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Chapter 3 Money and Financing I. Money A. Money Defined Money is a medium of exchange and a convenient way to measure and store value MONEY is manufactured under the control of the Treasury Department, but the Federal Reserve System controls its distribution Inflationary Economy Deflationary Economy Neither our “dollar” nor Europe’s “euro” are backed by assets, so they are called FIAT MONEY B. History of Money Prior to the acceptance of the idea that metal or paper could represent value, all commerce was based on trade Early paper money could be redeemed in precious metals by the issuer In the 1930’s, the need for government spending to fight the depression caused the country to stop tying our currency to gold C. Forgery Fake money, or FORGERY, has been a problem, but it’s believed that currently less than 1% of currency in circulation is bogus According to the Secret Service, 64% of the forged U.S. dollars are produced abroad Of great concern to the Treasury Department is the rapid improvement in the quality of photocopying D. Noncash Transfers Most large purchases or payments do not involve greenbacks being passed from hand to hand CHECKS are demand deposits that must be paid by the depositor’s bank to the payee upon presentation if the bank is holding sufficient funds of the depositor ELECTRONIC TRANSFERS coupled with checks and credit cards, are leading us to an almost cashless society E. Velocity of Money The VELOCITY OF MONEY is the number of times money changes hands, on average, to purchase newly produced goods or services during a period of time throughout the entire economy F. U.S. Dollars Abroad In December 2009, the Federal Reserve estimated that there was $829 billion in U.S. currency in circulation They believe that 60% of our currency is being held abroad 11 small countries, including Ecuador, El Salvador, and Panama, use the U.S. dollar as their currency U.S. dollars sent by workers abroad are a major factor in the economy of many countries G. Money Saved or Spent We have long regarded saving as a virtue If everyone suddenly increased their savings by a substantial amount, it would decrease spending, decrease the GDP in the short-term, and increase unemployment The long-term effect of increased savings would be beneficial because there would be more funds available for investment H. Money and Price Economist Milton Friedman concluded that a stable economy requires that the money supply be increased steadily in relationship to our ability to produce He believed that our economy has the ability to expand 3% - 5% annually MONETARISM is the economic school of thought which holds that the entire economy can be controlled by increasing or decreasing the supply of money II. The Federal Reserve System (Fed) Our Independent Central Bank Fed The FEDERAL RESERVE SYSTEM is our central bank, which is administered by an independent governing board The job of the Fed is to control the supply of money and credit so that the economy grows steadily at its optimum rate without causing either high inflation or high unemployment The Fed is kept as independent of politics as possible, so that its actions will not depend on the administration in office A. Interest Rates Interest rates strongly affect the demand for money The DISCOUNT RATE is the rate of interest at which member banks borrow from the Federal Reserve Bank Historically, the real estate housing market is “interest rate sensitive.” B. Reserve Requirements RESERVE REQUIREMENTS are the percentage of deposit funds that a bank must keep and not lend out C. Open Market Operations OPEN MARKET OPERATIONS consist of the buying and selling of government securities by the Federal Reserve’s Open Market Committee It puts money into or takes money out of circulation D. Expansionary Monetary Policy An “expansionary monetary policy” of the Federal Reserve: 1. 2. 3. reduces the federal reserve discount rate, reduces reserve requirements, and/or buys government bonds E. Contractionary Monetary Policy A “contractionary monetary policy” of the Federal Reserve: 1.increases the discount rate, 2.increases reserve requirements, 3.sells government bonds III. Fiscal Policy Federal Taxing and Spending Fiscal Policy The Federal Reserve’s job of controlling monetary policy includes smoothing out the fiscal policy of the Federal government The government’s fiscal policy can be either expansionary or contractionary for our economy A. Expansionary & Contractionary Fiscal Policies An EXPANSIONARY FISCAL POLICY increases government spending and/or decreases taxes Increases the income available to consumers A CONTRACTIONARY FISCAL POLICY decreases government spending and/or increases taxes Reduces the income that consumers can spend B. The Federal Budget Deficit When Congress and the President spend more money than is collected in income taxes; this produces a “deficit.” When the government spends more than it receives, the money must come from somewhere. It comes from