INCREASES in economic activity and in prices slowed again in thethird quarter, according to the “flash” GNP estimates. RealGNP increased at an annual rate of 3-1/2 percent, down from increases of10 percent in the first quarter and 7 percent in the second. The GNPfixed-weighted price index increased at an annual rate of 3-1/2 percent,down from increases of 5 percent and 4-1/2 percent, respectively (table1). These estimates do not take into account the strike in the autoindustry, which began September 15 at selected assembly plants.
If theproduction stoppage due to the strike continues in the fourth week ofSeptember at roughly the same level as in the third week, the effect ofthe strike on the third-quarter change in real GNP will be quitesmall–a reduction of no more than 0.3 percentage point. Although the decelerations in real GNP from the first quarter tothe second and from the second to the third were roughly equal in size,the contributions of inventory investment and final sales were verydifferent.
The deceleration in the second quarter was ininventoryinvestment. The effect on GNP was partly offset by an acceleration infinal sales, from an increase of 3-1/2 percent to one of 10-1/2 percent.In contrast, in the third quarter, final sales decelerated to anincrease of only 1 percent or less, and iventory investment provided apartial offset. In the three quarters, inventories accumulated, but therate varied sharply. The variation in the increases in final salescentered in personal consumption expenditures (PCE), net exports, andthe Commodity Credit Corporation portion of Federal Governmentpurchases: The three components contributed about equally to thesecond-quarter acceleration; PCE accounted for about one-half of thethird-quarter deceleration.
Third-quarter developments in these and other components of realGNP, in NGP prices, and in personal income are sketched below on thebasis of data available through mid- September. * PCE increased only fractionally after an unusually largeincrease–8 percent–in the second quarter. The deceleration wasconcentrated in goods and was spread across most major categories.
Several categories declined–motor vehicle purchases after severalquarters of increases, and purchases of clothing and shoes after a hugeincrease in the second quarter. Although some slowing of consumerspending would seem consistent with developments in real disposableincome and interest rates, part of the sharp slowing seems to be anaftereffect of the unusually large second-quarter increase. * Nonresidential fixed investment increased strongly, but at onlyabout one-half the second-quarter rate of 21-1/2 percent. The increaein structures moderated after three quarters of increases of 20 to 30percent. As in the second quarter, commercial structures were strong;other major categories showed little change. In producers’ durableequipment, the slowing was in motor vehicles. Both auto and truckpurchases declined–trucks after a very strong second-quarter increase.
As discussed in the article on the BEA plant and equipment expendituressurvey, the strength of investment in recent quarters and the increaseplanned for the final quarter of 1984 are consistent with favorabledevelopments in a number of investment indicators. * Residential investment again changed little. In the secondquarter, the major components of residential investment–single-familystructures, multifamily structures, and “other” (largelyadditions and alterations, mobile homes, and commissions on housesales)–had been essentially flat. In the third quarter, constructionof single-family structures slipped, but that of multifamily structurespicked up. Although recent increases in mortgage interest rates and inhouse prices appear to have put a damper on residential investment, theavailability of mortgage instruments other than the traditional fixedrate mortgage is widely credited with having been a sustaining factor.One of these mortgage instruments–the adjustable rate mortgage–isdiscussed later in the “Business Situation.
” * Inventories accumulated at a substantial rate, more than the$20-1/2 billion in the second quarter. Motor vehicle, farm, and otherinventories all appear to have followed this pattern. Motor vehicleinventories–the part of inventories for which information aboutthird-quarter developments is reasonably compele–were up, especiallythose of trucks; auto inventories had been down sharply in the secondquarter. Only fragmentary information is available about farminventories; it appears that accumulation was subtantially more than thesecond-quarter rate of $1-1/2 billion. Nonfarm inventories other thanmotor vehicles appear to have accumulated, perhaps somewhat more thanthe $22-1/2 billion in the second quarter. Reflecting the additions toinventories over the last three quarters and the variability of theincreases in final sales, inventory-sales ratios turned up in the firstquarter, dropped back in the second, and increased again in the third,but only to a moderate level. * For net exports, limited evidence suggests a declinesubstantially larger than the $3 billion decline in the second quarter.As discussed in the article reviewing international transactions, themerchandiese trade balance had improved in the second quarter eventhough the fundamental factors encouraging imports and discouragingexports–dollar appreciation and faster economic expansion in the UnitedStates than abroad–were unchanged.
