The Effect of Mortgage Refinancing on Money Demand and the Monetary Aggregates

Richard C. Anderson

Richard fi Anderson is a research officer with the Federal Reserve Bank of St. Louis. Heather Deaton provided research assistanca

ll~tONEY SERVES AS A medium of exchange Simple models of the demand for money as a for transactions involving financial instruments medium of exchange often implicitly assume that as well as real goods and services. Unfortunately, the purchase or sale of a good or service is com- the total volume of tt-ansactions iti the economy pleted within a relatively brief period. Unlike is not observable. As a result, economic analyses the transactiomis in these models, the refinancing of rnomiev demand typically focus on the t-elation- of a r’esidential mortgage that has been securi- ship between the quantity of money demanded tized in the secondary market initiates a sequence and the production of new goods and services, of transactions that may continue for four to six measured by either gross domestic product or weeks, or niore. During this time, the quantity personal consumption expenditures. Because ag- of liquid deposits demanded increases. When the gregate volumes of financial and nonfinancial last transactiomi in the sequence is concluded, transactions likely move in par~tllelwith the out- the quantity of deposits demanded falls back put of new goods and services, the use of out- ceterus paribas to its earlier level. put rather than the volume of transactions may Mortgage refinancing is an important phenome- cost little in terms of understanding movements non in the United States because most homes in the monetary aggregates. In some periods, are financed with long-term, fixed-rate amortized however, events occur which remind us that mortgages that contain a ‘‘put’’ option, allowing this is not always the case. This article examnines the horrower to repay the outstanding principal the effect of one such ongoimig recent event— amount of the loan at any time without pen alt~’. the refinancimtg of residential mortgages— Homeownet-s typically exercise that option when on money demand.’ mortgage rates fall significantly (1-2 percentage

1 Other recent examples include the Tax Reform Act of 1986, Committee on Monetary Statistics (1976). The Bank of which boosted household liquid deposits in late 1986 and England regularly publishes such analyses; see Pepper early 1987, and the closure of large numbers of thrifts by (1992, 1993) and Topping and Bishop (1989). the Resolution Trust Corporation. Recognizing that special factors can significantly distort growth of the monetary aggregates, the Bach commission recommended that the Federal Reserve regularly undertake and publish studies of the effects of special factors; see Report of the Advisory 50

points) below recent previous levels by taking during late 1991, the third quarter of 1992 and out a new mortgage loan to repay the old. the second quarter of 1993, liquid deposit growth As shown in figure 1,2 extensive mortgage re- accelerates. As refinancings continue at the financing has occurred during two periods in higher rate, deposit levels converge to the new the last decade, 1986—87 and 199 1—93. In the desired level and deposit growth slows. When former, an initial surge in refinancing during refinancing activity subsides—as in mid-1992 1986 was interrupted by a pause, before fears and early 1993—liquid deposit growth slows fur- of rising market rates launched a second round ther and deposits may run off. in 1987. In the latter, three waves of refinancing —of increasing magnitude—mirm’om’ed the halting Through its effect on liquid deposits, mortgage fall in long-term market interest rates. During refinancing sharply increased the volatility of 1992, for example, nearly one-fifth of all home- Ml during both 1986—87 and 1991—93, as shown 3 owners refinanced their mortgages. In 1993, in figure 34 At the same time, the volatility of the volume of refinancing activity will surpass the broadem’ aggregate M2, shown in figure 4, 1992’s record pace. apparently was only slightly affected. In large part, the lower sensitivity of M2 to mortgage The next section of this article describes the refinancing reflects the much smaller share of changes in the growth and volatility of liquid transaction deposits in M2 (about 20 percent) deposits and Ml that have occurred during than in Ml (about 70 percent). The small periods of extensive mortgage refinancing. The changes that do appear in the volatility of M2 article then examines the extent to which these closely resemble changes in its non-MI com- changes may be related to increases in mortgage ponent.5 securitization. Finally, it explores whether recent fluctuations in the growth of other checkable The ability of increases in mortgage m’efinancing deposits (OCD5) since 1991 also may be related to affect the level and volatility of liquid deposits to mortgage refinancing. and Ml is in part due to the borrowed reserves operating procedure used by the Federal Reserve MORTGAGE REFINANCING AND to control the growth of M2. During the last decade, this operating procedure has largely MONEY DEMAND evolved into one that closely stabilizes the feder- The increases in liquid deposits that have ac- al funds rate about a level thought to he consis- companied accelem’ations in mortgage refinanc- tent with the desired amount of discount ing since mid-1990 are shown in figure 2. The window borrowing and the growth of M2. To link betweemi mortgage refinancing and liquid maintain the desired levels of the federal funds deposit growth is a stock adjustment process rate and discount window borrowing, transitory wherein the stock of liquid deposits responds to imicreases in the demand for reserves are auto- changes in the flow of m’efimiancings. When the matically accommodated with increases in the 6 pace of mortgage refinancing increases, as it did supply of nonborrowed reserves.

