.
3.
4.
Controlling the money supply
Open market operations
Adjusting the discount rate
Setting bank's cash reserve requirements
B.
Money Supply
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Fed's target in handling the nation's money supply is to increase it commensurate with the
growth in population and productivity—if increase is at a greater rate, inflation ensues; if
at slower rate, a recession can be created.
C.
Definition of Money Page 17
The Fed uses a fairly limited definition which is those assets that have immediate
purchasing power. It is measured primarily by currency in circulation and deposits within
the banking system. Problems: (1) distinction between time deposits and demand deposits
no longer clear cut, (2) commercial banks are no longer the major keeper of money
assets, (3) substantial money assets are held in funds not under Fed supervision.
Fed identifies four categories of money in making its decisions. These measures are M- I,
M-2, M-3, and L.
D.
Management of Money Supply
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Amount of money available controlled by Fed. It works through approximately 4,500
commercial banks. Fed's Open Market Committee, comprising the 7 governors and 5 of
the 12 District presidents, makes the decisions. To increase money supply, the Fed simply
buys government securities from the Treasury department. In effect, the Fed has an openended bank account.
E.
Open Market Operations
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With a large reserve of both cash and government securities, the Fed can move these
assets in and out of the banking system, thus adjusting cash in the hands of banks.
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F. Discount Rate of Interest Page 20
Discount rate is the interest rate charged depository institutions that are eligible to borrow
from the Fed. Funds borrowed from the Fed are for short-term cash needs, not as a source
of capital. It is a cushion for the banking system. Thus, the discount rate does not
represent an operating cost of funds to the bank. It is a signal of rate movement.
G. Reserve Requirements
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Fourth tool that the Fed may use is to adjust reserve requirements for all federally insured
depository institutions. Reserves are held by the Fed in a noninterest bearing account to
serve as a cushion for the banking industry. It is these reserves that eligible institutions
may borrow at the discount rate of interest.
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.
III.
The United States Treasury Page 22
While the Fed is responsible for the amount of money in circulation, it is Treasury that pays the
government's bills. Treasury may have to upset the Fed's plans to make ends meet. There are
only three sources of funds to do this: 1) tax revenues, 2) borrowed money, and Sprinting new
money. If taxes are insufficient, Treasury must either borrow or ask the Fed to increase the
money supply through purchasing additional government securities. The decision to increase the
money supply (monetize the debt) is made by the Fed, not by Treasury.
Economic results: Treasury borrowing competes with other demands for credit and can increase
interest rates. Increasing the money supply above the increase in productivity debases the
currency.
IV.
Interest Rates Page 23
Interest rates in a free economy are set by competitive market forces, but not limited to only
supply and demand as are commodity prices. Government manipulation of the market has a short
term impact on rates. The key influences:
A.
Supply of Money
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No longer a serious problem with mortgage money. The shift from savings deposits to the
financial market for funds has brought an adequate supply.
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B.
Demand for Credit Page 24
Four major categories of demand: (1) government, (2) corporate, (3) mortgage loans, and
(4) consumer loans. Each needs roughly one quarter of available credit. Government can
crowd all others out of the market if necessary as there are no legal limits on what the
government may pay for funds.
C.
Monetary Policies of the Fed
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An increase in money supply causes a drop in interest rates.
D.
Fiscal Policies of the Government Page 25
Spending beyond tax revenues places an increased demand on both the credit markets
and the need for more money.
E.
Interest Rate Indicators
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Clues to the direction mortgage money costs are moving can be found in all the following
indicators:
F.
Treasury Bill Rate
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Auctions of Treasury securities give a frequent indication of rate movement.
G.
Prime Rate
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The interest rate charged by commercial banks is set by each bank—it is not a regulated
rate but tends to follow the lead of major New York banks.
H.
FNMA/FHLMC Administered Yields
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As major purchasers of mortgage loans, both federal agencies are constantly in the
market and set their own yield requirements at which they will purchase loans. It is a
guide to much of the industry.