In the third quarter, merchandiseimports appear to have increased much more than merchandise exports. * Government purchases increased, but much less than in the secondquarter. In the second quarter, Commodity Credit Corporationoperations, largely under the payment-in-kind (PIK) program, hadaccounted for about $9 billion of the $12-1/2 billion increase. In thethird quarter, when PIK was being wound down, these operations addedonly slightly to the increase. Other Federal purchasers, mainly fordefense, and State and local purchases, mainly for construction,increased roughly as much as in the second quarter. * The GNP fixed-weighted price index increased 3-1/2 percent, 1percentage point less than in the second quarter.
The continueddeceleration was widespread; lower petroleum and petroleum productprices, which affected several components, were a major factor. Foodprices, which had declined in the second quarter and had accounted forthe deceleration in GNP prices, turned up in the third. * Personal income increased about $60 billion, $4 billion less thanin the second quarter. The increase in wage and salary disbursementswas substantially smaller than the second-quarter increase of $37-1/2billion. Deceleration was apparent in all major private industrygroups. In contrast, farm proprietors’ income increased sharplyafter a $9 billion decline in the second quarter. In the second quarter,a falloff of Federal subsidy payments to farmers, largely due to thewinding down of the PIK program, had subtracted about $15 billion fromthe change in farm income. In the third quarter, these subsidy paymentschanged little.
Other components of farm income continued to registerthe effects of the stepped-up production, and, through the secondquarter, increases in farm prices. The other major components ofpersonal income registered increases about the same as, or a littlesmaller than, those in the second quarter. Personal taxes were up slightly more than in the second quarter, aswere prices of PCE, so that the increase in real disposable incomeslowed further–down about 2 percentage points from the 6-1/2 percent inthe second quarter. The increase in personal outlays was less than thatin disposable personal income, and personal saving increased.
Thesaving rate was up about one-half percentage point from 5.7 percent inthe second quarter. Second-quarter corporate profits Profits from current production–profits with inventory valuationand capital consumption adjustments–increased $14 billion in the secondquarter, to $291 billion, following a $17-1/2 billion increase in thefirst. The second-quarter estimate is $1/2 billion less than thepreliminary one published a month ago. Profits from the rest of theworld were revised down $5 billion, and domestic profits of financialcorporations were revised down $1-1/2 billion. These downward revisionswere partly offset by an upward revision of $6 billion in domesticprofits of nonfinancial corporations. Profits from the rest of the world declined $4-1/2 billion in thesecond quarter, to $21-1/2 billion, following no change in the firstquarter.
The relatively weak economic recovery in European countries, asoft petroleum market, and strikes in Germany and the United Kingdomcontributed to the lower earnings. Profits of nonfinancial corporations accounted for nearly all ofthe $18 billion increase in domestic profits; financial corporationscontributed only $1/2 billion. Domestic profits of nonfinancialcorporations were up because domestic product increased substantiallyand unit prices rose more than the slight increase in unit costs (chart1). Profits before tax–profits without inventory valuation adjustment(IVA) and capital consumption adjustment (CCAdj)–increased $2-1/2billion in the second quarter, to $246 billion.
They had increased $18billion in the first quarter. Profits from current production were upmore than profits before tax; the CCAdj was up $4-1/2 billion and theIVA became less negative by $6 billion. The adjustments convert thecosts of invetories and depreciation reported by businesses into thoseused in the national income and product accounts. Corporate tax liability was up $3 billion, following an $8 billionincrease in the first quarter. Dividends increased $2 billion,following a $2-1/2 billion increase; undistributed profits decreased$2-1/2 billion, following a $7-1/2 billion increase. Profits by industry.–Profits with the IVA but without theCCADJ–the variant of profits available by industry–increased $9billion in the second quarter, following a $13-1/2 billion increase inthe first quarter. Domestic profits of financial corporations wereunchanged.