2 ln the figure, the volume of refinancing activity is proxied No such correlations between refinancing-related deposit by liquidations of mortgage-backed securities, This concept inflows and nontransaction funding sources are apparent in is explored further in this article. the data, however. 3 6 Nineteen percent of the homeowners interviewed in Fannie For an analysis of the borrowed reserves procedure and its Mae’s 1993 national housing survey had last refinanced relationship to federal funds rate targeting, see Thornton their mortgage between January 1992 and March 1993. An (1988). For a careful discussion of why and how reserves- additional 3 percent had refinanced during 1991 and 1990. based targeting procedures evolve into federal funds rate 4 The coefficient of variation shown in the figure equals the targets, see Meulendyke (1990). ratio of the standard deviation to the mean of the series, each calculated from the most recent 12 months of data, The coefficient of variation indicates whether the variability of the data has increased or decreased over time relative to its average level. 5 The volatility of M2 differs little from that of its non-MI component. It is feasible that banks’ cash management practices might account for the insensitivity of M2 volatility. Increases in liquid deposits provide additional funds to banks. If bank cash managers respond by reducing their issuance of overnight repurchases (RPs), the change in the volatility of M2 might be considerably less than that of Ml. 51

Figure 1 Mortgage Interest Rate and Refinancing Activity

Percent Billions of dollars Monthly data, January 1984-September 1993 16

15 Contract rate on 30-year, fixed rate conventional mortgages 14 (left scale) 13

10 9

** Liquidations of federal-agency-guaranteed mortgage-backed securities.

Figure 2 Refinancing Activity and Liquid Deposits Billions of dollars Monthly data, seasonally adjusted 50 - Index of mortgage ~clngactlvlty** 40— Change in Liquid Deposits 30 —

20 —

10 L I till rdt liii I’d’ H Liquid Deposits Demand Oeposits+Other checkable Deposits..- Savings and MMDA deposits

~10 11111 J ASONDJFMAMJ JASONDJ FMAMJ JASONDJ FMAMJJ AS 1990 1991 1992 1993

** Liquidations of federal-agency-guaranteed mortgage-backed securities. 52

Figure 3 Refinancing and the Volatility of Ml Billions of dollars Index Monthly data, seasonally adjusted 25 18 20 16

15 14

10 12

5 10

-5 -10 -15 -20

Shaded areas are periods of heavy refinancing activity.

Figure 4 Refinancing and the Volatility of M2 Billions of dollars Index Monthly data, seasonally adjusted 35 lB 30 14 25 20 12 IS 10 10 5 8 0 -5 6 -10 4 -15

