The business situation in US Essay

INCREASES in economic activity and in prices slowed again in the
third quarter, according to the “flash” GNP estimates. Real
GNP increased at an annual rate of 3-1/2 percent, down from increases of
10 percent in the first quarter and 7 percent in the second. The GNP
fixed-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 (table

These estimates do not take into account the strike in the auto
industry, which began September 15 at selected assembly plants. If the
production stoppage due to the strike continues in the fourth week of
September at roughly the same level as in the third week, the effect of
the strike on the third-quarter change in real GNP will be quite
small–a reduction of no more than 0.3 percentage point.

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Although the decelerations in real GNP from the first quarter to
the second and from the second to the third were roughly equal in size,
the contributions of inventory investment and final sales were very
different. The deceleration in the second quarter was ininventory
investment. The effect on GNP was partly offset by an acceleration in
final 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 an
increase of only 1 percent or less, and iventory investment provided a
partial offset. In the three quarters, inventories accumulated, but the
rate varied sharply. The variation in the increases in final sales
centered in personal consumption expenditures (PCE), net exports, and
the Commodity Credit Corporation portion of Federal Government
purchases: The three components contributed about equally to the
second-quarter acceleration; PCE accounted for about one-half of the
third-quarter deceleration.

Third-quarter developments in these and other components of real
GNP, in NGP prices, and in personal income are sketched below on the
basis of data available through mid- September.

* PCE increased only fractionally after an unusually large
increase–8 percent–in the second quarter. The deceleration was
concentrated in goods and was spread across most major categories.
Several categories declined–motor vehicle purchases after several
quarters of increases, and purchases of clothing and shoes after a huge
increase in the second quarter. Although some slowing of consumer
spending would seem consistent with developments in real disposable
income and interest rates, part of the sharp slowing seems to be an
aftereffect of the unusually large second-quarter increase.

* Nonresidential fixed investment increased strongly, but at only
about one-half the second-quarter rate of 21-1/2 percent. The increae
in structures moderated after three quarters of increases of 20 to 30
percent. As in the second quarter, commercial structures were strong;
other major categories showed little change. In producers’ durable
equipment, the slowing was in motor vehicles. Both auto and truck
purchases declined–trucks after a very strong second-quarter increase.
As discussed in the article on the BEA plant and equipment expenditures
survey, the strength of investment in recent quarters and the increase
planned for the final quarter of 1984 are consistent with favorable
developments in a number of investment indicators.

* Residential investment again changed little. In the second
quarter, the major components of residential investment–single-family
structures, multifamily structures, and “other” (largely
additions and alterations, mobile homes, and commissions on house
sales)–had been essentially flat. In the third quarter, construction
of single-family structures slipped, but that of multifamily structures
picked up. Although recent increases in mortgage interest rates and in
house prices appear to have put a damper on residential investment, the
availability of mortgage instruments other than the traditional fixed
rate mortgage is widely credited with having been a sustaining factor.
One of these mortgage instruments–the adjustable rate mortgage–is
discussed 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 other
inventories all appear to have followed this pattern. Motor vehicle
inventories–the part of inventories for which information about
third-quarter developments is reasonably compele–were up, especially
those of trucks; auto inventories had been down sharply in the second
quarter. Only fragmentary information is available about farm
inventories; it appears that accumulation was subtantially more than the
second-quarter rate of $1-1/2 billion. Nonfarm inventories other than
motor vehicles appear to have accumulated, perhaps somewhat more than
the $22-1/2 billion in the second quarter. Reflecting the additions to
inventories over the last three quarters and the variability of the
increases in final sales, inventory-sales ratios turned up in the first
quarter, dropped back in the second, and increased again in the third,
but only to a moderate level.

* For net exports, limited evidence suggests a decline
substantially larger than the $3 billion decline in the second quarter.
As discussed in the article reviewing international transactions, the
merchandiese trade balance had improved in the second quarter even
though the fundamental factors encouraging imports and discouraging
exports–dollar appreciation and faster economic expansion in the United
States than abroad–were unchanged. In the third quarter, merchandise
imports appear to have increased much more than merchandise exports.

* Government purchases increased, but much less than in the second
quarter. In the second quarter, Commodity Credit Corporation
operations, largely under the payment-in-kind (PIK) program, had
accounted for about $9 billion of the $12-1/2 billion increase. In the
third quarter, when PIK was being wound down, these operations added
only slightly to the increase. Other Federal purchasers, mainly for
defense, 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, 1
percentage point less than in the second quarter. The continued
deceleration was widespread; lower petroleum and petroleum product
prices, which affected several components, were a major factor. Food
prices, which had declined in the second quarter and had accounted for
the deceleration in GNP prices, turned up in the third.

