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Mortgage Rates,
Homeownership Rates, and
Government-Sponsored
Enterprises

Volume 16 Number 1

The Region

2002
ISSN 1045-3369
Executive Editor: Arthur J. Rolnick
Editor: David Fettig
Managing Editor: Kathy Cobb
Art Director: Phil Swenson
Designer: Rick Cucci

The Region
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The views expressed in The Region are not necessarily those of
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Cover Art: Grant Wood
1931 (detail)

The Minneapolis Institute o f Arts owned jo in tly with the Des Moines Art Center
®Estate of Grant Wood/Licensed by VAGA, New York, N.Y.




3

Mortgage Rates, Homeownership
Rates, and Government-Sponsored
Enterprises

4

2001 Operations Report

25

Minneapolis Board of Directors

34

Helena Branch Board of Directors

35

Advisory Council on Small Business,
Agriculture and Labor

36

Officers

37

Financial Statements

40

Auditor Independence

Minneapolis, MN 55480-0291

The Birthplace o f Herbert Hoover, West Branch, Iowa,

President's Message




The Region

President s Message

A policy priority in the United States is to increase the
rate of homeownership. To achieve that objective,
policymakers rely on a host of policies and programs
that reallocate billions of dollars of resources. Several
of these policies and programs try to increase homeownership by reducing mortgage rates. More specifi­
cally, federal sponsorship for Fannie Mae and Freddie
Mac is one of the major tools that policymakers rely
on to reduce mortgage rates.
Given the public resources involved, many
aspects of Fannie Mae’s and Freddie Mac’s activities
have been subject to vigorous public discussion. As
part of that discussion, we think it important to
examine if the mortgage rate reduction produced by
Fannie Mae and Freddie Mac is likely to increase
homeownership. In the following essay, we con­
tribute to the discussion by reviewing evidence on
the effect of mortgage rate changes on people’s abil­
ity and desire to buy a house. Most of the evidence
we review finds that mortgage rate changes need to
be around 2 percentage points before they have
what many would consider a modest, but not trivial,
effect on homeownership.
Because Fannie and Freddie likely have an effect
on mortgage rates considerably lower than 2 per­
centage points, the effect of their mortgage rate
reductions on homeownership is likely to be quite
modest although, again, not trivial. Moreover, the
evidence in the essay also suggests that a more direct
method of subsidizing potential homeowners would
have a larger effect on homeownership, while using
the same amount of resources, than the reductions
in mortgage rates attributed to Fannie and Freddie.




Of course, an analysis of homeownership and
mortgage rates is complicated by a number of fac­
tors, including the complexity of the decision to
own and weaknesses in data. As a result, the studies
we summarize in the essay all have important weak­
nesses, many of which we highlight. Fannie Mae and
Freddie Mac also do more than alter rates and have
broader goals than an increase in homeownership.
In short, this essay is surely not the last word on the
topic, which we view as a welcome outcome. A live­
ly discussion of one of the nation’s top policy prior­
ities serves the public interest.

Gary H. Stern
President

0




The Region

The Region

Mortgage Rates, Homeownership Rates, and
Government-Sponsored Enterprises
Ron J. Feldman
Assistant Vice President
Banking and Policy Studies
Federal Reserve Bank of Minneapolis

I. Summary
black households for the no-down- payment policy
was between 1 and 5 percentage points. These find­
ings indicate that an inability to pay standard down
payments and closing costs could have a larger
effect on homeownership than mortgagerate-related factors.
Two of the simulations also examine the effects
on homeownership of a policy of providing cash
assistance to renters that they could use to pay for
down payments, closing costs and/or, in some cases,
to retire debt. They find that cash assistance on the
order of $5,000 to $10,000 per household would
lead to a three-to-ten times greater increase in the
percentage of renting households that could qualify
to purchase a lower-cost home than an elimination
of down payments.
The simulations have several attributes and lim­
itations worth noting. First, the simulations may
produce inflated results because they do not take
into account all of the factors that lenders consider
when funding mortgages. Second, the data used in

Mortgage rates influence a household’s ability and
desire to buy a home. The mortgage rate deter­
mines, in part, the monthly mortgage payment of
borrowers and therefore their ability to meet debtto-income standards used by mortgage lenders.
Rates also affect ownership costs and the desire of
households to become homeowners.
A small number of simulations have tried to quan­
tify how a change in mortgage rates affects the num­
ber of potential homeowners. Most of the simula­
tions find that a shift—generally a reduction— in
mortgage rates of roughly 2 percentage points
changes the percentage of households that can buy a
house by around 50 basis points.1 Most of the simu­
lations found that a similar swing in mortgage rates
would alter the percentage of black households that
could buy a house by around 10 basis points.2 Some
research examining the variation in homeownership
rates more directly suggests that small mortgage rate
changes do not explain much of the variation.
The simulations also measure the relative effect
of a mortgage rate reduction on homeownership by
comparing it to other changes in mortgage qualifi­
cation standards and/or policy options. The simu­
lations find that shifting from mortgages with a 5
percent down payment to a 0 percent down pay­
ment would increase the percentage of all house­
holds that could buy a house by between 2 and 4.5
percentage points. The increase in ownership for




1One basis point is 1/100 of a percentage point. In addition, one
simulation found a much larger effect from a smaller increase in
rates. An increase in rates of 50 basis points reduced the percentage
of households likely to become homeowners by 1 percentage point.
2Again, one study found a much larger effect from a smaller
increase in rates. An increase in rates of 50 basis points reduced the
percentage of black households likely to become homeowners by 3
percentage points.

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The higher home prices would offset, at least in
part, the effect of lower rates. In addition, Fannie
and Freddie finance rental properties. Subsidizing
both forms of housing can limit their ability to
reduce the relative price of ownership. Quantifying
the importance of these potential outcomes should
assist policymakers and analysts.

the simulations may not accurately reflect the true
condition of households. In particular, the data can
understate wealth and therefore the ability of
households to make down payments and the like.
Third, the results do not indicate how shifts in
mortgage rates or down payments alter the timing
of homeownership. Even if such shifts do not have a
large effect on the ability of households to purchase
a house at a point in time, a reduction in down pay­
ments can accelerate homeownership for some
households, while a small increase in mortgage rates
may slow home purchase for only a short time.
Fourth, the assumptions used in the simulations
(for example, the level of mortgage rate at which the
change in the rate occurs) influence the results.
Finally, some of the simulations do not account for
all of the factors that influence the decision of a
household to own a house.
The simulation results—keeping the aforemen­
tioned caveats in mind—provide context for the
federal policy to increase homeownership in the
United States by sponsoring the Federal National
Mortgage Association (Fannie Mae) and the
Federal Home Loan Mortgage Corporation
(Freddie Mac). The implied support of the federal
government reduces Fannie Mae’s and Freddie
Mac’s cost of funds, and they can pass on the sav­
ings in the form of lower mortgage rates for bor­
rowers whose mortgages they fund. Estimates indi­
cate that Fannie and Freddie reduce mortgage rates
by around 20 to 50 basis points, with estimates from
more recent research analyzing more current data
tending toward the lower end. A reduction in m ort­
gage rates of around 20 to 50 basis points is, of
course, considerably lower than the 2 percentage
point rate change just discussed and thus should
have a smaller effect on homeownership. In addi­
tion to reducing mortgage rates, Fannie Mae and
Freddie Mac fund special “affordable” mortgages
that have reduced down payment requirements and
offer other relaxed terms. The activities of Fannie
Mae and Freddie Mac could also have led to lower
down payments and relaxed terms on the standard
mortgage.
Additional research in two areas would inform
future discussions of Fannie’s and Freddie’s m ort­
gage rate reductions. A widespread reduction in
mortgage rates can end up increasing home prices.




II. Mortgage Rates and
Homeownership
We first discuss how mortgage rates affect homeownership. We then summarize two types of analy­
ses that quantify the effect of mortgage rate changes
on homeownership. (Appendix 1 provides back­
ground on trends and features of the homeowner­
ship rate.) Following the distinction made by
Rosenthal (2001, p. 6), we discuss studies that quan­
tify the number of households that “have the ability
to purchase a home under different underwriting
criteria” as well as studies that quantify the number
of households that “would choose to own a home
under different underwriting criteria.” We call the
former underwriting simulations and the latter
tenure choice simulations. In addition to summariz­
ing findings, we discuss factors to consider when
interpreting simulation results. We briefly reference
a third type of analysis that tries to explain changes
in the homeownership rate more directly.
Effect of Mortgage Rates on Homeownership
A mortgage rate reduction can increase the homeownership rate in two ways. First, a reduction can
make it feasible for a household to qualify for a
mortgage by lowering the monthly mortgage pay­
ment and allowing the household to meet the orig­
inators’ debt-to-income standard. In a standard
mortgage, monthly mortgage payments cannot
exceed 28 percent of monthly income. (Total debt
cannot exceed 36 percent of income.) Second, a
reduction can induce a household that has already
qualified for a mortgage to decide to own instead of
rent. A number of factors beyond mortgage qualifi­
cation standards influence the ownership decision,
including income, the relative price of ownership,
and demographic factors such as age and family
structure.

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data to determine the percentage of households or
families that would qualify for a mortgage on the
reference house using specified mortgage qualifica­
tion criteria and a prevailing mortgage rate. The
analysts can then adjust the qualification criteria
and the mortgage rate to examine how the change
alters the number of households or families that
can qualify for a mortgage on the reference house.
The U.S. Bureau of the Census regularly prepares
underwriting simulations, and the most recent
examines data from 1995. (See Savage 1999.) To
determine a household’s ability to qualify for a
mortgage, the Census uses the standard mortgage
qualification ratios from conventional mortgage
underwriting guidelines (for example, 5 percent
down payment, 28 percent mortgage debt-toincome ratio, and 36 percent total debt-to-income
ratio). The Census then determines the number of
renters who could qualify for a mortgage to buy a
house with a price at the 25th percentile (that is, 75
percent of all houses would sell for a higher price
than this “modestly priced” house). The Census
then estimates the effects of lower mortgage rates
on the percentage of renters who could qualify for
the mortgage on the modestly priced house.
The Census finds that mortgage rate declines of
up to 3 percentage points would have zero effect on
the percentage of black renters who could become
owners and close to zero effect on Hispanic renters.
(See Table 1.) Mortgage rate reductions would have
an effect on the percentage of all renters who could
purchase the modestly priced house. A 1 percentage
point reduction would raise the percentage of
renters who could buy the modestly priced house
by 30 basis points, while a 2 percentage point
reduction would raise it by 60 basis points.
As part of a larger analysis, Listokin et al. (2001)
follow the Census approach and examine how a
wide range of mortgage qualification standards and
policy options affect the ability of renting families
to become owners. They report the effect of reduc­
ing mortgage rates by 3.05 percentage points and
5.55 percentage points and by eliminating m ort­
gage rates altogether (that is, charging mortgage
rates of 0 percent). A reduction of mortgage rates to
0 percent increases the percentage of black and
Hispanic renters who can purchase the modestly
priced house by 30 basis points. The 3.05 percent-

In terms of mortgage standards, at least two
other factors can prevent a household from qualify­
ing for a mortgage. To the degree that these other
factors constrain a household from qualifying for a
mortgage, a mortgage rate reduction will be insuf­
ficient by itself to permit a household to buy a
house. First, a borrower can have insufficient cash
to make a down payment and pay for the closing
costs associated with the mortgage. The standard
minimum down payment has fallen over the years
and is now 5 percent.
Second, a borrower’s credit quality can be too
weak. Mortgage underwriters make use of credit
scores and other measures of credit quality when
assessing the ability and propensity of households
to repay the mortgage completely and in a timely
fashion. A borrower with a high score has a greater
chance of making full and timely payment than a
borrower with a low score. Fair Isaac—a firm that
calculates credit scores—reports that 40 percent of
individuals have a score higher than 745 and 40
percent have a score lower than 690. Fair Isaac’s
basic score ranges from 300 to 850. (See myfico.com
for data on the distribution of credit scores.)
A borrower can have such a low credit score that
a lender will not make a loan under any condition.
More likely, a lender will require the borrower to
have a higher down payment or mortgage rate to
compensate for low credit quality. The higher down
payment or mortgage rate could lead the borrower
to become wealth- or income-constrained. For
example, Fair Isaac reports that as of early April
2002, a borrower with a score between 500 and 559
would typically have a mortgage rate of 10.2 per­
cent, while a borrower with a score between 675
and 699, all else equal, would have a rate about 2.5
percentage points lower. The difference in rates
remains at 2 percentage points when the score rises
to between 560 and 619. (See myfico. com for data
on the relationship between mortgage rates and
credit scores.)
Underwriting Simulations
Some analysts simulate the loan underwriting
process to determine how mortgage rates affect the
ability of households to qualify for a mortgage. In
the underwriting simulation approach, analysts
choose a reference house. They then review financial




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to meet debt service requirements. Only 2 percent
of renters are constrained by income alone.
The underwriting simulations just discussed do
not account for the likelihood that a household will
buy the reference house.3 Some renters may not
want to own the home even if they could qualify for
a loan. Other renters may qualify for a loan prior to
the mortgage rate reduction but choose not to buy
until the rate reduction induces such behavior. The
affordability approach does not try to model or
account for such preferences.
We now turn to simulations that more fully
model the decision to rent or own.

Table 1

Underwriting Simulation Results: Mortgage Rate Reductions
Percentage of Renters Who Can Buy
All

Black

Hispanic

10.2

3.4

2.6

.3
.6

0
0

.9

0

0
.1
.1

Results from Savage 1999
Baseline1
Percentage Point Change When Interest
Rates are Reduced by2
1 Percentage Point
2 Percentage Points
3 Percentage Points

Tenure Choice Simulations
Following the approach of Linneman and Wachter
(1989), a number of analysts have modeled the
probability of a household owning a home as a
function of factors such as the relative price of own­
ing versus renting, income, demographic factors
that serve as proxies for the preferences of the
household, and the constraints imposed by m ort­
gage qualification standards.4 The approach is gen­
erally more econometrically complex than the
underwriting simulations. The approach can also
vary it its implementation between studies. The fol­
lowing review, as a result, provides only a high-level
summary of this complex approach.
Quercia et al. 2000 is one of the most recent
additions to this literature and takes two related
approaches to estimating the effect of a change in
mortgage rates on homeownership. In the first
approach, the authors develop a model to quantify
the probability of a household owning a house.
Variables used in the model include estimates of the
relative price of housing; an estimate of the perma­
nent income of the household; demographic vari­
ables such as household size, age, race, and gender;
and an estimate of whether a household was pre­
vented, or constrained, from buying a desired house

Results from Listokin et al. 2001
Baseline Situation1
Percentage Point Change When Interest
Rates are Reduced by3
3.05 Percentage Points
5.55 Percentage Points
8.05 Percentage Points

9.2

2.7

1.8

.8
1.4

0
0

.3
.3

2.0

.3

.3

1Assumes a fixed-rate, 30-year mortgage with a 5 percent down payment.
2Assumes an interest rate of 8.67 percent.
3Assumes an interest rate of 8.05 percent.

age point reduction increases the percentage of all
renters who can purchase the modestly priced
house by 80 basis points. (See Table 1.)
By way of context, 1 percent of renting house­
holds in 2000 equaled roughly 360,000. (See
factfinder.census.gov for data.) The average annual
change in homeownership rates from 1960 to 2001
is 20 basis points. The average annual change in
homeownership rates from 1995 to 2001 is 80 basis
points. [U.S. Bureau of the Census (2001b, Table 12)
reports homeownership data.]
Finally, the effects of mortgage rate reductions of
2 to 3 percentage points are small relative to other
policy changes the Census tests (discussed in
Section IV). According to the Census, the results
from the mortgage rate simulations reflect the fact
that renting households typically have both wealth
and income constraints. In the Census sample, 70
percent of renters have an inability to pay a down
payment and/or closing costs and too little income




3Other types of analyses by Listokin et al. (2001) rely on a ref­
erence house that reflects household preferences using an approach
similar to that of Linneman and Wachter (1989) and Calhoun and
Stark (1997), which we discuss. Listokin et al. (2001) also examine
how changes in mortgage rates and mortgage qualification stan­
dards affect the “purchasing power” of renting households.
4 Jones (1989) and Zorn (1989) also provide important contri­
butions to the analysis of income and wealth and homeownership.

