Transcript Chapter 3 Money and Financing

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
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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
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
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
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
Interest
Points
Interest Barrier
Effect of High Interest Rates on
Relocation
Loan Funds
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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