Domestic profits of nonfinancial corporations were up $13billion, about the same as in the first quarter. The second-quarterincrease more than offset the decline in profits from the rest of theworld. Trade profits contributed the most to the increase in domesticprofits of nonfinancial corporations. Profits of both wholesalers andretailers increased; among retailers, profits of food retailers were upthe most. Profits of manufacturers increased $2-1/2 billion.
Anincrease in profits of nondurable goods manufacturers. Petroleum profitscontributed substantially to the increase in profits of nondurable goodsmanufacturers. The decline in profits of durable goods manufacturersresulted from a decline in motor vehicles profits. Profits of mostother durable goods manufacturers improved. Second-quarter NIPArevisions The 75-day revisions of the national income and product accountsestimates for the second quarter of 1984 are shown in table 2. Adjustable Rate Mortgages: Recent Developments Adjustable rate mortgages (ARM’s) now account for two-thirdsof new conventional mortgage originations and for three-fourths of suchoriginations by thrift institutions (savings and loan associations andsavings banks). The use of ARM’s is widely credited with givingconsiderable support to residential investment; moreover, ARM’shave reduced the interest rate risk of mortgage lenders. ARM’shave not proven to be a cure-all for lenders, however, recent increasesin interest rates have focused attention on the fact that decreasedinterest rate risk has been achieved only at the expense of increasedcredit risk.
Increased credit risk, in this context, means that a lender is morelikely to have an ARM go into default than to have a fixed rate mortgagego into default. The reason is obvious: Payments on an ARM may increaseto a level that the borrower cannot afford; payments (for principal andinterest) on a fixed rate mortgage do not change. “Credit risk” focuses attention on the problems that faceARM lenders. The same basic problem, when viewed from the standpoint ofthe borrower, is sometimes referred to as “payment shock.”The problem, under one or both of its names, has been addressed by anumber of industry experts in recent months.
Most observers seem to agree that only a small percentage of ARMborrowers are likely to experience significant payment shock. Forexample, Federal Home Loan Bank Board Chairman Edwin J. Gray says thatsuch borrowers “appear to account for a modest fraction of thetotal ARM market,” and the U.
S. League of Savings Institutionsstates: . . . lenders are using a variety of features to insure thathomeowners with adjustable rate mortgages do not face unwarranteddangers of so-called “payment shock.” In 96.
7 percent of theloans being made . . . there is either an annual interest rate cap or anannual payment cap to sheild the borrower from excessive annualincreases in monthly mortgage payment. Nevertheless, even a relatively small share of unsound ARM’scould lead to regulatory and legislative changes that have far-reachingeffects on ARM’s, the mortgage market, and thrift institutions.
This discussion illustrates a case of payment shock, highlighting theimportance of deep introductory discounts, which are then discussed insomewhat more detail. Illustration of payment shock.–ARM’s are generally offered ata “program” rate that is lower than the rate on fixed ratemortgages; this lower rate compensates the borrower for the risk of rateincreases inherent in the ARM. Moreover, some ARM’s are discountedfor the first year or two of the mortgage.
At the end of theintroductory period, the discount expires and, in addition, the programrate is adjusted to an index rate. For purposes of illustration,consider a $60,000, 25-year ARM originated in May 1983 with a programrate of 12 percent, a 1-year introductory rate of 9 percent, and annualadjustments to the program rate linked to the rate on 1-year Treasurysecurities. At the introductory rate (9 percent), monthly payments forprincipal and interest are $509.
After 1 year, the rate goes up to itsprogram rate (12 percent) with payments of $637, an increase of 25percent. However, because the rate on 1-year Treasury securities wentup 2.76 percentage points during the year, the mortgage rate is furtheradjusted to 14.76 percent. At 14.76 percent, monthly payments are $762,50 percent above those in the first year.
In most instances, interest rate caps or payment caps would limitactual increases to much smaller amounts. For example, payments wouldrise to only about $590 if there were an interest rate cap of 2percentage points applicable to the introductory rate. Some rate caps,however, apply to the program rate rather than the introductory rate,and some caps are considerably higher than 2 percentage points.
