Some analysts believe that the United States of America (abbreviated as America) is treading a dangerous path by running "twin deficits"--the government budget deficit and the trade deficit. We have maintained that the trade deficit is the bane of America but the government budget deficit has only a secondary importance to the health of American economy. The natural result of relentless expansion of the trade deficit is the steady growth of the gap between domestic demand of credits from the government and the private sector combined and the credits available from domestic savings; the exploding gap is filled by the exploding trade deficit that is nothing but the borrowings from foreigners. We believe that America is already on the road of no return toward an eventual economic crash due to its wanton addiction to the expansion of the trade deficit. The crash of the American economy will bring down the economies of many other countries, large and small, and will mark the end of globalization, as we know it. However, there are opposing views. The commentary by David Malpase titled "Running on Empty?", published in the Wall Street Journal (March 29, 2005, page A16) is a typical example of such views. The author claims that the domestic savings rate is meaningless. His magic number to gauge the health of American economy is the net asset value of America. Most of that consists the home owners' equity in residential houses and the value of stocks held in the hands of American citizens. According to the tabulation of the Federal Reserve Board, this magic number has reached a new peak of about 65 trillion dollars and is growing rapidly. Since the magic number of America is growing much faster than the magic numbers of Europe and the Asian Pacific Rim countries as a whole, the author declares that the American economy will overwhelm all the other economic entities in the world soon, and thus America is ascending to an economic paradise. The purpose of this comment is to analyze Malpase's view and show that the so-called "magic number" is artificially adjustable so that it does not have any relevance to the health of a real economy. The thing to watch is still the trade deficit that will lead the American economy into a black hole.
We start our analysis by considering the following mathematical game:
Let us consider a subdivision that consists of 100 similar houses. We assume that each household has four members and an annual income of $100,000. The market value of each house is $300,000. For the sake of simplicity, we also assume that not a single household has any mortgage on its house outstanding. The total homeowner's equities for the whole subdivision is thus $300,000 x 100 = 30 million dollars.
Now suppose 10 households want to sell their houses and move away. An economic wizard among the remaining 90 households fears that the sell of 10 houses in a not so robust housing market may depress the market value of each house in the subdivision and thus reduce the total homeowners' equity of the subdivision; if the fear of the wizard should become the reality, the magic number tabulated by the Federal Reserve Board will naturally be reduced accordingly. The wizard proposes the following scheme to the other 89 households that will remain in the subdivision.
For the game to proceed up to Step 10, there must be an unrealistic assumption that the mortgage banker who grants all the mortgages is just a dumb computer; the computer will grant a mortgage automatically as long as the sum of the new mortgage and all the outstanding old mortgages on a house does not exceed the market value of the house at the time of the mortgage application. Actually at any step in the above table, the total amount of mortgage obligation outstanding on a house never exceeds the market value of the house at the end of the preceding step, so there is no problem for the dumb mortgage banker to let the game proceed up to Step 10. We will postpone the consideration of a more realistic situation to the next paragraph and consider first the case of this dumb mortgage banker and what is going to happen at the end of this game. At the end of Step 10, the fund will own all 100 houses. It has an outstanding mortgage obligation of around 12 billion dollars. Assuming a mortgage interest rate of 6%, the fund must pay 720 million dollars of mortgage interest a year. The fund has 2.145 billion dollars of cash retained from its most recently taken-out mortgage. Assuming that the 10 steps have proceeded so quickly that the cash retained at each step are still in the hands of the fund to maximize its cash position, the retained cash totals to 3.681 billion dollars. Assuming that the fund can invest the cash on hand with 6% return, a very optimistic assumption for the fund, the fund will have an investment income of 221 million dollars a year. Even with this highly inflated price per house, the rental income from each house should be expected to be just around $30,000 a year per house, the typical rental rate when the market value of a house was only $300,000. Thus the yearly rental income of the fund is only 3 million dollars. The fund will face about 500 million-dollar shortages in cash flow a year. This means that within 5 years the fund will be bankrupted and the dumb mortgage banker will sustain a loss of 9 billion dollars! When the mortgage banker possesses those houses and sells them at the real market value, about $300,000 per house, then the contribution of this subdivision to the magic number tabulated at the Federal Reserve Board will plunge from around 38 billion dollars back to the original 30 million dollars. The real winners of this game are the households that sold their houses to the fund. The ten households that sold their houses to the fund at Step 10 are, of course, the biggest winners; each one of them will net a windfall of about 430 million dollars! Among the old-fashion circle, this game is known as a variation of the “pyramid”; every financial “pyramid” will eventually collapse. The modern name of this game is a variation of “leveraged buyout”.
