Real estate finance 2

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Financing Residential Real Estate

Lesson 2:

Federal Fiscal
and Monetary Policy

Introduction

This lesson will cover:

federal government’s fiscal policy
taxation
federal government’s monetary policy
Federal Reserve system
tools for implementing monetary policy

Introduction

Federal government affects real estate finance by influencing cost of borrowing mortgage funds.

Major cost of borrowing money is interest charged by lender.

Market interest rates = current cost of $

Introduction

Cost of borrowing money is influenced by federal government in two ways:

fiscal policy
monetary policy

Introduction

Fiscal policy: government’s actions in raising revenue, spending money, and managing its debt.

Monetary policy: government’s direct efforts to control money supply and cost of money.

Fiscal Policy

Set by executive and legislative branches (president and Congress), who establish federal tax laws, budget.

U.S. Treasury Department manages government’s finances, carrying out fiscal policy.

Fiscal Policy

Federal deficit: shortfall when government spends more than it collects.

Treasury gets funds to cover shortfall by issuing interest-bearing securities.
By selling securities to investors,
government is borrowing money from
private sector.
Leaves less money for private borrowers.

Spending and debt financing

Fiscal Policy

Some economists believe federal deficit has little effect on interest rates.

Others believe federal borrowing pushes interest rates up.

Spending and debt financing

Fiscal Policy

Tax policies affect how much taxpayers have left for other purposes:

↓ taxes = more $ to lend/invest
↑ taxes = less $ to lend/invest

Taxation

Fiscal Policy

Tax policies also affect investment choices:

↑ taxes = tax-exempt securities preferred
↓ taxes = taxable investments attractive

Real estate, MBS are taxable.

Taxation

Fiscal Policy

Taxes implement social policy by providing benefits and incentives:

mortgage interest deductions
exclusion of gain on sale of principal
residence

Taxation

Fiscal Policy

Taxpayer can deduct (from taxable income) interest paid on one or more mortgages:

loans for buying, building, or improving
1st or 2nd residence
home equity loans
purchase loans on investment property

Deduction of mortgage interest

Fiscal Policy

Loans for buying, building, or improving 1st or 2nd residence.

Can deduct all interest on loans up to $750,000.
If loan amount exceeds that limit, interest on excess not deductible.

Deduction of mortgage interest

Fiscal Policy

Home equity loans – can deduct interest only if loan funds are used for substantial home improvements.

Deduction of mortgage interest

Fiscal Policy

Homeowners allowed to exclude from taxation a gain (profit) on sale of principal residence.

May exclude up to $250k ($500k for married couple filing jointly).
Excess taxed at capital gains rate.

Gain on sale of home

Fiscal Policy

Taxpayer must have owned and used property as principal residence for two of last five years.

If married, one spouse must meet ownership test; both must meet use test.
If only one spouse meets both tests,
maximum exclusion is $250k (if filing
jointly).

Gain on sale of home

Fiscal Policy

Reduced exclusions allowed under special circumstances when taxpayers have owned house for less than 2 years.

For example, if home sold because of:

change in health
change in place of employment
unforeseen circumstances

Gain on sale of home

Fiscal Policy

Owners of income property allowed to take depreciation deductions.

Deduct cost of buildings and property improvements that will eventually have to be replaced.
Cost spread out over number of
years, not deducted all at once.

Depreciation deductions for investors

Summary
Fiscal Policy

Fiscal policy
Federal deficit
Taxation
Deduction of mortgage interest
Exclusion of gain on sale of home
Depreciation deductions

Monetary Policy

Government uses its control over money supply to keep national economy running smoothly.

Monetary Policy

Monetary policy is set and implemented by Federal Reserve System (“the Fed”).

Federal Reserve System

In early 19th century, there was little government regulation of depository institutions.

Security of bank deposits depended on integrity of bank managers.

Historical background

Federal Reserve System

In 1863, Congress passed National Bank Act.

Established basic banking regulations/procedures for supervising commercial banks.

Historical background

Federal Reserve System

Economic downturns led to financial panics (bank depositors withdrew all their money at once).

Caused even financially sound banks
to fail.

Public previously resistant to idea of central national bank, but losses from panics of 1907 changed public opinion.

Historical background

Federal Reserve System

Federal Reserve Acts of 1913 and 1916 created Federal Reserve System and established modern banking system.

Reserve requirements: certain proportion of bank’s deposits must be held in reserve, available for immediate withdrawal on demand.

Historical background

Federal Reserve System

Fed is “lender of last resort,” providing short-term backup loans to banks that run low on funds.

Historical background

Federal Reserve System

Creation of Fed helped, but did not solve, problem of financial panics.

In 1930s, Federal Deposit Insurance Corporation (FDIC) and Federal Savings and Loan Insurance Corporation (FSLIC) created to boost depositor confidence.

