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1

The Federal Reserve System

The Federal Reserve System is a central bank established by Congress in 1913 to give the country an elastic currency, provide a system for discounting commercial paper, and to improve the supervision of the banking industry. It is made up of 12 regional banks that are managed by a Board of Governors. The Federal Reserve operates independently of the government; therefore, the actions of the central bank are not under the supervision or control of the President or Congress.

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The Federal Reserve System has 5 parts:

• The Board of Governors
• 12 Federal Reserve banks and their branches
• The Federal Open Market Committee
• The Federal Advisory Council
• Member banks. Member banks include federally regulated commercial banks and state-chartered banks that have voluntarily joined the system.

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The Board of Governors

consists of seven members who are appointed by the President and confirmed by Congress. Members are appointed to terms of 14 years. The chairperson of the Federal Reserve is appointed by the President and confirmed by the Senate for a term of 4 years. This term intentionally overlaps presidential terms of office to reduce governmental intrusion into the operations and decisions of the Federal Reserve.
The Board of Governors sets the reserve requirements for member banks, reviews and approves discount-rate actions, sets ceilings on the interest rates that banks pay on time and savings deposits, and issues regulations.
Members also sit on the Federal Open Market Committee, the principal instrument for implementing national monetary policy.

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Monetary Policy

the actions of the Board of Governors, regulate the cost and availability of credit in the United States.
Its actions effectively control the supply of money in the U.S. economy. Its policies affect the amount and cost of money which is available to lenders, and thus to borrowers. By limiting the supply of money and credit, it can create what is called a tight money market.
It is incorrect to say that the Federal Reserve sets interest rates. Rather, its policies affect the availability of funds, which in turn influences the cost of credit in the marketplace.

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Monetary Policy Tools (3)

1. Reserve Requirement
2. Discount Rate
3. Open Market Operations

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Reserve Requirement

is a percentage of the money on deposit in a bank that cannot be used for lending purposes and must be transferred to a district Federal Reserve Bank. The original purpose of the reserve requirement was to assure bank depositors that their funds were safe and accessible in the event of a run on the bank.
By increasing or decreasing the reserve requirements of member banks, the Federal Reserve can increase or decrease the amount of money a bank has available to lend.
If the reserve requirement is increased, the amount of money available for lending is decreased, which may cause interest rates to increase.
A decrease in the reserve requirement would result in more money available for lending, which would cause interest rates to decrease.
Banks are required to balance their deposit accounts daily at the close of business, and they must adjust their reserve requirement accordingly. Failure to do so could result in severe fines, other disciplinary action by the Federal Reserve, or possible withdrawal of the bank’s federal charter.
Changes in the reserve requirement are the most abrupt of the three control devices used by the Federal Reserve since this action takes place the day the requirement is announced.

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Discount Rate

Federal Reserve members can borrow money from one of the 12 Federal Reserve district banks. The rate of interest that is charged by the Federal Reserve to a member bank on funds loaned is called the discount rate. It is called this because the interest on the loan is deducted from the loan proceeds when the loan is originated, with the bank receiving the net difference.
An increase in the discount rate causes a bank’s cost of doing business to increase. This increased cost will be passed to the borrowers in the form of higher interest rates. A decrease in the discount rate would have the opposite effect. Therefore, the Federal Reserve can influence the cost of credit in the United States by increasing or decreasing the discount rate. Since this affects only a small portion of the banking system, changes in the discount rate are considered to be the least effective of the Federal Reserve’s three tools. Even so, it usually generates the most publicity.

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Open Market Operations

the FOMC meets regularly throughout the year to review the state of the economy. Its actions can greatly influence the course of events in our country and throughout the world.

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Stimulating the Economy

if the FOMC believes the economy is in need of stimulation, the Committee may decide to purchase government securities on the open market. More money is placed into the economy by purchasing securities and interest rates will be reduced.

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Slowing Down the Economy

if the economy is seen as overheated, the FOMC may decide to sell government securities with interest rates higher than banks pay on savings accounts. This action removes money from the economy (disintermediation), makes less money available for loans, referred to as making money tighter, which causes interest rates to rise. When interest rates rise, less money is borrowed, thereby causing the economy to slow down.