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because it could not meet a variety of underwriting
guidelines. Like many of the other variables in the
model, the borrowing constraint variables result
from a multistep estimation process. Essentially, the
authors calculate the price of the house that a
household desires to purchase based on the vari­
ables just discussed. They then determine whether
the household qualifies to purchase the desired
house based on its ability to meet mortgage qualifi­
cation standards.
After estimating all of the necessary variables,
the authors calculate the probability of ownership
using various down payment requirements, hous­
ing debt-to-income requirements, and mortgage
rates. They then compare the probability of owner­
ship resulting from the various scenarios. The com­
parisons indicate how changes in mortgage stan­
dards and mortgage rates affect the probability of
ownership.
The authors test two cases where mortgage rates
fall by 2 percentage points. (See Table 2.) In the first
case, the 2 percentage point drop in mortgage rates
increases the probability of homeownership for
black households by 10 basis points. In the second
case, a similar drop in rates increases the probabili­
ty of ownership by 20 basis points. The effect on the
probability of homeownership for all households is
similar. In the first case, the increase in the proba­
bility of ownership is 40 basis points, and in the sec­
ond case, the probability of ownership actually
declines by 10 basis points. The decline in owner­
ship probabilities in the second case may reflect the
link between wealth and income constraints in this
analysis. The lower the mortgage rate and higher
the mortgage debt-to-income standard, the more
expensive the house for which the household can
meet debt-to-income standards. However, the more
expensive the house, the greater the down payment,
and the more likely that the household will become
wealth-constrained.
As is the case in the affordability simulations,
Quercia et al. (2000, pp. 14-15) find that limited
wealth prevents lower rates from having a large
effect on homeownership. The authors note,
“Consistent with the literature, the downpayment
requirement is a greater detriment to home pur­
chase than the income requirement. Thus, lowering
the cost of borrowing does not necessarily allow




Table 2

Tenure Choice Simulation Results: Mortgage Rate Reductions

Change in
Mortgage Rates From

Change in
Homeownership Propensity
(Percentage P oints)

Black

A ll

Results from Quercia
et al. 2000: Main Approach

8% to 6%

.4

.1

-.1

.2

(20 percent down paym ent)1

8% to 6%
(3 percent dow n paym ent)2

Results from Quercia
et al. 2000: Replication of
Wachter et al. 1996
Results from Wachter
et al. 1996a

(Percent)

8% to 8.5%

-1.1

-1.8

(Percent and [Percentage Points])

10.12% to 10.62%

- 1 . 8 [- 1 .1 ]

- 6 . 5 [- 2 .8 ]

Change in
Expected Homeownership Rate
(Percentage Points)

Results from Linneman
et al. 1997

7% to 8%
7% to 9%
7% to 10%

-.0 7

N /A

-.1 1

N /A

-.2 2

N /A

1 Mortgage debt-to-income ratio constant at 28 percent.
2 Mortgage debt-to-income ratio increases from 33 percent to 38 percent.

more people to purchase once the downpayment
requirement becomes binding. For instance,
although the percentage of income-constrained
households decreases as a result of a 200 basis point
drop from 8 percent to 6 percent in the interest rate,
the percent of people that could actually buy a
house remained the same because the percentage of
downpayment constrained households remained
unchanged. This implies that there is a significant
overlap between the two constrained measures.
Because lack of wealth to meet the necessary downpayment is the dominant constraint, most house­
holds that are income constrained are also wealth
constrained. However, the reverse is not the case.”
In the second approach, Quercia et al. (2000)
update Wachter et al.’s (1996a) test of how an
increase in the mortgage rate of 50 basis points

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ership in simulations using the actual individual
probabilities of homeownership for each house­
hold. This approach is apparently not taken by
Wachter et al. (1996a). As a result, Quercia et al.
(2000, p. 16) report that their first approach pro­
vides more accurate estimates.
The results from the first and second approaches
in Quercia et al. 2000 may also differ because the
second approach examines an increase in mortgage
rates, while the first approach reviews a decrease in
mortgage rates. As noted, a decrease in rates in their
analysis can make the wealth constraint more bind­
ing because it can lead the household to demand a
more expensive house with a larger down payment.
The effect from the more binding wealth constraint
can outweigh the greater num ber of households
that can meet the debt-to-income standard with the
lower mortgage rate. In contrast, an increase in rates
makes the income constraint more binding while
relaxing the wealth constraint as the price of the
desired house decreases. If the income effect out­
weighs the wealth effect, the increase in rates can
have a larger effect on a household’s propensity to
own than the decrease in rates.
The findings of Quercia et al. (2000) in their first
approach are consistent with findings from the
tenure choice simulations of Linneman et al.
(1997), which updated Linneman and Wachter
1989 and added simulations on the effects of
changes in mortgage rates on expected homeown­
ership rates. In contrast to the results from the sec­
ond approach of Quercia et al., Linneman et al. find
that a 2 percentage point increase in mortgage rates
(from 7 percent to 9 percent) would lead to about a
10 basis point decrease in homeownership. (See
Table 2.) Although Linneman and Wachter (1989)
do not simulate changes in mortgage rates on
homeownership, they do find that due to financing
innovations, “the income constraint had little
impact on homeownership propensities” by the

affects the probability of ownership.5 Wachter et
al.’s (1996a) general description of their approach is
largely similar to the first approach taken by
Quercia et al. (2000). (We note one important dif­
ference below.) Wachter et al. (1996a) estimate the
probability of ownership using the same four types
of variables (the relative cost of ownership, income,
demographic factors, and income and wealth con­
straints). Using these estimates, Wachter et al.
(1996a) estimate the probability of ownership for
households under various mortgage rate and down
payment requirements.
We report the results for this second approach
for Quercia et al. 2000 and for Wachter et al. 1996a.
(See Table 2.) To provide comparability to the
underwriting simulations, we highlight the results
for all households and black households, although
both analyses also examine central city households
and low- and moderate-income households. In
their second approach, Quercia et al. find that an
increase in mortgage rates from 8 percent to 8.5
percent decreases the ownership probability of all
households by 1.1 percent and decreases the proba­
bility of ownership of black households by 1.8 per­
cent. (Results in percentage points are not provid­
ed.) Wachter et al. (1996a) find an increase in
mortgage rates from 10.12 percent to 10.62 percent
decreases the ownership probability of all house­
holds by 1.8 percent and decreases the probability
of ownership of black households by 6.5 percent.6
Quercia et al. note two reasons why the updated
results might be lower than the earlier findings.
They argue that changes in mortgage rates have a
larger effect on homeownership when rates are
higher. The smaller effect of rate increases in the
updated simulation may reflect the lower assumed
level of mortgage rates. They also hypothesize that
an “increased bifurcation in the national income
distribution” has left fewer households at the
income level where a small reduction in mortgage
rates produces more homeownership (Quercia et al.
2000, pp. 15-16).
In addition, Quercia et al. note a fairly technical
difference in methodology between their first and
second approaches that would lead Wachter et al.’s
(1996a) approach to overestimate the effect of a
change in mortgage rates. In their first approach,
Quercia et al. estimate the probability of homeown­




5Unlike the other simulations discussed, Wachter et al. (1996a)
specify the cause for the change in mortgage rates. They intend their
simulation to capture the effects of removing sponsorship from
Fannie Mae and Freddie Mac. This sponsorship and its effects on
mortgage rates are discussed in Section III.
6These simulations are performed on a full data set and on two
more narrowly focused data sets. We follow the authors’ example
and focus on results from the full data set.

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er estimate.) In addition, poor credit history is the
most frequently cited reason by mortgage origina­
tors for the denial of single-family mortgages
(Collins 2002, p. 10).
Second, the income and wealth data used in the
analysis come from surveys and/or econometric
estimates. Households can report their incomes or
wealth incorrectly on such surveys.9 An underesti­
mate of wealth can lead to underestimates of the
number of renting households that qualify for a
mortgage. Wachter et al. (1996a) and Quercia et al.
(2000) estimate household wealth, and these esti­
mates may be inaccurate.10 Quercia et al. (2000, p.
11) note, for example, that their estimate of wealth
does not include assets held in pensions.
Third, simulations reflect how mortgage rate
changes or mortgage qualification standards affect
households at a point in time. An increase in m ort­
gage rates or a down payment requirement delays,
but may not prevent, a household from becoming
an owner. As noted, Wachter et al. (1996a) find that
a 50 basis point increase in mortgage rates lowers
predicted homeownership rates for all households
by about 1 percentage point. However, they report
that this result would probably be “much less” if
calculated on an “ever-own” basis (Wachter et al.
1996a, p. 354). That is, the increase in rates may
simply delay some households from purchasing
homes but may not prevent them from doing so in
the future. Goodman and Nichols (1997) similarly
find that, at best, the Federal Housing
Administration (FHA) loan guarantee program
accelerates ownership.
Moreover, simulation results may reflect
assumptions related to the environment at the time
the simulation was conducted. As noted, the effect
of mortgage rate changes on homeownership can
depend on the prevailing mortgage rate used in the

1981 to 1983 period, while wealth constraints con­
tinued to matter (Linneman and Wachter 1989, p.
399).
Calhoun and Stark (1997) combine features of
the two types of simulations we have discussed.
They determine whether a renter would prefer to
own, estimate the type of house the renter would
prefer to own, and compare the value of the pre­
ferred home to the mortgage for which the borrow­
er could qualify. A ratio below one indicates that the
renting household cannot qualify for the house it
would prefer. Drops in mortgage rates of up to 6
percentage points lead to relatively small changes in
the ratio for all renters and almost never push it
above one.
Interpreting the Simulations
Several observations should be kept in mind when
considering the results of the simulations. First,
some simulations may overstate the effect of m ort­
gage rate reductions because they do not account
for important standards used to determine whether
a borrower qualifies for a mortgage. Quercia et al.
do not consider qualification standards related to
nonmortgage debt outstanding. The Census finds
that excessive nonmortgage debt is the single largest
reason that renters do not qualify for mortgages.
(See Savage 1999, p. 5.)
In addition, none of the simulations considers
credit quality. As a result, some of the renting
households that qualify for a mortgage with the
lower rate in the simulation may not actually qual­
ify because of a low credit score, for example. The
data to directly determine the importance of omit­
ting credit scores from the simulations are not read­
ily available. Some publicly available data from
1996 suggest that households without a mortgage, a
proxy for renters, have worse scores than house­
holds with a mortgage: 26 percent of households
with a mortgage had scores below 660 while 15 per­
cent had scores below 621, and 39 percent of
households without a mortgage had scores below
660 while 25 percent had scores below 621.7
Confirming the potential importance of credit
quality to homeownership, Rosenthal (2001) finds
that removal of credit constraints could increase the
homeownership rate by as much as 4 percentage
points.8 (See Duca and Rosenthal 1994 for an earli­




7These are the author’s calculations based on data in Avery et al.
1996, pp. 640—41, and Avery et al. 2000, p. 529.
8Credit constraints are measured by past credit denials, partial
credit approvals, or expected credit denials.
9The underwriting simulations discussed in this paper rely on
data from the Survey of Income and Program Participation con­
ducted by the U.S. Bureau of the Census.
10These studies rely on data from the U. S. Bureau of the Census
2000. Linneman and Wachter (1989) and Linneman et al. (1997)
rely on data from the Survey of Consumer Finances sponsored by
the Board of Governors of the Federal Reserve System.

11

The Region

simulation: A change in mortgage rate from a high­
er level potentially leads to a larger effect on homeownership than a change from a lower rate.
Homeownership Rate Analysis
Instead of modeling qualification standards direct­
ly, some analysts examine the factors that influence
the trend in and differences across homeownership
rates. Painter and Redfearn (2001) examine how
changes in mortgage rates affect short-run and
long-run homeownership rates. The analysts devel­
op and test models quantifying the relationship
between mortgage and homeownership rates over
time and across regions. The models account for
other explanatory factors, such as income, age of
households, house prices, and population. The
authors find that mortgage rates are not statistically
significant in explaining changes in rates of homeownership. The general fact that homeownership
rates vary a great deal across geographic regions
while mortgage rates are set in national markets
may also suggest that mortgage rates play a second­
ary role in determining the ability of households to
become owners. (See Coulson 2000 for an analysis
of the factors that help explain regional variations
in homeownership.)
More indirect evidence comes from recent analy­
ses of how demographic changes over the last
decade or two have affected homeownership rates.
Segal and Sullivan (1998) find that demographic
changes explain the changes in the homeownership
rate from 1977 to 1997. The authors infer from this
result that the effect of other potential influences on
homeownership rates, such as fluctuating mortgage
rates, either was constant or was offset by other fac­
tors. The authors also argue that the upswing in
homeownership rates from 1995 to 1997 relates to
factors such as rising income rather than “a
response to any special change in housing policy.
...” [In a similar fashion, Green (1996) finds that
the stagnating homeownership rate of the 1980s is
explained largely by demographic factors and
changes in household tastes.] This analysis also
seeks to examine the role of demographic trends in
examining the homeownership gap between whites
and blacks. In contrast to the overall homeowner­
ship rate, demographic factors do not explain the
gap, or the changes in the gap, very well.




Bostic and Surette (2001) segment households by
their incomes in their analysis of homeownership
rates. While the authors find that demographic fac­
tors explain a substantial portion of the change in
homeownership for families with incomes in the
upper quintiles of the income distribution, they find
that such factors do not account very well for changes
in the homeownership rate of families with incomes
in the lower quintiles. Because the authors cannot
attribute the changes in homeownership for lowerincome households to demographic factors, they see
a potential explanatory role for changes in regulation
that encourage financial institutions to make m ort­
gage loans to minority families and families with low
incomes. However, the authors note that the evidence
supporting their interpretation is suggestive rather
than conclusive. In his comment on the paper,
LaCour-Little (2001) notes the difficulty in attribut­
ing the unexplained increase in homeownership to
policies that encourage increased mortgage lending
to certain groups.

III. Mortgage Rate Reductions by GSEs
One aspect of federal policy to increase homeown­
ership rates is to reduce mortgage rates through
interventions in secondary mortgage market activi­
ty. The secondary mortgage market is where m ort­
gages are bought and sold after origination. The
federal government uses two distinct types of insti­
tutions active in secondary mortgage markets to
lower mortgage rates. The first is a governmentowned corporation, Ginnie Mae, that guarantees
timely payment on securities backed by a group of
mortgages that already have a guarantee of payment
from federal government organizations. These
securities are issued by private firms.
We focus on a second type of institution called
government-sponsored enterprises (GSEs), specifical­
ly Fannie Mae and Freddie Mac, because of the
greater scope of their activities. Fannie and Freddie
have financed more mortgages than Ginnie Mae
and guarantee both full and timely repayment of
funds to investors.11 Fannie Mae and Freddie Mac
11
Fannie and Freddie held 41 percent of the mortgage debt on
one- to four-family residences while Ginnie Mae held 10 percent as
of the third quarter of 2001 (FR Board 2002, p. A35).

