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http://www.fmcenter.org/pdf/flow12-02nocov.pdf

flowoffunds REVIEW &

ANALYSIS

3RD QUARTER 2002

A

P U B L I C A T I O N

O F T H E

F I N A N C I A L

M A R K E T S

C E N T E R

The Overheated Mortgage Machine

As GDP growth quickened to 4.0 percent in

the third quarter, the pace of borrowing

moderated for all sectors except households.

After surging by 15.5 percent in the second

quarter, new borrowing by the federal government

slowed to 7.5 percent and debt growth for state and

local governments dropped from 12.0 percent to

7.7 percent. Business borrowing also ratcheted

down (from 3.4 percent to 2.2 percent) as the

corporate sector virtually withdrew from credit

markets. During the third quarter, borrowing by

nonfinancial corporations increased by only 0.2

percent, leaving corporate debt accumulation close

to its year-end 2001 level (Table 1).*

By contrast, household debt continued to

climb, with banks and mortgage loans providing

the critical nexus. Flush with a resurgent deposit

base, banks became the driving force behind a

12.8 percent run-up in mortgage debt, which

eclipsed growth rates for the first two quarters of

2002 and the year 2001. And mortgage borrowing,

in turn, dwarfed other forms of household

borrowing by proportions not seen in a decade.

As homebuyers lined up for cash-out mortgage

refinancings and home equity loans (which

accounted for fully one-fifth of the quarter’s net

increase in new residential mortgage lending),

consumer-credit expansion slowed to 3.5 percent,

*Except where noted, all dollar amounts and percentages are annualized rates of increase or decrease.

Table 1: Growth in U.S. Credit Market Debt ($ billions)

Total

Percent Increase $ Increase Outstanding

Year Q1 Q2 Q3

2001 2002 2002 2002 Q3 2002 Q3 2002

Sectors

Domestic non-financial 6.1 4.8 8.2 6.6 1,329.4 20,336.8

Federal Government -0.2 1.2 15.5 7.5 265.7 3,587.4

Non-Federal 7.6 5.6 6.7 6.5 1,063.7 16,749.4

Households 8.6 9.1 8.7 9.6 770.7 8,219.0

Mortgage debt 9.7 10.3 11.0 12.8 724.1 5,850.2

Consumer debt 6.9 4.8 4.4 3.5 60.1 1,757.9

Business 6.3 1.8 3.4 2.2 153.2 7,055.2

Corporate debt 5.3 0.1 2.0 0.2 10.7 4,874.1

Small business & farm debt 8.6 5.5 6.7 6.6 142.5 2,181.1

State and local government 8.1 4.5 12.0 9.7 139.9 1,475.2

Domestic financial 11.4 9.2 9.0 8.7 855.9 10,043.0

Foreign -5.0 10.7 2.1 -5.1 -36.8 718.3

Total Credit 7.4 6.3 8.3 7.0 2,148.5 31,098.1

Memo item:

Debt of government sponsored

enterprises and federally

related mortgage pools 15.0 13.4 9.1 8.3 425.6 5,474.4

Quarterly data are seasonally adjusted annual rates.

SOURCE: Federal Reserve System, Flow of Funds Accounts of the United States

flowoffunds REVIEW &

ANALYSIS

P A G E 2

the lowest level since 1992.

Foreign investors significantly augmented

the availability of credit by expanding their net

purchases of U.S. financial assets by 45.9 percent.

The surge of inflows helped hold down U.S.

interest rates. And it continued to provide a ready

- if not necessarily sustainable - substitute for

domestic savings, as personal saving plummeted

from 5.6 percent of disposable income in the

second quarter to 1.4 percent in the third.

Households

With debt growing and personal saving in retreat,

households’ net financial investment - the difference

between net increases in financial assets and

liabilities - turned negative; the -$209.8 billion

third quarter gap equaled 2.7 percent of disposable

income. In addition, the net worth of households

and nonprofit organizations fell by a staggering

$1.8 trillion, or 4.5 percent, between July and

September (Table 2). As stock prices hemorrhaged,

total losses on financial assets amounted to

-6.0 percent, with the value of pension fund

reserves taking an especially hard hit (-7.1 percent).

Other aspects of households’ finances

presented a mixed picture. Disposable income

rose one percent for the quarter, maintaining the

upward trend that has followed a sharp slide in the

fourth quarter of 2001. And housing prices

continued to boom.

