President Obama has returned to Washington, D. C. We are told that he plans upon his return to focus on domestic economic issues.
The president has had two weeks that have not necessarily been the best of his administration. The mid-term election did not go the way he wanted and his sojourn into the international waters of the East did not go swimmingly.
Now, where is he going to go on the economic front?
His economic team is crumbling before his eyes and Ben and Tim are not getting the best critical reviews.
The economic news is not exactly what he would like to hear. It seems as if the results the economy is posting are exactly the opposite of what he has tried to do.
The front page of the Wall Street Journal trumpets: “Paychecks for CEOs Climb”. Here are the opening words:
“The chief executives of the largest U.S. public companies enjoyed bigger paydays in their latest fiscal year, as share prices recovered and profits soared amid the country's slow emergence from recession.
At these 456 companies, the median pretax value of CEO salaries, bonuses and long-term incentives, such as grants of stock and stock options, rose by 3% to $7.23 million, according to an analysis of their latest proxy filings for The Wall Street Journal by consulting firm Hay Group.
The Journal usually tracks executive compensation each spring. To provide a fuller post-recession picture, it followed up this year by analyzing pretax CEO pay at every U.S. public company with at least $4 billion in annual revenue that filed proxy statements between Oct. 1, 2009, and Sept. 30, 2010.
The results differ markedly from the April analysis, which covered 200 such companies and found median total direct compensation had dropped 0.9%.” (http://professional.wsj.com/article/SB10001424052748704756804575608434290068118.html?mod=wsjproe_hps_MIDDLESecondNews.)
The largest companies in the United States and their chief executives seem to be doing just fine, thank you. Plus, these companies are able to raise debt at record low interest rates and they seem to be piling up cash as fast as they can.
Recent headlines also reported that the income distribution in the United States again has moved more and more toward the wealthier end of the spectrum.
And, what do the policymakers and economists supporting the administration recommend? More spending because the administration has been too timid. More liquidity for the financial markets because we are in a liquidity trap.
Will this continue to be the economic policy of the Obama administration going forward?
I see no indication that it’s economic policy will change. And, if this is the case then this environment should drive investment decisions going forward.
The foundation of these investment decisions, I believe, is that the “largest U. S. public companies” will continue to prosper. The economic policies being proposed have little or nothing to do with resolving the underlying economic imbalances that exist in the United States and that is why the recovery, as it continues, will be skewed toward the larger companies.
Of course, not all of the largest U. S. public companies are going to thrive, but I believe that this is where a lot of the action will be. The action will be in the following companies: companies that will be bought by the large companies building up the large piles of cash; the companies that are engaged in “bubble” assets like commodities, emerging market financial instruments, and bond markets; and a select few companies that are doing the buying of the smaller companies.
I don’t immediately like companies that are doing the acquiring because mergers and acquisitions don’t always work out. In fact, my research indicates that at least two-thirds of the corporate combinations don’t work out. First off, those that move earlier tend to fare better because the acquisition prices don’t get inflated until the merger frenzy progresses: followers get killed. Second, I don’t trust a lot of executives in making mergers work. So many get caught up in “ego” problems that they either overpay for the target or move to make mergers without the culture or the expertise to pull off the acquisitions.
This makes the potential targets for takeover extremely attractive. Why? Because the targets in this instance will be those companies that are not performing well due to the recession and the tepid recovery and the price of their stocks will be relatively low with few prospects, except for being acquired, for they are still basically struggling companies.
To me the pieces are in place for a substantial consolidation of companies in the United States. The largest companies have cash and will have the ability to garner much more as they need it. Note: this just came across the net: Caterpillar Strikes $7.6 Billion Deal for Bucyrus. Caterpillar is offering $92 a share in cash for Bucyrus, a 32 percent premium, as the heavy equipment colossus makes a big push into mining equipment.
Alright!
The executives of these companies stand to make lots and lots of money by making their companies bigger, whether or not they make them bigger successfully. Given the information presented above, this seems to have already started. Continuing the government’s existing
economic policy will see this environment lasting for quite some time.
Companies dealing in “bubble” assets can obviously benefit from “going to the dance.” The downside is “staying too long at the dance.” But, the Treasury and the Fed have signaled that their current policies will continue for “an extended time.” Let the music play on.