A ratecap of 2 percentage points applied to the program rate in the example,or a cap of 5 percentage points applied to the introductory rate, wouldnot limit the increase much. Thus, the mere existence of caps does notmean that payment shock will be avoided. This illustration makes clear that two distinct elements cancontribute to payment shock: elimination of the introductory discount,and adjustment of the program rate. In some cases, adjustment of thenondiscounted rate will be minor. Chart 2 shows three of the most popular ARM index rates: the rateon 1-year Treasury securities, the Federal Home Loan Bank Board’saverage mortgage rate, and the Bank Board’s median cost of funds ratio.
The difference between these rates is striking. From May 1983to May 1984, for example, the Treasury rate increased 2.76 percentagepoints, while the average mortgage rate fell 0.73 percentage point, andthe cost of funds ratio was virtually unchanged. ARM’s linked tothe last two indexes obviously would not have confronted borrowers withpayment shock.
Thus, only the fraction of ARM borrowers with mortgageslinked to a rate that increased substantially, like the rate on 1-yearTreasury securities, face potential payment shock. Many of theseborrowers, presumably, are protected by rate or payment caps. If thereare no other complicating factors, then the vast majority of borrowerswould probably be able to budget the monthly payment resulting fromadjusting the program rate. Expiration of a deep introductory discount,in contrast, may be sufficient in itself to produce payment shock. Introductory discount.–The Federal Home Loan Mortgage Corporation (FHLMC) surveyed adjustable rate mortgages made during the first half of1983 by a randomly selected sample of savings and loan associations andfound that about one-third of these mortgages carried discounts. Theaverage introductory discount ranged from 0.
76 percentage point foruncapped ARM’s indexed to 1-year Treasury securities to 1.73percentage points for capped ARM’s indexed to the Bank Board’smortgage interest rate series. No information is available on thedispersion of initial discounts around these averages. In any event,the use of deep initial discounts appears to have become significantduring the second half of the year and, thus, would not be reflected inthe sample. The deeper the discount, of course, the larger the increase inpayments when the discount expires, and the greater the probability ofpayment shock. The probability of payment shock is increased further ifthe introductory rate, rather than the program rate, was used indeciding whether a borrower was qualified for the mortgage. When a mortgage is applied for, the borrower’s income is theprime determinant of whether he or she will qualify for the loan.
Thetest of whether a borrower qualifies or not is–in oversimplified outline–whether mortgage payments would constitute more than a certainfraction of the borrower’s income. If the introductory rate isused to calculate payments in this test, more borrowers can qualify.When the discount expires, however, monthly payments could well increasea level that, according to the lending criterion, the borrower is notqualified to handle. Considering the mortgage used in the earlier example, annualpayments amount to $6,108 at the introductory rate of 9 percent and$7,644 at the program rate of 12 percent.
If the lender uses aone-fourth ratio of mortgage payment to income to determinequalification, income must be at least $24,432 or $30,576, respectively.IF the introductory rate is used, a borrower who barely qualifies willbe taking on a mortgage that, after the first year, the borrower is notqualified for. Most borrowers and lenders may be expected to avoid a mortgage thatthe borrower is technically qualified for if they realize that theborrower’s obligation may soon reach unmanageable proportions. Theborrower’s self-discipline is undermined, however, if the potentialmagnitude of his or her obligation is not clear. In fact, confusion onthe part of borrowers about future rate and payment changes seems to benot uncommon. A lender’s motive for entering into such a mortgagecan only be surmised.
(To repeat, the number of lenders doing so,although unknown, is assumed to be small.) Perhaps the lender is in anarea where competition for mortgages is particularly intense. Perhaps,too, the lender’s portfolio is heavily weighted with old,low-yielding loans and a rapid buildup of ARM’s is seen as the onlyroute to profitability. Finally, the lender is aware that some of therisk can be pased premiums on ARM’s to compensate themselves fortheir increased risk.) Clearly, behavior on the part of borrowers and lenders such as justdescribed could lead to increased mortgage delinquency and default.
Aswas suggested earlier, if payment shock does cause a significantincrease in defaults, then–even though the absolute number of defaultedloans may be small–pressure may build to constrain or even eliminateARM’S.