However, the increase in real estate value

($180.8 billion) lagged the growth in household

mortgage debt ($184.3 billion). And the rising

value of housing - up $4.63 trillion or 52.7

percent since 1997 - has not produced substantial

additions to owners’ equity. In fact, the opposite

has occurred.

When housing prices dipped during the

recession of the early 1990s, equity declined as a

percentage of household real estate value from

65.0 in 1989 to 59.0 percent in 1993. Over the

rest of the decade, the equity ratio continued to

inch down. In the third quarter of 2002, this trend

intensified, as increases in home equity borrowing

and cash-out refinancings pushed owners’ equity

down to 56.4 percent from 57.2 percent in the

previous quarter. Given this trend, a larger

number of households could see their equity

disappear altogether if housing prices fall.

Businesses

During the third quarter, the major sources of

credit for nonfinancial corporations all contracted,

as bank loans, commercial paper, and bonds

registered declines of -$43.6 billion, -$28.7 billion

and -$23.4 billion respectively. Some of this

contraction was offset by foreign lending, credit

from finance companies and mortgage loans.

However, net equity issuance by corporations

turned negative again, effectively reducing

external financing to a trickle at the same time

firms found themselves struggling to generate

funds internally for new investment.

Although before-tax corporate profits rose

for a third consecutive quarter, these gains have

not yet erased the effects of a 33.2 percent collapse

in the final quarter of 2001. Indeed, for the

year ending September 30, profits were down 2.8

percent. Squeezed by both internal and external

funding constraints, companies saw their capital

expenditures for fixed investment shrink by 5.1

percent on a year-over-year basis. Perhaps more

than any other factor, the failure of business

investment to revive has fueled both a widespread

sense of retrenchment and growing concern over

the possibility of a double-dip recession.

Corporate balance sheets mirrored the same

trends. Aggregate net worth continued to decline

and has now fallen $410.1 billion or 4.6 percent

from its peak of $8.96 trillion at year-end 2000.

flowoffunds REVIEW &

ANALYSIS

P A G E 3

Meanwhile, outstanding corporate debt swelled to

57.2 percent of net worth - an increase of one

percentage point since year-end 2001 and nearly

nine percentage points since 1997. Without a

strong pick-up in earnings or stock prices, corporate

efforts to pare debt and rebuild net worth

likely will remain an uphill challenge.

Small businesses seemed to be in somewhat

better shape than their bigger brethren, enjoying

growth in both net income (4.8 percent) and net

worth (2.3 percent) for the year ending in September.

In addition, small firms increased their

capital expenditures ($173.2 billion) at a faster

clip than their liabilities ($121.4 billion) during the

third quarter. But over the four most recent

quarters, small-business capital expenditures have

Table 2: Change in Net Worth of Households and Nonprofit Organizations

($ billions; amounts not seasonally adjusted)

Q2 2002 Q3 2002 Change Change

$ Amount $ Amount $ Amount Percent

Assets 48,443.2 46,811.3 -1,631.9 -3.4

Tangible assets 17,462.6 17,700.7 238.1 1.4

Household real estate1 13,233.5 13,414.3 180.8 1.4

Consumer durables2 2,899.8 2,953.0 53.2 1.8

Other3 1,329.4 1,333.5 4.1 0.3

Financial assets 30,980.6 29,110.6 -1,870.0 -6.0

Deposits4 4,883.2 4,994.7 111.5 2.2

Credit market instruments5 2,425.1 2,351.3 -73.8 -3.0

Corporate equities6 4,970.2 4,021.4 -948.8 -19.1

Mutual fund shares7 2,809.3 2,469.4 -339.9 -12.1

Pension fund reserves 8,328.1 7,737.4 -590.7 -7.1

Equity in non-corporate business8 4,906.5 4,947.4 40.9 0.8

Other9 2,658.3 2,589.0 -69.3 -2.6

Liabilities 8,317.1 8,496.2 179.1 2.1

Home mortgages10 5,665.4 5,849.7 184.3 3.2

Consumer credit 1,700.3 1,720.6 20.3 1.2

Other11 951.3 926.0 -25.3 -2.7

Net worth 40,126.1 38,315.1 -1,811.0 -4.5

1 At market value. Includes vacant land and vacant homes for sale.

2 At replacement (current) cost.

3 Includes real estate and equipment and software owned by nonprofit organizations.

4 Includes checkable deposits and currency, time and savings deposits, money market fund shares and foreign deposits.

5 Includes open market paper, U.S. government and agency securities, municipal securities, corporate and foreign bonds and mortgages.