The results of this? The income distribution will continue to skew toward the wealthy end. Big businesses will get bigger. Small businesses will do alright, but they will be on the periphery not at the center and will be devoted more to upper income tastes. Employment will continue to be weak because mergers and acquisitions tend to result in layoffs and a shrinking workforce rather than an increasing one. Capital investment will not be too lively because mergers and acquisitions, at first, result in the scrapping of old physical plant and equipment and not the expansion of it.
Basically, the scenario I have described translates in the following way: the stimulus is going to be paper, and, therefore, the profits and wealth that are going to be created are going to be primarily paper.
Money will be made in this environment…lots of it! Just don’t remain too long at the dance!
Showing posts with label cash. Show all posts
Showing posts with label cash. Show all posts
Monday, November 15, 2010
Sunday, August 22, 2010
Dynamic Portfolio Management and the Buildup of Cash
I am responding to a comment I received about one of my recent posts. The post related to the buildup of cash on the balance sheets of large commercial banks, large non-financial companies, and investment funds. The comment was:
“This giant 'pile of cash' is a myth. Check the other side of the balance sheet and you will see even more debt.”
In this post I will present the situation as I see it. I will use some of the concepts and arguments presented in the book “Financial Darwinism” by Leo Tilman which I just reviewed for Seeking Alpha. (http://seekingalpha.com/article/221607-making-money-in-the-21st-century-financial-darwinism-create-value-or-self-destruct-in-a-world-of-risk-by-leo-tilman)
To begin with I argue that the managements of the large organizations mentioned in the first paragraph have adapted to the new world in which finance is looked on as a dynamic exercise rather than the static one that existed in the “Golden Age” of banking. In the dynamic world of finance, senior managements are constantly assessing and re-assessing the economic environment and adjusting their tactics and risk-taking strategies to match the financial environment as it changes due to variations in economic policy on the part of governments or economic shocks that can alter the trajectory of the business cycle.
About twenty months ago, the Federal Reserve decided that it needed to establish its target rate of interest in a range between zero and twenty-five basis points. And, the Fed decided that it needed to re-enforce this strategy by adding that it would continue to maintain this target range for “an extended time.” That was twenty months ago.
At the time, the yield on the ten-year Treasury bond was around 3.5%
Looking at this situation, senior managements could see that the financial terrain had changed. There was a real opportunity in the “carry trade” where they could borrow in the commercial paper market or in some other short term market for around 50 basis points and then buy Treasury securities that would yield them 350 basis points.
This meant that senior management could change its incremental business strategy, given the new circumstances, and earn a net spread of 300 basis points, RISK FREE. There was no credit risk because they would be investing in Treasury securities. And, there would be no interest rate risk because the Federal Reserve had promised that their interest rate policy would stay in effect for an “extended time.”
Tilman, in his book, refers to this kind of activity as “Balance Sheet Arbitrage” which is defined as “the ability of an institution to borrow at submarket levels.” This used to be the primary business of banks in the static world of banking, but had become less important in recent years as financial markets have changed and financial institutions have become more “intertwined.”
Certainly, however, there was an opportunity for senior managements to benefit from “Balance Sheet Arbitrage” within this new dynamic environment created by the monetary policy of the Federal Reserve. This was not a permanent change because the policy would only stay in effect for an “extended time”. Once the Fed allowed short term interest rates to rise again, interest rate risk would become a problem once again and the senior managements would have to re-assess and re-adjust their tactics in response to this changing environment.
While this Federal Reserve policy remained in place, commercial banks could do the following. On the liability side of its balance sheet, a bank could issue $1.0 billion in short term debt. The bank would then take the $1.0 billion and invest in 10-year Treasury securities. This investment, if my calculations are correct, would provide the bank with $30.0 million in profits, given the 300 basis point spread they could earn. The marginal costs of such a transaction would be miniscule so that we can basically ignore these expenses. But, now the bank has $30.0 million in “cash” which is covered on the other side of the balance sheet by an increase in net worth.
Instead of doing this the bank could write off $20.0 million in bad loans which would be taken against net worth, but the $30.0 in cash would still remain on the balance sheet. The $20.0 million write-off would not only improve the balance sheet of the bank but it would also reduce the taxes the bank would have to pay. This whole transaction would result in the bank earning a one percent return on its assets after taxes, something that most banks would not object to.