-20 2 -25 -30 0 1984 85 86 87 88 89 90 91 92 1993

Shaded areas are periods of heavy refinancing activity. 53

THE ROLE OF MORTGAGE a part of the Department of Rousing and Urban SECURITIZATION Development, guarantees payments on MBSs backed by pools of Federal Housing Administra- The increase in mortgage securitization during tion (Fl-IA) and Veterans Administration (VA) the last decade has increased the potential for mortgages. ‘T’he Federal National Mortgage mortgage refinancing to affect the growth of the Association (Fannie Mae, or FNMA), a federally 7 monetary aggregates. ‘The sale of mortgages in chartered, privately owned stock corporation, the secondary market creates an additional finan- and the Federal Home Loan Mortgage Corpora- cial instrument—the mortgage-backed security, tion (Freddie Mac, or FHLMC), a wholly owned or NIBS—and involves a number of additional subsidiat’y of the federally charter’ed Federal firms in the mortgage process, including the 1-lomne Loan Bank System, guarantee payments originators of the mortgages, the assembler of on MUSs hacked by pools of conventional 9 the mortgage pool (who also issues the MBS5), mortgages. the servicer of the mortgage pool (who collects monthly payments and disburses funds to inves- Absent refinancings or home sales, MBS investors receive a monthl payment that includes tors) and, typically, at least one government agency. The refinancing of securitized mortgages the scheduled amortization of the pool’s mort- thus beconies a circuitous calling and refunding gage principal plus the accumulated interest. of relatively large amounts of long-term, publicly Refinancings, home sales and an occasional ex- held debt. Elevated levels of liquid deposits may tra payment by a homeowner return additional persist for four to six weeks or more, until all (or unscheduled) principal pro rata to the related transactions are settled. holders of the MBSs backed by that mortgage pool. The monthly liquidation for a mortgage Legally, mortgage securitization entails com- pool is the sunt of the scheduled and unscheduled bining a fixed pool of mortgages imito a trust. principal payments returned to investors. Note The mortgages serve as collateral for MBSs sold that MBSs aren’t “called” in the traditional sense against the trust. The servicer of the MBSs, as a associated with corporate bonds, hut rather are trustee, collects payments from homeowners only proportionately liquidated or repaid. and passes them through without taxation to the holders of the MBSs. Liquidity of the MBSs As shown in the upper panel of figure 5, the is enhanced by obtaining a third-party guaran- outstanding stock of MBSs increased about six tee covering the payments that will be due to fold during the last decade, much more rapidly investors if homeowners pay at the scheduled, than Ml or M2. With few changes in mortgage minimum contract rate. Three federal-govern- servicing rules and practices during the last mnent-sponsored enterprises, known as ‘agen- decade, the rapid growth of securitization sug- cies,” dominate that business.t For a fee, these gests that the transactions incurred in refinancing agencies guarantee the payment of principal securitized mortgages will have larger effects on and interest on securities backed by pools of the monetary aggregates in the 1990s than they specified mortgages. The Government National did in the mid-I 980s. Annual liquidations of Mortgage Association (Ginnie Mae, or GNMA), MBSs, shown in the lower panel of the figure,

7 See Duca (1990) for an analysis of the interactions between the balance was originated by private lenders under a demand deposits and mortgage refinancing during 1986—87. FNMA guarantee plan. FNMA’s 1992 Annual Report em- °Asmall amount or MBSs is issued without agency guaran- phasizes the off-balance-sheet contingent risk nature of these securities: “MBS are not assets of the corporation tees. Bank of America issued the first such private mortgage pool in 1977. In 1992, private mortgage pools IFNMAI, except when acquired for investment purposes, nor are the related outstanding securities recorded as lia- represented only 8 percent of all outstanding pools. For bilities. However, the corporation is liable under its guaran- background, see Downs (1985) and Pavel (1986). tee to make timely payment of principal and interest to °Theprecise nature of the guarantee varies somewhat by investors. The issuance of MBSs creates guaranty fee in- agency. ONMA and FNMA guarantee timely (within the come with Fannie Mae assuming credit risk, but without month) payment of principal and interest, regardless of assuming any debt refinancing risk on the underlying payments by the borrower, FHLMC guarantees timely pay- pooled mortgages.” In 1992, FNMA recorded $834 million ment of interest and eventual (within the year) payment of in guaranty fees. principal. In addition to issuing guarantees on MBSs backed by privately assembled mortgage pools, FNMA and FHLMC may purchase mortgages outright and market MBSs backed by pools of those mortgages. In 1992, for example, FNMA “issued” (guaranteed) $194 billion in MBSs. Of that amount, about $13 billion were originated by FNMA itself; CD -~ -L -~ CD ii ‘A ,,.A M 0 0 = r’3 a CD CD 0 l~) a -~ CD 0 Ui 0 01 0 01 = 0000000 = 0(0 0 000 0 00 00 ~ 0000000 00 -% C -s I ~JJJJ~j~~ ~ CL) CD 0 a t°°~ _____ a -~ _____ a

