(Begin with Sect 22 – 00 Beginning Slide)
ECONOMICS - Before we can look at the availability of money in the financial market and its impact on interest rates, we have to look at the basics of economics within
America. Interest rates and the financial markets are influenced by several outside areas and it is important to understand how they work. With this section on economics we will look at basic concepts as well as how they affect the real estate industry and your client's purchasing practices.
President, Treasury Department, and Federal Reserve - Pretty much all of the economic text books state that the economic system is most affected by the President,
Treasury Department, and the Federal Reserve. In theory, they work together to achieve the economic goals of the government. The main areas of interest consist of the following:
1. Full Employment - To have a strong economy, America needs to have as many people working as possible. The more people that are working then the more money that is flowing into the economy.
2. Continued Economic Growth - With the expansion of the economy, more workers are needed to provide for the demand for goods. Steady growth on a constant basis is the safest means of economic growth.
3. Control Inflation Rate - With full employment and economic growth, the problem that is normally faced is the problem of inflation. Too much demand for too little goods causes the price of goods to go up = inflation. The main area of control is to slow down the economic growth and therefore, the demand.
4. Economy - The 8 years that Clinton and Greenspan worked together produced the strongest economy in the history of America. The amazing aspect was that we had full employment, economic growth, AND low inflation. Up until now we continued to have economic growth with low inflationary trends under George W. Bush. The immediate future, at the moment, is up in the air.
5. Interest Rate Tool - Whenever the economy began too expand too rapidly, the Federal
Reserve would increase interest rates and slow down credit buying. Presidents Clinton and W. Bush went along with the Federal Reserve and didn't work against its interests as some presidents have.
(On the next page put slides Sect 22 – 001 and 001A)
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The main controlling power the Federal Government has is the supply of money available for lending. If they slow down the money supply there is a demand for money; a shortage. If they cause an abundance of money to be available for lending, demand for funds slows down; an excess. Let's see how this works.
1. Interest Rates - The cost of obtaining money from the Treasury Department is affected by the borrowing demand of the public. With a shortage of money OR an excess of money comes the volatility of interest rates. a. Shortage - When the supply of money is reduced (tightened up), interest rates increase. The banks need the depositor's money in order to make loans and the way to gain more deposits (money) to pay higher interest on the deposits. b. Higher Interest - This causes the bank to charge higher interest rates for loans. c. Slow Down - People have to pay a higher amount of interest for the use of borrowed money. Therefore, some people decide not to borrow money. Now there is less money spent in the economy. This slows down the economy.
(On the next page put slides Sect 22 – 002 and 002A)
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If there is too much money available in the economy, the demand for additional borrowed funds slows down. The bank now has excess funds and doesn't have to entice depositors with an increased interest payout. Interest rates come down. Example : In the early
Reagan years the interest rates were up to 15%. By the time George Bush, Sr. became president, interest rates were down to 10%. During the Clinton era, interest rates went down to 6%. This was because of the good economy and a surplus of available money.
1. Surplus of Money in the Economy - Interest rates reduce, but people don't need to borrow as much money. The lower interest rates dissuades the public from putting money in the bank and earning low interest.
2. Interest Rates Fall - Low demand for loans cause interest rates to fall. If the banks have excess funds to loan, they will lower their interest rate to entice people to borrow.
(On the next page put slides Sect 22 – 003 and 003A)
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In order to have full employment and economic growth, the economy requires an adequate supply of money. Not enough money that would cause interest rates to increase which slows down the economy. This is why the stock market moves with the swings of interest rates.
(On the next page put slides Sect 22 – 004 and 004A)
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Inflation is when the price of goods and services increasing due to the fact that too much money is being spent in the economy. People don't save. They spend their money which creates demand for goods and services then the providers increase their pricing. This demand for goods and services creates the problem of INFLATION.
High Inflation Rate - When the public starts spending and there is a greater demand for goods, the faster prices will rise. Demand causes the following:
1. Expansion - Manufacturers have to increase their lines of production and expand.
These are additional costs which causes the manufacturer to increase the price of their goods.
2. Less Competition - When an increased demand for product occurs and if there is not enough competition, the manufacturers can safely increase the cost of their goods to gain greater profit.
Slowing Inflation - The main tool to slow down inflation is to increase interest rates. If interest rates go up, the public is less likely to borrow money and spend.
1. Less Money - If people don't borrow to make purchases, the inflationary trend will slow down. The last case of double-digit inflation was under Jimmy Carter. We had 13% inflation during his last year in office. The Federal Reserve raised interest rates up to 12% to slow down spending and, therefore, slow inflation.
