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Real Estate Finance

2/18/2020 Sample Content Topic

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Introduction: Banks originally owned and maintained in their
portfolios all the real estate loans they created. However, this
often caused banks to restrict new loans due to capital
restrictions. With the creation of the secondary market, banks
were able to sell a large number of their real estate loans,
creating additional liquidity for new home purchases. In this
Assignment, you will apply your understanding of how loans
are sold by primary lenders to the secondary market, and how
the secondary market creates liquidity for the real estate
market.

The Real Estate Credit Market

The following Course Outcome is assessed in this Assignment:

MT431-1: Diagram how money flows in the real estate credit
market.

Introduction:

Visual presentations to buyers and sellers in real estate is a
necessity in order to illustrate complex processes and explain
various considerations that can affect seller and buyer
decisions. In this Assignment, you will apply diagramming to
show the flow of funds in a particular scenario.

Read the scenario and respond to the checklist items.

Scenario: Henri and Lila who own the Three Forks Restaurant
have decided to possibly purchase a home and they can put
down 20% on a home loan. They have been informed by the
bank that their loan might be sold off at some point after
closing.

Checklist:

Explain the kind of mortgage market they will apply to and
what mortgage interest rate they might obtain based on a 30-
year, fixed-rate mortgage at this week’s rate.

Assignment Details 

2/18/2020 Sample Content Topic

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Diagram how the mortgage will travel through different
channels to end up being sold on Wall Street. (You can use
the insert tab in Microsoft® Word®, then select SmartArt®.)

Explain the diagram and discuss each step in the overall
process.

Access the Unit 2 Assignment grading rubric.

Submit your minimum 1–2-page Word document to the Unit 2
Assignment Dropbox.

https://kapextmediassl-a.akamaihd.net/business/MT431/1904c/rubrics/u2_rubric

© 2018 Rockwell Publishing
Financing Residential Real Estate
Lesson 2:
Federal Fiscal
and Monetary Policy
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© 2018 Rockwell Publishing
Introduction
This lesson will cover:
federal government’s fiscal policy
taxation
federal government’s monetary policy
Federal Reserve system
tools for implementing monetary policy

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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 $

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

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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.
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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.

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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
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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
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Fiscal Policy
Tax policies affect how much taxpayers have left for other purposes:
↓ taxes = more $ to lend/invest
↑ taxes = less $ to lend/invest
Taxation
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Fiscal Policy
Tax policies also affect investment choices:
↑ taxes = tax-exempt securities preferred
↓ taxes = taxable investments attractive

Real estate, MBS are taxable.
Taxation
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Fiscal Policy
Taxes implement social policy by providing benefits and incentives:
mortgage interest deductions
exclusion of gain on sale of principal
residence
Taxation
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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
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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
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Fiscal Policy
Home equity loans – can deduct interest only if loan funds are used for substantial home improvements.
Deduction of mortgage interest
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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
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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
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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
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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
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Summary
Fiscal Policy
Fiscal policy
Federal deficit
Taxation
Deduction of mortgage interest
Exclusion of gain on sale of home
Depreciation deductions

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

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Monetary Policy
Monetary policy is set and implemented by Federal Reserve System (“the Fed”).
Federal Reserve System
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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
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Federal Reserve System
In 1863, Congress passed National Bank Act.
Established basic banking regulations/procedures for supervising commercial banks.
Historical background
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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
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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
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Federal Reserve System
Fed is “lender of last resort,” providing short-term backup loans to banks that run low on funds.
Historical background
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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
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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
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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
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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
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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
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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

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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
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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
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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
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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
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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
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Tools for Implementing Policy
Fed has control over two key interest rates:
federal discount rate
federal funds rate
Interest rates
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Tools for Implementing Policy
Interest rate charged when bank borrows money from Federal Reserve Bank to cover shortfall in funds.
Federal discount rate
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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Summary
Implementing Monetary Policy
Interest rates
Discount rate
Federal funds rate
Federal Open Market Committee
Open market operations
Inflation

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Financing Residential Real Estate
Lesson 3:
The Primary and Secondary Markets
© 2018 Rockwell Publishing

© 2018 Rockwell Publishing
Introduction
This lesson will cover:
primary vs. secondary mortgage markets
primary market lenders and funding of mortgage loans
sale of loans on secondary market
mortgage-backed securities
government-sponsored enterprises and their role in the mortgage industry

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Introduction
Residential mortgage industry made up of:
financial institutions
private companies
government-sponsored enterprises
other investors

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Two Mortgage Markets
Industry is divided into two “markets” that supply funds for mortgage loans.
Primary market: market where lenders make loans to home buyers.
Secondary market: market where lenders sell their loans to investors.