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have on balance increased in proportion to the two to six weeks (see the shaded insert).” outstanding stock except for significant surges Estimates of the size of this effect on monthly during periods of refinancing. Annual liquida- growth rates of demand deposits, Ml and M2, tions iumped to ahout 17 percent of the out- are shown in figure 6.12 When MBS liquidations standimig stock of Ntl3Ss during 1986—87 and 19 accelerate, the growth rates of demand deposits percent during 1991—92. More recently, liquida- and Ml after removing the MI3S effect are tions dut’ing June through September 1993 smaller than the published growth rates. Con- averaged nearly $44 billion a month, almost a ver’selv, when MBS liquidations slow, the NIBS- 40 percent annual rate. Recent further decreases adjusted growth rates are larger than the pub- 111 mot1gage rates portend continuing high liqui- lished rates. Overall, the estimated differences dation rates during late 1993 and early ]994b0 in growth rates equal in some months as mnuch ‘I’he increase in deposits that follows an in- as one-half of the change in MI. F’rom Decemher ct-ease in mortgage refinancing activity may in 1991 to March 1992, for example, inflows to part he traced to the mechanics of mortgage mortgage servicers’ custodial accounts are esti- securitization and servicing. Mortgage servicers’ mated to have added hetween 5 to 10 percentage handling of the unscheduled principal payments poitils to the monthly growth rates of demand associated with refinancings is governed by the deposits. ‘l’he largest estimated effects were in rules of the federal agency that guam’antees the October 1992 and May 1993, when MUS-related MBSs issued against the mortgage pool. In gener- inflows likely accounted for four-fifths and al, these rules require that mortgage servicers three-fifths, respectively, of demand deposit hold unscheduled principal payments in special growth. In both cases, deposit growth slowed custodial accounts during the interval between sharply in later months when deposit levels had receipt from homeowners and disbursement to increased enough to support the accelera ted NIBS investors. GNMA requires that these cus- pace of mnortgage activity. Subsequemitly, during todial accounts be non-interest-bearing demand the first quarter of 1993, runoffs of servicers’ deposits. FNMA allows funds to he held in custodial balances likely depressed monthly interest-bearing accounts as long as they are imn- average deposit growth by as much as 10 per- mediately available without prior notice of with- centage points. dra’ val. FFILMC’s rules are similar to ENMA’s. 1 ‘these patterns show through to Ml (see the A surge in refinancing greatly increases the center panel of figure 6) but are muted. Curren- monthly average amount of funds held in liquid cy and OCDs, which comprise two-thirds of Nil, deposits by a mortgage servicer. In a typical are unlikely to he affected by MBS activity.” month without refinancing, a set-vicer holds a Nonetheless, the distortions to demand deposits homeowner’s mortgage payment for a relatively are sufficient that monthly growth rates of MI brief period of time (up to 15 days) before since mid-1992 appear to ha~•’ebeen distorted remittance to investors. Following a mortgage by as much as 5 to 7 percentage IJoints. Similar refinancing, however, the servicer will hold the estimates for M2 that include estimated effects unpaid principal balance of the extinguished on money market demand account (MMDA) mortgage loan—an amount perhaps 10 to 100 balances are shown in the hottormi panel of the (or- more) times as large as the homeowner’s figure. regular monthly principal payment—in a custodial account for a much longer period, often Overall, fluctuations in mortgage servicers’

ttWhile it is always risky to forecast financial market activity, ing a refinancing, the funds received by the servicer from recent decreases in mortgage rates (through October 1993) the homeowner (at any time within the month) are placed are likely to trigger substantial further increases in re- in a custodial account, These funds are remitted by the financing and MBS activity during late 1993 and early servicer to MBS investors after the middle of the following 1994. In addition to older mortgages issued during the month. The exact date, however, depends on the contract 1980s, mortgages that were issued as little as 12 to 18 specifications of the agency guarantee program under months ago at 7 to 7-112 percent rates now may profitably which the M8Ss backed by the mortgage pool that con- be refinanced. Rather than the pace of refinancing slowing tained the extinguished mortgage were issued, See, for ex- and related distortions to the monetary aggregates diminish- ample, Karcher (1989). ing as the outstanding stock of seasoned MBSs are rolled “Construction of these estimates is discussed in the ap- over, recent rate decreases have placed nearly the entire pendix. outstanding stock of MBSs “in the money” for rollover. 1t “The next section raises the possibility that OCD balances Homeowners typically make monthly mortgage payments also might have been affected by refinancing since 1991, between the 1st and 15th of the month, with the servicer albeit not through MBS-related transactions. remitting these funds to M6S investors on the 15th. Follow- 56