* Personal income increased about $60 billion, $4 billion less than
in the second quarter. The increase in wage and salary disbursements
was substantially smaller than the second-quarter increase of $37-1/2
billion. Deceleration was apparent in all major private industry
groups. In contrast, farm proprietors’ income increased sharply
after a $9 billion decline in the second quarter. In the second quarter,
a falloff of Federal subsidy payments to farmers, largely due to the
winding down of the PIK program, had subtracted about $15 billion from
the change in farm income. In the third quarter, these subsidy payments
changed little. Other components of farm income continued to register
the effects of the stepped-up production, and, through the second
quarter, increases in farm prices. The other major components of
personal income registered increases about the same as, or a little
smaller than, those in the second quarter.

Personal taxes were up slightly more than in the second quarter, as
were prices of PCE, so that the increase in real disposable income
slowed further–down about 2 percentage points from the 6-1/2 percent in
the second quarter. The increase in personal outlays was less than that
in disposable personal income, and personal saving increased. The
saving rate was up about one-half percentage point from 5.7 percent in
the second quarter. Second-quarter corporate profits

Profits from current production–profits with inventory valuation
and capital consumption adjustments–increased $14 billion in the second
quarter, to $291 billion, following a $17-1/2 billion increase in the
first. The second-quarter estimate is $1/2 billion less than the
preliminary one published a month ago. Profits from the rest of the
world were revised down $5 billion, and domestic profits of financial
corporations were revised down $1-1/2 billion. These downward revisions
were partly offset by an upward revision of $6 billion in domestic
profits of nonfinancial corporations.

Profits from the rest of the world declined $4-1/2 billion in the
second quarter, to $21-1/2 billion, following no change in the first
quarter. The relatively weak economic recovery in European countries, a
soft petroleum market, and strikes in Germany and the United Kingdom
contributed to the lower earnings.

Profits of nonfinancial corporations accounted for nearly all of
the $18 billion increase in domestic profits; financial corporations
contributed only $1/2 billion. Domestic profits of nonfinancial
corporations were up because domestic product increased substantially
and unit prices rose more than the slight increase in unit costs (chart

Profits before tax–profits without inventory valuation adjustment
(IVA) and capital consumption adjustment (CCAdj)–increased $2-1/2
billion in the second quarter, to $246 billion. They had increased $18
billion in the first quarter. Profits from current production were up
more than profits before tax; the CCAdj was up $4-1/2 billion and the
IVA became less negative by $6 billion. The adjustments convert the
costs of invetories and depreciation reported by businesses into those
used in the national income and product accounts.

Corporate tax liability was up $3 billion, following an $8 billion
increase 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 the
CCADJ–the variant of profits available by industry–increased $9
billion in the second quarter, following a $13-1/2 billion increase in
the first quarter. Domestic profits of financial corporations were
unchanged. Domestic profits of nonfinancial corporations were up $13
billion, about the same as in the first quarter. The second-quarter
increase more than offset the decline in profits from the rest of the

Trade profits contributed the most to the increase in domestic
profits of nonfinancial corporations. Profits of both wholesalers and
retailers increased; among retailers, profits of food retailers were up
the most. Profits of manufacturers increased $2-1/2 billion. An
increase in profits of nondurable goods manufacturers. Petroleum profits
contributed substantially to the increase in profits of nondurable goods
manufacturers. The decline in profits of durable goods manufacturers
resulted from a decline in motor vehicles profits. Profits of most
other durable goods manufacturers improved. Second-quarter NIPA

The 75-day revisions of the national income and product accounts
estimates 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-thirds
of new conventional mortgage originations and for three-fourths of such
originations by thrift institutions (savings and loan associations and
savings banks). The use of ARM’s is widely credited with giving
considerable support to residential investment; moreover, ARM’s
have reduced the interest rate risk of mortgage lenders. ARM’s
have not proven to be a cure-all for lenders, however, recent increases
in interest rates have focused attention on the fact that decreased
interest rate risk has been achieved only at the expense of increased
credit risk.

Increased credit risk, in this context, means that a lender is more
likely to have an ARM go into default than to have a fixed rate mortgage
go into default. The reason is obvious: Payments on an ARM may increase
to a level that the borrower cannot afford; payments (for principal and
interest) on a fixed rate mortgage do not change.

“Credit risk” focuses attention on the problems that face
ARM lenders. The same basic problem, when viewed from the standpoint of
the borrower, is sometimes referred to as “payment shock.”
The problem, under one or both of its names, has been addressed by a
number of industry experts in recent months.

Most observers seem to agree that only a small percentage of ARM
borrowers are likely to experience significant payment shock. For
example, Federal Home Loan Bank Board Chairman Edwin J. Gray says that
such borrowers “appear to account for a modest fraction of the
total ARM market,” and the U.S. League of Savings Institutions

. . . lenders are using a variety of features to insure that
homeowners with adjustable rate mortgages do not face unwarranted
dangers of so-called “payment shock.” In 96.7 percent of the
loans being made . . . there is either an annual interest rate cap or an
annual payment cap to sheild the borrower from excessive annual
increases in monthly mortgage payment.