The ”giant pile of cash”, however, is not a myth. You can look on the other side of the balance sheet and “you will see even more debt.” However, in the “carry trade” you have investments that match up with this debt. This is how the “carry trade” works. The cash is “real”!
The important thing here, as Tilman argues, is that senior managements must change their strategies once the environment changes. The investments that resulted from the activity describe above were not obtained to “buy and hold” as banks did in the static world of banking. Once the environment changes, senior management must change as well.
What are we looking for here? We are looking for any indication that the Fed is going to change its monetary stance and allow short term interest rates to rise. Rising short term interest rates will also result in rising long term interest rates but the long term rates will generally not rise as rapidly as will the short term interest rates. The spread on the “carry” will lessen and could even turn negative. Senior managements will not want to continue this investment activity given a shift in the monetary policy of the Federal Reserve.
One other point that Tilman makes that I should mention. In such an environment where senior managements continually re-assess and re-position their organizations, “mark-to-market” or fair market accounting is a must. In the static world of finance where institutions bought and held investments, mark-to-market accounting was not as much of an issue as it is in the modern, dynamic world of finance.
In using the “carry trade” within the current policy regime of the Federal Reserve, these large organizations are taking advantage of the opportunities that exist within the “real time” financial markets. When the policy situation changes, they, too, must change their efforts: and this will mean selling off the assets.
If these organizations insist in accounting for these assets at purchase price they are deceiving themselves and deceiving their stakeholders. The risk that the Federal Reserve will change its policy stance exists. The senior managements of these organizations must accept the reality of this risk and reflect this in the changing market value of its assets. There is no way they can justify maintaining the accounting value of the assets as if they were in a “buy and hold” mode.
Furthermore, in a dynamic environment where the senior managements of banks are constantly re-assessing and re-adjusting their portfolios it is very difficult to justify some portion as assets that have been obtained to hold to maturity. This is another fall-out of moving to the dynamic world of finance. The lines between categories blur and it becomes harder and harder to make distinctions between what is something and what is something else. Since environments change, assets that were “honestly” purchased to hold to maturity may have to be sold. The risk of selling assets at a loss must be recognized by banks and presented to stakeholders in mark-to-market accounting.
Conclusion: large quantities of cash have been amassed on the balance sheets of big banks, big non-financial organizations, and big investment funds. This build up is not a “myth”. The buildup of cash has been subsidized by Mr. Bernanke and the Federal Reserve System. If would seem as if these large organizations owe Mr. Bernanke a big “thank you” for all he has done for them.
“This giant 'pile of cash' is a myth. Check the other side of the balance sheet and you will see even more debt.”
In this post I will present the situation as I see it. I will use some of the concepts and arguments presented in the book “Financial Darwinism” by Leo Tilman which I just reviewed for Seeking Alpha. (http://seekingalpha.com/article/221607-making-money-in-the-21st-century-financial-darwinism-create-value-or-self-destruct-in-a-world-of-risk-by-leo-tilman)
To begin with I argue that the managements of the large organizations mentioned in the first paragraph have adapted to the new world in which finance is looked on as a dynamic exercise rather than the static one that existed in the “Golden Age” of banking. In the dynamic world of finance, senior managements are constantly assessing and re-assessing the economic environment and adjusting their tactics and risk-taking strategies to match the financial environment as it changes due to variations in economic policy on the part of governments or economic shocks that can alter the trajectory of the business cycle.
About twenty months ago, the Federal Reserve decided that it needed to establish its target rate of interest in a range between zero and twenty-five basis points. And, the Fed decided that it needed to re-enforce this strategy by adding that it would continue to maintain this target range for “an extended time.” That was twenty months ago.
At the time, the yield on the ten-year Treasury bond was around 3.5%
Looking at this situation, senior managements could see that the financial terrain had changed. There was a real opportunity in the “carry trade” where they could borrow in the commercial paper market or in some other short term market for around 50 basis points and then buy Treasury securities that would yield them 350 basis points.
This meant that senior management could change its incremental business strategy, given the new circumstances, and earn a net spread of 300 basis points, RISK FREE. There was no credit risk because they would be investing in Treasury securities. And, there would be no interest rate risk because the Federal Reserve had promised that their interest rate policy would stay in effect for an “extended time.”
