Real Clear Analysis 1: Gas Prices and Mortgages

In all the talk and all the panic of the last months there has been a lot of blaming, a lot of political posturing and quite a bit of fabricating… but few facts.

The basic story being told is straightforward: The system is unraveling because of bad mortgages, mostly mortgages issued to lower-income households. When bank loans go bad, bad things happen (that is the topic for another day).

But why did the mortgages go bad? Looking at the data, such as it is, the answer appears to be pretty simple, but it requires doing some math. The facts come from disparate sources and from different years, but they hang together pretty well.

There are about 60 million households in the United States that earn less than $50,000 per year. That is more than half of all households. These households generate average income of about $24,800 annually, or about $477 per week.

About 59% of households in this segment are homeowners. About 32% have a mortgage. That totals about 19 million mortgages among lower-income homeowners. The average mortgage in this segment is about $68,500. On average, there is also about $3,200 of home equity debt, resulting in total debt of $71,700 per household. In total, the 19 million households in this segment represent nearly $1.4 trillion of borrowing.

Back in 1995, Adjustable Mortgage (ARM) Rates averaged 4.1%. At that point, the payment on the average mortgage was $4,200 per year or $81 per week. $81 per week was 17% of pretax income. This is clearly a reasonable level of home debt. Of the 60 million lower-income households, about 54.5 million own a car. Those lower-income, car-owning households burned more than 51 billion gallons of fuel annually in 2001. Let’s guess that those households burn, say, 60 billion gallons per year today. That works out to 1,100 gallons of gasoline per household, or about 21 gallons per week. That is about a tank of gas per week, clearly not extreme usage.

Back in early 2005, when the dream of home ownership burned brightly, the average price of a gallon of gasoline in the United States was $1.82. 21 gallons of gas times $1.82 equals $38, or about 8% of pretax income. Together, gas and mortgage were 25% of pretax income, leaving about $350 per week for taxes, food, clothing, heat and other things.

Then came the oil shock.

By mid-2008, the price of an average gallon of gasoline had peaked at $4.10 per gallon. 21 gallons of gasoline times $4.10 equals $86 per week versus the $38 back in 2005. $86 represents 18% of pretax income for households in this segment for gasoline alone. In short, nearly $50 in higher gasoline costs per week made perhaps millions of households simply unable to meet the necessities of life and still pay the mortgage. To make things worse, ARM rates had increased to 5.5%, raising the mortgage payment to $95 per week. Gas and housing that had once cost $119 per week increased to $181, or 38% of pretax income.

Nobody comes off as a criminal in this analysis. Homeowners took on reasonable debt burdens and lenders made reasonable loans based on the economic situation at the time.

Were there excesses? Undoubtedly. Were the excesses what brought down the system? The facts would argue “no”: Gasoline prices are the root cause.

In June, just over 1.5 million mortgages had gone or were going bad and another million were falling behind. Considering the economic headwinds facing 19 million lower-income households with mortgages, we are lucky that the numbers aren’t worse. The majority still current on their mortgages had to have been cutting corners or dipping into savings to meet their payments.

By August of 2008 the old rule of thumb had been proven correct: a 10% reduction in demand has resulted in a 50% reduction in oil prices. The national average gas price of $2.35 is at 11% of pretax income for lower-income households and may be nearing an affordable level.

An extra $30 per week might even mean Christmas is on again for the children of these households, though rising unemployment may derail a recovery.

Assuming we survive, what do we take away? We must not fail to learn the lessons of 2007-2008. The danger has not passed. For Americans, reducing demand for oil – particularly imported oil – may be the preeminent strategic issue of our time.

Higher-income households hold the key. They burned 62 billion gallons of gas in 2001, perhaps 75 billion today. A strategic reduction in gasoline use by these households would be felt around the world.

Two-thirds of higher-income household gasoline usage is in cars getting fewer than 22 miles per gallon. Even a 10% increase in fuel efficiency in this segment would reduce demand by 5 billion gallons of gas annually.

Permanently lower demand for gasoline will lower prices dramatically, relieve pressure on lower-income households, deny our enemies the cash that funds their schemes against us and perhaps even allow our financial system the chance to get healthy again.