In 2018 we learned the extent to which mortgage rates can affect the amount of business mortgage originators do. Rates went up about 1 percentage point over the year, and refinance volume sank to an 18-year low.
Higher rates combined with higher home prices negatively impacted the purchase market as well. If mortgage business volume is so sensitive to a 1 percentage point increase in rates, what would have happened if rates went up much more? It serves mortgage originators well to consider what could provoke a drastic increase in rates.
One thing that those who are concerned about mortgage rates never think about is the supply of lendable funds. It is very large, but not infinite. We could be approaching a time when the demand for borrowing of all types strains lendable funds, causing all interests rate to rise. The effect could be triggered if the accumulation of debt is not met with an equivalent increase in savings.
Debt is residue of money spent in the past that cannot be spent at present. Domestic debt can be divided into four sets: Federal government debt and obligations; state and local government debt and obligations; corporate debt; and individual debt. Federal obligations, apart from Treasury debt, stem from the social safety-net programs of Social Security and Medicare. State and local government obligations, apart from debt, stem from pensions.
The national debt
It’s important to distinguish the U.S. budget deficit from the increase in the national debt. The national debt increases faster than the deficit because money also is borrowed to make student loans, Small Business Administration loans, Export-Import Bank loans and more. These loans have offsetting assets and only student loans have significant default rates.
The biggest problem by far is the amount of debt that the federal government has accumulated. This consists of the national debt of $22 trillion (which is growing daily), plus the present value of the under-funding of Social Security and Medicare — which combined is about $75 trillion over a 75-year window. The size of our borrowing is not yet painful because low interest rates have made it more affordable.
The extent to which the amount of federal debt is a problem depends on two things: interest rates on Treasury debt and the national debt to gross domestic product (GDP) ratio. If interest rates rise, it is more expensive to service the interest on the national debt. Interest payments on the national debt represented 6.6 percent of all federal government spending in 2017 and that’s expected to jump to 13 percent in a decade, The New York Times reported.
In 2009, with interest rates low, Treasury decided to lengthen the average duration of its debt. In November 2017, however, Treasury ended that policy. The result is lower total interest rates in the short run, with rate risk increased in the long run.
Professionals in the mortgage business are familiar with debt ratios. A similar metric for Treasury debt is the ratio of national debt to GDP — the latter a measure of gross economic activity. The higher the ratio is, the more difficult it is to service. The Federal Reserve produces a graph of the ratio of total federal (or national) debt to GDP. It shows that the ratio rose from 62 percent in third-quarter 2007 to over 105 percent in fourth-quarter 2016, but has been relatively flat since 2015.
Medicare and Social Security
In addition to the national debt, the federal government has liabilities associated with Social Security and Medicare. The 2018 report from the Trustees of these funds estimates that while they hold substantial reserves at present, those reserves will soon be depleted. If not addressed, the Social Security Trust fund will run out of reserves in 2034 and the Medicare’s hospital insurance fund’s reserves will be depleted in 2026.
The trust-fund underfunding is not technically debt, but it does, nonetheless, represent obligations. The present value of the underfunding of Social Security over a 75-year window is $13.2 trillion. The present value of the unfunded liability of Medicare is $37 trillion over the same time frame.
One of two things is going to happen: Either politicians will address this or, at some point in the future, our capacity to borrow will not be enough to sustain the regular budget plus the entitlement spending of Social Security and Medicare. We are running our nation’s finances with zero regard for future generations. Part of the problem is that there is no accountability. While everyone loves to blame things on politicians, the fact is that, unless voters demand fiscal sustainability, it will not happen until a debt-induced fiscal disaster occurs.
Local government debt
Liabilities from debt and the underfunding of pensions of public employees will likely cause some large U.S. cities to file bankruptcy in the future. Some cities can solve the problem by raising taxes, decreasing benefits or increasing employee contributions, or a combination of those.
For some cities, however, there is no easy solution. Public debt can cause local government to increase taxes, drive people out and make the problem worse. Politicians often have too little inclination toward fiscal sustainability.
There is no provision in the bankruptcy code for a state to file bankruptcy. The public pensions of New Jersey, for example, have only 31 percent of the assets needed to make pension payments. Illinois has 36 percent. State and local pension underfunding are the result of unrealistic policies. In brief, not enough money is being put into the pension funds to cover the promises made.
The corporate debt load has reached a record $6.3 trillion, rising by $2.7 trillion over the past five years. Too much corporate debt has been used for stock buybacks, which produced higher equity prices but almost zero economic growth. Borrowing for capital expenditures was concentrated in the oil industry, and that debt could turn bad if oil prices fall.
Debt taken on by a corporation to buy back stock might make sense if the company has a revenue stream to pay down the debt incurred. General Electric, for example, spent $40 billion on stock buybacks between 2015 through 2017. Stock buybacks generally drive up share prices, perhaps rewarding executives whose income is based on share price. This is bad corporate governance, however, and may be the next chapter in the “corporations are evil” narrative.
Too much corporate debt today is low quality, much of it in what are called “leveraged loans.” Professionals in the mortgage industry would call these subprime loans. These loans were made in search of higher yields when the federal funds rate was near zero. Should the economy sour, these leveraged loans have the potential to spark another banking-liquidity crisis.
Personal debt can be either productive or unproductive. A home loan, buying a car on credit so that one can get to work and student loans that enable higher incomes are examples of productive debt. Mortgage debt also usually makes sense because the alternatives are renting, living with friends or relatives, or homelessness. These are investments in one’s future.
There are mainly four types of personal debt: Mortgage debt ($9.0 trillion outstanding nationwide), student-loan debt ($1.5 trillion outstanding), auto loans ($1.24 trillion outstanding) and credit card debt (in excess of $830 billion outstanding).
Buying consumer goods on credit to supplement the difference between one’s income and lifestyle expense is bad debt. Having credit extended by a bookmaker is bad debt. Using your credit card to gamble is bad debt.
Student-loan debt is a special case. The amount of debt is large. It is owned by the federal government, which has to borrow money to make the loans. It makes homeownership difficult.
According to the National Association of Realtors, student-loan debt delays homeownership by seven years for millennials, the younger generation that is now the largest source of first-time homebuyers. It also delays marriage, having kids and auto purchasing. If debt causes people to have fewer children, the problem is compounded because in the future there will be fewer people to pay off the debt.
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Too much debt has some major ill effects on the mortgage business. People who are too heavily indebted may never be able to buy a home. Students with too much debt will, at minimum, delay buying homes.
If the total amount of borrowing gets excessive, compared to total savings, it can create higher rates for all lending. That outcome would not bode well for the mortgage business long term.