The Region

are privately owned, publicly traded firms. The fed­
eral government does not own stock in either firm.
At the same time, the firms have many attributes of
public entities. (See Appendix 2 for a discussion of
these public attributes.) Observers see Fannie and
Freddie as “sponsored” by the federal government
because of these attributes. Sponsorship leads many
investors who buy securities issued by the GSEs to
believe that the federal government will protect
them from loss if Fannie and Freddie cannot make
good on their financial obligations. This protection
is referred to as the GSEs’ implied guarantee.
Sponsorship and the implied guarantee reduce
the GSEs’ costs by, for example, exempting the GSEs
from certain taxes. The implied guarantee also
reduces the cost to the firms of raising cash by mak­
ing their securities safer and more liquid. Investors
will accept a lower rate of interest on securities that
pose a low risk of loss and that can be sold with
minimal costs. Because of the implied guarantee,
the GSEs can also hold fewer financial resources to
absorb losses than can competitors, which reduces
their costs.
These cost advantages come to bear when the
GSEs borrow funds to buy or otherwise fund m ort­
gages that “conform” to size and risk criteria. (See
Appendix 2 for the major restrictions on the GSEs’
activities.) Because they have lower costs of raising
funds, the GSEs can pay a higher price for m ort­
gages than non-GSE competitors, thereby reducing
the interest rate on mortgages while still earning
sufficient returns to attract capital. In this way, the
lower cost made possible by federal sponsorship
can work its way into lower mortgage rates for
households.12
To estimate the degree to which the GSEs lower
mortgage rates, analysts examine the difference in
rates between conforming mortgages and those
loans above the conforming limit {jumbo m ort­
gages) while trying to hold other factors constant.
The CBO (2001a, pp. 12-13, 26-32) summarizes
estimates of how much Fannie and Freddie reduce
mortgage rates.13 These estimates generally range
between 20 and 50 basis points, with more recent
estimates analyzing more current data generally
falling toward the lower end of the range. A reduc­
tion in mortgage rates of around 20 to 50 basis
points is, of course, considerably lower than the 2




Table 3

First-Time Home Buyers, 1997-99

First-Time
Home Buyers

As a Percentage of
All Home Purchases

As a Percentage of As a Percentage of
FHA-lnsured Home
GSE-Financed
Purchase Loans Home Purchase Loans

All

41

81

25

Black and Hispanic

11

27

3

Source: Author's calculations based on data in Bunce 2002, Table 10.

percentage point rate change discussed in Section II
and thus should have a smaller effect on homeownership.
We note that analysts look to the difference in
overall mortgage rates on two large classes of m ort­
gages (conforming and jumbo) when estimating
the mortgage rate reduction induced by the GSEs.
This approach reflects the widespread distribution
of assistance by the GSEs, which, in turn, helps to
explain why the estimated mortgage rate reductions
are relatively small per household. GSEs do not, for
example, provide assistance solely to renters unable
to become homeowners without GSE help. Data
and analysis on first-time home buyers from the
U.S. Departm ent of Housing and Urban
Development (HUD) is suggestive in this regard.
The percentage of home purchase loans financed by
the GSEs that go to first-time buyers, particularly
blacks or Hispanics, is smaller than the percentage
in the overall market and for FHA-insured loans.
(See Table 3.) The GSEs’ limited role in the first­
time home buyer market may reflect the fact that
the majority of mortgages Fannie and Freddie
12Other aspects of the GSEs’ operations can reduce the cost of
buying a house, but we focus on mortgage rate reduction unless
specifically noted. Fannie Mae (1996) discusses how the GSEs serve
home buyers beyond reductions in mortgage rates and describes
objectives for the GSEs besides increases in homeownership.
Appendix 2 lists the public purposes of the GSEs from their con­
gressional charters.
13In addition, the forthcoming Journal of Real Estate Finance
and Economics (vol. 25, issue 2) includes several articles examining
the effect of GSE activity on mortgage rates.

13

The Region

finance have down payments equal to or exceeding
20 percent, even when borrowers have lower
incomes (Bunce 2002, pp. 37-38).

IV. Simulation Evidence
on Cash Assistance and
Down Payment Reductions
To provide additional context for the relationship
between mortgage rate changes and homeownership,
the simulations compare the effect of mortgage rate
reductions to other policy alternatives. Both under­
writing and tenure choice simulations review how
reducing mortgage down payments can affect the
number of households that own homes. They find
that down payment reductions have larger effects
than mortgage rate reductions. The underwriting
simulations examine how providing lump-sum cash
assistance to renters affects their ability to qualify for
a mortgage. They find that such assistance can have a
larger effect than either a down payment reduction
or a mortgage rate reduction.
Lower Down Payments
The literature on the effect of mortgage standards
on homeownership finds that wealth constraints
play a larger role than income constraints in pre­
venting households from becoming owners. Thus,
one might expect a policy of reducing down pay­
ments to have a greater effect on the ability of fam­
ilies to purchase a house than mortgage rate reduc­
tions. Both the underwriting and tenure choice sim­
ulations confirm this hypothesis. In terms of the
underwriting simulations, the Census finds that a
no-down-payment standard increases the percent­
age of all renters who can become owners by 2.5
percentage points, the percentage of black renters
by 2.3 percentage points, and the percentage of
Hispanic renters by 60 basis points. Listokin et al.
(2001) find generally similar results. (See Table 4.)
In terms of the tenure choice simulations,
Quercia et al. (2000) estimate the effect of moving
from a 5 percent to a 0 percent down payment. The
probability of ownership moves up 4.5 percentage
points for all households and 5 percentage points
for black households. However, not all reductions
in down payments in their simulation have as large




Table 4
Underwriting Simulation Results: Down Payment Reductions
Percentage Point Change
When Down Payment is Reduced From

Percent of Renters Who Can Buy
-------------------------------------------All
Black
Hispanic

Results from Savage 19991,2
5% to 2.5%

1.1

1

5% to 0%

2.5

2.3

.6
2.1

.1

.2

1.3

.6

.3
.6

Results from Listokin et al. 20011,3
5% to 3%
5% to 0%

1Assumes a fixed-rate, 30-year mortgage with a 5 percent down payment.
Baseline information is in Table 1.
A ssu m e s an interest rate of 8.67 percent.
A ssu m e s an interest rate of 8.05 percent.

an effect. Linneman et al. (1997) find that shifting
from a 20 percent down payment to a 5 percent
down payment raises the expected homeowner­
ship rate by between 2 and 3 percentage points.
(See Table 5.)
Our earlier observations about interpreting simu­
lation results apply to these outcomes as well. The
absence of credit risk data in these simulations, for
example, may reduce the accuracy of the results.
Those bearing the risk of the mortgage may want bor­
rowers to have a higher credit score to compensate for
the lower down payment. For example, the GSEs have
special programs under which they will fund mort­
gages with down payments ranging from 3 to 0 per­
cent. (They have also relaxed other mortgage qualifi­
cation standards.) In 1997, mortgages with down pay­
ments of equal to or less than 5 percent equaled 2.5
percent of the home purchase mortgages the GSEs
financed. By 2000, the percentage had risen to 5.1 per­
cent of the home purchase mortgages the GSEs
financed (authors calculation based on data from
Bunce 2002, Table 9a). More generally, the GSEs are
credited by some for reducing down payments to cur­
rent levels from higher historical levels and relaxing
other terms. That said, applicants for such special
mortgages must meet the credit standards of private
mortgage insurers and the GSEs. (See Temkin et al.
1999 and Listokin et al. 2001 for a review of GSE

The Region

simulation results accurately capture the effect of
offering such mortgages. Specifically, the simula­
tions can overstate the effect on homeownership of
the GSEs’ provision of mortgages with low down
payments and relaxed mortgage debt-to-income
ratios because the simulations do not account for
the presence of competing products, such as those
offered by FHA. Yezer (1996) also questions the
degree to which the simulations take into account
the dynamic responses of borrowers and partici­
pants in mortgage markets to a change in mortgage
terms and rates.

Table 5

Tenure Choice Simulation Results: Down Payment Reductions
Change in Homeownership Propensity
Reduce Down Payment From

(Percentage Points)

All

Black

1.0
4.5
3.5

4.9
4.1

Results from Quercia et al. 2000
5% to 3%1
5% to 0%1
3% to 0%1

.8

Change in Expected Homeownership Rate

Lump-Sum Cash Assistance
The underwriting simulations review the effect on
mortgage qualification of providing renters with
cash they can use to make a down payment, pay
closing costs, and/or, in the Census simulations, to
retire current debt. Cash payments starting around
$5,000 have larger effects than other options on the
ability of renting households to purchase a modest­
ly priced home. Savage (1999) finds that a $5,000
payment increases the percentage of all renters who
can buy the modestly priced home by 11 percentage
points. (The percentage point increases are 13 and
7 for black and Hispanic households, respectively.)
A payment of $10,000 per household has an effect
almost twice as large. Listokin et al. (2001) find
larger effects, although the cash assistance they
examine can only be used for down payment and
closing costs. (See Table 6.) In a similar vein, Green
and Vandell (1999, pp. 441-42) find that shifting
the tax-favored treatment of housing from its cur­
rent status to more of a lump-sum payment could
increase its effect on homeownership.
Of course, the same observations about interpret­
ing these results hold (for example, concerns about
data and lack of tenure choice models in these simu­
lations). It is also not clear from the affordability
simulations how a program providing cash assis­
tance might operate. Appendix 3 provides an illus­
trative description of a cash assistance program.

(Percentage Points)2

Results from Linneman et al. 1997
20% to 10%
10% to 5%
20% to 5%

1.1 to 1.8
.85 to 1.1
2 to 2.9

N/A
N/A
N/A

1Mortgage rates remain at 8 percent and mortgage debt-to-income ratio remains at 33 percent.
2Lower part of range assumes a mortgage debt-to-income ratio of 28 percent. Upper part of range
assumes a mortgage debt-to-income ratio of 33 percent.

underwriting standards over time and for the role of
credit quality in such standards. Ambrose et al. 2002
also highlight the importance of the GSEs in relaxing
underwriting standards.)
In addition, Listokin et al. (2001, pp. 503-6) note
that households in practice buy houses which the
simulations suggest they cannot. They suggest that
underreporting of wealth needed to pay down pay­
ments and closing costs may partially explain the
discrepancy. Another possible explanation is the
ability of households to change behavior such that
they can rather quickly afford a house previously
considered unaffordable. For example, a household
can alter spending and working patterns to bolster
savings and income in the short term. However,
Haurin, Hendershott, and Wachter (1997) find that
mortgage qualification standards reduce the proba­
bility of ownership for young households even when
accounting for household behavior that could mini­
mize the constraint of mortgage standards.
Quercia et al. (2000, p. 19) also note that the
amount of existing competition in providing m ort­
gages with favorable attributes, such as a low down
payment, can influence the degree to which the




V. Additional Research
Future discussion of the relationship between the
mortgage rate reductions induced by the GSEs and
the homeownership rate would be informed by

15

The Region

subject to much analysis (Cappoza, Green, and
Hendershott 1999), the question of how much of
the GSEs’ mortgage rate subsidy ends up as higher
prices has received less attention.

Table 6

Underwriting Simulation Results: Cash Assistance
Percentage Point Change
From Cash Assistance of

Percentage of Renters Who Can Buy
-----------------------------------------------All
Black
Hispanic

Results from Savage 19991>2-3
$1,000

.8
2.4

$2,500
$5,000
$7,500
$10,000

.8

11.0

1.8
12.7

17.5
21.7

19.2
22.1

.3
.7
7.3
12.1
16.0

Results from Listoken et al. 20011as
$1,000
$5,000
$10,000

.7

.3

.5

7.0
26.4

5.8
27.1

2.0
18.3

1Assumes a fixed-rate, 30-year mortgage with a 5 percent down payment. Baseline Information in Table 1.
A ssum es an interest rate of 8.67 percent.
3Cash assistance can be used to pay down payment or closing costs and/or retire debt.
4Assumes an interest rate of 8.05 percent.
5Cash assistance can be used to pay down payment and/or closing costs.

additional research in two areas. First, mortgage
rate reductions could affect, or be capitalized into,
house prices. Second, GSE activity could reduce
mortgage rates on the financing of both rental
properties and owner-occupied properties, leading
to a potentially ambiguous effect on the relative cost
of ownership.
Capitalization
An overall decrease in mortgage rates may simply
increase housing prices. Buyers may be willing to
pay more for a house if mortgage rates are lower, all
else equal, because the combination of lower rates
and higher house prices leaves them as well off as
they were previously (with higher rates and lower
house prices). Because the GSEs spread their sub­
sidy so widely, they may end up encouraging a very
large group of home buyers to bid up home prices.
For example, Freddie Mac (1996, p. iii) argues that
“if Freddie Mac’s and Fannie Mae’s charters were
repealed, higher mortgages rates would cause home
values to decline.” Although capitalization of the
favorable tax treatment of mortgage rates has been




Effect on Relative Cost of Ownership
The GSEs fund rental properties. Their funding for
such housing has risen considerably. The GSEs held
20 percent of outstanding multifamily mortgage
debt as of third-quarter 2001, nearly double their
level from 1990 (authors calculation based on data
from FR Board 1992, p. A37, and FR Board 2002, p.
A35). Moreover, those purchasing a house can rent
it out. Through both methods, the GSEs’ activity
can affect the price of rental housing. As a result,
Yezer (1996) argues that the degree to which the
GSEs change the relative price of owning versus
renting is not clear. If the mortgage rate changes do
not lower the relative costs of owning, then their
effect on homeownership is unclear. At least as of
1996, some analysts believed that the GSEs’ activity
in the rental market was too small to have a materi­
al effect on the rental market. (See Wachter et al.
1996b, p. 382.)

Helpful comments were received from Bob Avery, Raphael
Bostic, Harold Bunce, Charles Capone, Edward Demarco,
John Duca, Scott Frame, John Gardner, Preston Miller,
Wayne Passmore, Marvin Phaup, Art Rolnick, Jason
Schmidt, Jenni Schoppers, Robin Seiler, Gary Stern, David
Torregrosa, and Mario Ugoletti.

The Region

Appendix 1

The U.S. H om eow ner ship Rate

Graph 1

A goal of U.S. housing policy is to increase the rate
of homeownership. This appendix summarizes
major trends and features of the homeownership
data.
First, the overall rate of homeownership grew
significantly from the 1940s to the 1960s, with slow­
er growth until a recent rapid increase. The decen­
nial data in Table 1 show the homeownership rate
fluctuating within a relatively narrow band from
1900 to 1930, followed by a dramatic increase from
1940 to 1960 when it rose by 18 percentage points
(from 44 percent to 62 percent). The annual data in
Graph 1 show that since that time, the rate has gone
through periods of slower growth (a 3.5 percentage
point increase from 1960 to 1980), stagnation (1980
to 1995), and more rapid growth recently (rising by
2.4 percentage points from 1996 to 2001).
Second, homeownership rates differ a great deal
by the race, ethnicity, and location of the house­
hold. Graph 2 shows that the Hispanic and black
homeownership rates have been around 63 percent
of the white rate from the mid-1970s to the current
period. A large gap also exists between nonmetro

Annual Homeownership Rate in the United States
1960-2001

Source: U.S. Bureau of the Census 2001b, Table 12

and suburban households and households in cen­
tral cities. (See Graph 3.) Significant gaps in homeownership rates also occur by other geographic
regions. In 2001, California had a homeownership
rate of 58 percent while Michigan’s was 77 percent
(U.S. Bureau of the Census 2001b).