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Primary Market
In primary market, home buyers apply for mortgage loans and lenders originate them.
Loan origination involves:
processing application
approval decision
funding loan

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Primary Market
Primary market was originally local, made up
of community financial institutions.
More complicated now, due to developments
such as:
interstate banking
online lenders
Local model still useful in understanding
primary and secondary markets.

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Primary Market
Local market is subject to real estate cycles.
Real estate cycles: periodic shifts in level of real estate activity (sales, loans).
Caused by changes in supply of and demand for:
real estate for sale
funds for mortgage lending
Real estate cycles
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Primary Market
Local real estate cycles are affected by many factors, including:
economic forces
political events
social trends

These factors may be either local or national.
Factors affecting real estate cycles
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Primary Market
At one time, local lenders couldn’t do much about real estate cycles in their communities.
Dealing with real estate cycles
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Primary Market
They needed:
a source of extra funds to lend when
demand exceeded supply; and
a place to invest surplus funds when
supply exceeded demand.

Secondary market helped meet both needs.
Dealing with real estate cycles
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Summary
Primary Market
Primary market
Loan origination
Real estate cycles

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Secondary Market
Solution to primary market problems was secondary market, where mortgages secured by real estate all over U.S. are bought and sold.

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Secondary Market
Secondary market activities:
buying and selling loans
buying and selling mortgage-backed securities

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Secondary Market Activities
Like other investments, loans can be bought and sold.
Loan purchaser pays present value of right to receive payments from borrower.
Rate of return on loan compared with rate of return on other investments to determine present value.
Buying and selling loans
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Buying and Selling Loans

Mortgage lenders may sell their loans to:
other lenders
government-sponsored enterprises:
created by federal government to establish strong secondary market for mortgage loans
often referred to as GSEs
Who buys loans?
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Federal National Mortgage Association
(FNMA or “Fannie Mae”)
Federal Home Loan Mortgage Corporation (FHMLC or “Freddie Mac”)
Buying and Selling Loans
Government-sponsored enterprises
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Lenders “package” similar loans together for sale to government-sponsored enterprise.

After sale, loans may be serviced by original lender or by another servicer.
Loan servicing: payment processing, collections, working with borrowers to prevent default.
Buying and Selling Loans
Government-sponsored enterprises
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Secondary Market Activities
GSEs also issue mortgage-backed securities (MBS): investment instrument with mortgage
loans as collateral; a type of bond.
Investor returns are monthly payments
from GSE.
GSE passes borrowers’ payments
on to investors.
Mortgage-backed securities
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Mortgage-backed Securities
Securitizing: buying mortgages, pooling them together, pledging pool as collateral, issuing securities.
Private-label mortgage-backed securities: securities issued by private firm rather than GSE.
Securitizing loans
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Mortgage-backed Securities
Reasons investors prefer buying MBSs to buying actual mortgage loans include:
convenience
greater liquidity
can be purchased in relatively
small denominations
Advantages for investors
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Functions of Secondary Market
Secondary market serves two important functions for real estate industry:
moderates adverse effects of real
estate cycles, providing some stability
makes funds available for mortgage
loans, promoting home ownership
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Functions of Secondary Market
Availability of funds in primary market depends on secondary market.
Mortgage funds flow between the two markets.
Flow of mortgage funds
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Functions of Secondary Market
Lender loans funds to buyer in primary market.
Lender sells mortgage to GSE
GSE pools mortgages and sells MBSs, freeing entity’s funds to buy more mortgages.
As GSE buys mortgages, more funds available for more loans in primary market.
Flow of mortgage funds
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Functions of Secondary Market
If lender doesn’t sell loan on secondary market, loan is kept in portfolio.
Only small percentage of loans are kept in portfolio today.
Portfolio loans
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Summary
Secondary Market
Secondary market
Government-sponsored enterprise
Loan servicing
Mortgage-backed securities
Securitizing
Portfolio loan