Historical background

Federal Reserve System

Federal Reserve System is made up of:

12 regional Federal Reserve Banks
in 12 Federal Reserve Districts
Federal Reserve Board
Federal Open Market Committee
advisory councils
over 3,000 member banks

Organization

Federal Reserve System

Board of Governors: controls Federal Reserve system.

7 members, appointed by President, confirmed by Senate for 14-year terms.
Members chosen from different Federal Reserve Districts.

Organization

Federal Reserve System

Board of Governors, cont.

Chairman chosen for 4-year term from
among governors.
Sets reserve requirement for commercial
banks.
Controls discount rate (interest rate set by Federal Reserve Banks).

Organization

Federal Reserve System

Federal Reserve Banks: each district has one main Federal Reserve Bank. Some districts also have branch banks.

Each reserve bank appoints a banker to Federal Advisory Council.

Organization

Summary
Federal Reserve System

Monetary policy
Federal Reserve System
Reserve requirements
Lender of last resort
Board of Governors
Federal Reserve Board
Federal Open Market Committee

Federal Reserve System

Fed’s goal: maintain healthy U.S. economy.

Economic growth that is too strong or too fast results in inflation.
Inflation: trend of general price increases throughout economy.

Economic growth and inflation

Federal Reserve System

The Fed uses three tools to implement its monetary policy and influence economy:

reserve requirements
interest rates
open market operations

Tools for implementing policy

Tools for Implementing Policy

Banks required to maintain percentage of deposits on reserve in own vaults or at district Federal Reserve Bank.

May be as much as 10% depending on amount of deposits at bank.

Reserve requirements

Tools for Implementing Policy

Depository Institutions Deregulation and Monetary Control Act of 1980 subjected all commercial banks to same reserve requirements as Federal Reserve members.

Reserve requirements

Tools for Implementing Policy

Increase in reserve requirements = decrease in funds available for investment and increase in interest rates.

Decrease in reserve requirements = increase in supply of funds and decrease in interest rates.

Reserve requirements

Tools for Implementing Policy

Fed has control over two key interest rates:

federal discount rate
federal funds rate

Interest rates

Tools for Implementing Policy

Interest rate charged when bank borrows money from Federal Reserve Bank to cover shortfall in funds.

Federal discount rate

Tools for Implementing Policy

Interest rate banks charge each other for overnight, unsecured loans.

Banks borrow from other banks to meet reserve requirements.
Rate set by banks.
Federal Open Market Committee sets target for federal funds rate.

Federal funds rate

Tools for Implementing Policy

When Fed raises or lowers either rate, it’s an indication of overall view of economy.

Lenders often make corresponding changes to interest rates they charge customers.

Some lenders change rates in anticipation of rate changes by Fed.

Interest rates

Tools for Implementing Policy

Short-term interest rates most affected by changes in discount and federal funds rates.

Long-term interest rates (mortgage rates) don’t respond directly to Fed’s rate adjustments.

Interest rates

Tools for Implementing Policy

Fed also buys and sells government securities in transactions called open market operations.

Conducted by Securities Dept. of
Federal Reserve Bank of New York
(“Trading Desk”).
Federal Open Market Committee (FOMC) directs transactions.

Open market operations

Tools for Implementing Policy

FOMC is most important policy-making organization in Fed.

8 regularly scheduled meetings per year.
12 members:
7 members of Federal Reserve Board
president of NY Federal Reserve Bank
4 other Reserve Bank presidents

Open market operations

Tools for Implementing Policy

Open market operations are Fed’s primary means of controlling money supply.

Money supply:

increases when Fed buys government
securities
decreases when Fed sells government
securities

Open market operations

Tools for Implementing Policy

Increased money supply is supposed to lower interest rates.

But other factors can put pressure
on rates.

The Fed uses open market operations and other tools to balance complicated forces.

Open market operations

Federal Reserve System

Monetary policy is experimental, and Fed changes strategies from time to time.

1970s: Fed moderated interest rates by increasing money supply when interest rates rose.
When inflation became a concern, Fed
tried to control it by restricting growth of money supply.
Then interest rates soared.

Changes in monetary policy

Federal Reserve System

By 1982, inflation under control.
Fed then focused on preventing large
fluctuations in interest rates.
Remainder of 20th century:
moderate inflation
lower, stable interest rates

Changes in monetary policy

Federal Reserve System

New century: economy slowed.
Fed lowered interest rates sharply to
stimulate growth.
Growth led to inflation concerns again,
so Fed gradually increased rates.
2007: as credit crisis began, Fed started lowering interest rates again.
Rates stayed low for many years, but began to rise in the last few years.

Changes in monetary policy

Summary
Implementing Monetary Policy

Interest rates
Discount rate
Federal funds rate
Federal Open Market Committee
Open market operations
Inflation