Real mortgage bankers are, of course, smarter than the dumb computer. They will scrutinize the cash flow of each mortgage borrower. For example, at the end of Step 3 the total sum of the outstanding mortgage of each household is about $750,000. With a mortgage interest rate of 6%, each household must pay $45,000 a year as the mortgage interest. Since each household has an annual income of $100,000, the burden of the mortgage interest, though heavy, is still sustainable. Therefore, a reasonable mortgage banker will allow the game to proceed up to Step 3. However, Step 4 is a different story. At the end of Step 4, each household's outstanding mortgage amount will be about 1.68 million dollars; this means that the mortgage interest for a year will be $100,800; it will exceed the annual income of the household. Thus we must assume that the game will be stopped at Step 3. Let us look into the financial situation at the end of Step 3. First, the fund has assumed mortgages totaled $10,920,000, so it must pay $655,200 a year as the mortgage interest. It retained cash from Step 3 and Step 2 totaled $3,276,000 that can generate an investment income of $196,560 a year. The rental income from 30 houses, $30,000 per house, will amount to $900,000 a year. Thus the fund will have a positive cash flow of $441,360 a year to cover maintenances and other costs required to run the rental properties. This means that the fund can keep going forever. The situation of each of the remaining households has been discussed already; the remaining households are also not in danger of default. Who are the winners if the game ends at Step 3? The mortgage bankers are some of the winners. Before the game they generated no business from the subdivision. At the end of Step 3 they have a mortgage of 63 million dollars outstanding, and the mortgages are not in danger of default. Those who rely on the “magic number” are also winners since the total homeowners' equity for the subdivision is inflated to 214 million dollars from the original 30 million dollars, and this jump will naturally be reflected in the “magic number” tabulated by The Federal Reserve Board. The real winners are the households that sold their houses to the fund. The ten households that sold their houses at Step 3 will see a windfall of about 2.3 million dollars each. The ten households that sold their houses to the fund at Step 2 have a windfall of about 1.1 million dollars per household, and the first ten households that sold their houses to the fund have a windfall of $330,000 per household. The losers are the remaining 70 households at the end of Step 3. They will suffer the diminished cash flow for next 30 years, the duration of their mortgages. In other words, the future consumption power of those 70 poor households is transferred to the 30 exiting households as the current consumption power. Thus the current GDP will be boosted by current consumption but the future GDP will decrease due to the poor future consumption of 70 losing households. It should also be noted that liquidation of the fund is not a desirable option for the remaining 70 households. If the fund is liquidated, the 30 houses in the hand of the fun can be sold at only around $300,000 a piece. Thus the liquidation of the fund will not generate much return for those 70 households. On the other hand, those households not only must continue to pay the same amount of mortgage interests, but also will see the market value of their houses plunge back to $300,000 a piece; they will have a negative homeowner’s equity. They are better off letting the fund continue and keep the market value of each house suspended at a highly inflated level.
Readers may question whether the game, even stopped at Step 3, has any relevance to the actual situation in America. Any homeowners who have made aggressive mortgage refinancing are unwittingly participating in the game, especially those who have used the money generated by the new mortgage less the old mortgage for personal spending. They are active participants in this game. Since money flows, their money spent will flow to someone else’s pocket, and this someone else will buy houses to boost the prices of houses. Thus, the original homeowner that did the aggressive refinancing can do the aggressive refinancing again to sustain the chain of the game. Those that carelessly take a new mortgage with larger mortgage interest payments than their original mortgage interest payment or rely on adjustable-rate mortgages to improve their cash flows will see their future cash flow strained as mortgage interest rate rise, just like the 70 poor losing households in the game.
Based on the above analysis we do not believe the “magic number” tabulated by the Federal Reserve Board can serve as a meaningful measure to gauge the health of the American economy. The focus is still on the exploding American trade deficit and the unavoidable collapse of the US dollar. The question is still whether the collapse of the US dollar will trigger a worldwide depression that we believe is inevitable, or whether the event will be benign as some researchers of the Federal Reserve Board are claiming. As mentioned in Comment 17, the discussion of that crucial issue will be postponed to another future article or comment.
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