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custodial deposits likely account for about one- els. Also omitted are any increases in liquid half of the i ect nt increase in Ml volatility It is deposits that arise because of the stgnificant unlikely that these estimates ate too large, since volume of additional transactions used to pur- they are based on legal restrictions imposed on chase and sell large qu-intities of mortgages and mortgage servicers by federal agencies and NIBS. realistic but conservative assumptions regat ding intra month patterns of mortgage closings and HOUSEHOLD DEPOSITS AND deposit behavior. REFINANCING The estimates may be biased dot~nwaid, however, for a number of reasons. The most In addition to demand deposits, changes in nportant perhaps is the omission ot any in OCDs since mid-1991 also have reflected the crease in deposits held by issuers of new MBSs. ebbs and flows in the pace of mortgage As some issuers draw on bank warehouse refinancing (ste the upper panel of figure 7). credit lines to fumJd the purchase of mortgages I lie apparent increase in the correlation of to be assembled into new MBS pools, they may Of Ds with demand deposits contrasts with its offs.t part of the hank charges for these lines behavior before 1991 and during 1986—87, the via earnings credits ha ed on their deposit let’ latter shown in the lower panel of figut e 7. 57

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Should some poi-tion of the OCD fluctuations to mortgage activity is necessar ilv less direct during 1991—93 be attributed to mortgage re- and more circumstantial than that for demand financing activity? If so, and if the impact of re- deposits. I racing direct links between house- financtng on OCUs were similar to its effect on hold deposits and economic activity is generally demand deposits, then their combined effects not possible, since the Federal Reser~e collects could account for as much as three-quarters of deposit data from the issuers of deposits such as Ml’s growth during a number ol months since banks and thrifts rather than from the o~net s of 1991. deposits, including households and firms.” I he recent parallel monthly movements in Why might a household increase its OC I) these two types of liquid accounts i- compelling balances following a mortgage refinancin~Q One hut puzzling. Any ct idence linking these deposits possibility could be thc convt m sion of home eq

“Although the Federal Reserve Boards flow of funds ac- for firms and government. See Guide to the Flow of Funds counts present a fairly complete balance sheet for the Accounts, p. 120 household sector, few items are directly observed Most en- tries are calculated as residuals, interred from the double- entry nature of the accounts and from balance sheet data 58

