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Sunday, July 31, 2011

Fun and Folly With Facts and Figures

Perhaps the most maddening aspect of watching the deficit debacle unfolding in Washington, DC is the utter failure of any parties (Presidents, Senators, Representatives, voters, media) involved with the spectacle to analyze the true financial impact of any of the proposals or the likely cost of a failure to formulate a viable solution and explain it to the public. Most Americans avoid any real-life use of mathematics like the plague but this is a situation where a few relatively simple calculations can cut through a great deal of FUD -- fear, uncertainty and DUMB.

The thought exercise below is intended to illustrate the true magnitude of ANY of the proposed spending reduction plans by contrasting them with a few obvious, IMMEDIATE impacts of an increase in interest rates that might result from a spooked credit market as our fiscal situation worsens. Why focus on interest rates? First, short term interest rates have a direct impact on both federal budgets and consumers that lends itself to being calculated, Second, the amount of federal and individual debt is a large enough "nut" that any increase in interest rates will produce additional, immediate and quantifiable "ripples" throughout the economy.

The point of the exercise is to illustrate how any voter in the country can cut through the fog emitted by our politicians using publicly available, politically neutral data and nothing more sophisticated than a calculator and a little bit of algebraic problem solving. Think of it as fun and folly with facts and figures -- and your financial future.

Key Statistics

First, here are the key statistics required for the analysis. Sources for most of these are provided as footnotes. A few of the values are calculated from the other values and a few are estimated and explained in the sections below.

2010 United States GDP: 14,814,922,500,000
2011 Federal Budget: 3,834,000,000,000
2011 Federal Tax Receipts: 2,334,000,000,000
2011 Federal Deficit: 1,500,000,000,000
United States Debt: 14,553,830,999,000
Yearly Federal Debt Interest Cost: 213,226,898,000
US Households with taxable income: 111,839,400
Consumer Residential Mortgate Debt: 11,297,753,000,000
Consumer Credit Card Debt: 799,758,370,000
# Housing Units: 130,159,000
Home Ownership %: 66.5%
Outright Home Ownership %: 28.0%
% Federal Debt w/ 1-year Financing: 40%
% Home Loans with Adjustable Rates: 25%
1-year Treasury Interest Rate: 0.20%
Avg HH Balance for those with CC debt: $15,788
Avg APR on cards with balance: 14.67%
Avg Penalty APR: 27.00%

Any analysis based on these statistics must begin with some obvious caveats. First, federal government budget statistics use the government's fiscal year interval (October 1, 2010 to September 30, 2011 for "2011") while most consumer and business statistics involve calendar years. Figures on home ownership are partly derived from 2010 census statistics which may not be exact for 2011 but should not have changed more than a few percentage points. Finally, the interest calculations below avoid monthly accrual calculations of interest and stick with "simple interest." Since the analysis only looks at one year increments, the complexity of compounding interest over multiple years using monthly interest rates just clouds the underlying concept. If anything, the calculations below will understate the problems slightly.

Immediate Interest Rate Impacts

No person can claim to have a clue about exactly what will emerge from the Congressional sausage making regarding fiscal policies or how world markets will react to those policies. However, interest expense is such a huge portion of overall outlays that it's easy to quantify the impact on the budget of any change in interest rates. Since interest rates are already nearly zero and uncertainty and risk are only going up, it's more likely that rates go up rather down. So what happens in response?

First, we have $14.5 trillion in debt. Roughly 40% of that debt is financed with the equivalent of a 1-year adjustable rate mortgage in the form of Treasuries with maturities of one year or less. That means forty percent of that $14.5 trillion can IMMEDIATELY float to higher interest rates within one year. Here's the impact of a one percent increase in the 1-year Treasury rate:

   additional interest = (total debt) x (short term share) x (one percent)
= $14.55T x .40 x 0.01 = $58.2 billion

That's the impact to the government's books. The impact on families can quantified using the same process -- looking at debt floating at short term interest rates keyed off the 1-year Treasury. For families, the most obvious debts in that category are credit card debt and adjustable rate mortgages. There are obviously millions of consumers who use credit cards as a payment convenience only and pay their balances off in full every month or nearly every month. However, according to the credit card industry itself, the average balance carried by households who DO carry a balance at all is an astounding $15,788. For those households, the extra interest for a one percent increase in their rate is:

   addition CC interest = (avg balance) x (one percent)
= $15,788 x 0.01 = $158 yearly

Again, that's the yearly increase for each one percent increase in their credit card rate, Not too bad, huh? Well, keep reading.