government borrowing. By borrowing money, the government takes away capital that would otherwise be available to the private sector. Government agencies do not have incentives to cut expenditures or produce more work for the money allocated to them IV. Balance of Trade Imports Equals Exports Imports Equals Exports FREE TRADE is the concept that trade between countries should be free of restrictions, tariffs, and quotas so that the people of each country benefit economically from it as much as possible Principle of Comparative Advantage Positive Balance of Trade Negative Balance of Trade A. Exchange Rates EXCHANGE RATES refer to the value of one country’s currency compared to another’s A low-valued dollar encourages exports, whereas a high-valued dollar encourages imports B. Foreign Investments in U.S. Real Estate A 2008 survey by FIFIRE concluded that the U.S. is regarded as the most stable and secure contry for real estate investors This belief, coupled with a weak dollar, depressed the U.S. real estate values and the decline in worldwide stock markets brought many foreign investors to America C. The Stock Market and the Real Estate Market The relationship between the stock market values and real estate values stems largely from consumer confidence. The bear market starting in 2008 exacerbated a real estate market already in dire straits A return to a bull market will serve as a force for recovery of the real estate marketplace V. The Federal Government and Financing A. National Housing Act of 1934 This National Housing Act of 1934 established the Federal Housing Administration (FHA) The FHA is operated by the Department of Housing and Urban Development (HUD) and administers the federal loan program which insures mortgages, reducing lender’s risks and making them willing to give longer term residential loans at lower rates. B. VA Loans The GI Bill of Rights established government guaranteed loans for veterans The DEPARTMENT OF VETERAN AFFAIRS (VA) administers loans C. Federal National Mortgage Association (Fannie Mae) FNMA is a federally sponsored, privately owned corporation that buys FHA, VA, and conventional mortgages or trust deeds from lenders in order to supply new funds to mortgage companies and banks D. Freddie Mac – Federal Home Loan Mortgage Corporation FHLMC buys mortgages and generally resells them as mortgage securities Conforming Loans Nonconforming Loans Fannie Mae and Freddie Mac establish loan standards for most real estate loans in America E. Ginnie Mae – Government National Mortgage Association GNMA is a government corporation and an agency of HUD that guarantees assistance loans where other financing is not available VI. The Secondary Mortgage Market Secondary Mortgage Market The Secondary Mortgage Market is a marketplace that allows lenders to sell their loans to obtain cash to make new loans Credit deficit areas benefit from the secondary mortgage market, bringing in investment capital from other areas of the nation and even from other countries A. Mortgage Warehousing Mortgage bankers will accumulate inventories of loans that they will sell, in packages, to other lending investment institutions Because mortgage originators need more capital, they will borrow on their loan inventory which is called MORTGAGE WAREHOUSING B. Foreign Investment in Mortgage-Backed Securities European and Asian investment in mortgageserved to help the booming real estate market An estimated 80% of the current $2.8 trillion in mortgages is expected to end up as mortgagebacked securities VII. Credit Credit Credit is essential to our present American economy It would be impractical for people to postpone large purchases, such as real property, until they save enough cash During recessionary periods: Lenders tend to be in a more liquid position Businesses reduce inventory and capital expenditures In an expansionary period: Lenders have less liquidity because of the higher demand for credit to expand inventories A. Interest INTEREST is the rental charge for the use of money Interest is expressed as a percentage of the money being used ANNUAL PERCENTAGE RATE (APR) is the effective interest rate that includes all loan charges A COMPENSATING BALANCE is a deposit that must be kept with the lender as a condition of making the loan B. Points Lenders charge “points” on a loan to lower the interest rate One POINT is 1 percent of the loan amount Lenders consider each point to be the equivalent of 1/8 percent interest Points are really prepaid interest, in the form of more money down on a loan C. Interest Barrier When the demand for loan funds exceeds the funds available, a credit crunch occurs The demand for funds cause interest rates to rise, bringing more investment funds into the market Housing is one of the first areas to feel the effects of tight money An INTEREST BARRIER may exist if borrowers will NOT pay more than say 10% for a housing loan D. Effects of High Interest Rates on Relocation Owners who have low fixed rate loans do not like to give up bargain rates