Figure 6 Published Growth Rates Less Rate Adjusted for MBS Activity

Demand Deposits Percent 30

-10

-20 JASONDJFMAMJJASONDJFMAMJJASONDJFMAMJJAS 1990 1991 1992 1993

Ml Percent Monthly data 8 6- 4- 2— 0— -2—

-4— -6- JASONDJFMAMJJASONDJFMAMJJASONDJFMAMJJAS 1990 1991 1992 1993

M2 Percent Monthly data 3

0 —1 ~ -2 JASONDJFMAMJJASONDJFMAMJJASONDJFMAMJJAS 1990 1991 1992 1993 59

HQLIrO / Average Month’y Change in Demand DeposiS ard OCDs. by Quarier

B!lhons CT dollars

1990 1991 1992 1993

-, . ,~T r.p ~eLt~ ~

OCDs ~--i[ ~1

m:~7 ~--- ~j_ i9~35 1936 1927 19a8 60

uity into cash at the time of refinancing. If at refinancing more households tended to forego operative, this factor should be much stronger a shorter maturity in favor of lower monthly during the 1990s than during 1986—87, for two payments, consistent with reducing the impor- reasons. First, many households have been res- tance of home equity in their portfolios. (Unfor- tructuring their balance sheets, seeking to reduce tunately, the survey did not ask about the the levels of debt (and debt service) that they withdrawal of home equity at refinancing.) took on during the 1980s. Flomne equity convert- Home equity lending at banks, shown in figure ed to cash at refinancing allows them to repay 8, also has been weak since mid-1991, with other outstanding debt and reduce monthly reports suggesting that homeowners are indeed debt service. Second, households generally ex- repaying outstanding home equity loans with perienced large capital gains on houses during cash withdrawn at the time of a mortgage the 1980s. For many, capital gains in housing refinancing. appeared largely as a windfall, accruing mom-c rapidly than had been anticipated when the While the growth in OCDs likely reflects home was purchased and without any overt ef- changes in households’ deposits, some profes- fort by the homeowner. As such, these in- sionals and small businesses also may account creases in wealth likely were not optimally for a portion of the increase. Some real estate deployed (from a portfolio standpoint) across all payment practices tend to increase the demand household asset categories. For other home- for OCDs when mortgage activity increases. I’he owners who nught have preferred to consume 1969 Truth in Lending Act, for example, im- the increased wealth rather than save it, the plemented through the Federal Reserve’s Regu- capital gain appears as a type of forced saving lation Z, requires a three-day, right-of-rescission in the form of home equity. While a home equi- period for any new credit transaction secured ty loan may increase the liquidity of home equi- by the borrower’s principal residence.’~During ty, it doesn’t permit the household to consume a this period, settlement agents typically hold windfall increase in home equity, since the loan funds in a liquid deposit, or perhaps in the must be repaid. Flence, there may be some form of cashier’s and officers’ checks. If the pent-up demand by homeowners for redirecting funds are held solely for the beneficial interest part of their home equity toward balance sheet of the household, they may he placed in an restructuring (reducing other consumer debt), OCD account.’°Cashier’s and officers’ checks consumption or perhaps redeployment into issued by banks are included as demand deposits more liquid assets. in Ml, while such checks issued by thrifts typically are included in OCDs. Although no direct data on cash withdrawals at mortgage refinanciugs are available, recent This supportive yet largely circumstantial evi- evidence is supportive. Fannie Mae’s 1993 na- dence leaves a number of unanswered questions. tional housing survey asked households whether If a household extracts funds at refinancing to their primary motivation in refinancing was to repay a home equity loan, how long will it keep shorten the maturity of the loan (thereby build- the funds in a liquid deposit? And isn’t the ing equity more quickly) or to reduce their amount of funds almost surely far smaller than monthly payments. While a shorter maturity the amounts held by mortgage servicers, associ- was the motive more frequently stated, in fact ated with MBS refunding activity? If so, can the

“These provisions do not apply to home purchases, nor to ence to hold the funds as OCOs. OCDs have no restrictions refinancings with the same lender for an amount equal to on the number of third-party withdrawals per month. While or less than the unpaid principal balance. The Act exempts both OCDs and MMDA deposits are included in M2, data from right-of-rescission provisions residential mortgage on MMDAs have not been collected by the Federal transactions’ which are defined in the Act as extensions of Reserve System since September 1990. Banks and thrifts credit to acquire a principal residence. In May 1987, at the began reporting that month only a combined total for all request of mortgage market participants, refinancings with savings and MMDA deposits. Hence, no separate analysis the same lender were exempted from Regulation Z. At the of MMDA deposits is shown in this article. time, it was felt that this change likely would significantly reduce the number of refinancings subject to right-of- rescission provisions. 16 0n the eligibility of lawyers to hold a client’s funds in OCD deposits, see section 2-341 of the Fed’s Regulation 0 in Federal Reserve Regulatory Service (1993). Client funds also may be placed in MMDA deposits, although the rul- ings contained in section 2-341 perhaps suggest a prefer- 61

Figure 8 Refinancing Home Equity Lending

Billions of dollars Billions of dollars Monthly data

3 - bu

Index of mortgage 2.5 refinancing activity 50 -40 Chan9e hi outstanding stock ~ 2 commercial banks (left scale) t5

1 I I I III~ I - I

0.5 - 0 I 0

-0.5 II liii Iii till Ill liii II liii iii liii ill 10 JASONDJ EMAMJJASONDJFMAMJJASONDJ FMAMJJA 1990 1991 1992 1993

increasingly parallel movements in OCDs reason- rules governing the custodial accounts of mort- ably he attributed to refinancing activity? On gage servicers. The mechanism generating balance, while the sharp increase in the correla- parallel high-frequency movements in OCDs, tion between the changes in OCDs and demand however, is far less clear. The coincidence of its deposits since 1991 suggests an underlying rela- timing with changes in refinancing activity and tionship to mortgage refinancing, the magnitude the onset of unusual weakness in home equity of any effect on the monetary aggregates remains lending in 1992 suggest that it may be related uncertain and a convincing explanation elusive. to the ongoing restt’uctur’ing of household balance sheets during the 1990s. SUMMARY