Nevertheless, even a relatively small share of unsound ARM’s
could lead to regulatory and legislative changes that have far-reaching
effects on ARM’s, the mortgage market, and thrift institutions.
This discussion illustrates a case of payment shock, highlighting the
importance of deep introductory discounts, which are then discussed in
somewhat more detail.

Illustration of payment shock.–ARM’s are generally offered at
a “program” rate that is lower than the rate on fixed rate
mortgages; this lower rate compensates the borrower for the risk of rate
increases inherent in the ARM. Moreover, some ARM’s are discounted
for the first year or two of the mortgage. At the end of the
introductory period, the discount expires and, in addition, the program
rate is adjusted to an index rate. For purposes of illustration,
consider a $60,000, 25-year ARM originated in May 1983 with a program
rate of 12 percent, a 1-year introductory rate of 9 percent, and annual
adjustments to the program rate linked to the rate on 1-year Treasury

At the introductory rate (9 percent), monthly payments for
principal and interest are $509. After 1 year, the rate goes up to its
program rate (12 percent) with payments of $637, an increase of 25
percent. However, because the rate on 1-year Treasury securities went
up 2.76 percentage points during the year, the mortgage rate is further
adjusted 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 limit
actual increases to much smaller amounts. For example, payments would
rise to only about $590 if there were an interest rate cap of 2
percentage 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 rate
cap of 2 percentage points applied to the program rate in the example,
or a cap of 5 percentage points applied to the introductory rate, would
not limit the increase much. Thus, the mere existence of caps does not
mean that payment shock will be avoided.

This illustration makes clear that two distinct elements can
contribute to payment shock: elimination of the introductory discount,
and adjustment of the program rate. In some cases, adjustment of the
nondiscounted rate will be minor.

Chart 2 shows three of the most popular ARM index rates: the rate
on 1-year Treasury securities, the Federal Home Loan Bank Board’s
average mortgage rate, and the Bank Board’s median cost of funds ratio. The difference between these rates is striking. From May 1983
to May 1984, for example, the Treasury rate increased 2.76 percentage
points, while the average mortgage rate fell 0.73 percentage point, and
the cost of funds ratio was virtually unchanged. ARM’s linked to
the last two indexes obviously would not have confronted borrowers with
payment shock. Thus, only the fraction of ARM borrowers with mortgages
linked to a rate that increased substantially, like the rate on 1-year
Treasury securities, face potential payment shock. Many of these
borrowers, presumably, are protected by rate or payment caps. If there
are no other complicating factors, then the vast majority of borrowers
would probably be able to budget the monthly payment resulting from
adjusting 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 of
1983 by a randomly selected sample of savings and loan associations and
found that about one-third of these mortgages carried discounts. The
average introductory discount ranged from 0.76 percentage point for
uncapped ARM’s indexed to 1-year Treasury securities to 1.73
percentage points for capped ARM’s indexed to the Bank Board’s
mortgage interest rate series. No information is available on the
dispersion of initial discounts around these averages. In any event,
the use of deep initial discounts appears to have become significant
during the second half of the year and, thus, would not be reflected in
the sample.

The deeper the discount, of course, the larger the increase in
payments when the discount expires, and the greater the probability of
payment shock. The probability of payment shock is increased further if
the introductory rate, rather than the program rate, was used in
deciding whether a borrower was qualified for the mortgage.

When a mortgage is applied for, the borrower’s income is the
prime determinant of whether he or she will qualify for the loan. The
test of whether a borrower qualifies or not is–in oversimplified outline–whether mortgage payments would constitute more than a certain
fraction of the borrower’s income. If the introductory rate is
used to calculate payments in this test, more borrowers can qualify.
When the discount expires, however, monthly payments could well increase
a level that, according to the lending criterion, the borrower is not
qualified to handle.

Considering the mortgage used in the earlier example, annual
payments 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 a
one-fourth ratio of mortgage payment to income to determine
qualification, income must be at least $24,432 or $30,576, respectively.
IF the introductory rate is used, a borrower who barely qualifies will
be taking on a mortgage that, after the first year, the borrower is not
qualified for.

Most borrowers and lenders may be expected to avoid a mortgage that
the borrower is technically qualified for if they realize that the
borrower’s obligation may soon reach unmanageable proportions. The
borrower’s self-discipline is undermined, however, if the potential
magnitude of his or her obligation is not clear. In fact, confusion on
the part of borrowers about future rate and payment changes seems to be
not uncommon. A lender’s motive for entering into such a mortgage
can only be surmised. (To repeat, the number of lenders doing so,
although unknown, is assumed to be small.) Perhaps the lender is in an
area 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 only
route to profitability. Finally, the lender is aware that some of the
risk can be pased premiums on ARM’s to compensate themselves for
their increased risk.)

Clearly, behavior on the part of borrowers and lenders such as just
described could lead to increased mortgage delinquency and default. As
was suggested earlier, if payment shock does cause a significant
increase in defaults, then–even though the absolute number of defaulted
loans may be small–pressure may build to constrain or even eliminate


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