in favor of new loans at market rates Owners are more likely to stay put rather than move up to a larger house or relocate to a smaller one if their current loan is at a low rate VIII. Loan Funds Source of Loan Funds New development and real estate purchases depend on a flow of funds Sources of funds for real estate financing comes from either private or business deposits in financial institutions Life Insurance Companies Savings Banks Commercial Banks Pension Funds Investment Banks A. Real Estate Investment Trusts (REITs) These popular publicly owned trusts avoid the double taxation of corporations They must invest in real estate or real property securities REITs are seldom loan originators They generally buy their loans on the secondary mortgage market B. Mortgage Brokers and Mortgage Bankers MORTGAGE BROKERS arrange loans between borrowers and lenders Mortgage brokers do not make loans, they are the middle person who bring lenders and borrowers together MORTGAGE BANKERS use their own funds to make loans, which they then sell to lenders C. The Role of the Internet in Loan Origination The Internet can cut the processing time for the average loan down from over one month to just a few days Exposed to many lenders on the Internet, borrowers can become informed as to which lender is offering the loan that best meets their needs D. Competition for Savings There is competition for savings among banks, savings banks, insurance companies, brokerage firms, etc. The government also competes for savings by offering Treasury CDs, notes and bonds E. Intermediation and Disintermediation INTERMEDIATION is the depositing of funds into savings institutions The rapid withdrawal of funds from savings institutions is known as DISINTERMEDIATION F. Assumability of Loans Due on Sale Clauses prohibit most loan assumptions DUE-ON-SALE CLAUSES state that the entire loan balance becomes due and payable when the property is sold, assigned, or transferred IX. Lender Crisis Lender Crisis Lenders never anticipated the inflation and high interest rates of the late 1970’s After the savings and loan and bank failures, lenders adopted more conservative attitudes regarding lending policies including higher down payment requirements The RTC, Resolution Trust Corporation, was set up by the U.S. Treasury to bail out the failed savings and loan associations A. Problems of Low Down Payments When down payments are low, and the economy is in a recessionary period, loan defaults rise In the mid-2000’s, lenders were involved in a multitude of low down payment loan products This resulted in a high rate of foreclosures, huge losses in collateralized securities, and lender failure B. Private Mortgage Insurance PRIVATE MORTGAGE INSURANCE (PMI) is insurance charged by private companies to cover the top 20% of a loan amount if the buyer does not meet the lender’s 20% down payment requirement Private mortgage insurance allows people who can afford only a low down payment to own a home C. Loan-to-Value Ratio A lender’s LTV is the ratio of a loan amount to the value of a property, based on risk exposure The FEDERAL FINANCIAL INSTITUTIONS REFORM, RECOVERY, AND ENFORCEMENT ACT OF 1989 (FIRREA) – established requirements for licensing and certification of appraisers X. Other Forms of Loans and Financing A. Other Equity Loans Tax laws changes that have phased out the deductibility of interest on consumer loans have made home equity loans more attractive Homeowners are able to borrow against the built up equity in their home to obtain a loan Lenders making home equity loans demand good credit as well as a premium interest rate Interest on a home equity loan up to $100,000 is deductible, providing the total home loan does NOT exceed the home’s fair market value B. Creative Financing CREATIVE FINANCING is simply seller financing In times of high interest rates, there is a greater interest in creative financing A WRAPAROUND LOAN is a new loan written for the amount of the existing loan, together with the seller’s carry-back financing. Money ◦ ◦ ◦ ◦ ◦ ◦ Interest rates Reserve Requirements Open Market Operations Expansionary Monetary Policy Contractionary Monetary Policy Fiscal Policy ◦ Deficit Balance of Trade ◦ Exchange Rates ◦ Foreign Investments ◦ Stock Market & Real Estate Market Federal Gov’t and Financing ◦ ◦ ◦ ◦ ◦ FED ◦ ◦ ◦ ◦ ◦ Forgery Noncash Transfers Velocity of Money U.S. Dollars Abroad Savings Money & Price National Housing VA Loans Fannie Mae Freddie Mac Ginnie Mae Secondary Mortgage Market ◦ Mortgage warehousing ◦ Foreign Investment in Mortgage-Backed Securities Credit ◦ ◦ ◦ ◦ Interest Points Interest Barrier Effect of High Interest Rates on Relocation Loan Funds ◦ ◦ ◦ ◦ ◦ ◦ REITs Mortgage Brokers/Bankers Role of Internet on Loan Origination Competition for Savings Intermediation and Disintermediation Assumability of Loans Lender Crisis ◦ Problems of Low Down Payments ◦ Private Mortgage Insurance ◦ Loan-to-Value Ratio Other Forms of Loans and Financing ◦ Other Equity Loans ◦ Creative Financing