2. Restrict Mortgages - The government attempts to restrict the amount of mortgage money. It might increase the requirements for people to qualify for real estate loans. This of course, would be bad for the real estate industry.
3. Raises Interest Rates - By raising interest rates the government would hope to reduce demand for new housing. This would slow down the economy. They measure this with what is called the "New Housing Index". This shows the requests for new housing starts; requests by builders to obtain building permits.
Cool Off Economy - These three areas are tools that the government can use to "Cool
Off" the economy; thus leading to a lower inflationary rate.
Investments and Inflation - Historically, the purchase of stocks as well as real estate has allowed investors to keep pace with inflation. There might be temporary setbacks from time-to-time, but overall this has been true.
(On the next page put slides Sect 22 – 005 and 005A)
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Too little spending by the public can also create problems for the economy as well. The following would occur with this economic development:
1. High Deflation - If the public doesn't spend money, then we have the opposite situation and this is called deflation. With decreased demand for consumer goods, the businesses have to decrease prices to entice the public to spend.
2. Eventually Leads to Recession - This is when businesses have to lower their costs and lay workers off; increased unemployment. Less people working causes less money to be spent in the economy. Which causes more lay offs, etc.
3. History - The last time we had this situation was when George Bush, Sr. was president. In the latter years of his presidency, the unemployment rate was rising at an alarming rate.
Correction of the Economy - The government would do the following to develop a slow economy:
1. Increased Money Supply - To get the public to start spending, the government attempts to increase the money supply. One of the main tools they can use is to increase the availability for mortgage money.
2. Lower Interest Rates - The Federal Reserve would work to lower interest rates. This encourages the public to buy on credit. This would encourage the public to buy real estate.
3. Not too Much - If the government does too much, it "heats up" the economy; with increased spending, this could lead to a higher rate of inflation.
(On the next page put slides Sect 22 – 006 and 006A)
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I think you can see that government intervention is necessary from time-to-time, but when should it be done?
How Much - How much intervention should be done?
No One Agrees - There is no single indicator to look at. There is no one person in charge. We are subject to multiple opinions by economists.
Politics - Unfortunately, the use of government control is also tied to political pressures, interest groups, etc.
1. How Much - How much do we increase/decrease the money supply?
2. Action - Generally it takes large action on the part of the government to have an effect on the economy. The Clinton era is one of the few times the government did not have to take drastic action at some point during that 8 year period.
3. How Much Suffering is Acceptable?
a. Unemployment - When the economy is too hot and we have inflation, how much unemployment is necessary to cool down the economy? b. Inflation - If the economy is in recession, how much do we "jump start" the business sector to get out of a recession? If it is too much, we have inflation that hurts fixed income retirees and low income families. c. Economy - Can the economy take care of itself? There are economists that claim that the economy can take care of itself.
Bigger Problem?
- The world is becoming smaller and smaller. We now have other outside influences that are beyond our control.
1. e.g. OPEC Oil - In the year 2006, we saw gas prices go up 100% in some areas of the country.
It topped out in 2008 at $120 a barrel. This caused greater transportation costs. Greater costs for electricity. Currently gas prices are soaring! Hefty diesel fuel price increases not only impact the trucking industry but businesses that must pass the freight costs to consumers. We all feel it in the pocketbook.
2. Japanese Autos - In the years 1999 and 2003, Americans increased their purchase of Japanese auto by 103%. Toyota, as an example, is bigger than Ford and Chrysler. The Japanese have invested in auto plants in the eastern part of America, but all autos sold west of the Mississippi have American money that left and didn't come back.
3. Foreign Investors vs. The National Debt - Another outside influence is the National Debt.
Currently it is over 10 Trillion Dollars. The government has to pay interest payments to those who have purchased U. S. debt issues such as Treasury Bills and Bonds. A lot of foreigners have purchased these issues. Especially China and the OPEC countries. What would happen if they all sold their U.S. government issues all at once? (On the next page put slides Sect 22 – 007 and
007A)
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The Open Market - If actions by the government cause more money to be invested, interest rates will come down. If actions by the government cause less money to be invested and spent, interest rates will go up. One of the main controlling factors regarding investing/saving is the use of interest rates.
Negotiable Interest - With conventional and private loans, the interest rate is negotiable between the borrower and lender. There are certain limits that are set by the current supply of and demand for mortgage money.