The system Fannie Mae calls eCommitONE™ was developed to allow approved
conventional mortgage lenders to submit their loan packages through and easy to use
software application.
I.
U. S. Treasury Security Rates
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Important to the mortgage industry as treasury rates have become a widely used index
applied to limit the periodic adjustments on adjustable rate loans.
J.
London Interbank Offered Rate
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More commonly referred to as LIBOR, it is a daily reference rate based on the interest
rates at which banks borrow unsecured funds from other banks in the London wholesale
money market (or interbank lending market). LIBOR rates are a favorite referenced rate
for adjustable rate mortgages.
V.
Usury
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State law that limits interest rates that can be charged on various classes of loans. No longer of
critical importance in the mortgage industry: (1) usury ceilings are generally well above
mortgage rates, and (2) Congress preempted usury limits for first mortgage residential loans in
1980.
Historical significance of usury has a religious basis. Early Christians and some Moslem faiths
today consider earning money by other than the product of one's labor to be sinful.
Because usury laws vary in the different states, it is suggested that you research your state laws
and report this information to the students.
Suggested Classroom Exercises:
Exercise 1: To help reinforce how the Federal Reserve Bank uses Monetary Policies describe
the four basic tools the Federal Reserve Bank Board uses to influence the economy by:
Money Supply
The most important tool available to the Fed is control of the supply of money. The difficult task
is to increase the money supply at close to the same rate as the growth of the economy. Too
much money in circulation can cause destructive inflation. Too little money can cause damaging
depressions. Think of the fixed about of money only could exist say $1,000,000,000 (a billion)
and the total output of milk or wheat had increased to meet the demands of a growing population,
then the price per unit of the increased production would have to go down for the billion to be
used to pay for them thus depressing prices. On the other hand if you were to double the amount
of money in circulation to $2 billion the possibility of inflation of price then can become an
issue.
Because of the changing nature of how money is held, the balance is harder to meet. Today,
brokerage firms, investment bankers, life insurance companies and foreign accounts provide
consumers with some of the services previously handled mostly by banks.
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Open Market Operations
Since the Fed has a large supply of both government bonds and cash in its possession, the Fed
can move either of the two in or out of the banking system. If they want to an input of cash
(created by the Fed purchasing bonds) has the effect of giving the banks more money to loan.
Withdrawal of cash (through the sale of bonds) tightens the bank's ability to loan and causes
some restriction on the economy to grow.
Discount Rate of Interest
This is the rate the Fed charges its member depository institutions eligible to borrow from it. The
loans are for short term use to meet sudden demands by the bank's customers and must be fully
collateralized.
Reserve Requirements
The Fed controls the amount a bank must set aside as a reserve and place it on deposit with the
Fed at no interest. The requirement is not changed very often. An increase in reserve reduces the
loanable funds in the banking system.
Exercise 2 - More fully describe the Influences on Interest Rates that include:
1.
2.
3.
SUPPLY OF MONEY
A.
Secondary Market Funding
B.
Local Market Conditions
DEMAND FOR MONEY
A.
Business Borrowing
B.
Consumer and Personal Borrowing
C.
Government Financing
D.
Mortgage Loans
MONETARY POLICY
A.
Policies Of The Federal Reserve Bank – if time allows go onto the web to this
site: http://www.econlib.org/library/Enc/MonetaryPolicy.html and lead the class through a
discussion after allowing them to read the first 4 short paragraphs.
4.
FISCAL POLICY
A.
Taxing and Spending Policies as Determined by Congress and the President
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Multiple Choice Questions
1. Monetary policies in this country are under the control of the
A. Office of Thrift Supervision
B. Secretary of the Treasury
C. Federal Reserve Bank Board
D. Federal Deposit Insurance Corporation
2. Which of the following is most likely to result from a substantial increase in the money
supply?