The story for holders of adjustable rate mortgages is much worse. The math is simple but takes a few steps. The following numbers need to be calculated:

1) the total number of current mortgages
2) the average outstanding balance of current mortgages

For #1, we need the total number of housing units from census figures, the current "home ownership" statistic and the current "free and clear" ownership statistic. The math is simple:

  # mortgages = (total units) x (%ownership) x (1 - % free & clear) 
= 130,159,000 x 66.5% x (1- 28%) = 62.3 million

For #2, the average mortgage balance can be calculated by looking at Federal Reserve data summarizing ALL mortgage debt, deducting out non-housing related mortgages then dividing by #1:

   avg mortgage balance = (housing mortgage debt) / # mortgages
= $11,297,753,000,000 / 62,320,129 = $181,286

The additional interest expense of a one percent jump in an adjustable rate mortgage with the average mortgage balance would then be:

    additional ARM interest = (avg mortgage balance) x (one percent)
= $1,813 yearly

Ouch. Now think back to the credit card debt portion of the picture. Interest rates on credit card balances aren't guaranteed of only jumping a few percentage points. Legislation enacted in 2009 prevents Bank B from raising a customer's rate to the default rate if the customer is current with Bank B but late with Bank A. That legislation does NOT block bank B from dropping the customer entirely and certainly doesn't prevent Bank A from raising the customer's interest rate to the default rate that averages 27%. Now that extra $1,813 in mortgage interest expense looms more ominously. That's $1813 less the consumer has to pay their credit card bills, increasing the likelihood of defaulting on one or all of their cards carrying the average balance of $15,883. If that entire balance shifts from an average 14.67% interest rate to the 27% penalty rate, the consumer is now looking at an additional $1947 in credit card interest charges yearly. Combined, at least a few "average" consumers could thus be out a total of $3760 in higher interest expenses.

Interest Rate Impacts on the Aggregate Economy

The real impact of interest rate hikes to individuals isn't fully apparent until those individual impacts are added together into a macroeconomic view. The math here isn't any more difficult. For consumers carrying $15,788 on revolving credit cards, any increase in interest expense is likely going to diminish net spending on new goods and services. If they HAD the money to pay off the balances before while still spending more money, the balances wouldn't be there. To determine the total amount of extra interest spent by consumers for this one percent increase in interest rates, the math is:

   total extra interest = (# households carrying balances) x (per household increase)

The number of households actually carrying a credit card balance can be reverse engineered from the total credit card debt statistic and the average carrying balance:

   # HH with balance = (total CC debt) / (average carrying balance)
= $799,758,370,000 / $15,788 = 50,656,091

The total extra interest paid by these households would then be:

   total extra interest = 50,656,091 x $158 = $7,997,583,700 yearly

Determining the total extra interest paid on adjustable rate mortgages from our one percent increase in interest rates takes a bit more doing. The total number of current adjustable rate mortgages isn't directly reported in any easy-to-find sources. However, the Federal Reserve DOES provide statistics on mortgage originations by fixed / adjustable terms and that mix has changed from 40% ARMs in 2007 to only 10% in June 2011. Borrowers who still qualify have grown wary of ARMs and the most aggressive lending practices built upon ARMs have been abandoned by most mortgage lenders. The number clearly isn't 40% but it clearly isn't 10% either. Why?

First, a huge percentage of ARMS originated between 2005 and 2008 likely involve homes whose value has dropped between 10-20 percent. Since the vast majority of those with ARMs paid little down on homes now worth 10-20 percent less, they have no equity. Second, the fact that many were "marginally eligible" borrowers to begin with means virtually none have assets that would allow them to put down a 10-20 percent down payment to re-qualify for a fixed rate mortgage.

Due to these factors, a conservative estimate of current adjustable rate mortgages could be SWAGed at 25%. From that, we can calculate an estimate of the total additional mortgage interest expense produced by a one percent increase in rates as:

   total increase = (# mortgages) x (ARM share) x (interest increase)
= 62,320,129 x 25% x $1813 = $28,244,382,500

Wow. That's a big number. Add all of the aggregate interest payment increases together and you get:

    federal interest increase        $58,215,323,996
credit card interest increase $ 7,997,583,700
mortgage interest increase $28,244,382,500
TOTAL interest increase $94,457,290,196

Consider what that number means. It means for each one percent increase in interest rates, the US economy faces an additional $94.5 billion dollar drag on economic activity that goes to big banks that aren't lending to jump start the economy and to Treasury holders, many of which are outside the US. This is for a SINGLE PERCENTAGE POINT increase in short term interest rates. The current 1-year rate on Treasuries is an absurdly low 0.2 percent. Over time, a rate between 3 and 7 percent is much more typical.

Political Conclusions

A quick review of various debt reduction plans is enlightening but -- as will become evident shortly -- also infuriating. The April 2011 Obama plan called for $2.5 trillion in spending reductions over twelve years -- averaging $208 billion in yearly spending reductions -- and roughly $1.5 trillion in additional tax revenue. The Boehner plan that died on July 29, 2011 after reaching the Senate called for $1.2 trillion in spending reductions over ten years, averaging $120 billion per year in spending reductions with no additional revenue. The Reid plan still gasping for air calls for $2.2 over ten years averaging $220 billion in yearly spending reductions.