Tilman, in his book, refers to this kind of activity as “Balance Sheet Arbitrage” which is defined as “the ability of an institution to borrow at submarket levels.” This used to be the primary business of banks in the static world of banking, but had become less important in recent years as financial markets have changed and financial institutions have become more “intertwined.”
Certainly, however, there was an opportunity for senior managements to benefit from “Balance Sheet Arbitrage” within this new dynamic environment created by the monetary policy of the Federal Reserve. This was not a permanent change because the policy would only stay in effect for an “extended time”. Once the Fed allowed short term interest rates to rise again, interest rate risk would become a problem once again and the senior managements would have to re-assess and re-adjust their tactics in response to this changing environment.
While this Federal Reserve policy remained in place, commercial banks could do the following. On the liability side of its balance sheet, a bank could issue $1.0 billion in short term debt. The bank would then take the $1.0 billion and invest in 10-year Treasury securities. This investment, if my calculations are correct, would provide the bank with $30.0 million in profits, given the 300 basis point spread they could earn. The marginal costs of such a transaction would be miniscule so that we can basically ignore these expenses. But, now the bank has $30.0 million in “cash” which is covered on the other side of the balance sheet by an increase in net worth.
Instead of doing this the bank could write off $20.0 million in bad loans which would be taken against net worth, but the $30.0 in cash would still remain on the balance sheet. The $20.0 million write-off would not only improve the balance sheet of the bank but it would also reduce the taxes the bank would have to pay. This whole transaction would result in the bank earning a one percent return on its assets after taxes, something that most banks would not object to.
The ”giant pile of cash”, however, is not a myth. You can look on the other side of the balance sheet and “you will see even more debt.” However, in the “carry trade” you have investments that match up with this debt. This is how the “carry trade” works. The cash is “real”!
The important thing here, as Tilman argues, is that senior managements must change their strategies once the environment changes. The investments that resulted from the activity describe above were not obtained to “buy and hold” as banks did in the static world of banking. Once the environment changes, senior management must change as well.
What are we looking for here? We are looking for any indication that the Fed is going to change its monetary stance and allow short term interest rates to rise. Rising short term interest rates will also result in rising long term interest rates but the long term rates will generally not rise as rapidly as will the short term interest rates. The spread on the “carry” will lessen and could even turn negative. Senior managements will not want to continue this investment activity given a shift in the monetary policy of the Federal Reserve.
One other point that Tilman makes that I should mention. In such an environment where senior managements continually re-assess and re-position their organizations, “mark-to-market” or fair market accounting is a must. In the static world of finance where institutions bought and held investments, mark-to-market accounting was not as much of an issue as it is in the modern, dynamic world of finance.
In using the “carry trade” within the current policy regime of the Federal Reserve, these large organizations are taking advantage of the opportunities that exist within the “real time” financial markets. When the policy situation changes, they, too, must change their efforts: and this will mean selling off the assets.
If these organizations insist in accounting for these assets at purchase price they are deceiving themselves and deceiving their stakeholders. The risk that the Federal Reserve will change its policy stance exists. The senior managements of these organizations must accept the reality of this risk and reflect this in the changing market value of its assets. There is no way they can justify maintaining the accounting value of the assets as if they were in a “buy and hold” mode.
Furthermore, in a dynamic environment where the senior managements of banks are constantly re-assessing and re-adjusting their portfolios it is very difficult to justify some portion as assets that have been obtained to hold to maturity. This is another fall-out of moving to the dynamic world of finance. The lines between categories blur and it becomes harder and harder to make distinctions between what is something and what is something else. Since environments change, assets that were “honestly” purchased to hold to maturity may have to be sold. The risk of selling assets at a loss must be recognized by banks and presented to stakeholders in mark-to-market accounting.
Conclusion: large quantities of cash have been amassed on the balance sheets of big banks, big non-financial organizations, and big investment funds. This build up is not a “myth”. The buildup of cash has been subsidized by Mr. Bernanke and the Federal Reserve System. If would seem as if these large organizations owe Mr. Bernanke a big “thank you” for all he has done for them.
Friday, August 20, 2010
Is the Dam Starting to Break?
Over the past six months or so, I have commented on the buildup of cash at many of the major banks and manufacturing firms in the United States. My bet has been that at some point in the future, these cash hoards would be used by the large, healthy organizations amassing them to buy up other firms in a period of consolidation that would rival any other in United States history.