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What is the most effective tool available to the Federal Reserve for controlling the money supply

Open market operations.
Each dollar transacted at the federal level leverages to about six dollars at the consumer level; every billion dollars leverages to about six billion dollars.

12

The Primary Mortgage Market

This is where loans are originated. The market consists of individuals and businesses that want or need to borrow money and the various sources for those loans. The sources may be individuals, institutional lenders, and other organizations formed to loan money as agents or middlemen for insurance companies or pension funds.
A major problem that faces a lender in the primary market is a constant flow of funds in order to continue to provide mortgage loans. A lender can exhaust its ability to make loans if the demand for mortgage money exceeds the amount of deposits received. This can occur during periods of disintermediation.

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The Secondary Mortgage Market

This has developed to provide a constant source of funds with which to make real estate loans. This market consists of secondary market lenders who purchase mortgages that originated in the primary mortgage market. Mortgages originated by primary lenders are bundled or packaged and sold to another lender in what is termed a secondary market transaction.
Investors in the secondary market are making a relatively low-risk investment since the primary lender has already qualified the borrowers and the properties. Each lender is requested to provide an estoppel letter thereby confirming the balance of each loan before the loan is sold in the secondary market. Federal lending law required that each borrower be notified whenever a loan is being sold to another lender. the terms of the original loan are unaffected by the sale.

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Benefits of a Secondary Mortgage Market

The secondary mortgage market provides liquidity to the primary market and solves the problem of the primary lender running out of funds. When the loan is sold, the amount that was originally loaned is replaced, thereby allowing the same money to be loaned again. The primary lender makes a profit by retaining the loan origination fees and the points charged to the borrower. It usually continues to service the loan after it has been sold.

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Secondary Market Lenders

The federal government has been instrumental in the organization of the secondary mortgage market. The principal secondary lenders are governmental or quasi-governmental agencies.

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Primary Mortgage Market Lenders

is a licensed individual who lends money. A mortgage lender’s license is required for anyone making a mortgage loan for compensation or gain, directly or indirectly, or selling or offering to sell a mortgage loan to a non-institutional investor.
Making a mortgage loan means closing a mortgage loan in a person’s name, advancing funds, offering to advance funds, or making a commitment to advance funds to an applicant for a mortgage loan.

17

Different types of mortgage lenders

1. Savings Associations (SA)
2. Commercial Banks
3. Credit Unions
4. Life Insurance Companies (LICs)
5. Real Estate Investment Trusts (REITs)
6. Mortgage Bankers

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Savings Associations (SA)

primarily used for residential loans. Saving associations, previously known as savings and loan associations, were originally organized to assist members with the financing of residential property. They were designed to serve only their own members. The association members would pool their money and take turns using the money to fund construction of members’ homes. After all the members built homes, the association was dissolved.

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Today a savings association can be organized either as

a stock organization owned by stockholders or as a mutual association owned by the depositors. Savings associations are chartered by either the federal government or by the states in which they operate. Savings associations provide both savings accounts that are called time deposits, and negotiable order of withdrawal (NOW) accounts that are referred to as demand accounts, which are the equivalent of a checking account.

20

Savings associations dominated

the residential mortgage market until deregulation of the banking industry in the 1980s. in the past, these institutions made most of their mortgage loans with depositors’ funds. The loans were held full term, with the savings association receiving the principal and interest payments from the borrower. A lender that retains and services mortgages that they originate rather than sell them to other investors is referred to as a portfolio lender.

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What happened to SA after the deregulation in the 1980s

many savings associations faced severe problems as a result of bad loans, poor decisions about the economy, fraudulent activities, and numerous other factors. The Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA) was passed by Congress to reorganize financial institutions in an effort to prevent a repeat of the crisis. The Resolution Trust Corporation (RTC) was formed to manage insolvent thrift institutions and sell their assets. The RTC completed the task of selling the assets of failed savings associations and was closed in December of 1996.

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Commercial Banks

are stock companies that are owned by their stockholders and are chartered either by the state or federal government. Commercial banks make short-term loans to assist commerce. Although commercial banks make some long-term real estate loans, the largest impact of commercial banks in the real estate market is that they make short-term construction loans.
Commercial banks also provide funds to mortgage brokers. Their funds come from demand deposits in checking accounts and time deposits in savings accounts. Deposits are insured for up to $250,000 by the Bank Insurance Fund (BIF), a division of the Federal Deposit Insurance Corporation (FDIC).
In recent years, commercial banks have assumed a larger role in the financing of residential property due to the failure of so many savings and loan associations.