Graph 2
Table 1

Homeownership Rate by Race and Ethnicity

Homeownership Rate by Decade

1976-2000
■ Hispanic/White

Year

Rate

1900
1910
1920
1930
1940
1950

46.5%
45.9
45.6

%

47.8
43.6
55.0

1960

61.9

1970

62.9

1980

64.4

1990

64.2

2000

66.2

Sources: 1900 to 1990 from http://www.census.gov/hhes/www/housing/census/historic/owner.html
2000 from http://factfinder.census.gov/bf_lang=en_vt_name=DEC_2000_SF1_U_QTH1_geo
_id=01000US.html




Source: U.S. Bureau of the Census 2001a

17

■ Black/White

The Region

Graph 3

Graph 5

Homeownership by Metro and Nonmetro Location

Homeownership Rate by Select Family Structure

1965-2001

1982-2001
Married Couple Rate

%

Female Headed/Married Couple Rate

%

%

■Rates for 1986 to 1994 are not comparable to earlier or later years. Rates for 1995
and later are not directly com parable to earlier years.
Source: U.S. Bureau of the Census 2001 b, Table 1
Source: U.S. Bureau of the Census 2001b, Table 15

Graph 4

Homeownership Rates by Age
2001

Table 2

Homeownership Rates by Household Size
and Education Level

%

1999
Homeownership Rate
Household Size

1 Person

Age of Head of Household
Source: U.S. Bureau ot the Census 2001b, Table 15

Third, demographic factors such as age and edu­
cation level of the household and family structure
of the household influence the homeownership
rate. Households led by people in their late fifties
have a homeownership rate 26 percentage points
higher than those led by people in their early thir­
ties. (See Graph 4.) The rates of homeownership are
also relatively low for families headed by a female
with no husband, households with one household
member, and households headed by people with
lower levels of education. (See Table 2 and Graph 5.)




2 Persons
3 Persons
4 Persons
5 Persons
6 Persons
More Than 7 Persons

53%
73
69
75
73
68
68

Education Level
Less Than High School Degree

58

High School Degree

69

Greater Than High School Degree
But Less Than Bachelor’s Degree

66

Bachelor’s Degree

71

Graduate or Professional Degree

76

Source: Author’s calculations based on U.S. Bureau of the Census 2000.

The Region

Graph 6

Cross-Country Homeownership Rates*
Percent

* V arious dates based on currently available data
Sources: See footnote 1 of Appendix 1.

Finally, the United States has a homeownership
rate a bit above the median of a group of developed
countries. Graph 6 reports the most recent homeownership rates for countries in the European
Union, Japan, and several English-speaking coun­
tries. The rate in the United States rests at the 60th
percentile of this group.1

Sources for the data are Australian Bureau of Statistics, Housing:
Home ownership and renting, accessed at http://www
.ahs.gov.au/ausstats/abs%40.nsf/94713ad445ffl425ca25682000
192af2/affae0316a2c7090ca256b350014de3e!OpenDocument on
2/17/02; Netherlands Ministry of Housing (2000, p. 33); Statistics
Canada, Selected Dwelling Characteristics and Household
Equipment, accessed at http://www.statcan.ca/english/ Pgdb/People
/Families/famil09a.htm on 2/17/02; Statistics Bureau and Statistics
Center of Japan, Housing of Japan, “Home Ownership,” accessed at
http://jin.jcic.or.jp/stat/stats/13HSG13.html on 2/17/02; New Zealand
Ministry of Housing, The New Zealand Housing Situation, accessed at
http://www.minhousing.govt.nz/situation.html on 2/17/02; United
Kingdom Department for Transport, Local Government and the
Regions, Housing Statistics 2000, accessed at http:/Zwww.housing
.detr.gov.uk/research/hss/hs2000/pdf/hsan_chl.pdfon 2/17/02; and U.S.
Bureau of the Census 2001b.




19

The Region

Appendix 2

Public A ttributes o f the GSEs

Fannie Mae and Freddie Mac, or government-spon­
sored enterprises (GSEs), have several public attrib­
utes. They include the following:
First, the financial instruments issued or guaran­
teed by the GSEs are uniquely similar to financial
instruments issued by the U.S. Treasury. Some of
these similarities include the following: (1) eligibil­
ity for Federal Reserve open market purchase, (2)
eligibility to collateralize Federal Reserve bank dis­
count loans, (3) exemption from registration
requirements of the Securities and Exchange
Commission and the states, and (4) eligibility for
unlimited investment by national banks, Federal
savings associations, and Federal credit unions
(HUD 1996, pp. 26-27).
Second, Fannie Mae and Freddie Mac have a
unique organizational structure as well as tax and
regulatory treatment, including (1) a charter grant­
ed by an act of Congress, (2) appointment of mem­
bers to Fannie Mae’s and Freddie Mac’s boards by
the president of the United States, (3) exemption of
corporate earnings from state and local taxes, and
(4) authorization of the Treasury to lend $2.25 bil­
lion to both Fannie Mae and Freddie Mac (Frame
and Wall 2002, pp. 32-33).
Third, Fannie Mae’s and Freddie Mac’s charters
provide the following statement of public purpose:
The GSEs should (1) provide stability in the sec­
ondary market for residential mortgages, (2)
respond appropriately to the private capital market,
(3) provide ongoing assistance to the secondary
market for residential mortgages (including activi­
ties related to mortgages on housing for low- and
moderate-income families involving a reasonable
economic return that may be less than the return
earned on other activities) by increasing the liquid­
ity of mortgage investments and improving the dis­
tribution of investment capital available for resi­
dential mortgage financing, and (4) promote access
to mortgage credit throughout the nation (includ­
ing central cities, rural areas, and underserved
areas) by increasing the liquidity of mortgage
investments and improving the distribution of
investment capital available for residential m ort­
gage financing.
Fourth, the GSEs face limits on their activities




based on the size and riskiness of the mortgages
they can finance. The 2002 cap on mortgages eligi­
ble for Fannie Mae/Freddie Mac financing is
$300,700. The GSEs cannot finance mortgages
where the owner has less than 20 percent equity in
the house unless an acceptable credit enhancement
such as private mortgage insurance is offered. In
addition, the firms can only purchase mortgages
that meet the standards of private institutional
mortgage investors.
Fifth, legislation passed in 1992 required the U.S.
Department of Housing and Urban Development
(HUD) to establish housing goals for the GSEs.
Under these goals, the GSEs must target some of
their funding for families with lower incomes and
households acquiring units located in underserved
communities. The GSEs also have a goal for funding
qualifying multifamily housing. (See HUD 2001 for
a discussion of the housing goals.)
Sixth, both firms have a historical connection to
the federal government. Fannie Mae was originally
a governmental entity. Freddie Mac was originally
controlled by a pseudo-governmental organization
(Feldman 1996, p. 7).
Finally, the federal government has taken action,
or refrained from taking action, to support GSEs.
Fannie Mae was not closed when it was insolvent on
a market basis. HUD estimated that the market
value of Fannie Mae’s assets minus the market value
of its liabilities equaled -$11 billion in 1981 (CBO
1991, p. 129). Congress has twice taken action that
reduced the chance of default of two nonhousing
GSEs, the Farm Credit System (CBO 1991, pp.
79-80) and the Financing Corporation (Leggett and
Strand 1997).

The Region

Appendix 3

An Illustrative Direct Assistance Program

Targeting Households
In the preceding illustration, cash assistance is
restricted to renting households. Policymakers
could come up with other forms of targeting based
on easy-to-observe characteristics (for example,
income of the borrower). Targeting has a potential
downside if it imposes significant cost processes.
Policymakers could reduce potential costs by rely­
ing on existing processes. The current mortgage
origination process should capture and verify all of
the information needed to determine if a house­
hold qualifies for the cash assistance: current
income, price and location of the home being pur­
chased, and location and renter status of the bor­
rower. Moreover, the analytical talents and data
required for targeting already exist. The
Department of Housing and Urban Development,
for example, reports on area median income for
metro areas each year.

A direct subsidy program providing households
with cash that they can use to pay off debt, make a
down payment, or pay closing costs appears to be
able to help a relatively large number of renters
become owners. This appendix illustrates how such
a program might work. We touch on the program’s
ability to increase homeownership, effectively target
households, and maximize the resources that reach
beneficiaries. This appendix is illustrative and does
not review most aspects of a direct subsidy pro­
gram’s design and implementation. (See Calomiris
2001 for another discussion of a direct assistance
program to increase homeownership.)
Increasing Homeownership
The direct subsidy program would provide renting
households with cash from the government that
they could use to pay off debt, make a down pay­
ment, or pay for closing costs. For discussion pur­
poses, we assume the funding for the direct pro­
gram equals the $8.3 billion that analysts estimate
was provided on average to the GSEs annually from
1995 to 2000. (See CBO 2001b for the estimate and
Toevs 2001 and Pearce and Miller 2001 for a cri­
tique of the estimate.) Policymakers must decide
how much to give each program participant.
Census Bureau analysis suggests that cash assistance
must equal $5,000 per recipient household to allow
more renting households to qualify for a mortgage
than would be achieved by eliminating down pay­
ments. (See Tables 4 and 6 in the preceding text.) A
program with total funding of $8.3 billion which
provides $10,000 per renting household would
serve 830,000 households a year. In three years, the
direct subsidy program would assist 2.5 million
renting households. There were 105 million house­
holds in the United States as of 2000, according to
the Census Bureau, with 69.8 million homeowners.
A direct subsidy program serving 2.5 million
households over three years would, all else equal,
increase the homeownership rate by 2.4 percentage
points. Even if this estimate were overstated by onethird to one-half, the direct subsidy program would
achieve material increases relative to historical
changes in the homeownership rate over such a
short period and to estimates of the effect of small
mortgage rate reductions.




Minimizing Costs
As just suggested, qualification for the cash assis­
tance program could occur when a borrower
applies for a loan in order to minimize costs.
Therefore, the government’s major administrative
expense from the direct assistance program would
arise from fund disbursement and accounting, limit­
ed participant verification, potential reimbursement
to contractors, and other administrative functions.
Policymakers could look to the administrative costs
of other government programs to gauge potential
costs. (See Social Security Administration 2000 and
CBO 1993 for the following data.) Large-scale pay­
ment systems, such as the old-age survivors insur­
ance part of Social Security, have lower administra­
tive costs (about 50 basis points of total costs). Food
stamp and Medicaid programs that require more
verification and have a finer level of means testing
have administrative costs of 13 percent and 4 per­
cent of total costs, respectively. Programs such as
Women, Infants and Children, which include coun­
seling services, have administrative costs of 25 per­
cent of total costs. The program outlined seems to
fall between large-scale payment programs and
programs that carry out more verification. This
would put administrative costs below double-digit
levels.

21

The Region

References

Ambrose, Brent W.; Thibodeau, Thomas G.; and Temkin,
Kenneth. 2002. An analysis of the effects of the GSE afford­
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Report. Urban Institute (for U.S. Department of Housing and
Urban Development).
Avery, Robert B.; Bostic, Raphael W.; Calem, Paul S.; and
Canner, Glen B. 1996. Credit risk, credit scoring, and the per­
formance of home mortgages. Federal Reserve Bulletin 82
(July): 621-48.
Avery, Robert B.; Bostic, Raphael W.; Calem, Paul S.; and
Canner, Glen B. 2000. Credit scoring: Statistical issues and
evidence from credit-bureau files. Real Estate Economics 28
(Fall): 523-47.
Bostic, Raphael W., and Surette, Brian J. 2001. Have the doors
opened wider? Trends in homeownership rates by race and
income. Journal of Real Estate Finance and Economics 23
(November): 411-34.
Bunce, Harold L. 2002. The GSEs’ funding of affordable loans:
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Department of Housing and Urban Development.
Calhoun, Charles A., and Stark, Marya T. 1997. Credit quality
and housing affordability of renter households. Manuscript.
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Wallison, pp. 85-109. Washington, D.C.: American Enterprise
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Capozza, Dennis R.; Hendershott, Patric H.; and Green,
Richard K. 1999. Tax reform and house prices: Large or small
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Development.




Federal Reserve Board of Governors (FR Board). 1992. Federal
Reserve Bulletin 78 (December). Washington, D.C.: Board of
Governors of the Federal Reserve System.
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Reserve Bulletin 88 (May). Washington, D.C.: Board of
Governors of the Federal Reserve System.
Feldman, Ron. 1996. Uncertainty in federal intervention:
Fannie Mae, Freddie Mac and the housing subsidy trail. The
Region 10 (September): 5-13. Federal Reserve Bank of
Minneapolis.
Frame, W. Scott, and Wall, Larry D. 2002. Financing housing
through government-sponsored enterprises. Federal Reserve
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Goodman, John L., Jr., and Nichols, Joseph B. 1997. Does FHA
increase home ownership or just accelerate it? Journal of
Housing Economics 6 (June): 184-202.
Green, Richard K. 1996. Should the stagnant homeownership
rate be a source of concern? Regional Science and Urban
Economics 26 (June): 337-68.
Green, Richard K., and Vandell, Kerry D. 1999. Giving house­
holds credit: How changes in the U.S. tax code could promote
homeownership. Regional Science and Urban Economics 29
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Susan M. 1997. Borrowing constraints and the tenure choice of
young households. Journal of Housing Research 8 (2): 137-54.
Jones, Lawrence D. 1989. Current wealth and tenure choice.
AREUEA Journal 17 (Spring): 17-40.
Leggett, Keith J., and Strand, Robert W. 1997. The financing
corporation, government-sponsored enterprises, and moral
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LaCour-Little, Michael. 2001. Comment: Credit market access
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and Cho, Man. 1997. Do borrowing constraints change U.S.
homeownership rates? Journal of Housing Economics 6
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Linneman, Peter, and Wachter, Susan. 1989. The impacts of
borrowing constraints on homeownership. AREUEA Journal
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Union. The Hague: Netherlands Ministry of Housing, Spatial
Planning and the Environment.

The Region

U.S. Congress, Congressional Budget Office (CBO). 1993. The
costs of administering selected poverty-related programs.

Painter, Gary, and Redfearn, Christian L. 2001. The role of
interest rates in influencing long-run homeownership rates.
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Real Estate Finance and Economics 25 (2).

U.S. Congress, Congressional Budget Office (CBO). 2001a.
Interest rate differentials between jumbo and conforming
mortgages, 1995-2000. Available at http://www.cbo.gov.

Pearce, James E., and Miller, James C. III. 2001. Response to
CBO’s draft report: Federal subsidies and housing GSEs.
Freddie Mac Press Release, May 18.

U.S. Congress, Congressional Budget Office (CBO). 2001b.
Federal subsidies and the housing GSEs. Available at
http://www.cbo.gov.

Quercia, Roberto G.; McCarthy, George W.; and Wachter,
Susan M. 2000. The impacts of affordable lending efforts on
homeownership rates. Manuscript. Federal Home Loan
Mortgage Corporation.

U.S. Department of Housing and Urban Development
(HUD). 1996. Privatization of Fannie Mae and Freddie Mac:
Desirability and feasibility. Available at: http://www.
huduser.org/ publications/hsgfin/fredfan.html.

Rosenthal, Stuart S. 2001. Eliminating credit barriers to
increase homeownership: How far can we go? Working Paper
01-01. Research Institute for Housing America.