The growth of these cash hoards has been subsidized by the Federal Reserve System as it has kept its target interest rate near zero for twenty months and promises to continue to do so for an “extended time.” This has allowed large banks, non-bank companies, and investment funds to engage in the “carry trade”, regain their health and profitability, and build up their cash positions to historic levels. In so doing the Fed has underwritten a bubble in the bond market. (http://seekingalpha.com/article/221151-a-bubble-in-the-bond-market)
Behind this policy stance is the concern of the Federal Reserve for the solvency of large numbers of smaller commercial banks. On May 20, 2010, the FDIC claimed that there were 775 banks on its list of problem banks as of March 31, 2010. (The new list should be out any day.) As of last Friday, the FDIC had seen 110 banks close this year a rate of about 3.5 banks per week. Elizabeth Warren has stated in front of Congress that around 3,000 smaller banks face serious problems in the near future, especially in terms of commercial real estate. (http://seekingalpha.com/article/215958-elizabeth-warren-on-the-troubled-smaller-banks) For the problems of these smaller banks to be worked out in an orderly fashion, the Federal Reserve needs to keep interest very low well into 2011.
The consequence of this policy has been a bifurcation of American finance…and American industry. The bigger and better off companies have profited from the extraordinarily low borrowing costs and the promise that the huge, risk-free spreads that could be earned in the bond market would not go away soon. The smaller and less-well-off companies just held on, hoping that they would survive.
So, the bigger and better off companies built up their cash pools. The banks didn’t use the funds to make loans. The non-financial firms didn’t spend them to invest in new plant and equipment. The investment funds kept the perpetual money machines going. The question was, when would these organizations use these cash pools to begin the consolidation frenzy?
Now the Friday newspapers are full of the “deals” that have taken place this week. BHP has a $40 billion offer on the table for Potash Corporation. Intel is spending almost $8 billion for McAfee. Rank group has put out about $5 billion to acquire Pactiv and Dell has obtained 3PAR for a little over $1 billion.
And, in the banking area, First Niagara has paid $1.5 billion to acquire NewAlliance Bancshares. This latter deal seems to be particularly significant because both financial organizations are healthy. There have been many bank acquisitions over the past several years in which only one of the combining institutions have been healthy, but none where both have been in good shape.
This move by First Niagara is seen as something new in the current environment from both the company side, but also from the regulatory side. Regulators have been so pre-occupied in the past several years with problems in the banking space that little time has been available to give any attention to healthy combinations, if they existed. The announcement of this deal raises the question about whether or not more regulatory time will be given to healthy deals in the near future.
Bottom line: the cash is around in the coffers of many banks and non-financial companies. These organizations do not seem to be intent upon using these funds in a way that will speed up the economic recovery. The strategy seems to be to take part in a substantial consolidation and re-structuring of American finance and industry. The companies I would focus on at this time are those that are profitable, that have a large accumulation of cash, and that have the management team and will to lead this effort. As we saw in the buyout mania that took place in the late 1970s and 1980s, the best performers were the ones that moved first before higher and higher premiums were required to pull off deals. I believe that this will be the case in the present situation. Who said that the world was worried about companies that were “too big to fail”? They ain’t seen nothin’ yet!
The growth of these cash hoards has been subsidized by the Federal Reserve System as it has kept its target interest rate near zero for twenty months and promises to continue to do so for an “extended time.” This has allowed large banks, non-bank companies, and investment funds to engage in the “carry trade”, regain their health and profitability, and build up their cash positions to historic levels. In so doing the Fed has underwritten a bubble in the bond market. (http://seekingalpha.com/article/221151-a-bubble-in-the-bond-market)
Behind this policy stance is the concern of the Federal Reserve for the solvency of large numbers of smaller commercial banks. On May 20, 2010, the FDIC claimed that there were 775 banks on its list of problem banks as of March 31, 2010. (The new list should be out any day.) As of last Friday, the FDIC had seen 110 banks close this year a rate of about 3.5 banks per week. Elizabeth Warren has stated in front of Congress that around 3,000 smaller banks face serious problems in the near future, especially in terms of commercial real estate. (http://seekingalpha.com/article/215958-elizabeth-warren-on-the-troubled-smaller-banks) For the problems of these smaller banks to be worked out in an orderly fashion, the Federal Reserve needs to keep interest very low well into 2011.