6 At market value.

7 Value based on the market values of equities held and the book value of other assets held by mutual funds.

8 Owners’ equity in noncorporate business, farm business and unincorporated security brokers and dealers.

9 Includes security credit, life insurance reserves, investment in bank personal trusts and miscellaneous assets.

10 Includes loans made under home equity lines of credit and home equity loans secured by junior liens.

11 Includes municipal securities, bank loans n.e.c., other loans and advances, commercial mortgages (liabilities of nonprofit organizations),

security credit, trade payables (liabilities of nonprofit organizations) and deferred and unpaid life insurance premiums.

SOURCE: Federal Reserve System, Flow of Funds Accounts of the United States

flowoffunds REVIEW &

ANALYSIS

P A G E 4

declined by a cumulative 12 percent, compounding

the business sector’s sluggish investment

performance and feeding economic unease.

At the same time, rising debt ratios could

jeopardize the gains small businesses have recorded

in recent years. Between July and September,

debt as a share of small firms’ net worth rose

to 49.0 percent - a 2.1 percentage-point jump

from September 2001 and 10.5 percentage point

increase over the year-end 1997 level. Since the

vast bulk of this debt is being acquired through

residential mortgage borrowing, small enterprises

have become at least as vulnerable as

homeowners to the vicissitudes of the housing

market.† Should soaring housing values begin to

lose altitude, the net worth of many small firms

could take a decided turn for the worse.

Financial Sectors

As losses on their financial portfolios mounted,

households continued to shift funds into small

time and saving deposits (up $341.4 billion for the

quarter) in order to preserve principal. In the third

quarter, banks used this influx of deposits to

become the primary channel for new lending,

boosting their net extension of credit by 62.2

percent to $632.4 billion and raising their share of

total financial sector lending to 34.4 percent - a

full 11 percentage points higher than in the

previous quarter.

Tellingly, the renewed prominence of bank

lending made its biggest impacts in housing

markets. During the third quarter, banks supplied

39.6 percent of new mortgage loans and

bought a whopping 31.0 percent of net new

issues of agency securities (thereby supporting

additional residential lending by government

sponsored enterprises such as Fannie Mae and

Freddie Mac and federally related mortgage

pools). All in all, acquisitions of these assets

accounted for four-fifths of the increase in bank

credit for the quarter.

Meanwhile, the portion of total financial

sector lending conducted by GSEs and federally

related mortgage pools fell from 28.6 percent in

the second quarter to 19.1 percent in the third.

Agency borrowing continued to expand at a

robust 8.3 percent pace. But the financial sector’s

overall share of total credit market borrowing

(39.8 percent) remained far below the peak (50.0

percent) established in 1998 - an artifact largely

of the build-up in time and savings deposits,

which are not classified as borrowed funds.

Foreign Sector

During the third quarter, inflows of foreign

investment burgeoned by 45.9 percent as the

financing of America’s trade deficit continued to

require unprecedented levels of external funding.

Net foreign acquisitions of U.S. financial assets

rose to $857.8 billion, up from $588.1 billion in

the second quarter. And foreign investors’

continued willingness to buy dollar-denominated

financial instruments played a crucial role in

supporting U.S. asset prices and maintaining

downward pressure on U.S. interest rates.

Between July and September, foreigners

bought $249.4 billion of Treasury securities (an

amount equal to 93.3 percent of net new issues),

$151.3 billion of agency securities (35.5 percent

of net new issues), $89.9 billion of corporate

bonds (52.5 percent of net new issues), and $31.2

† Balance sheet data on the replacement-cost value of structures owned by small businesses show that: a) the cost of nonresidential

buildings is one-third the cost of residential structures; and b) the replacement-cost value of residential structures equals 138.6 percent of

small firms’ outstanding mortgage debt.

flowoffunds REVIEW &

ANALYSIS

P A G E 5

billion of corporate equities. In addition, lending

by foreign investors through security repurchase

agreements accounted for $182.2 billion (85.2

percent) of the increase in these instruments.

Overall, the foreign sector supplied 26.1

percent of total funds raised by all sectors -

domestic and foreign, financial and nonfinancial -

in U.S. credit markets, up from 22.7 percent in the

previous quarter. At the end of September,

foreign investors held 31.6 percent ($1.11 trillion)

of outstanding U.S. Treasury securities, 22.5

percent ($1.26 trillion) of outstanding corporate

bonds, 10.9 percent ($1.19 trillion) of outstanding

corporate equities and 11.9 percent ($641.6

billion) of outstanding agency securities.