U.S. Department of Housing and Urban Development
(HUD). 2001. HUD’s affordable lending goals for Fannie Mae
and Freddie Mac. Office of Policy Development and Research
Issue Brief V. Washington, D.C.: U.S. Department of Housing
and Urban Development.

Savage, Howard A. 1999. Who could afford to buy a house in
1995? Current Housing Reports H121/99-1. U.S. Census
Bureau.

Wachter, Susan; Follain, James; Linneman, Peter; Quercia,
Roberto G.; and McCarthy, George. 1996a. Implications of
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vatizing Fannie Mae and Freddie Mac, pp. 338-77.
Washington, D.C.: U.S. Department of Housing and Urban
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Segal, Lewis M., and Sullivan, Daniel G. 1998. Trends in homeownership: Race, demographics, and income. Federal Reserve
Bank of Chicago Economic Perspectives 22 (Spring): 53-72.
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performance and accountability report for fiscal year 2000.
Available at: http://www.ssa.gov/finance/fyOO_accountability.
html.

Wachter, Susan; Follain, James; Linneman, Peter; Quercia,
Roberto G.; and McCarthy, George. 1996b. Response to
Anthony M. Yezer’s comments. In Studies on privatizing
Fannie Mae and Freddie Mac, p. 382. Washington, D.C.: U.S.
Department of Housing and Urban Development.

Temkin, Kenneth; Quercia, Roberto; Galster, George; and
O’Leary, Sheila. 1999. A study of the GSEs’ single family
underwriting guidelines. Final Report. Urban Institute (for
U.S. Department of Housing and Urban Development).

Yezer, Anthony M. 1996. Comments on the Wachter et al.
paper. In Studies on privatizing Fannie Mae and Freddie Mac,
pp. 378-81. Washington, D.C.: U.S. Department of Housing
and Urban Development.

Toevs, Alden. 2001. Federal subsidies and the governmentsponsored enterprises: An analysis of the CBO study. Bank
Accounting & Finance 15 (Fall): 24-31.

Zorn, Peter M. 1989. Mobility-tenure decisions and financial
credit: Do mortgage qualification requirements constrain
homeownership? AREUEA Journal 17 (Spring): 1-16.

U. S. Bureau of the Census. 2000. American housing survey
for the United States: 1999. U.S. Department of Commerce,
Bureau of the Census, and U.S. Department of Housing and
Urban Development, Office of Policy Development and
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pubs/hl50-99.pdf.
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the Census, and U.S. Department of Labor, Bureau of Labor
Statistics. Available at http://www.census.gov/population/
www/socdemo/hh-fam.html.
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homeownership: Annual statistics 2001. U.S. Department of
Commerce, Bureau of the Census. Available at http://
www.census.gov.
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Controlling the risks of government-sponsored enterprises.
Washington, D.C.: U.S. Government Printing Office.




23







The Region

2001

O P E R A T I O N S REPORT

Commercial and Industrial Loans
Loans to Individuals
Agricultural Loans
Loans to Foreign Govts, and Inst.
Other Loans and Leases
1 ess: Unearned Income
Loans & Leases

FRB

M P LS

0 9 1 0 -0 0 0 6 -0

0 3 -2 4 -9 4
410i*r5749 8S78 8880

64

4 10 12 57 49

BB 045' ’ ■>
B2
—
FRB

M PLS

091C

-.

SKEWS'
.-..-..A .

?:
,




The Region

EXECUTIVE

MESSAGE

The year 2001 presented daunting economic challenges to the nation and to
the U pper Midwest— the region that forms the Ninth District of the Federal
Reserve System. We began the year with the economy slowing, unem ploym ent
growing and business investment falling. As the year unfolded the Federal O pen
Market Committee moved aggressively to lower short-term interest rates. The
terrorist attacks of Sept. 11 and the resulting uncertainty and business restruc­
turing dealt a further shock to the economy. But, as evidence of the resilience
of the U.S. economy, even with the Sept. 11 shock, it is increasingly clear that
last year’s “recession” was extremely mild and short-lived by historical standards.
In fact, early 2002 data show the economy growing at a very healthy rate.
As the nation’s central bank, the Federal Reserve has a rich tradition of
confronting and helping to resolve financial sector crises. O n Sept. 11 and in
the days and weeks that followed, the Federal Reserve did its part to mitigate
the im pact of the terrorist attack on one of the natio n ’s key financial districts.
The Federal Reserve addressed liquidity needs and payments m echanism
issues when financial markets were disrupted, helping to ensure that critical
payments system infrastructure and financial services continued to function.

As the Reserve Bank respon­
sible for the operation of the
System’s autom ated clearing
house operations (ACH), we
were able to provide direct
support to New York finan­
cial institutions. W ithin the
district, we worked diligently

iipiS P rT ^ipiiiv: '..i 'iuhhpu ’"!ijpipiuii l mvmwK

Gary Stern, President and
Jam es Lyon, First Vice President

to minimize the disruption
to check flows created by the grounding of all air traffic. We are proud of our
employees’ response and contribution in this time of national emergency.
For 2001, the Minneapolis Fed’s key operational goals were to improve our
productivity and strengthen our financial performance. We also continued to
modify our operations to maintain alignment with the increasingly standardized
and centralized approach the Federal Reserve is adopting to operations across the
12 Federal Reserve Banks. These changes reflect our continuing com m itm ent to
efficient use of public resources and to effective response to the changing land-




t■

M




The Region

scape of banking. We m ade considerable strides in improving our productivity
last year, improvements we will build upon going forward. We are com m itted to
making these changes while continuing our tradition of excellence in both serving
Ninth District financial institutions and fulfilling our public m andate.
From a policy perspective, the Bank has continued to prom ote the benefits
of m arket discipline as a com ponent of bank regulation and m ore broadly as
an im portant consideration in public policy deliberations.
In our conversations with policymakers, bankers, students and others we
often find that people are not fully aware of the diverse roles that the Federal
Reserve plays in its three key functions: m onetary policy, banking supervision
and regulation, and financial services. To address this gap we provide in this
year’s annual report a prim er of the roles and functions our Bank perform s and
how they touch the lives of people throughout our district.
We are proud of the accom plishm ents of the Federal Reserve Bank of
M inneapolis and look forward to continuing to serve the changing needs of the
N inth District and Federal Reserve System.

Gary H. Stern

Jam es M. Lyon

PRESIDENT

FIRST VICE P R E S I D E N T

The Region

Payments Services
MAKING

YOU

MA Y N O T

REALIZE

(s

u r e

t h e

)

ENDS MEET

Fed is a key player in ensuring that this infra­

that when you

structure is always up and running.

write a check to pay your electric bill, get
m oney from a cash m achine or receive notice

The Fed provides three payments services:

that your paycheck has been deposited directly

check clearing, currency and coin delivery to

into your bank account th at the Federal

banks and thrift institutions, and the electronic

Reserve System is working behind the scenes

transfer of funds. W hen it comes to the first two

on those transactions. Indeed, you probably

services—checks and currency—the Minneapolis

d o n ’t worry about how those financial transac­

Fed faces particular challenges owing to the

tions are com pleted; you simply take them for

rem ote locations of many financial institutions

granted. And th a t’s ju st fine with the Fed.

in the Ninth Federal Reserve District. The
N inth

Every day in the U nited States, trillions of

District stretches

from

the

Rocky

dollars are transferred by a variety of m eans—

Mountains, across the Great Plains and to the

w hether in the form of paper or electronics—

Great Lakes, and is one of the largest Federal

and the economy depends on the safe and

Reserve districts as m easured by square miles,

sound accounting of those funds. In effect,

encom passing M ontana, N orth and South

there is an infrastructure for these m ethods of

Dakota, M innesota, northw estern Wisconsin

paym ent that underlies our economy, and the

and the U pper Peninsula of Michigan. To help




29

The Region

ensure efficient delivery of services across the

tronic payments, from direct deposit of payroll

N inth District, the M inneapolis Fed has a

and Social Security payments, to multimillion-

branch office in H elena, Mont.

dollar transfers between banks.

The M inneapolis Fed processed about 996

O f course, no m atter how popular electronic

million checks in 2001 worth about $800 tril­

payments becom e or no m atter how many

lion, including m ore than 177 million checks

checks people continue to write, there will

w orth nearly $335 trillion at the H elena

always be a need for currency in the economy.

Branch. Together, the 12 Banks of the Federal

The Minneapolis Fed helps m eet this need by

Reserve System, including 45 branch and pro­

processing currency for circulation to banks,

cessing locations, clear about 34 percent of all

recycling used bills that are returned to the Fed

the checks issued in the U nited States. But even

and destroying unfit currency and replacing it

comm ercial banks that clear their own checks

with new bills. In 2001, the M inneapolis Fed

still use accounts at the Federal Reserve to set­

recirculated $11.2 billion in cash and coin—

tle with banks at the end of the day. In other

about $43 million a day.

words, ju st like you balance your checkbook, so

T here is one o th er responsibility that the Fed

does the entire U.S. financial system, and the

has as the natio n ’s central bank, and that is to

Fed is responsible for ensuring that this com­

serve as the governm ent’s fiscal agent, m anag­

plex jo b is com pleted without a hitch.

ing the process of funding the country’s debt.

T hat responsibility also extends to electronic

W hat this m eans to you, for example, is that the

paym ents. Almost since its inception, the

Fed provides such Treasury services as selling

Federal Reserve has transferred funds electron­

and redeem ing Savings and Treasury Bonds.

ically between banks. But starting in the early

The Federal Reserve Bank of M inneapolis spe­

1970s the Fed pioneered the use of electronic

cializes in the retail side, working directly with

paym ents for such transactions as payroll

individual purchasers and providing behind-

deposits, thus providing the efficiency and secu­

the-scenes support to financial institutions and

rity of this technology to consumers. This eco­

o th e r firms th at offer th eir custom ers or

nomical system has grown in popularity and use;

employees opportunities to buy bonds.

in 2001, the Fed processed $655 trillion in elec­




The Region

M onetary Policy
WORKING TO

ENSURE

PRICE STABILITY

PRIMARY

and the presidents of the 12 Federal Reserve

is to chart a course for

Banks. The m em bers of the Board of Governors

the country’s m onetary policy. You often hear

and the president of the New York Fed are per­

that the Fed has lowered or raised interest rates

m anent voting m em bers of the FOMC, with

and then are told how this will likely affect the

four other Federal Reserve Bank presidents vot­

price of goods or affect econom ic growth.

ing on a rotational basis. Even when they are

Many consum er choices are influenced by the

not voting members, each president partici­

cost of borrowing, from w hether to buy a new

pates in policy discussions during the meetings,

car or hom e, or w hether to borrow money for

which occur eight times a year. This group

hom e repairs or other purposes; businesses

works to establish a m onetary policy focused on

also make choices about jobs and expansion

low and stable inflation, thus creating an eco­

based, in part, on borrow ing costs.

nomic environm ent that will sustain the highest

THE

FEDERAL

R E S E R V E ’S

RESPONSIBILITY

Clearly, the health of the U.S. economy is an

possible growth and jo b creation.

im portant responsibility and one the Fed takes

The decisions of the FOMC are not m ade in

very seriously. The policymaking arm of the Fed

a vacuum. To ensure that the committee has the

is the

M arket Com m ittee

best information available to make its decisions,

(FOMC), consisting of the Board of Governors

each Federal Reserve Bank—along with the




Federal O pen

31

The Region

Federal Reserve Board—engages in data-gathering

e-mail updates and statistical analysis. The assem­

and economic forecasting. For the Minneapolis

bled Ninth District information is used to better

Fed, this means keeping track of the Ninth

understand the entire U.S. economy. Much of

District’s diverse economy through meetings with

this analysis and data are made available to the

the Bank’s directors and other representatives of

public through the Bank’s publications and its

the Ninth District economy, regular phone calls,

Web site: www.minneapolisfed.org.

Banking Supervision
SAFETY

e n s u r i n g

a n d

ACCESS

lercial and Industrial Loans
Loans to Individuals
Agricultural Loans
Loans to Foreign Govts, and Inst.
Other Loans and Leases
Less: Unearned Income
Loans & Leases

100,366

Net of Unearned Income

96,393

90,818

87.682

C om m unity Reinvestm ent Act

dloft for Loan & lease Losses

1.518

.425

INFRA­

ensuring that banks are operated in a safe, sound

S T R U C T U R E to ensure that you have access to

and fair manner, and consistent with consumer

your money and working to make sure that inter­

banking regulations, while m eeting the conven­

est rates are set at a level that allows the economy

ience and needs of their communities.

PROVIDING

THE

FINANCIAL

to grow at a sustainable pace are just two of the

T he Banking Supervision D epartm ents of

primary ways that the Fed impacts your financial

the Reserve Banks, along with o th er federal

life. The third elem ent supports the first two:

and state regulators, ensure th at banking laws




The

are followed, that risk is managed effectively
and that banks maintain business relation­

but

CHANGE

NEW

IN

IS N O T H I N G

BANKING,

and the Federal

ships with all members of their community.
Essentially, the examinations performed by

Reserve is accustomed to such change, whether it

the Minneapolis Fed fall into two categories,

be in financial services products, monetary policy

and both have a direct impact on consumers:
the first deals with how banks manage their
money, the second with how banks relate to
their customers.
The first type of examination verifies the
financial viability of the bank and includes an
evaluation of its assets, capital, earnings, liq­

research or supervision of the financial system.
Through it all, the Federal Reserve System’s mis­
sion remains the same: to maintain a stable price
environment to better generate economic growth
and job creation, and to ensure the safety and

uidity and sensitivity to market risk, as well as
the bank’s managerial policies, among many

soundness of the nation’s financial system. That

other factors. The second ensures that banks

way, when you write your check or use a cash

comply with all bank-related consumer legisla­
tion, including accurate communication of
bank interest rate information, and fair and
equal access to credit regardless of gender,
race, marital status or other characteristics. For
example,

you

may have

heard

of the

Community Reinvestment Act (CRA), which
was established by Congress with standards to
assess whether a bank is meeting the credit
needs of its community.
Part of the role of the Federal Reserve’s
examiners is to monitor and analyze broader
trends in banking and determine how they
impact the safety and soundness of the indus­
try. In recent years, as banks have grown larger
and as they have moved into increasingly com­
plex businesses, the Federal Reserve’s supervi­
sory efforts have become even more important.




machine you can take the Fed for granted—and
feel good about it.

The Region

2001 Minneapolis Board of Directors
James J. Howard

Ronald N. Zwieg

Chairman

Deputy Chairman

CLASS B ELECTED BY
MEMBER BANKS

CLASS C APPOINTED BY THE
BOARD OF GOVERNORS

Roger N. Berglund

D. Greg Heineman

James J. Howard

President and Chief Executive Officer
Dakota Western Bank
Bowman, N.D.

Chairman
Williams Insurance Agency Inc.
Sioux Falls, S.D.

Chairman
Xcel Energy Inc.
Minneapolis, Minn.

W. W. Lajoie

Jay. F Hoeschler

Linda Hall Whitman

Chairman and Chief Executive Officer
Central Savings Bank
Sault Ste. Marie, Mich.

President
Hoeschler Realty Corp.
La Crosse, Wis.

Maple Plain, Minn.

Dan M. Fisher

Rob L. Wheeler

Chief Information Officer
Community First Bankshares Inc.
Fargo, N.D.

Vice President and Sales Manager
Wheeler Manufacturing Co. Inc.
Lemmon, S.D.

CLASS A ELECTED BY
MEMBER BANKS




Ronald N. Zwieg
President
United Food and
Commercial Workers Local 653
Plymouth, Minn.