The consequence of this policy has been a bifurcation of American finance…and American industry. The bigger and better off companies have profited from the extraordinarily low borrowing costs and the promise that the huge, risk-free spreads that could be earned in the bond market would not go away soon. The smaller and less-well-off companies just held on, hoping that they would survive.
So, the bigger and better off companies built up their cash pools. The banks didn’t use the funds to make loans. The non-financial firms didn’t spend them to invest in new plant and equipment. The investment funds kept the perpetual money machines going. The question was, when would these organizations use these cash pools to begin the consolidation frenzy?
Now the Friday newspapers are full of the “deals” that have taken place this week. BHP has a $40 billion offer on the table for Potash Corporation. Intel is spending almost $8 billion for McAfee. Rank group has put out about $5 billion to acquire Pactiv and Dell has obtained 3PAR for a little over $1 billion.
And, in the banking area, First Niagara has paid $1.5 billion to acquire NewAlliance Bancshares. This latter deal seems to be particularly significant because both financial organizations are healthy. There have been many bank acquisitions over the past several years in which only one of the combining institutions have been healthy, but none where both have been in good shape.
This move by First Niagara is seen as something new in the current environment from both the company side, but also from the regulatory side. Regulators have been so pre-occupied in the past several years with problems in the banking space that little time has been available to give any attention to healthy combinations, if they existed. The announcement of this deal raises the question about whether or not more regulatory time will be given to healthy deals in the near future.
Bottom line: the cash is around in the coffers of many banks and non-financial companies. These organizations do not seem to be intent upon using these funds in a way that will speed up the economic recovery. The strategy seems to be to take part in a substantial consolidation and re-structuring of American finance and industry. The companies I would focus on at this time are those that are profitable, that have a large accumulation of cash, and that have the management team and will to lead this effort. As we saw in the buyout mania that took place in the late 1970s and 1980s, the best performers were the ones that moved first before higher and higher premiums were required to pull off deals. I believe that this will be the case in the present situation. Who said that the world was worried about companies that were “too big to fail”? They ain’t seen nothin’ yet!
Monday, July 26, 2010
Where Economic Success is Going to Come From
One piece of economic information that I have focused on over the past 18 months has been the Federal Reserve’s figures on capacity utilization of the industrial sector of the United States.
The story that can be read from this information is that capacity utilization in the United States has fallen from the middle of the 1960s to the present time. In 1967 when the data series was started, capacity utilization was about 90%. Over the past fifty years, every cyclical peak of capacity utilization has been lower than the previous one. In the 1990s, capacity utilization reached a peak of around 85% while in the middle 2000s the peak dropped to 82%.
Currently, although capacity utilization has risen above its recent cyclical trough of about 68%, it is still languishing around 74%. One should note that as cyclical peaks during this period have been at lower and lower values, cyclical bottoms have also been at lower and lower values.
The conclusion one can draw from this is that United States industry does not seem to be “tooled-up” for the right output.
If the United States is going through a major secular restructuring both economically and financially, as some of us believe that it is, then United States industry will be restructured so as to shed some of this excess capacity.
There are many indications that such restructuring is taking place and will continue to take place over the next few years. This, of course, will mean that the economy will not recover real quickly which will mean that it will take just that much longer to resolve the “under-employment” problem.
The evidence of this restructuring can be observed in places like the front page article in the New York Times, “Industries Find Surging Profits in Deeper Cuts”: See http://www.nytimes.com/2010/07/26/business/economy/26earnings.html?_r=1&hp. The gist of the article is that companies are producing very good profits, not through revenue growth, but through the reductions in their cost structure, predominately through cuts in labor costs.
Of course, the real “economies of scale” in this effort are found in the larger companies. Smaller companies can reduce labor costs but they don’t have anywhere near the impact that large companies achieve when they go through a major restructuring.
Rod Lache, of Deutsche Bank: “These companies cracked the code of a successful turnaround. They’re shrinking the business to a size that’s defendable and growing off a lower base.”
Over the past fifty years industry did not downsize in this way because success seemed to come from “hoarding” labor and getting the company positioned for the next surge in sales revenue. This attitude was re-enforced by the federal government that underwrote the “nest surge” in consumer spending through fiscal stimulus programs created through deficit spending and the expansion of the money stock.