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Secondary Market Entities
Government-sponsored enterprise (GSE):
created and supervised by federal
government
owned by private stockholders
Historical background
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Historical Background
1938 – Created by federal government in response to Depression-era credit
problems. Authorized to buy FHA loans.
1948 – Also authorized to buy VA loans.
1968 – Reorganized as government-
sponsored enterprise.
Fannie Mae
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Historical Background
1968 – Created as agency within HUD when Fannie Mae was privatized.
Wholly-owned government corporation.
Now securitizes FHA and VA loans.
Ginnie Mae
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Historical Background
1970 – Created by Emergency Home
Finance Act as government-sponsored
enterprise.
Original purpose: to assist savings and loans hit hard in 1969 recession.
1970 act authorized both Freddie Mac and Fannie Mae to buy conventional loans.
Freddie Mac
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Government-sponsored Enterprises
As GSEs, Fannie Mae and Freddie Mac were given some advantages over ordinary private corporations.
Exempted from certain types of taxes.
Not subject to certain SEC registration and disclosure requirements.

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Government-sponsored Enterprises
GSEs were also given special responsibilities and limitations.
Restricted by charter to investment in
residential mortgage assets (mortgages
and mortgage-backed securities).
Required to meet annual affordable housing goals.

GSE status
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Government-sponsored Enterprises
Ginnie Mae started first MBS program in 1970, but now only guarantees loans.
Fannie Mae and Freddie Mac followed with securities backed by conventional loans.
MBS programs
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Government-sponsored Enterprises
1980s: Congress removed certain restrictions on mortgage-backed securities.
Made them more competitive with
corporate bonds.
Fueled expansion of secondary market.
MBS programs
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Government-sponsored Enterprises
Investors can buy MBSs:
directly from issuing entity
on Wall Street, through securities dealers

Direct purchases typically made by large investors such as insurance companies or pension funds.
MBS programs
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Government-sponsored Enterprises
MBS issued by GSE is guaranteed by entity.
Investor receives full payment from GSE even if borrowers default on some loans in pool.
Guaranty fees and servicing fees subtracted before payments passed on to investors.
MBS programs
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Government-sponsored Enterprises
Lender who wants to sell loan to Fannie Mae or Freddie Mac must:
comply with GSE’s underwriting rules when qualifying loan applicant
use uniform loan documents

If lender violates GSE’s rules, may be required to buy loan back from entity.
Standardized underwriting
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Government-sponsored Enterprises
Underwriting guidelines and uniform documents serve as quality control to ensure loans purchased by GSEs meet minimum standards.
Inspires investor confidence.
Strongly influences primary market lenders.
Standardized underwriting
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Government-sponsored Enterprises
Prime loan: loan made to borrower with A credit rating.
Subprime loan: loan made to less creditworthy borrower.
At one time, Fannie Mae and Freddie Mac bought only prime loans.
Subprime loans didn’t meet their standards.
GSEs and subprime loans
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Government-sponsored Enterprises
In 2005 Fannie Mae and Freddie Mac
began buying subprime loans.
Primarily A-minus loans: top layer of
subprime market.
Encouraged by government, to help meet affordable housing goals.
GSEs and subprime loans
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Government-sponsored Enterprises
Before most recent crisis, analysts credited Fannie Mae and Freddie Mac with:
increasing home ownership rates
reducing mortgage interest rates
improving underwriting practices
providing mortgage lenders with access to global capital markets
GSEs and the economic crisis
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GSEs and the Economic Crisis
Before crisis, critics argued:
claims of GSEs’ benefit to public exaggerated
GSEs too large, with too much power over mortgage industry
GSEs limited opportunities for other investors and enterprises
GSEs not run well (2003/04 accounting scandals)
Criticism before crisis began
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GSEs and the Economic Crisis
By 2007, 1/3 of Fannie Mae and Freddie Mac’s new purchases and guaranties involved riskier loans.
As subprime crisis unfolded, house prices dropped and foreclosure rates rose sharply.
Caused GSEs’ stock prices to plunge, further undermining their financial stability.
On the brink of insolvency
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GSEs and the Economic Crisis
Housing and Economic Recovery Act of 2008 (HERA) created new independent regulatory agency to oversee GSEs.
Federal Housing Finance Agency (FHFA)
September 2008: to prevent economic
consequences of GSE failure, FHFA placed both entities in conservatorship.
Conservatorship
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GSEs and the Economic Crisis
Terms of GSE conservatorship:
top management replaced
voting power of shareholders and directors terminated
to maintain solvency of GSEs, government would:
buy securities from GSEs
buy billions of dollars of stock
in each GSE
Conservatorship
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Summary
Government-sponsored Enterprises
Fannie Mae
Freddie Mac
Guaranties
Subprime loan / A-minus loan
Federal Housing Finance Agency
Conservatorship

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