Knowledgeable Buyer - The real estate buyer of today is more knowledgeable than those in the past. The buyer will tend to shop around for the best deal regarding mortgage interest rates and points. You as a real estate agent can score points with your clients by knowing who is offering the best deal.
Internet - There are Internet services that can provide various quotes and information regarding mortgage contracts. They usually have quotes all across the country.
(On the next page put slides Sect 22 – 008 and 008A)
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The government can offer or not offer to recall government debt issues of treasury bills, bonds, and notes. If people sell their issues they will have more money to spend. If they buy government issues they will have less money to spend. This impacts the supply of money in the economy.
Government Actions - We are now going to look at the influence of U.S. government action.
1. Sell Issues - If the Feds offer attractive bonds and notes, investors will buy these issues and take spendable dollars out of the economy. a. Institution Reaction - If institutions buy these issues, they will have a smaller amount of money to lend. This will drive up interest rates. b. Public Reaction - If the public buys government issues, they will have less money to spend. This slows down the economy and drives up unemployment. c. National Debt - If more people are buying U.S. debt issues, the economy slows down. This trend of selling issues to pay for the national debt has subsided.
During the Clinton era, the national debt finally started to decline. This was the first time since Lyndon Johnson. d. Don't Sell Issues - If the Feds do not offer attractive U. S. Bonds and Notes, they do not take money out of the economy. If institutions do not buy U.S. government issues, they will have more money to lend. This keeps moderate amounts of money available to lend to the public. This keeps interest rates fairly stable. This is what happened during the Clinton years. The debt reduced and more money was put into the economy.
Feds Buy Issues - If the Feds pay off bonds and notes (pay down the national debt), this will put more money in the public sector. The government buys back its issues from institutions. Now the institutions have an increase of money that they can lend to the public. This will drives interest rates down.
1. Purpose of Buyback - The purpose of all this control is to increase or decrease the amount of money that can be spent in the economy. Thereby increasing or decreasing future interest rate.
(On the next page put slides Sect 22 – 009 and 009A)
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The government can control the supply of money by changing deposit requirements for institutions. When a person deposits money with a bank or Savings and Loan, it cannot lend all that money to the public. It has to have a portion of that deposit to be held in reserve. The government determines how much money has to be held in reserve with each dollar that is deposited by the public.
State and Federal Control - The reserve requirement for institutions is determined by the government entity that they are chartered with. If they are a Federal chartered institution, they must abide by the Federal Reserve requirement. If they are State chartered, they have to abide by the State requirement.
1. Reserve Definition - This is the amount of money that must be held to cover a "run" on deposits at an institution. Back in the 1920s, some banks had very little money held in reserve. People went in to get money and the bank couldn't pay them. This caused runs on banks when everyone wanted their money all at the same time.
2. Increased Reserve - Example: 10% Reserve Requirement - This means that an institution can only loan 90% of its deposits. If the Federal Reserve System increased the reserve requirement to 12%, this would cause the institution to lend less money. This would cause the following: a. Bank would have less money to lend b. This would effectively shrink the money supply. c. This would increase interest rate in the future.
3. Decrease Reserve - Example: The Federal Reserve decreases the reserve requirement to 8%. The institutions would now have more money to work with. This would cause the following: a . Institutions would have more money to lend. b . This would effectively increase the supply of money. c . This would decrease interest rate in the future.
Last Resort - The changing of the reserve requirement by the Federal Reserve is the last resort that it would use in controlling the economy. This has too large of an effect for day-to-day control of the economy.
1. Instant Effect - A 1% change has a $10 billion dollar effect on an instant basis.
(On the next page put slides Sect 22 – 010 and 010A)
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The Treasury Department and the Federal Reserve can control the supply of money by changing lending requirements.
Change the "Discount Rate" - The discount rate is the rate of interest that member banks can borrow from the Federal Reserve System. This is sometimes called discounted loans .
1. FRS Tool - The FRS can increase or decrease the discount interest rate on funds lent to lending institutions.
2. Lowering/Increasing Discount Rate - This would be passed on to consumers as higher or lower interest rate that they would have to pay to the institution.
3. Change Rules on Obtaining Loans - When all those banks and Savings & Loans failed during the Reagan era, one of the reasons was a lack of control by the Treasury
Department. The buyer qualification requirements for a loan were less than half of the requirements of today. The following are some of the loan requirements:
4. Example: Raise the LTV (Loan to Value Ratio) - If the Feds require the buyers to make a higher down payment on a home purchase, this would cause: a. Less Buyers - Fewer buyers that could qualify for a loan. b. Less Money In Economy - A shrinking of the money supply in that more cash would have to put down on the residence. c. Similar - An effect similar to having a higher interest rate.