Any factors that increase the demand for transaction deposits can distort the growth of the REFERENCES monetary aggregates over significant periods of time. Recent waves of mortgage refinancing ac- Board of Governors of the Federal Reserve System. Federal Reserve Regulatory Service, volume 1 (October 1993). tivity have caused significant fluctuations in liquid deposits and Ml. Under current Federal ______Guide to the Flow of Funds Accounts (Board of Governors of the Federal Reserve System, 1993), Reserve operating procedures for controlling the “Improving the Monetary Aggregates;’ Report of the growth of M2, such transitory changes in the Advisory Committee on Monetary Statistics (1976). demand for liquid deposits, like those associated “Money Stock Revisions,” supplement to the Federal with mortgage refinancing, at-c automatically ac- Reserve statistical release, /1.6 (February 4, 1993). commodated through changes in bank reserves, Downs, Anthony. The Revolution in Real Estate Finance (The leading to increased volatility of Ml - Brookings Institution, 1985). Duca, John V. “The Impact of Mortgage Activity on Recent A large portion of this increased volatility of Demand Deposit Growth,” Economics Letters (February demand deposits can be traced to fiduciary 1990), pp. 157—61. 62

Federal National Mortgage Association. 1992 Annual Report Pepper, Gordon, “Controls and Distortions: Monetary Policy in (Federal National Mortgage Association, 1992). the 1970s,” National Westminster Bank Quarterly Review (February 1992), pp. 58—72. ______Fannie Mae National Housing Survey 1993 (Federal National Mortgage Association, 1993). “Monitoring the Money Supply and Distortions to Karcher, Louis J. Processing Mortgage-Backed Securities Monetary Data;’ National Westminster Bank Quarterly (New York Institute of Finance, 1989). Review (February 1993), pp. 40—58. Meulendyke, Ann-Marie. “A Review of Federal Reserve Policy Targets and Operating Guides in Recent Decades;’ in Inter- Thornton, Daniel. “The Borrowed-Reserves Operating Proce- mediate Targets and Indicators for Monetary Policy (Federal dure: Theory and Evidence,” this Review (JanuarylFebruary Reserve Bank of New York, 1990), pp. 452—73. 1988), pp. 30—54. Pavel, Christine. “Securitization;’ Federal Reserve Bank of Topping, S.L., and S.L. Bishop. “Breaks in Monetary Series,” Chicago Economic Parspectives (JulylAugust 1986), Bank of England Discussion Paper, Technical Series No. pp. 16—31. 23 (February 1989).

Appendix Estimates of Mortgage Servicers’ Custodial Account Balances

This appendix employs methodology suggested for example, hut only one-quarter in 1991—93. by Duca (1990) to estimate the impact of re- The largest volumne of liquidations during financing on the amount of liquid deposits held 1991—93, on balance, has been FFILMC issues by mortgage servicers.1 At refinancing, the out- that have a smaller impact, dollar for dollar, on standing principal of an extinguished securitized liquid deposits than liquidations of GNMA- or mortgage is returned to the mortgage servicer. FNMA-guaranteed MBS. Following rules established by the federal agency ‘the increase in liquid deposits due to MRS liq- that guaranteed the MI3Ss issued against the pool uidations is estimated from a simple simulation. containing the mortgage, servicers place incom- The parameters are’: ing unscheduled payments in custodial accounts The proportion of MRS liquidations during a (liquid deposits) until remnitted to the holders of month that result from scheduled amortization the MBSs around the middle of the following of principal (not-rn hq}. Separation of sched- month. Since the servicing rules of the three uled from unscheduled payments mailers for agencies differ, the overall increase in custodial reasons explained in the text. Estimates in this deposits that follows an increase in refinancing article assume that scheduled principal pay- depends on the agency composition of MBS liq- ments equal 1 percent tat an annual rate) of the 2 uidations. Differences in this composition during outstanditig stock of MBSs. 1991—93 relative to earlier periods have attenu- The average number of days, expressed as a pro- ated the deposit impact of recent MBS liquida- portion of the month, that unscheduled principal tions from what might have been expected. payments are held in custodial accounts during GNMA-guaranteed issues made up about one- the month in which the refinancing occurred half of aggregate liquidations during 1986—87, (GNMA this rnonth, FNMA ~,. this