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Credit Unions

is a nonprofit, cooperative financial institution owned and run by its members. Credit unions are membership organizations that provide their members with loans at reasonable rates. Members pool their funds to make loans to one another. The volunteer board that runs each credit union is elected by the members.
The Federal Reserve does not supervise or regulate credit unions. Federally chartered credit unions are regulated by the National Credit Union Administration, while state-chartered credit unions are regulated at the state level.

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Life Insurance Companies (LICs)

are organized as either stock companies owned by stockholders or mutual associations owned by the policyholders. Life insurance companies are regulated by the states in which they operate.
Life insurance companies have policyholders who pay premiums. These premiums accumulate and become available for loans and investments. Since actuarial tables make payouts fairly predictable, life insurance companies are interested in long-term real estate loans.
Life insurance companies are the largest source of funds for financing both apartment projects and commercial properties. They make direct loans or use the services of mortgage brokers. They also make extensive purchases of mortgage-backed securities in the secondary market.

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Real Estate Investment Trusts (REITs)

are formed by private investment groups to purchase real estate for investment, and to make short-term construction loans and long-term mortgage loans. A REIT is a business trust that operates similarly to a mutual stock fund in that individual investors make investments in the trust, thereby creating a pool of money that can be used to purchase, construct, or fund its real estate ventures. Its investments and loans are primarily in apartment complexes and commercial properties. If qualified, a REIT receives special tax treatment under federal income tax laws.

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Real estate investment trusts can be categorized

according to the purpose of the formation. Those that are formed to buy, own, and manage investment properties are called equity trusts. Others that are formed for the purpose of lending money to fund the construction and/or purchase of commercial or apartment projects are called mortgage trusts. Trusts that engage in both lending and ownership activities are called mixed trusts.
In the 1970s and early 1980s, REITs came on bad times, which was due largely to the economy and a lack of experienced management. They suffered a poor reputation in the market and were distrusted by investors.
In recent years, however, the economy has treated REITs more favorable. Professional management has become available and changes in the tax laws have made them a viable investment vehicle.
Today, REITs play a major role in the development, financing, and ownership of large apartment complexes and commercial properties.

27

Mortgage Bankers

is a company, individual, or institution that originates loans and earns fees associated with the origination.
The mortgage banker represents a certain funding source, such as a pension fund or insurance company. The funding source and the mortgage company develop their own set of guidelines unique to the industry. The mortgage banker locates consumers that meet these guidelines, funds the loan using the investor’s funds, and services the loan on their behalf.

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Warehouse Lending

In a process referred to as warehousing, or warehouse lending, mortgage lenders may borrow money as a line of credit from a commercial bank. These borrowed funds are used to fund additional mortgage loans that borrowers initially use to buy property. The mortgage lender secures an investor to whom the mortgage loan will be sold. Mortgage lenders depend on the eventual sale of the loan to replay the line-of-credit loan to the warehouse lender.
A warehouse loan typically lasts from the time it is originated to when the loan is sold into the secondary market.

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Mortgage Loan Originators (MLOs)

A mortgage loan originator (MLO) is an individual, who take residential mortgage loan applications or offers or negotiate terms of a residential mortgage loan for compensation.
MLOs do not make loans. They arrange loans by taking mortgage applications and searching for lenders who offer the lowest interest rates and easiest borrower qualification. MLOs charge borrowers an application fee and often earn a finder’s fee or commission for arranging loans.
MLOs may negotiate the terms or conditions of a new or existing mortgage on behalf of a borrower or lender. A MLO may also negotiate the sale of an existing mortgage loan to a noninstitutional investor for compensation.
A MLO license must be obtained from the Florida Office of Financial Regulation to engage in this business in this state.

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Mortgage Brokers

A mortgage broker is an individual who conducts loan originator activities through one or more licensed MLOs. The MLOs may be employed by the mortgage broker or work as independent contractors to the mortgage broker. A mortgage broker must be licensed by the Florida Office of Financial Regulation.