The Federal Reserve System
The role of the Federal Reserve System (the Fed) is to maintain sound credit conditions, help counteract inflationary and deflationary trends, and create a favorable economic climate.
The Federal Reserve System regulates the flow of money and interest rates in the marketplace through its member banks by controlling reserve requirements and discount rates.
Reserve requirements
The Federal Reserve System requires that each member bank keep a certain level of assets on hand as reserve funds. These reserves are unavailable for loans or any other use. This requirement not only protects customer deposits but also provides a means of manipulating the flow of cash in the money market. The amount of money a bank can loan is tied to this reserve amount.
Fed Controls
Decreasing reserve requirements lowers rates – Increases money for loans Increasing reserve requirements raises rates – Decreases money for loans
By increasing its reserve requirements, the Federal Reserve System in effect limits the amount of money that member banks can use to make loans. When the amount of money available for lending decreases, interest rates (the amount lenders charge for the use of their money) rise. By causing interest rates to rise, the Fed can slow down an overactive economy; higher rates limit the number of loans that would have been directed toward major purchases of goods and services. The opposite is also true: By decreasing the reserve requirements, the Fed can encourage more lending. Increased lending causes the amount of money circulated in the marketplace to rise while simultaneously causing interest rates to drop.
Discount rate
Federal Reserve member banks are permitted to borrow money from the district reserve banks to expand their lending operations (increase reserves).
The discount rate is the rate charged by the Federal Reserve when it lends money to its member banks.
The prime rate (the short-term interest rate charged to a bank’s largest, most creditworthy customers) is strongly influenced by the Fed’s discount rate. In turn, the prime rate is often the basis for determining a bank’s interest rate on other loans, including home mortgages.
When the Federal Reserve System discount rate is high, bank interest rates are high. When bank interest rates are high, fewer loans are made and less money circulates in the marketplace. A lower discount rate results in lower interest rates, more bank loans, and more money in circulation.
The Primary Mortgage Market
The primary mortgage market is made up of the lenders that originate mortgage loans. These lenders make money available directly to borrowers. From a borrower’s point of view, a loan is a means of financing an expenditure; from a lender’s point of view, a loan is an investment. All investors look for profitable returns on their investments. Income on the loan is realized from two sources:
In addition to the income directly related to loans, some lenders derive income from servicing loans for other mortgage lenders or the investors who have purchased the loans. Servicing loans involves such activities as:
Primary Mortgage Market
Thrifts
Savings associations
Commercial banks
Insurance companies
Credit unions
Pension funds
Endowment funds
Investment group financing
Mortgage banking companies
Mortgage Broker Licensing
The federal Secure and Fair Enforcement for Mortgage Licensing Act of 2008 (SAFE Act) requires that each individual state must license and register mortgage loan originators (MLOs).
A MLO is defined as anyone who, for compensation or expectation of compensation, takes a residential mortgage loan by phone or in person. Among those exempt from license requirements are those who perform only clerical or administrative tasks and real estate licensees unless compensated by a loan originator. Because Illinois is a participant, all Illinois MLOs are required to register. Illinois also requires an eight-hour continuing education course.
The Secondary Mortgage Market
In the secondary mortgage market, loans are bought and sold only after they have been funded by primary lenders.
Lenders routinely sell loans to increase reserves, avoid interest rate risks and to realize profits on the sales. This secondary market activity helps lenders raise capital to continue making mortgage loans. Secondary market activity is especially desirable when money is in short supply; it stimulates both the housing construction market and the mortgage market by expanding the types of loans available.
When a loan is sold, the original lender may continue to collect the payments from the borrower. The lender then passes the payments along to the investor who purchased the loan. The investor is charged a fee for servicing of the loan.
In the secondary market, various agencies purchase a number of mortgage loans and assemble them into packages (called pools). These agencies purchase the mortgages from banks and savings associations. Securities that represent shares in these pooled mortgages are then sold to investors or other agencies and the public.
Institution                                Secondary Market Function
Fannie Mae                             Conventional, VA, FHA Loans
Freddie Mac                            Mostly conventional loans
Ginnie Mae                              Special assistance loans
Fannie Mae
In September 2008, the Federal National Mortgage Association (Fannie Mae) became a government-owned enterprise. Until that time, it was organized as a completely privately owned corporation that issued its own stock.
Then, as now, it provides a secondary market for mortgage loans. Fannie Mae deals in conventional and Federal Housing Administration (FHA) and Department of Veterans Affairs (VA) loans. Fannie Mae buys from a lender a block or pool of mortgages that may then be used as collateral for mortgage-backed securities that are sold on the global market.
Ginnie Mae
The Government National Mortgage Association (Ginnie Mae) has always been a governmental agency. Ginnie Mae is a division of the Department of Housing and Urban Development (HUD), organized as a corporation without capital stock.
Ginnie Mae guarantees mortgage backed securities using FHA and VA loans as collateral.
The Ginnie Mae pass-through certificate is a security interest in a pool of mortgages that provides for a monthly pass-through of principal and interest payments directly to the certificate holder. Such certificates are guaranteed by Ginnie Mae.
Freddie Mac The Federal Home Loan Mortgage Corporation (Freddie Mac) is also now a government-owned enterprise, similar to Fannie Mae, which provides a secondary market primarily for conventional loans.
Many lenders use the standardized forms and follow the guidelines issued by Fannie Mae and Freddie Mac. In fact, the use of such forms is mandatory for lenders wishing to sell mortgages in the agencies’ secondary mortgage market. The standardized documents include loan applications, credit reports, and appraisal forms.