‘The model in this appendix differs from Duca’s in some tive set of estimates that assumed scheduled monthly respects, including assuming a more uniform rate of mort- amortization equal to 2 percent of outstanding aggregate gage closings during each month and that funds remain in principal had a relatively large number of months wherein liquid deposits somewhat longer during the month follow- actual principal payments were less than estimated sched- ing the refinancing before they are withdrawn by investors. uled payments and, hence, was rejected as implausible. 2 The exact monthly scheduled amortization rate is a func- tion of the outstanding balances, rates and terms on the mortgages in the pool. Such calculations require extensive databases well beyond the scope of this study. An alterna- 63

month, FHLMC this — month). Payments Liquidations and unscheduled principal pay- received by servicers early in the month have ments for FNMA and FHLMC are calculated in larger impacts on month-average deposit levels the same manner. than payments received late in the month. Herein it is assumed that mortgages close at a ‘I’he amount of demand deposits that are cus- uniform rate during the month. Under this as- todial account balances due to GNMA mortgage sumption, the weighted average holding period servicers is calculated as: for payments received by GNMA and FNMA

ser\’icers is 0.50 months, i.e., GiMVIA — this VIA — dda = GNMA this — month *Gj\TMA

month — ENMA — this month = 0.50. for — on + GNMA — last month *GNMA on FHLMC serviccrs, who generally hold unsche- — lag. duled principal payments for five days or less, an average holding period of 0.15 months is For FNMA servicers, the amount is: assumed,

The average number of days, expressed as a pro- FNMA — dc/a = (1 -MMIJA share) * (FNMA — portion of the month, that funds due to MRS this — month * FNMA — on + FNMA /ast investors are held in liquid deposits during the — month *FNMA tin lag); month following the refinancing (GNMA last month, FNMA last — month). Under and for- FHLMC it is: GNMA and FNMA servicing rides, unscheduled principal payments received by servicers during FHLMC — dda = FHLMC — this month * the preceding month are remitted to investors FF-JLMC — on on the 15th and 18th of the current month, te- spectively. Funds may be on deposit longer if A similar calculation is made for’ the holdings of investors do not withdraw them immediately. Values of 20 days and 23 days, corresponding MMDAs by FNMA servicer-s. to GNMA last — month = 0.67 and FIVIvIA An MRS-adjusted, not seasonally adjusted last month 0.77, are used in the calcula- (n.s.a.) demand deposit series is obtained by tions below. These somewhat longer periods subtracting the sum (GNMA — dda + ENMA — wet-c suggested by examination of daily deposit dda + FHLMC — dda) from published n.s.a. data reported to the Federal Reserve by sever-al monthly levels of demand deposits. The resulting large banks. For FHLMC, this is set equal to zero, demand deposit series is seasonally adjusted us- ing the seasonal factors for demand deposits For l”NMA servicers, the proportion of incom- published by the Federal Reserve Board staff in ing funds placed in MMDAs rather than demand Money Stock Revisions (1993). (Seasonal factors deposits (IVIA’IDA share). A value of 0.25 is as- are recovered from the published data by divid- sumed below,’ Funds in M MUAs are assumed to ing the n.s.a. level by the s.a. level.) The differ- remain on deposit for the same nutnber of days ences in growth rates of demand deposits and as funds placed in demand deposit accounts. MI shown in the upper two panels of figure 6 Monthly liquidation of GNMA-guaranteed MBSs are calculated from published and these adjust- equals, by definition, the amount of GNMA- ccl data. guaranteed MRSs issued during the month minus An MBS-adjusted, non-MI component of M2 is the change in the amount of GNMA-guaranteed obtained by subtracting the estimated amount MBSs outstanding as of the end of each month: of MRS-related MMDA deposits from the pub- liq (JNMA — iss — AGi\~\4A — sth. lished, seasonally adjusted. non-MI component of 212. (Since the non-MI component of M2 is In turn, the amnount of unscheduled principal pay- seasonally adjusted by the Federal Reserve ments received by GN MA ser~’icersduring a Board staff as a whole, and separate data on month is assumed to equal the liquidations of MMFJA are not available, the seasonally adjusted GNMA-guaranteed MRSs minus 1 percent of the series was adjusted liv MRS effects.) The growth amount of GNMA-guaranteed MBSs outstanding rates shown in the lower panel of figure 6 are at the end of the previous month: calculated from published M2 and from the sum

GNMA — on = GNMJI lit; — norm — lit; * of the MRS-adjusted Ml and non-Mt compo-

GNMA stk — lag. nents of M2.

‘The value of 0.25 is from Duca (1990).