5. Give "Encouragement(s)" to Lenders - The FRS can encourage lenders to tighten or loosen lending practices on loans. Some examples would include: a. Pursue Stability - The borrower must have an acceptable employment history.
An institution may require steady employment for at least 2 years. b. Pursue Payment Ability - The net income (after taxes) has to be high enough to where the mortgage payment is no greater than 1/3 of their paycheck. This can include the combined incomes of a couple. c. Effect - Increase or decrease activity in the Secondary Mortgage Market.
(On the next page put slides Sect 22 – 011 and 011A)
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Confusing Name - When we say Secondary Mortgage Market we are NOT referring to secondary mortgages. This has nothing to do with second mortgages. This is the market for selling 1st mortgages that have already been issued. As you recall, we talked about mortgage brokers issuing a mortgage and then selling the 1st mortgage to an institution.
This is accomplished in the Secondary Mortgage Market. The Secondary Mortgage
Market is basically a "clearing house" for existing 1st mortgages.
Buying and Selling Mortgages - The Secondary Market participants (institutions) buy and sell first mortgage notes among each other. If you are, or have been, a residence owner, you probably started a mortgage with one lender and then ended up with another lender in a relatively short period of time.
History - The Crash - When banks were failing in the 1920s, the main reason was that they had lent depositor's money to finance home and building purposes. There was little cash money held in reserve. When depositors made a "run" on the banks and demanded their money, the banks only had paper mortgages in the vault. The idea of the Secondary
Mortgage Market came into being so that if a bank needed cash, it could sell the mortgages (for cash) with little difficulty and meet the cash needs of their depositors.
Need For the 2nd Mortgage Market - These agencies of the Secondary Mortgage
Market can buy mortgage notes from banks and S&L's upon demand. There are times of a large turnover of mortgages in the market; a need for supply and demand.
Sale/Purchase Demand - With these market swings, interest rates would fluctuate wildly. The Secondary Mortgage Market prevents these large interest rate swings by creating a market where institutions can sell their mortgages on a moment's notice. If there weren't a secondary market for mortgages the banks and S&L's would soon have a vault full of paper and no money.
Stable Interest - By providing a ready market for mortgages, this pretty much keeps mortgage interest rates level throughout the nation. A person in California would get the same interest rate as a person in West Virginia.
(On the next page put slides Sect 22 – 012 and 012A)
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The government's goal is to keep stability of interest and to help the economy when necessary. We now will look at the tools that can be used for specific situations in the economy. The following are remedies for specific problems areas:
1. Recession Occurs - To get the economy of the nation to "heat up" the agencies would buy notes in the secondary market. This puts more money in the bank. This allows institutions to lend money into the economy.
2. Inflation Occurs - To slow down the economy of the nation, to "cool off" the economy, the agencies would sell notes in the secondary market. This takes money out of the banks. This prevents the institutions from lending more money into the economy.
This slows the economy down as well as inflation.
(On the next page put slides Sect 22 – 013 and 013A)
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The following are the agencies of the Secondary Mortgage Market. These are the agencies that buy and sell mortgages within the mortgage market. Some are private organizations and some are agencies of the U.S. Government.
1. Federal National Mortgage Association (FNMA) - This is one of the oldest agencies that deal in 1st mortgages. It is affectionately known as "Fannie Mae". a. FNMA - Fannie Mae was created by Title III of the National Housing Act of
1934. Title II of the same act created the Federal Housing Administration or the
FHA.
b. Private Organization - The FHA was originally a government agency. It sold stock to what are called its member banks and was determined to be a government corporation. In order for a bank to sell their mortgages to Fannie Mae, the bank had to be a stock member of Fannie Mae. Fannie Mae is no longer part of the government and is now a private corporation. c. FNMA Trades - Fannie Mae trades (buys & sells) in VA, FHA, and uninsured conventional mortgage notes. It will not trade MGIC insured notes. d. Government Help Soon Fannie Mae was out of funds and needed help. The
Feds decided to start up a similar agency that became the brother of Fannie Mae and it is called Freddie Mac.