Seated (from left):
Jay Hoeschler,
Roger Berglund,
Linda Hall Whitman,
Rob Wheeler;
standing (from left):
Dan Fisher,
W.W. Lajoie,
James Howard,
Ronald Zwieg

34

The Region

2001 Helena Branch Board of Directors
William P. Underriner

Thomas O. Markle

Chairman

Vice Chairman

APPOINTED BY THE BOARD
OF GOVERNORS

APPOINTED BY THE
MINNEAPOLIS BOARD
OF DIRECTORS

Thomas O. Markle
President and Chief Executive Officer
Markle’s Inc.
Glasgow, Mont.

William P. Underriner
General Manager
Selover Buick Inc.
Billings, Mont.

Emil W. Erhardt
Chairman, President
and Chief Executive Officer
Citizens State Bank
Hamilton, Mont.

Richard E. Hart
President
Mountain West Bank
Kalispell, Mont.

Marilyn F. Wessel
Dean and Director
Museum of the Rockies
Bozeman, Mont.

Seated (from left):
Marilyn Wessel,
Richard Hart;
standing (from left):
Thomas Markle,
Emil Erhardt,
William Underriner

FEDERAL ADVISORY
COUNCIL MEMBER
R. Scott Jones
President and Chief Executive Officer
Signal Financial Corp.
Mendota Heights, Minn.




35

The Region

Advisory Council on Small Business,
Agriculture and Labor
Rob L. Wheeler, Chairman
Vice President and Sales Manager
Wheeler Manufacturing Co. Inc.
Lemmon, S.D.

Terry Anderson

Curt Niemala

Joe Rothschiller

President
Anderson Chemical Co.
Litchfield, Minn.

Secretary Treasurer
Blizzard Corp.
Calumet, Mich.

General Manager
Steffes Corp.
Dickinson, N.D.

John T. Forkan Jr.

Donald C. Peterson

Gae Veit

Business Manager
Plumbers and Pipefitters Local 141
Butte, Mont.

Owner
Yaggie’s Inc.
Yankton, S.D.

Chief Executive Officer
Shingobee Builders
Loretto, Minn.

Carrie Holmen
Rancher
Billings, Mont.

Karl Murch
Controller
Nortrax Equipment Co.
Eau Claire, Wis.

Seated (from left):
Gae Veit,
Rob Wheeler;
standing (from left):
Joe Rothschiller,
Curt Niemala,
Terry Anderson,
Karl Murch




36

The Region

Federal Reserve Bank of Minneapolis

Senior Management
Gary H. Stern

Sheldon L. Azine

Arthur J. Rolnick

President

Senior Vice President
and General Counsel
Treasury Services, Cash Operations,
Protection and Law

Senior Vice President
and Director of Research
Research and Public Affairs

James M. Lyon
First Vice President
Chief Operating Officer




Claudia S. Swendseid
Scott H. Dake
Senior Vice President
Check Standardization Project Office

Senior Vice President
Priced Services,
FedACH Support Services
and Helena Branch

Creighton R. Fricek
Niel D. Willardson

Senior Vice President
and Corporate Secretary
Information Technology,
Human Resources
and Financial Management

Senior Vice President
Banking Supervision
and Risk Management

Seated (from left):
Claudia Swendseid,
Gary Stern,
James Lyon,
Niel Willardson,
standing (from left):
Scott Dake,
Arthur Rolnick,
Creighton Fricek,
Sheldon Azine

37

The Region

Federal Reserve Bank of Minneapolis

December 31, 2001

Officers
Duane A. Carter
Vice President
Cash Operations

Thomas M. Supel
Vice President
Financial Management

Jean C. Garrick
Assistant Vice President
Check

Michael Garrett
Vice President
Human Resources

Richard M. Todd
Vice President
Information Technology

Peter J. Gavin
Assistant Vice President
FedACH Support Services

Linda M. Gilligan
General Auditor

Thomas H. Turner
Vice President
Treasury Services

Elizabeth W. Kittelson
Assistant Vice President
Financial Management

Warren E. Weber
Senior Research Officer
Research

Matthew D. Larson
Assistant Vice President
Information Technology

Caryl W. Hayward
Vice President
Check
Richard L. Kuxhausen
Vice President
Customer Relations
Susan J. Manchester
Vice President
Treasury Services
Preston J. Miller
Vice President
Banking and Policy Studies
Kinney G. Misterek
Vice President
Banking Supervision
H. Fay Peters
Vice President
Protection and Facilities
Susan K. Rossbach
Vice President and Deputy
General Counsel
Julie Stackhouse
Vice President and
Community Affairs Officer
Risk Management




Kelly A. Bernard
Assistant Vice President
Check Standardization
Project Office
Jacquelyn K. Brunmeier
Assistant Vice President
Banking Supervision
James A. Colwell
Assistant Vice President
Banking Supervision
Barbara G. Coyle
Assistant Vice Presiden
Risk Management
James T. Deusterhoff
Assistant Vice President
and Discount Officer
Risk Management
Ron J. Feldman
Assistant Vice President
Banking and Policy Studies
David G. Fettig
Assistant Vice President
and Public Affairs Officer

Marie R. Munson
Assistant Vice President
Treasury Services
Richard W. Puttin
Assistant Vice President
Check
Paul D. Rimmereid
Assistant Vice President
Financial Management
Randy L. St. Aubin
Assistant General Auditor
Kenneth C. Theisen
Assistant Vice President
Check
Cheryl L. Venable
Assistant Vice President
FedACH Support Services
John E. Yanish
Assistant Vice President
and Assistant General
Counsel

Helena Branch
Samuel H. Gane
Vice President
Branch Manager
R. Paul Drake
Assistant Vice President
Check and Support
Susan M. Woodrow
Assistant Vice President
Cash and Support




90 Hennepin Avenue, P.O. Box 291
Minneapolis, Minnesota 55480-0291

Federal Reserve Bank of Minneapolis




Phone 612 204-5000

March 4, 2002
To the Board of Directors:
The management of the Federal Reserve Bank of Minneapolis (FRB of Minneapolis) is
responsible for the preparation and fair presentation of the Statement of Financial Condition,
Statement of Income, and Statement of Changes in Capital as of December 31,2001 (the
“Financial Statements”). The Financial Statements have been prepared in conformity with the
accounting principles, policies, and practices established by the Board of Governors of the
Federal Reserve System and as set forth in the Financial Accounting Manual for the Federal
Reserve Banks, and as such, include amounts, some of which are based on judgments and esti­
mates of management.
The management of the FRB of Minneapolis is responsible for maintaining an effective
process of internal controls over financial reporting including the safeguarding of assets as
they relate to the Financial Statements. Such internal controls are designed to provide reason­
able assurance to management and to the Board of Directors regarding the preparation of reli­
able Financial Statements. This process of internal controls contains self-monitoring mecha­
nisms, including, but not limited to, divisions of responsibility and a code of conduct. Once
identified, any material deficiencies in the process of internal controls are reported to manage­
ment, and appropriate corrective measures are implemented.
Even an effective process of internal controls, no matter how well designed, has inherent
limitations, including the possibility of human error, and therefore can provide only reasonable
assurance with respect to the preparation of reliable financial statements.
The management of the FRB of Minneapolis assessed its process of internal controls over
financial reporting including the safeguarding of assets reflected in the Financial Statements,
based upon the criteria established in the “Internal Control - Integrated Framework” issued by
the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Based on
this assessment, the management of the FRB of Minneapolis believes that the FRB of
Minneapolis maintained an effective process of internal controls over financial reporting
including the safeguarding of assets as they relate to the Financial Statements.

Gary H. Stern, President

40

FtoCB/VATERMUS^COPERS




PricewaterhouseCoopers LLP
650 Third Avenue South
Suite 1300
Minneapolis MN 55402-4333
Telephone (612) 596 6000
Facsimile (612) 373 7160

Report of Independent Accountants
To the Board of Directors of the
Federal Reserve Bank of Minneapolis:
We have examined management’s assertion that the Federal Reserve Bank of Minneapolis
(“FRB of Minneapolis”) maintained effective internal control over financial reporting and the
safeguarding of assets as they relate to the Financial Statements as of December 31, 2001,
included in the accompanying Management’s Assertion. The assertion is the responsibility of
FRB of Minneapolis management. Our responsibility is to express an opinion on the assertions
based on our examination.
Our examination was made in accordance with standards established by the American Institute
of Certified Public Accountants, and accordingly, included obtaining an understanding of the
internal control over financial reporting, testing, and evaluating the design and operating effec­
tiveness of the internal control, and such other procedures as we considered necessary in the
circumstances. We believe that our examination provides a reasonable basis for our opinion.
Because of inherent limitations in any internal control, misstatements due to error or fraud
may occur and not be detected. Also, projections of any evaluation of the internal control over
financial reporting to future periods are subject to the risk that the internal control may
become inadequate because of changes in conditions, or that the degree of compliance with the
policies or procedures may deteriorate.
In our opinion, management’s assertion that the FRB of Minneapolis maintained effective
internal control over financial reporting and over the safeguarding of assets as they relate to the
Financial Statements as of December 31, 2001, is fairly stated, in all material respects, based
upon criteria described in “Internal Control - Integrated Framework” issued by the Committee
of Sponsoring Organizations of the Treadway Commission.

March 4, 2002
Minneapolis, Minnesota

41




Federal Reserve Bank of M inneapolis

Financial
Statements
for years ended
December 31, 2001
and 2000

42

P rICB/VATeRHOUs EQ o PERS




PricewaterhouseCoopers LLP
650 Third Avenue South
Suite 1300
Minneapolis MN 55402-4333
Telephone (612) 596 6000
Facsimile (612) 373 7160

Report of Independent Accountants
To the Board of Governors of The Federal Reserve System
and the Board of Directors of The Federal Reserve
Bank of Minneapolis
We have audited the accompanying statements of condition of The Federal Reserve Bank of
Minneapolis (the “Bank”) as of December 31, 2001 and 2000, and the related statements of
income and changes in capital for the years then ended. These financial statements are the
responsibility of the Bank’s management. Our responsibility is to express an opinion on the
financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the
United States of America. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material misstatement.
An audit includes examining, on a test basis, evidence supporting the amounts and disclosures
in the financial statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall financial statement
presentation. We believe that our audits provide a reasonable basis for our opinion.
As discussed in Note 3, the financial statements were prepared in conformity with the account­
ing principles, policies, and practices established by the Board of Governors of The Federal
Reserve System. These principles, policies, and practices, which were designed to meet the spe­
cialized accounting and reporting needs of The Federal Reserve System, are set forth in the
“Financial Accounting Manual for Federal Reserve Banks” and constitute a comprehensive basis
of accounting other than accounting principles generally accepted in the United States of
America.
In our opinion, the financial statements referred to above present fairly, in all material respects,
the financial position of the Bank as of December 31,2001 and 2000, and results of its opera­
tions for the years then ended, on the basis of accounting described in Note 3.

March 4,2002
Minneapolis, Minnesota

43




Federal Reserve Bank of Minneapolis

STATEMENTS OF CONDITION
(in millions)

As of December 31,
2001
Assets
Gold certificates

$

$

30

Special drawing rights certificates
Coin
Items in process of collection
Loans to depository institutions
U.S. government and federal agency securities, net
Investments denominated in foreign currencies
Accrued interest receivable
Prepaid expense-interest on Federal Reserve notes
to the U.S. Treasury
Interdistrict settlement account
Bank premises and equipment, net
Other assets
Total assets

143

2000
158
30
33
516

31
526
3
1,752

5
2,183

563
18

572
25

31
12,065
144

31
—
150

18

19

$

15,324

$

3,722

$

14,055

$

1,587

Liabilities and Capital
Liabilities:
Federal Reserve notes outstanding, net
Deposits:
Depository institutions
Other deposits
Deferred credit items
Interdistrict settlement account
Accrued benefit costs
Other liabilities

460
1
457
—
43
10

456
2
451
642
41
10

15,026

3,189

Capital paid-in

180

368

Surplus

118

165

298

533

Total liabilities
Capital:

Total capital
Total liabilities and capital

$

15,324

The accompanying notes are an integral part of these financial statements.

$

3,722




Federal Reserve Bank of Minneapolis

STATEMENTS OF INCOME
(in millions)

For the years ended December 31,
2000
2001
Interest income:
Interest on U.S. government and
federal agency securities
Interest on investments denominated in

$

102

$

1

10
4

115

211

12

foreign currencies
Interest on loans to depository institutions
Total interest income

197

•

Other operating income:
52

Income from services
Reimbursable services to government agencies

23

Foreign currency (losses), net
U.S. Government securities gains (losses), net

(55)
1

46
25
(51)
(1)
1

1

Other income
Total other operating income
Operating expenses:
Salaries and other benefits
Occupancy expense
Equipment expense
Assessments by Board of Governors
Other expenses
Total operating expenses
Net (loss) income prior to distribution

22

20

77
12
10
12

70
13

55

43

166

145

9
10

$

(29)

$

86

$

18
(47)

$

19
67

$

(29)

$

86

Distribution of net (loss) income:
Dividends paid to member banks
Transferred to (from) surplus
Total distribution

The accompanying notes are an integral part of these financial statements.

45




Federal Reserve Bank of Minneapolis

STATEMENTS OF CHANGES IN CAPITAL
for the years ended December 31, 2001, and December 31, 2000
(in millions)

Capital
Paid-in
Balance at January 1, 2000
(4.7 million shares)

$ 235

Surplus

$ 235
67

Total
Capital

$ 470

Net income transferred to surplus

—

Surplus transfer to the U.S. Treasury
Net change in capital stock issued

—

(137)

(137)

133

—

133

(2.7 million shares)
Balance at December 31,2000
(7.4 million shares)
Transferred from surplus
Net change in capital stock redeemed
(3.8 million shares)
Balance at December 31, 2001
(3.6 million shares)

$ 368
—

$ 165
(47)

67

$ 533
(47)

(188)

—

(188)

$ 180

$ 118

$ 298

The accompanying notes are an integral part of these financial statements.

Federal Reserve Bank of Minneapolis

Notes to Financial Statements




1. ORGANIZATION
The Federal Reserve Bank of Minneapolis (“Bank”) is part of the Federal Reserve System
(“System”) created by Congress under the Federal Reserve Act of 1913 (“Federal Reserve Act”)
which established the central bank of the United States. The System consists of the Board of
Governors of the Federal Reserve System (“Board of Governors”) and twelve Federal Reserve
Banks (“Reserve Banks”). The Reserve Banks are chartered by the federal government and pos­
sess a unique set of governmental, corporate, and central bank characteristics. Other major ele­
ments of the System are the Federal Open Market Committee (“FOMC”) and the Federal
Advisory Council. The FOMC is composed of members of the Board of Governors, the presi­
dent of the Federal Reserve Bank of New York (“FRBNY”) and, on a rotating basis, four other
Reserve Bank presidents.

Structure
The Bank and its branch in Helena, Montana, serve the Ninth Federal Reserve District, which
includes Minnesota, Montana, North Dakota, South Dakota, and portions of Michigan and
Wisconsin. In accordance with the Federal Reserve Act, supervision and control of the Bank
are exercised by a Board of Directors. Banks that are members of the System include all nation­
al banks and any state-chartered bank that applies and is approved for membership in the
System.

