© 2012 Rockwell Publishing Financing Residential Real Estate Lesson 2: Federal Fiscal and Monetary Policy

© 2012 Rockwell Publishing 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 $

© 2012 Rockwell Publishing Introduction Cost of borrowing money is influenced by federal government in two ways: fiscal policy monetary policy

© 2012 Rockwell Publishing 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.

© 2012 Rockwell Publishing 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.

© 2012 Rockwell Publishing 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

© 2012 Rockwell Publishing 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

© 2012 Rockwell Publishing Fiscal Policy Tax policies affect how much taxpayers have left for other purposes: ↓ taxes = more $ to lend/invest ↑ taxes = less $ to lend/invest Taxation

© 2012 Rockwell Publishing Fiscal Policy Tax policies also affect investment choices: ↑ taxes = tax-exempt securities preferred ↓ taxes = taxable investments attractive Real estate, Mortgage Backed Securities (MBS) are taxable. Taxation

© 2012 Rockwell Publishing Fiscal Policy Taxes implement social policy by providing benefits and incentives: mortgage interest deductions exclusion of gain on sale of principal residence Taxation

© 2012 Rockwell Publishing Fiscal Policy Taxpayer can deduct (from taxable income) interest paid on one or more home mortgages: loans for buying, building, or improving 1 st or 2 nd residence home equity loans Deduction of mortgage interest

© 2012 Rockwell Publishing Fiscal Policy Loans for buying, building, or improving 1 st or 2 nd residence. Can deduct all interest on loans up to $1m ($500k for married filing separately). If loan amount exceeds that limit, interest on excess not deductible. Deduction of mortgage interest

© 2012 Rockwell Publishing Fiscal Policy Home equity loans – can deduct interest on smaller of: total loan amount up to $100k ($50k for married filing separately), or difference between property value and remaining debt on purchase loan. Deduction of mortgage interest

© 2012 Rockwell Publishing Fiscal Policy Homeowners allowed to exclude from taxation 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

© 2012 Rockwell Publishing 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

© 2012 Rockwell Publishing 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 place of employment unforeseen circumstances Gain on sale of home

© 2012 Rockwell Publishing 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

© 2012 Rockwell Publishing Monetary Policy Government uses its control over money supply to keep national economy running smoothly.

© 2012 Rockwell Publishing Monetary Policy Monetary policy is set and implemented by Federal Reserve System (“the Fed”). Federal Reserve System

© 2012 Rockwell Publishing Federal Reserve System In early 19 th century, there was little government regulation of depository institutions. Security of bank deposits depended on integrity of bank managers. Historical background

© 2012 Rockwell Publishing Federal Reserve System In 1863, Congress passed National Bank Act. Established basic banking regulations/procedures for supervising commercial banks. Historical background

© 2012 Rockwell Publishing 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

© 2012 Rockwell Publishing Federal Reserve System Federal Reserve Acts of 1913 and 1916 created Federal Reserve System and established modern banking system. Reserve requirement: certain proportion of bank’s deposits must be held in reserve, available for immediate withdrawal on demand. Historical background

© 2012 Rockwell Publishing Federal Reserve System Fed is “lender of last resort,” providing short-term backup loans to banks that run low on funds. Historical background

© 2012 Rockwell Publishing 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

© 2012 Rockwell Publishing 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 2,500 member banks Organization

© 2012 Rockwell Publishing 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

© 2012 Rockwell Publishing 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

© 2012 Rockwell Publishing Federal Reserve System Federal Reserve Banks: each district has one main Federal Reserve Bank. Some districts also have branch banks. Each reserve bank is owned by member banks in its district. Each reserve bank appoints a banker to Federal Advisory Council. Organization

© 2012 Rockwell Publishing 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

© 2012 Rockwell Publishing 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

© 2012 Rockwell Publishing 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

© 2012 Rockwell Publishing 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

© 2012 Rockwell Publishing 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

© 2012 Rockwell Publishing Tools for Implementing Policy Fed has control over two key interest rates: federal discount rate federal funds rate Interest rates

© 2012 Rockwell Publishing Tools for Implementing Policy Interest rate charged when bank borrows money from Federal Reserve Bank to cover shortfall in funds. Federal discount rate

© 2012 Rockwell Publishing 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

© 2012 Rockwell Publishing 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

© 2012 Rockwell Publishing 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

© 2012 Rockwell Publishing 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

© 2012 Rockwell Publishing 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

© 2012 Rockwell Publishing 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

© 2012 Rockwell Publishing 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

© 2012 Rockwell Publishing 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 concern, Fed tried to control it by restricting growth of money supply. Then interest rates soared. Changes in monetary policy

© 2012 Rockwell Publishing Federal Reserve System By 1982, inflation under control. Fed then focused on preventing large fluctuations in interest rates. Remainder of 20 th century: moderate inflation lower, stable interest rates Changes in monetary policy

© 2012 Rockwell Publishing 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 have been very low since. Changes in monetary policy