2. Federal Home Loan Mortgage Corporation (FHLMC). It is affectionately known as "Freddie Mac". It is a twin of Fannie Mae. Freddie Mac effectively does the same exact thing, but ALSO buys and sells conventional loans issued by lenders. This is one of the reasons that it has had such a hard time and bailed out by the federal government. It is currently a stockholder owned firm, but might end up a government agency again. a. FHLMC - Freddie Mac buys mortgage notes from banks, S & Ls, and a few life insurance companies. It trades in VA, FHA, conventional uninsured, and insured mortgage notes. b. Conventional vs. Non-Conventional Requirements - The uninsured conventional loans have to have a LTV debt ratio less than 80%. The insured loans can have an LVR debt ratio greater than 80%.
(On the next page put slides Sect 22 – 014 and 014A)
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In the 1960s, with Lyndon Johnson's Great Society, the Federal government was sponsoring low income housing and urban development to try to get rid of the slums. To help with the secondary mortgage needs of the HUD programs, the government formed an agency known as the
Government National Mortgage Association (GNMA). It is affectionately known as "Ginnie
Mae".
NOW a Government Agency - Ginnie Mae was established to buy only government backed loans with a heavy emphasis of dealing with Federally subsidized loan programs of the FHA.
1. Housing and Urban Development Rules - The buying and selling decisions regarding FHA subsidized loans is set by the HUD (Housing and Urban Development) Department.
2. Function of GNMA It will also help out Fannie Mae and Freddie Mac by trading in VA and
FHA loans, but its main emphasis is to provide a market for low income assisted or subsidized
FHA mortgages. Fannie Mae and Freddie Mac do not trade in low income assisted or subsidized
FHA mortgages such as urban renewal projects, housing for elderly, experimental housing interest subsidies, etc. Only Ginnie Mae works with these mortgage programs.
Guarantee Insurance Corporation Investment Corporation (MGICIC) - The agencies of the
Secondary Mortgage Market would not work with conventional loans that were insured by outside/private organizations. The banks loved privately insured conventional loans because they could earn a higher interest rate than the non-conventional loans. Since there was no trading agency for these insured conventional loans, the banks pushed to get an organization and the
Mortgage Guarantee Insurance Corporation Investment Corporation (MGICIC) was formed. This is affectionately called "Maggie Mae".
1. Not An Agency - This "private" agency only buys and sells conventional first mortgage notes insured by the Mortgage Guarantee Corporation.
2. Other Traders/Investors - A small part of the Secondary Mortgage Market are the buyers and sellers of 1st mortgages in the open market. These institutions work with about 10% to 15% of the sales of 1st mortgages in the Secondary Mortgage Market. These entities that buy and sell 1st mortgages include: a. Insurance Companies Life insurance companies will buy long term high interest mortgages to provide benefits for their insured. b. Pension funds - A lot of pension plans buy long term high interest mortgages to fund the lifetime income that is paid to their pensioners. c. Endowments - Endowment funds and other private investors.
3. Function - The above institutions will buy warehoused mortgage notes as investments. They need long term interest bearing investments to provide benefits for those that they serve.
(On the next page put slides Sect 22 – 015 and 015A)
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Secondary Markets - The advantages of having a Secondary Mortgage Market are the following:
1. Uniform Mortgage Documents - Fannie Mae, Ginnie Mae, and Freddie Mac have established their own mortgage documents. If an institution wants to sell a 1st mortgage to one of them, the institution will find it easier to sell if they use that agency's mortgage form. a. Makes Paper Marketable - This increases the institutions chance to sell the mortgage paper to another agency at a later date. b. Standardization - If an institution uses a standardize mortgage form, it will be more marketable to sell. This has caused standardized mortgage forms in the industry.
2. Mortgage Money Availability - The agencies affect the amount of money available for lending for 1st mortgages. If an institution wants money to set up 1st mortgages for clients, it can sell its existing 1st mortgages for a profit and obtain cash funds. a. Helps Economy - The availability of money affects the interest rates overall and thereby the future direction of the economy. b. Stabilize Interest Rates - Since institutions do not have to sell mortgages on an emergency basis, this stabilizes interest rates equally across the nation.
3. Liquidity - When an institution needs money it simply sells its 1st mortgages. The mortgages would not be very liquid without the Secondary Mortgage Market. 1st mortgages are now considered equal in liquidity to stocks and bonds. It makes 1st mortgages more attractive as an investment vehicle.
Farmers' National Home Administration (FNHA) - This program is designed for the needs of rural farmers. When we say rural, we mean rural. They are unable to obtain loans in their area. The FNHA provides the means for these farmers to fund their purchase needs for the farm.
(On the next page put slides Sect 22 – 016 and 016A)
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