Of course, no one really mentions that NONE of these plans actually BALANCE a yearly budget to STOP ADDING to the cumulative debt. If the purpose of all of this posturing is to calm world credit markets to allow deficit spending to continue while we work on the REAL strategy, how likely are any of these plans to provide that confidence? The prior analysis estimated the yearly hit in additional interest expense on EXISTING debt as $58.2 billion for EACH PERCENT INCREASE in interest rates. If interest rates return to historical norms, interest expense for the Federal government will jump nearly $240 billion, completely wiping out any "spending reductions" claimed by any of these plans.

That impact doesn't even factor in the drag on the larger economy due to interest expenses incurred by consumers. At a time when overall economic growth as measured by GDP has already slowed to 1.3% for the second quarter of 2011, the extra $36.2 billion in credit card and mortgage interest paid by consumers will shrink retail sales by an amount equal to 0.24% of GDP at a time when every tenth of a percent in growth is CRUCIAL to supporting jobs and tax revenue. It can be argued that this $36.2 billion still counts as part of GDP since it is income to banks but given their reluctance to lend, much of this money essentially "dead ends" in the system and doesn't support growth.

In short, none of the interim solutions proposed by any of the parties so far materially move the country towards a long term trajectory that balances expenses and revenues, much less helps pay off actual debt. The question then becomes WHY ON EARTH would our politicians then risk spooking credit markets in the short term playing chicken with the debt ceiling when the downside of any panic in the market is so obvious? The answer is that our political process is selecting politicians who accurately reflect the ignorance of those doing the voting.

Conclusions for Individual Americans

The fatal ignorance of America's politicians and voters can be demonstrated by posing a single question:

You are an average American. Your household has the average American income of $50,000 dollars. Your household has an average size mortgage of $181,000. You are faced with the choice between:

A) a one percent increase in your average tax rate
B) a one percent increase in the interest rate on your mortgage

Quick! Which would you prefer? ____

If you're the average Tea Party supporting taxpayer, you reflexively answered (B) because you don't want more money going to the government. If you're the average Republican politician at the federal or state level, you reflexively answered (B) as well because your party has captured a predictable portion of the overall electorate who vote (B) allowing you to protect your corporate special interests who benefit disproportionately from those tax policies. In reality, (A) costs you well south of $500 while (B) costs you $1,810.

Just to reinforce the point, here's another test:

You are a typical American. Your household has an income of $80,000 dollars. Your household owns an home worth $235,000. Your current state has an income tax rate of 6%. Your CEO has decided to move your company to a state with zero state income tax. Whoopee! He or she makes $6 million yearly and will buy a house worth $2.35 million. You are faced with the following choices:

A) finding a job with identical pay and staying put
B) moving, buying an identical home and enjoying the zero state income tax rate in your new home

Quick! Which would you prefer? ____

This is a trick question. To find the right answer, you need two additional pieces of information -- the property tax rates in your current state and the new state. Let's assume the current tax rate is 2.5% and the new state's property tax rate is 5%.

For you, your state income tax savings won't be any larger than $4800 dollars. (6% of an $80,000 "nut") but your property tax bill will jump 2.5% on a $235,000 "nut" or $5875 dollars. At best, you lose $1075 by moving. Let's see how your CEO fares with the relocation. They save 6% on their $6 million salary "nut" -- $360,000 -- and their property tax bill jumps 2.5% on a mere $2.35 million "nut -- $58,750 -- saving them a net of $301,250. It's good to be the king, isn't it?

If you chose (B) for either question, you're an idiot, plain and simple. Like all things in finance, choosing the right strategy involves understanding the percentages working for and against you and the size of the "nut" to which those percentages are applied. Forget either one of these factors and you will eventually find you've lost a good portion of your "nut" to players who CAN keep them straight in their head.

The real conclusion from all of this analysis is that we are headed towards major problems. Choosing the right solutions or weeding out the bad solutions only requires the simplest of algebra to solve for a few unknowns. Our leaders instead focus on distracting voters from reality using arguments and statistics that amount to first and second order derivatives in calculus (percentage changes of percentage figures of growth or reductions, etc.). This approach will continue to succeed at draining our economy and enriching the few as long as the majority of voters fail to master even simple arithmetic. At least until we bankrupt the country. When we reach the point that we cannot assure soldiers under fire in a war their paychecks will be issued and Apple Computer has more cash on hand than the Treasury of a country that owns aircraft carriers and nuclear warheads, it's pretty easy to argue we're already there.


1) budget -- http://www.gpoaccess.gov/usbudget/fy11/index.html

2) debt / tax payers / households -- http://www.usdebtclock.org/

3) residential mortgage debt -- http://www.federalreserve.gov/econresdata/releases/mortoutstand/current.htm

4) Treasury Rates -- http://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yield

5) credit card statistics -- http://www.creditcards.com/credit-card-news/credit-card-industry-facts-personal-debt-statistics-1276.php

6) home rent / own stats -- http://www.census.gov/compendia/statab/cats/construction_housing.html