Board of Directors
The Federal Reserve Act specifies the composition of the Board of Directors for each of the
Reserve Banks. Each board is composed of nine members serving three-year terms: three
directors, including those designated as Chairman and Deputy Chairman, are appointed by the
Board of Governors, and six directors are elected by member banks. Of the six elected by
member banks, three represent the public and three represent member banks. Member banks
are divided into three classes according to size. Member banks in each class elect one director
representing member banks and one representing the public. In any election of directors, each
member bank receives one vote, regardless of the number of shares of Reserve Bank stock it
holds.

2. OPERATIONS AND SERVICES
The System performs a variety of services and operations. Functions include: formulating and
conducting monetary policy; participating actively in the payments mechanism, including
large-dollar transfers of funds, automated clearinghouse (“ACH”) operations and check pro­
cessing; distributing coin and currency; performing fiscal agency functions for the U.S.
Treasury and certain federal agencies; serving as the federal governments bank; providing
short-term loans to depository institutions; serving the consumer and the community by pro­
viding educational materials and information regarding consumer laws; supervising bank hold­
ing companies and state member banks; and administering other regulations of the Board of
Governors. The Board of Governors’ operating costs are funded through assessments on the
Reserve Banks.
The FOMC establishes policy regarding open market operations, oversees these operations, and
issues authorizations and directives to the FRBNY for its execution of transactions. Authorized

47

Federal Reserve Bank
of Minneapolis

Notes to
Financial Statements
(Continued)




transaction types include direct purchase and sale of securities, matched sale-purchase transac­
tions, the purchase of securities under agreements to resell, and the lending of U.S. government
securities. The FRBNY is also authorized by the FOMC to hold balances of and to execute spot
and forward foreign exchange and securities contracts in nine foreign currencies, maintain
reciprocal currency arrangements (“F/X swaps”) with various central banks, and “warehouse”
foreign currencies for the U.S. Treasury and Exchange Stabilization Fund (“ESF”) through the
Reserve Banks.

3. SIGNIFICANT ACCOUNTING POLICIES
Accounting principles for entities with the unique powers and responsibilities of the nation’s
central bank have not been formulated by the Financial Accounting Standards Board. The
Board of Governors has developed specialized accounting principles and practices that it
believes are appropriate for the significantly different nature and function of a central bank as
compared to the private sector. These accounting principles and practices are documented in
the Financial Accounting Manual for Federal Reserve Banks (“Financial Accounting Manual”),
which is issued by the Board of Governors. All Reserve Banks are required to adopt and apply
accounting policies and practices that are consistent with the Financial Accounting Manual.
The financial statements have been prepared in accordance with the Financial Accounting
Manual. Differences exist between the accounting principles and practices of the System and
accounting principles generally accepted in the United States of America (“GAAP”). The pri­
mary differences are the presentation of all security holdings at amortized cost, rather than at
the fair value presentation requirements of GAAP, and the accounting for matched salepurchase transactions as separate sales and purchases, rather than secured borrowings with
pledged collateral, as is generally required by GAAP. In addition, the Bank has elected not to
present a Statement of Cash Flows. The Statement of Cash Flows has not been included as the
liquidity and cash position of the Bank are not of primary concern to the users of these finan­
cial statements. Other information regarding the Bank’s activities is provided in, or may be
derived from, the Statements of Condition, Income, and Changes in Capital. Therefore, a
Statement of Cash Flows would not provide any additional useful information. There are no
other significant differences between the policies outlined in the Financial Accounting Manual
and GAAP.
Effective January 2001, the System implemented procedures to eliminate the sharing of costs by
Reserve Banks for certain services a Reserve Bank may provide on behalf of the System. Data
for 2001 reflects the adoption of this policy. Major services provided for the System by this
bank, for which the costs will not be redistributed to the other Reserve Banks, include: FedACH
Application Business Functions, Check Standardization Project Office, Banking Application
Management System, and Electronic Access Products.
The preparation of the financial statements in conformity with the Financial Accounting
Manual requires management to make certain estimates and assumptions that affect the report­
ed amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date
of the financial statements and the reported amounts of income and expenses during the
reporting period. Actual results could differ from those estimates. Certain amounts relating to
the prior year have been reclassified to conform to the current year presentation. Unique
accounts and significant accounting policies are explained below.

Federal Reserve Bank
of Minneapolis

a. Gold Certificates

Notes to
Financial Statements

The Secretary of the Treasury is authorized to issue gold certificates to the Reserve Banks to
monetize gold held by the U.S. Treasury. Payment for the gold certificates by the Reserve Banks
is made by crediting equivalent amounts in dollars into the account established for the U.S.

(Continued)




Treasury. These gold certificates held by the Reserve Banks are required to be backed by the
gold of the U.S. Treasury. The U.S. Treasury may reacquire the gold certificates at any time and
the Reserve Banks must deliver them to the U.S. Treasury. At such time, the U.S. Treasury’s
account is charged and the Reserve Banks’ gold certificate accounts are lowered. The value of
gold for purposes of backing the gold certificates is set by law at $42 2/9 a fine troy ounce. The
Board of Governors allocates the gold certificates among Reserve Banks once a year based upon
Federal Reserve notes outstanding in each District.

b. Special Drawing Rights Certificates
Special drawing rights (“SDRs”) are issued by the International Monetary Fund (“Fund”) to its
members in proportion to each member’s quota in the Fund at the time of issuance. SDRs
serve as a supplement to international monetary reserves and may be transferred from one
national monetary authority to another. Under the law providing for United States participa­
tion in the SDR system, the Secretary of the U.S. Treasury is authorized to issue SDR certifi­
cates, somewhat like gold certificates, to the Reserve Banks. At such time, equivalent amounts
in dollars are credited to the account established for the U.S. Treasury, and the Reserve Banks’
SDR certificate accounts are increased. The Reserve Banks are required to purchase SDRs, at the
direction of the U.S. Treasury, for the purpose of financing SDR certificate acquisitions or for
financing exchange stabilization operations. At the time SDR transactions occur, the Board of
Governors allocates amounts among Reserve Banks based upon Federal Reserve notes outstand­
ing in each District at the end of the preceding year. There were no SDR transactions in 2001.

c. Loans to Depository Institutions
The Depository Institutions Deregulation and Monetary Control Act of 1980 provides that all
depository institutions that maintain reservable transaction accounts or nonpersonal time
deposits, as defined in Regulation D issued by the Board of Governors, have borrowing privi­
leges at the discretion of the Reserve Banks. Borrowers execute certain lending agreements and
deposit sufficient collateral before credit is extended. Loans are evaluated for collectibility, and
currently all are considered collectible and fully collateralized. If any loans were deemed to be
uncollectible, an appropriate reserve would be established. Interest is accrued using the appli­
cable discount rate established at least every fourteen days by the Board of Directors of the
Reserve Banks, subject to review by the Board of Governors. Reserve Banks retain the option
to impose a surcharge above the basic rate in certain circumstances.

d. U.S. Government and Federal Agency Securities and Investments
Denominated in Foreign Currencies
The FOMC has designated the FRBNY to execute open market transactions on its behalf and
to hold the resulting securities in the portfolio known as the System Open Market Account
(“SOMA”). In addition to authorizing and directing operations in the domestic securities mar­
ket, the FOMC authorizes and directs the FRBNY to execute operations in foreign markets for
major currencies in order to counter disorderly conditions in exchange markets or to meet
other needs specified by the FOMC in carrying out the System’s central bank responsibilities.
Such authorizations are reviewed and approved annually by the FOMC.

49

Federal Reserve Bank
of Minneapolis

Notes to
Financial Statements
(Continued)




Matched sale-purchase transactions are accounted for as separate sale and purchase transac­
tions. Matched sale-purchase transactions are transactions in which the FRBNY sells a security
and buys it back at the rate specified at the commencement of the transaction.
The FRBNY has sole authorization by the FOMC to lend U.S. government securities held in the
SOMA to U.S. government securities dealers and to banks participating in U.S. government
securities clearing arrangements on behalf of the System, in order to facilitate the effective
functioning of the domestic securities market. These securities-lending transactions are fully
collateralized by other U.S. government securities. FOMC policy requires FRBNY to take pos­
session of collateral in excess of the market values of the securities loaned. The market values
of the collateral and the securities loaned are monitored by FRBNY on a daily basis, with addi­
tional collateral obtained as necessary. The securities loaned continue to be accounted for in
the SOMA.
Foreign exchange (“F/X”) contracts are contractual agreements between two parties to
exchange specified currencies, at a specified price, on a specified date. Spot foreign contracts
normally settle two days after the trade date, whereas the settlement date on forward contracts
is negotiated between the contracting parties, but will extend beyond two days from the trade
date. The FRBNY generally enters into spot contracts, with any forward contracts generally
limited to the second leg of a swap/warehousing transaction.
The FRBNY, on behalf of the Reserve Banks, maintains renewable, short-term F/X swap
arrangements with two authorized foreign central banks. The parties agree to exchange their
currencies up to a pre-arranged maximum amount and for an agreed upon period of time (up
to twelve months), at an agreed upon interest rate. These arrangements give the FOMC tem­
porary access to foreign currencies that it may need for intervention operations to support the
dollar and give the partner foreign central bank temporary access to dollars it may need to sup­
port its own currency. Drawings under the F/X swap arrangements can be initiated by either
the FRBNY or the partner foreign central bank, and must be agreed to by the drawee. The F/X
swaps are structured so that the party initiating the transaction (the drawer) bears the exchange
rate risk upon maturity. The FRBNY will generally invest the foreign currency received under
an F/X swap in interest-bearing instruments.
Warehousing is an arrangement under which the FOMC agrees to exchange, at the request of
the Treasury, U.S. dollars for foreign currencies held by the Treasury or ESF over a limited peri­
od of time. The purpose of the warehousing facility is to supplement the U.S. dollar resources
of the Treasury and ESF for financing purchases of foreign currencies and related international
operations.
In connection with its foreign currency activities, the FRBNY, on behalf of the Reserve Banks,
may enter into contracts which contain varying degrees of off-balance sheet market risk,
because they represent contractual commitments involving future settlement and counter-party
credit risk. The FRBNY controls credit risk by obtaining credit approvals, establishing transac­
tion limits, and performing daily monitoring procedures.
While the application of current market prices to the securities currently held in the SOMA
portfolio and investments denominated in foreign currencies may result in values substantially
above or below their carrying values, these unrealized changes in value would have no direct

50

Federal Reserve Bank
of Minneapolis

Notes to
Financial Statements
(Continued)




effect on the quantity of reserves available to the banking system or on the prospects for future
Reserve Bank earnings or capital. Both the domestic and foreign components of the SOMA
portfolio from time to time involve transactions that can result in gains or losses when holdings
are sold prior to maturity. However, decisions regarding the securities and foreign currencies
transactions, including their purchase and sale, are motivated by monetary policy objectives
rather than profit. Accordingly, earnings and any gains or losses resulting from the sale of such
currencies and securities are incidental to the open market operations and do not motivate its
activities or policy decisions.
U.S. government and federal agency securities and investments denominated in foreign curren­
cies comprising the SOMA are recorded at cost, on a settlement-date basis, and adjusted for
amortization of premiums or accretion of discounts on a straight-line basis. Interest income is
accrued on a straight-line basis and is reported as “Interest on U.S. government and federal
agency securities” or “Interest on investments denominated in foreign currencies,” as appropri­
ate. Income earned on securities lending transactions is reported as a component of “Other
income.” Gains and losses resulting from sales of securities are determined by specific issues
based on average cost. Gains and losses on the sales of U.S. government and federal agency
securities are reported as “U.S. government securities gains (losses), net.” Foreign-currencydenominated assets are revalued daily at current market exchange rates in order to report these
assets in U.S. dollars. Realized and unrealized gains and losses on investments denominated in
foreign currencies are reported as “Foreign currency losses, net.” Foreign currencies held
through F/X swaps, when initiated by the counter-party, and warehousing arrangements are
revalued daily, with the unrealized gain or loss reported by the FRBNY as a component of
“Other assets” or “Other liabilities,” as appropriate.
Balances of U.S. government and federal agency securities bought outright, securities loaned,
investments denominated in foreign currency, interest income, securities lending fee income,
amortization of premiums and discounts on securities bought outright, gains and losses on
sales of securities, and realized and unrealized gains and losses on investments denominated in
foreign currencies, excluding those held under an F/X swap arrangement, are allocated to each
Reserve Bank. Income from securities lending transactions undertaken by the FRBNY are also
allocated to each Reserve Bank. Securities purchased under agreements to resell and unrealized
gains and losses on the revaluation of foreign currency holdings under F/X swaps and ware­
housing arrangements are allocated to the FRBNY and not to other Reserve Banks.
Statement of Financial Accounting Standards No. 133, as amended and interpreted, became
effective on January 1, 2001. For the periods presented, the Reserve Banks had no derivative
instruments required to be accounted for under the standard.

e. Bank Premises and Equipment
Bank premises and equipment are stated at cost less accumulated depreciation. Depreciation is
calculated on a straight-line basis over estimated useful lives of assets ranging from 2 to 50
years. New assets, major alterations, renovations and improvements are capitalized at cost as
additions to the asset accounts. Maintenance, repairs and minor replacements are charged to
operations in the year incurred. Internally-developed software is capitalized based on the cost
of direct materials and services and those indirect costs associated with developing, implement­
ing, or testing software.

51

Federal Reserve Bank
of Minneapolis

Notes to
Financial Statements
(Continued)




f. Interdistrict Settlement Account
At the close of business each day, all Reserve Banks and branches assemble the payments due to
or from other Reserve Banks and branches as a result of transactions involving accounts resid­
ing in other Districts that occurred during the day’s operations. Such transactions may include
funds settlement, check clearing and ACH operations, and allocations of shared expenses. The
cumulative net amount due to or from other Reserve Banks is reported as the “Interdistrict set­
tlement account.”
g. Federal Reserve Notes
Federal Reserve notes are the circulating currency of the United States. These notes are issued
through the various Federal Reserve agents to the Reserve Banks upon deposit with such
Agents of certain classes of collateral security, typically U.S. government securities. These notes
are identified as issued to a specific Reserve Bank. The Federal Reserve Act provides that the
collateral security tendered by the Reserve Bank to the Federal Reserve Agent must be equal to
the sum of the notes applied for by such Reserve Bank. In accordance with the Federal Reserve
Act, gold certificates, special drawing rights certificates, U.S. government and federal agency
securities, triparty agreements, loans to depository institutions, and investments denominated
*

in foreign currencies are pledged as collateral for net Federal Reserve notes outstanding. The
collateral value is equal to the book value of the collateral tendered, with the exception of secu­
rities, whose collateral value is equal to the par value of the securities tendered. The Board of
Governors may, at any time, call upon a Reserve Bank for additional security to adequately col­
lateralize the Federal Reserve notes. The Reserve Banks have entered into an agreement which
provides for certain assets of the Reserve Banks to be jointly pledged as collateral for the Federal
Reserve notes of all Reserve Banks in order to satisfy their obligation of providing sufficient
collateral for outstanding Federal Reserve notes. In the event that this collateral is insufficient,
the Federal Reserve Act provides that Federal Reserve notes become a first and paramount lien
on all the assets of the Reserve Banks. Finally, as obligations of the United States, Federal
Reserve notes are backed by the full faith and credit of the United States government.
The “Federal Reserve notes outstanding, net” account represents Federal Reserve notes reduced
by currency held in the vaults of the Bank of $2,015 million, and $7,994 million at December
31,2001 and 2000, respectively.

h. Capital Paid-in
The Federal Reserve Act requires that each member bank subscribe to the capital stock of the
Reserve Bank in an amount equal to 6 percent of the capital and surplus of the member bank.
As a member bank’s capital and surplus changes, its holdings of the Reserve Bank’s stock must
be adjusted. Member banks are those state-chartered banks that apply and are approved for
membership in the System and all national banks. Currently, only one-half of the subscription
is paid-in and the remainder is subject to call. These shares are nonvoting with a par value of
$100. They may not be transferred or hypothecated. By law, each member bank is entitled to
receive an annual dividend of 6 percent on the paid-in capital stock. This cumulative dividend
is paid semiannually. A member bank is liable for Reserve Bank liabilities up to twice the par
value of stock subscribed by it.