Outlook

The third quarter surge in residential lending by

banks reflects a steady transformation of deposittaking

institutions into a housing-finance colossus

that supports - and is supported by - the quasigovernmental

institutions (GSEs), which channel

savings into mortgages. Underway since early

2001 (and facilitated by the Federal Reserve’s

aggressive easing campaign), this transformation

has compounded imbalances within credit markets

by flooding homebuilders and homeowners with

borrowed cash while sectors such as manufacturing

go begging for funds.

The conversion of the deposit-taking industry

to a housing-finance machine has also exacerbated

a sustained pattern of divergence between

credit and output growth. Over the past five

years, increases in domestic nonfinancial borrowing

have outpaced GDP growth in 17 of 19

quarters. And during that period, outstanding

residential mortgage debt has ballooned from an

amount equal to 49.0 percent of GDP to a level

($6.2 trillion) equaling 59.0 percent of GDP.

The rapid growth in mortgage debt and the

broad distribution of agency securities across the

financial system has exposed banks and other

financial intermediaries (including the GSEs

themselves) to considerable risk in the event that

interest rates rise and/or housing prices fall. In

addition to their own mortgage loans, banks hold

16.6 percent ($890.0 billion) of outstanding

agency issues, while thrift institutions and credit

unions own another 4.9 percent ($264.8 billion).

Private pension funds and public-employee

retirement funds have 7.9 percent ($425.4 billion)

of these securities and mutual funds hold 13.4

percent ($718.4 billion).

Unlike these institutional investors, households

do not own substantial volumes of agency

paper outright. However, households are indirectly

exposed to the GSEs’ fortunes through the

holdings of their pension and mutual funds. If

rising interest rates triggered a decline in the value

of agency securities, household net worth would

diminish as a result of these holdings. In addition,

higher interest rates could also precipitate a

reversal of the booming real estate prices that

have recently helped many households cushion

their losses on equities. (Under current conditions,

it seems highly unlikely that rising interest

rates would simply reverse the cushion by sparking

an increase in stock prices.)

As previously noted, a correction in housing

prices would also affect small businesses, since

residential mortgage borrowing now represents

their primary source of funding. If such a correction

occurred, it would both threaten the availability

of new lending for small firms and lower the value

of their equity. And because equity in non-corporate

business currently constitutes nearly one-fifth

of household financial assets - more than the share

claimed by either mutual funds or directly held

corporate stocks - these consequences would, in

turn, further burden the household sector.

The multi-faceted risks embedded in recent

housing and mortgage market developments are

profoundly relevant to the emerging debate over

central banks targeting asset prices. In recent

months, Chairman Alan Greenspan has joined that

debate by defending the Federal Reserve against

charges that it failed to prick the 1990s stock

market bubble in time. Greenspan argues that

bubbles are inherently difficult to discern, that

raising interest rates to deflate stock prices would

also have flattened the economy, and that regulatory

interventions such as margin adjustments

would have proven ineffectual.

More importantly, Greenspan and his Fed

colleagues - like the vast majority of central

bankers around the world - have declined to take

responsibility for the conditions that cause market

bubbles. As the evidence of the past two centuries

suggests, bubbles typically arise out of

excessive and unbalanced credit flows. And

Chairman Greenspan’s assertions notwithstanding,

large increases in debt relative to economic

growth - for example, the ten percentage point

jump in mortgage borrowing as a share of GDP

since 1997 - provide a fairly reliable signal that a

bubble is evolving.

As a number of voices inside and outside

central banking have insisted, the Fed need not

stand by passively while yet another sector

follows the fin de siecle trajectory of NASDAQ,

only to leave sizable losses in output, jobs and

asset values in its wake. Instead, the central bank

should make muscular and judicious use of new

and existing regulatory tools - including quantitative

instruments - to moderate and re-balance

credit flows.

The need for such tools is growing more

urgent. The bursting of a mortgage bubble could

unleash broader financial disruptions with deeper

macroeconomic implications than the shakeout

following the S&L crisis of the 1980s. Home

equity borrowing is a poor substitute for increased

profits, investment, employment and disposable

income. And consumption spending financed by

excessive debt accumulation is a not a path to

sustainable recovery.

- Jane D’Arista

flowoffunds REVIEW &

ANALYSIS

P A G E 6

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