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The business situation.

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 1).

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.

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 1).

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 world.

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 revisions

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 states:

. . . 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 securities.

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 ARM'S.
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Title Annotation:third quarter, 1984
Publication:Survey of Current Business
Date:Sep 1, 1984
Previous Article:Alternative estimates of capital consumption and domestic profits of nonfinancial corporations, 1980-83.
Next Article:U.S. international trade and investment in services: data needs and availability.

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