A. A lowering of inflation
B. A reduction of interest rates
C. An increase in interest rates
D. An increase in the value of a dollar
3. When the Federal Reserve buys or sells government securities in the financial markets, it is
called
A. Juggling the credit markets
B. Cycling the discount rate
C. Discounting the market rates
D. Open market operations
4. One of the tools used by the Federal Reserve to influence the economy is
A. Changing the discount rate of interest
B. Limiting a bank’s authority to accept deposits
C. Changing the prime rate of interest
D. Encouraging competition with non-bank banks
5. The agency responsible for raising the money and paying federal government obligations is
the
A. Office of Management and Budget
B. U.S. Treasury
C. Federal Reserve Bank
D. Comptroller of Currency
6. The major source of money funding residential mortgage loans today is
A. Money market funds
B. Commercial bank time deposits
C. The federal government
D. The sale of mortgage backed securities
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7. The purpose of cash reserves as required by the FED are best described as
A. Cash placed on deposit with the FED at no interest as a cushion to meet emergency
requirements of member banks
B. Cash held off the market to controlled interest rates
C. A source of income for the fed
D. A better control over a bank’s lending policies
8. Categories of demand for money are all of the following EXCEPT
A. Government requirements
B. Consumer loans
C. Mortgage loans
D. Deposits in saving associations
9. Fiscal policies of the government can best be described as
A. Budgetary control measures
B. Management of the U.S. Treasury
C. Government taxing and spending policies
D. Policies that control the banking system
10. Of the following, which can be the best indicator of mortgage interest rates?
A. The discount rate of interest
B. Fannie Mae/Freddie Mac administered yield requirements
C. The results of weekly Treasury bill offerings
D. Reports made by the Farm Credit System
11. Usury can best be described as
A. Interest rates set by the federal government
B. Rates charged by unscrupulous lenders
C. Interest paid or received that exceeds state laws
D. Interest limitations based on religious beliefs
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Answer Key:
1. C
2. B
3. D
4. A
5. B
6. A
7. A
8. D
9. C
10. C
11. B
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Questions for Discussion
1.
Outline the monetary system used in this country.
Answer: The amount of money available in the United States is controlled by the Federal
Reserve Bank Board. It operates through a system of 12 districts, each with some
branch Federal Reserve Banks to facilitate local operations. The system works with
the approximately 8,800 commercial banks that handle most of the cash transfers
in the country. The Fed’s Open Market Committee, comprising seven governors
and five of the 12 Federal Reserve District presidents, meets each month. At these
meetings, the committee reviews monetary aggregates, examines the influence
of current interest rates, and considers the state of the economy. Then it makes a
decision on whether or not an increase in the available money supply is justified.
2.
How does the Federal Reserve increase the money supply?
Answer: 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.
3.
How does the Treasury raise money when it has to borrow?
Answer: Treasury borrowing is accomplished through periodic sales of government bonds, notes,
and bills to the general public at open auctions.
4.
Explain the major factors that influence interest rates and describe the effects
interest rate factors have on the residential mortgage market.
Answer: Supply of money, demand for credit, monetary policies, and fiscal policies
5.
Explain the meaning of the terms fiscal policies and monetary policies.
Answer: Fiscal policies are how the government handles taxation and spending and monetary
policies is how the government controls the money supply.
6.
Define discount rate of interest and prime rate.
Answer: Prime rate is the interest rate charged by a commercial bank to its most creditworthy
customers and discount rate is that rate charged by the Fed to depository institutions that are
eligible to borrow from it.
7.
Identify the four major areas of demand for money.
Answer: Government, corporate, mortgage loans, and consumer.
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8.
How does a change in interest rates affect business borrowing?
Answer: As rates increase businesses are less likely to expand or must pass the increased cost of
funds on to the consumer.
9.
Discuss the effects of the new loan commitment software applications on residential
mortgage lending.
Answer: It allows lenders to more speedily sell loans the Fannie Mae so that they may focus their
efforts in expanding their business and serving the consumer.
10.
Suggest ways to improve our banking system.
Answer: Make it more transparent to the consumer and stop the concentration of banking into a
few mega-banks. Encourage competition in the financial marketplace.
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