REAL ESTATE
FINANCE
10th Edition
J. Keith Baker and John P. Wiedemer
Chapter 2
Money and Interest Rates
2
LEARNING OBJECTIVES
At the conclusion of this chapter, students will be
able to:
•
Discuss 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.
•
Discover 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.
3
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.
4
Federal Reserve Bank System
• Federal control over the nation’s money supply was
established by the creation in 1913 of the Fed, 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.
5
Federal Reserve Bank System
(continued)
• The chair has the authority to influence the
selection of the 12 Federal Reserve District
presidents, which adds to the power of that
office.
• The chair also influences the selection of which
of the five out of 12 district presidents who 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
The Fed uses four basic tools to influence the economy
through the nation’s monetary system, as follows.
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.
8
Money Supply
• The difficult task faced by the Fed is to create equilibrium
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 increase
workforce 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 workforce
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.
11
Definition of Money
(continued)
• 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.
12
More than half of all U.S. currency
is printed in Fort Worth!
www.moneyfactory.gov
13
The Money Supply
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.
14
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 11th).
There are 8,800 commercial banks that handle most of
the cash transfers in the country.
The Open Market Committee decides whether or not to
increase the money supply.
15
Management of the Money Supply
(continued)
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.
16
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.
17
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.
18
Discount Rate of Interest
(continued)
• 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.
19
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.
20
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.
21
Reserve Requirements
(continued)
• The Federal Reserve can be a very profitable
operation for the government.
• The reserve requirement in place as of January 22,
2015, for those defined financial depository
institutions is 14.5 percent for liabilities in excess
of $103.6 million, 3 percent for those liabilities
from $79.5 million to $103.6 million, and 0 percent
on the balance below $12.4 million.
22
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.
23
The United States Treasury
(continued)
• 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.
24
Resource – The United States Treasury
www.treasury.gov
25
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.
26
Implications for the Real Estate Market
Imagine that someone wants to buy a home priced
at $300,000. The buyer will make a 20% down
payment and borrows $240,000. If the interest rate
is 5%, her monthly payment will be $1,288.37 and
her monthly income required to qualify for the 30year fixed rate loan will be $4,600. If the interest rate
goes to 6% she will need to have a monthly income
of $5,139. If interest rates climb to 7%, an increase
in income to $5,703 will be required, the equivalent
of a raise of almost $1,103 per month after all
payroll taxes are withheld. For a 90% LTV loan, the
variations are even more dramatic. The monthly
income requirement at 5% would be $5,178 while at
6% it would be $5,781, a difference of over $600 per
month.
27
FHLMC 30-Year Fixed Rate
28
Resource – The Real Estate Center –
www.recenter.tamu.edu
29
Source – The Real Estate Center
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.
30
Demand for Credit
The demand for credit comes from four categories
of borrowers.
1. Government
2. Corporate
3. Mortgage loans
4. Consumer
31
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.
32
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.
33
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.
34
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.
35
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%.
36
Fannie Mae/Freddie Mac–Administered Yield
Requirements
• During the early 1980s, the 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.
37
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.
38
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 for 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.
39
Usury
• State laws limiting the amount of interest on different
kinds of loans.
• Before the late 1970s, 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 in the late
1970s, usury limits began to surface and restricted
mortgage lending in some states.
40
Usury
(continued)
• States with higher interest limits were able to attract
the big investors.
• Many states were excluded from the national market
by restrictive usury laws.
• Congress preempted state usury limits for firstmortgage 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.
41
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.
42
Questions for Discussion
(continued)
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.
43