Federal Reserve Bank
of Minneapolis

Notes to
Financial Statements
(Continued)




i. Surplus
The Board of Governors requires Reserve Banks to maintain a surplus equal to the amount of
capital paid-in as of December 31. This amount is intended to provide additional capital and
reduce the possibility that the Reserve Banks would be required to call on member banks for
additional capital. Reserve Banks are required by the Board of Governors to transfer to the U.S.
Treasury excess earnings, after providing for the costs of operations, payment of dividends, and
reservation of an amount necessary to equate surplus with capital paid-in.
The Consolidated Appropriations Act of 2000 (Public Law 106-113, Section 302) directed the
Reserve Banks to transfer to the U.S. Treasury additional surplus funds of $3,752 million dur­
ing the Federal Government’s 2000 fiscal year. Federal Reserve Bank of Minneapolis transferred
$137 million to the U.S. Treasury. Reserve Banks were not permitted to replenish surplus for
these amounts during fiscal year 2000, which ended September 30, 2000.
Due to the substantial increase in capital paid-in and the transfer of surplus required by the
Consolidated Appropriations Act of 2000, surplus was not equated to capital paid-in at
December 31, 2000. The amount of additional surplus required due to these events exceeded
the Bank’s net income in 2000. Surplus was not equated to capital paid-in at December 31,
2001, due to foreign currency losses and less income from the lower participation in SOMA
accounts. Net income is affected by SOMA participation as discussed in footnote 4.
In the event of losses or a substantial increase in capital paid-in, payments to the U.S. Treasury
are suspended until such losses or increases in capital paid-in are recovered through subsequent
earnings. At December 31, 2001, the Bank’s payments had not resumed. Payments made to the
U.S. Treasury in the year 2000 are classified as “Prepaid expense-interest on Federal Reserve
notes to the U.S. Treasury” for each of the years ended December 31, 2001 and 2000.

j. Income and Costs related to Treasury Services
The Bank is required by the Federal Reserve Act to serve as fiscal agent and depository of the
United States. By statute, the Department of the Treasury is permitted, but not required, to pay
for these services. The costs of providing fiscal agency and depository services to the Treasury
Department that have been billed but not paid are immaterial and included in “Other
Expenses.”

k. Taxes
The Reserve Banks are exempt from federal, state, and local taxes, except for taxes on real prop­
erty, which are reported as a component of “Occupancy expense.”

4. U.S. GOVERNMENT AND FEDERAL AGENCY SECURITIES
Securities bought outright are held in the SOMA at the FRBNY. An undivided interest in
SOMA activity, with the exception of securities held under agreements to resell and the related
premiums, discounts and income, is allocated to each Reserve Bank on a percentage basis
derived from an annual settlement of interdistrict clearings. The settlement, performed in
April of each year, equalizes Reserve Bank gold certificate holdings to Federal Reserve notes
outstanding. The Bank’s allocated share of SOMA balances was 0.312 percent and 0.421 per­
cent at December 31, 2001 and 2000, respectively.

53

Federal Reserve Bank
of Minneapolis

Notes to
Financial Statements

The Bank’s allocated share of securities held in the SOMA at December 31, that were bought
outright, were as follows (in millions):

(Continued)




2001
Par value:
Federal agency

$

—

2000
1

$

U.S. government:
Bills

568

752

Notes
Bonds

830
323

1,011
391

Unamortized premiums

1,721
35

2,155
41

Unaccreted discounts
Total allocated to Bank

(4)
1,752

(13)
2,183

Total par value

$

$

Total SOMA securities bought outright were $561,701 million and $518,501 million at
December 31, 2001 and 2000, respectively.
The maturity distribution of l J.S. government and federal agency securities bought outright,
which were allocated to the Baink at December 31,2001, were as follows (in millions):
Par value
U.S. Government
Securities

Maturites of Securities Held
Within 15 days

$

16 days to 90 days

33

Federal Agency
Obligations
$

Total

389

91 days to 1 year
Over 1 year to 5 years
Over 5 years to 10 years
Over 10 years
Total

$

408
478
166
247
1,721

33

$

389
408
—

$

$

478
166
247
1,721

At December 31,2001 and 2000, matched sale-purchase transactions involving U.S. government
securities with par values of $23,188 million and $21,112 million, respectively, were outstanding,
of which $72 million and $89 million were allocated to the Bank. Matched sale-purchase transac­
tions are generally overnight arrangements.
At December 31,2001 and 2000, U.S. government securities with par values of $7,345 million and
$2,086 million, respectively, were loaned from the SOMA, of which $23 million and $9 million
were allocated to the Bank.

54

Federal Reserve Bank
of Minneapolis

Notes to
Financial Statements
(Continued)




5. INVESTMENTS DENOMINATED IN FOREIGN CURRENCIES
The FRBNY, on behalf of the Reserve Banks, holds foreign currency deposits with foreign
central banks and the Bank for International Settlements, and invests in foreign government
debt instruments. Foreign government debt instruments held include both securities bought
outright and securities held under agreements to resell. These investments are guaranteed as to
principal and interest by the foreign governments.
Each Reserve Bank is allocated a share of foreign-currency-denominated assets, the related
interest income, and realized and unrealized foreign currency gains and losses, with the excep­
tion of unrealized gains and losses on F/X swaps and warehousing transactions. This allocation
is based on the ratio of each Reserve Bank’s capital and surplus to aggregate capital and surplus
at the preceding December 31. The Bank’s allocated share of investments denominated in
foreign currencies was approximately 3.869 percent and 3.653 percent at December 31,2001
and 2000, respectively.
The Bank’s allocated share of investments denominated in foreign currencies, valued at current
exchange rates at December 31, was as follows (in millions):
2001

2000

European Union Euro:

Foreign currency deposits

$

Government debt instruments
including agreements to resell

178

$

169

104

99

73

100

206
2

201
3

Japanese Yen:

Foreign currency deposits
Government debt instruments
including agreements to resell
Accrued interest

Total

$

563

$

572

Total investments denominated in foreign currencies were $14,559 million and $15,670 million
at December 31, 2001 and 2000, respectively.

55

Federal Reserve Bank
of Minneapolis

Notes to
Financial Statements
(Continued)




The maturity distribution of investments denominated in foreign currencies which were
allocated to the Bank at December 31, 2001, was as follows (in millions):
Maturities of Investments Denominated in Foreign Currencies
Within 1 year
Over 1 year to 5 years

$

Over 5 years to 10 years

530
16
17

Over 10 years
Total

$

0
563

At December 31, 2001 and 2000, there were no open foreign exchange contracts or outstanding
F/X swaps.
At December 31, 2001 and 2000, the warehousing facility was $5 billion, with zero outstanding.

6. BANK PREMISES AND EQUIPMENT
A summary of bank premises and equipment at December 31 is as follows (in millions):
2001

2000

Bank premises and equipment:
Land
Buildings
Building machinery and equipment

$

Furniture and equipment
Accumulated depreciation
Bank premises and equipment, net

$

13
110
14

$

13
110
14

48
185

48
185

(41)
144

(35)
150

$

Depreciation expense was $9 million for each of the years ended December 31,2001 and 2000.
This Bank has not entered into any capitalized leases for bank premises and equipment.
Future minimum payments under agreements in existence at December 31,2001, were not
material.

Federal Reserve Bank
of Minneapolis

Notes to
Financial Statements
(Continued)




7. COMMITMENTS AND CONTINGENCIES
Rental expense under operating leases for certain operating facilities, warehouses, and data pro­
cessing and office equipment (including taxes, insurance and maintenance when included in
rent), net of sublease rentals, was $710 thousand and $255 thousand for the years ended
December 31, 2001 and 2000, respectively. Certain of the Bank’s leases have options to renew.
Future minimum rental payments under noncancelable operating leases and capital leases, net
of sublease rentals, with terms of one year or more, at December 31,2001, were not material.
Under the Insurance Agreement of the Federal Reserve Banks dated as of March 2, 1999, each
of the Reserve Banks has agreed to bear, on a per incident basis, a pro rata share of losses in
excess of 1 percent of the capital paid-in of the claiming Reserve Bank, up to 50 percent of the
total capital paid-in of all Reserve Banks. Losses are borne in the ratio that a Reserve Bank’s
capital paid-in bears to the total capital paid-in of all Reserve Banks at the beginning of the
calendar year in which the loss is shared. No claims were outstanding under such agreement at
December 31,2001 or 2000.
The Bank is involved in certain legal actions and claims arising in the ordinary course of busi­
ness. Although it is difficult to predict the ultimate outcome of these actions, in management’s
opinion, based on discussions with counsel, the aforementioned litigation and claims will be
resolved without material adverse effect on the financial position or results of operations of the
Bank.
There were no other commitments and long-term obligations in excess of one year at
December 31, 2001.

8. RETIREMENT AND THRIFT PLANS
Retirement Plans
The Bank currently offers two defined benefit retirement plans to its employees, based on
length of service and level of compensation. Substantially all of the Bank’s employees partici­
pate in the Retirement Plan for Employees of the Federal Reserve System (“System Plan”) and
the Benefit Equalization Retirement Plan (“BEP”). The System Plan is a multi-employer plan
with contributions fully funded by participating employers. No separate accounting is main­
tained of assets contributed by the participating employers. The Bank’s projected benefit
obligation and net pension costs for the BEP at December 31, 2001 and 2000, and for the years
then ended, are not material.

Thrift Plan
Employees of the Bank may also participate in the defined contribution Thrift Plan for
Employees of the Federal Reserve System (“Thrift Plan”). The Bank’s Thrift Plan contributions
totaled $2 million for each of the years ended December 31, 2001 and 2000, and are reported as
a component of “Salaries and other benefits.”

57

Federal Reserve Bank
of Minneapolis

Notes to
Financial Statements
(Continued)




9. POSTRETIREMENT BENEFITS OTHER THAN PENSIONS
AND POSTEMPLOYMENT BENEFITS
Postretirement Benefits other than Pensions
In addition to the Bank’s retirement plans, employees who have met certain age and length of
service requirements are eligible for both medical benefits and life insurance coverage during
retirement.
The Bank funds benefits payable under the medical and life insurance plans as due and,
accordingly, has no plan assets. Net postretirement benefit costs are actuarially determined
using a January 1 measurement date.
Following is a reconciliation of beginning and ending balances of the benefit obligation (in
millions):
Accumulated postretirement benefit obligation at January 1

$

Service cost-benefits earned during the period
Interest cost of accumulated benefit obligation
Actuarial loss
Contributions by plan participants
Benefits paid
Plan amendments, acquisitions, foreign currency exchange
rate changes, business combinations, divestitures,
curtailments, settlements, special termination benefits
Accumulated postretirement benefit obligation
at December 31

2001
33.2

2000
30.3

$

1.1

0.9

2.6
5.3

2.2
1.1

0.1

0.1

(1.5)

(1.4)

(3.6)
$

$

37.2

33.2

Following is a reconciliation of the beginning and ending balance of the plan assets, the
unfunded postretirement benefit obligation, and the accrued postretirement benefit costs (in
millions):
2000

2001
Fair value of plan assets at January 1
Actual return on plan assets
Contributions by the employer
Contributions by plan participants
Benefits paid
Fair value of plan assets at December 31
Unfunded postretirement benefit obligation

$

$
$

Unrecognized initial net transition asset (obligation)
Unrecognized prior service cost
Unrecognized net actuarial gain (loss)
Accrued postretirement benefit costs

$

—
—
1.3

$
—
1.2

0.1

0.1

(1.4)

(1.3)

37.2

$
$

33.2

—

—

3.6
(3.5)

—
1.8

37.3

$

35.0

Accrued postretirement benefit costs are reported as a component of “Accrued benefit costs.”

Federal Reserve Bank
of Minneapolis

Notes to
Financial Statements
(Continued)




At December 31, 2001 and 2000, the weighted average discount rate assumptions used in
developing the benefit obligation were 7.0 percent and 7.5 percent, respectively.
For measurement purposes, a 10.00 percent annual rate of increase in the cost of covered health
care benefits was assumed for 2002. Ultimately, the health care cost trend rate is expected to
decrease gradually to 5.00 percent by 2008, and remain at that level thereafter.
Assumed health care cost trend rates have a significant effect on the amounts reported for
health care plans. A one percentage point change in assumed health care cost trend rates would
have the following effects for the year ended December 31, 2001 (in millions):
1 Percentage
Point Increase
Effect on aggregate of service and interest cost
components of net periodic postretirement benefit costs

$

Effect on accumulated postretirement benefit obligation

0.8
7.1

1 Percentage
Point Decrease
$

(0.6)
(5.5)

The following is a summary of the components of net periodic postretirement benefit costs for
the years ended December 31 (in millions):
2000

Interest cost of accumulated benefit obligation
Amortization of prior service cost

2.6

0.9
2.2

—

—

Recognized net actuarial loss

—
3.6

—
3.1

Service cost-benefits earned during the period

Net periodic postretirement benefit costs

$

2001
1.0

$

$

$

Net periodic postretirement benefit costs are reported as a component of “Salaries and other
benefits.”

Postemployment benefits
The Bank offers benefits to former or inactive employees. Postemployment benefit costs are
actuarially determined and include the cost of medical and dental insurance, survivor income,
and disability benefits. Costs were projected using the same discount rate and health care trend
rates as were used for projecting postretirement costs. The accrued postemployment benefit
costs of $6 million were recognized by the Bank for each of the years ended December 31, 2001
and 2000. This cost is included as a component of “Accrued benefit costs.” Net periodic
postemployment benefit costs were $1 million for each of the years ended December 31, 2001
and 2000.

59




Auditor Independence
The firm engaged for the audits of the individual and combined financial statements
of the Reserve Banks for 2001 was PricewaterhouseCoopers LLP (PwC). Fees for these
services totaled $1.3 million. In order to ensure auditor independence, the Board requires
that PwC be independent in all matters relating to the audit. Specifically, PwC may not
perform services for the Reserve Bank or others that would place it in a position of auditing
its own work, making management decisions on behalf of the Reserve Banks, or in any
other way impairing its audit independence. In 2001 the Reserve Banks engaged PwC
for advisory services totaling $0.9 million, $0.7 million of which was for project manage­
ment advisory services related to the System's check modernization project. The Board
believes that these advisory services do not directly affect the preparation of the financial
statements audited by PwC and are not incompatible with the services provided by PwC
as an independent auditor.

For more information on the Minneapolis Fed and the
Federal Reserve System, go to minneapolisfed.org.
Useful telephone numbers
(612 area code unless otherwise indicated):
For the Public

Consumer Affairs Help Line: 204-6500
Job Hot Line: 204-5366 or 1-877-766-8533
Media Inquiries: 204-5261
Research Library: 204-5509
Treasury Auction Results, Current Offerings,
Bills, Notes, Bonds: 1-800-722-2678
For Financial Institutions

Cash Services Help Line: 204-5227
CBAF Help Desk: 204-5400
Customer Relations Help Desk: 204-7010





Federal Reserve Bank of St. Louis, One Federal Reserve Bank Plaza, St. Louis, MO 63102