The “artificial” underwriting of economic growth by federal government largesse can only go so far. Throughout this period, the question that always lurked in the background concerned the burden of the debt being created, both private and public debt, and the economic mismatch that was being created between where the country should be technologically and where it was both in terms of physical and human capital. The growth in labor under-employment and the decline in capacity utilization over this time pointed to the fact that at some time an economic and financial restructuring would have to take place.
And how are these companies that are doing so well using their profits? They are building up their cash reserves. Jamie Dimon at JPMorgan Chase has indicated that it is not time to pay these profits out in dividends. There are just too many uncertainties present in today’s economy…and there are just too many other possible ways to use the funds in the future. Many other CEOs agree with this assessment.
The New York Times article contains a chart that shows the relationship between “Corporate Cash as a Share of Corporate Assets.” The most recent data show this relationship to be 6.1%. Guess what? One has to go back to the middle of the 1960s to find this figure at such a high level. Through most of the last fifty years the share of cash ran between 3% and 5%. This shift is huge and is taking place primarily in the larger, better positioned companies.
This same thing is happening in the commercial banking arena. The larger, more successful banks are piling up cash reserves. The smaller banks are not the ones with the profits or with the cash resources.
What does all this mean?
It means that the next few years will see a massive restructuring of industry, in manufacturing, financial services, and in other services. Reconsolidation will be in vogue, not expansion. The cash will be used for mergers and acquisitions, for rationalization of industry, for capacity reduction, and for control.
The one caution about this is that these companies cannot get too far ahead of the financial markets for investors will punish those that seem to be “jumping-the-gun”. In the Wall Street Journal we observe the warning, “Markets Say No to Expansionist Companies”: See http://professional.wsj.com/article/SB10001424052748704719104575389172070900184.html?mod=ITP_moneyandinvesting_0&mg=reno-wsj. The economy, in the near term, does not look strong. Profit performance is not seen as coming from increasing revenues, but from continued cost containment or cost reduction. Companies that appear to be moving too quickly in this environment are getting hurt by investors that believe cash should be conserved for use on another day at a different time.
Financial markets seem to want prudence now and not outright aggressive behavior.
Yet, people are getting prepared for the time when action is called for. But, the action will not be toward expansion, but toward containment. In the Financial Times we read of the return of “merger arbitrage funds”: See http://www.ft.com/cms/s/0/d74a2fa6-980c-11df-b218-00144feab49a.html. These funds attempt to profit from the spread between the price of a merger target after a deal is announced and the closing price at the completion of the deal. The funds “smell” something in the wind and they want to be ready when the time is right.
Gerard Griffin of GLG Partners’ event-driven team is quoted as saying: “Companies have built up large cash balances and the economy is not looking particularly strong, so earning growth will have to come through synergies.”
That is, consolidation will have to take place within industries reducing industry capacity and thereby increasing capacity utilization. For the time being, however, this rationalization of industry will reduce the number of jobs that are available and will also result in changing the nature of who is employed in these more technologically advanced and productive firms.
The evidence is growing that a massive restructuring of industry is taking place. This restructuring will not speed up either economic growth or the reduction of unemployment or under-employment in the near term, only over the longer term. But, the types of things managements and companies are doing are similar to what has happened at other times. However, these restructuring events are captured in the economic writings of Joseph Schumpeter, and not in the economic writings of John Maynard Keynes.
The story that can be read from this information is that capacity utilization in the United States has fallen from the middle of the 1960s to the present time. In 1967 when the data series was started, capacity utilization was about 90%. Over the past fifty years, every cyclical peak of capacity utilization has been lower than the previous one. In the 1990s, capacity utilization reached a peak of around 85% while in the middle 2000s the peak dropped to 82%.
Currently, although capacity utilization has risen above its recent cyclical trough of about 68%, it is still languishing around 74%. One should note that as cyclical peaks during this period have been at lower and lower values, cyclical bottoms have also been at lower and lower values.
The conclusion one can draw from this is that United States industry does not seem to be “tooled-up” for the right output.
If the United States is going through a major secular restructuring both economically and financially, as some of us believe that it is, then United States industry will be restructured so as to shed some of this excess capacity.
There are many indications that such restructuring is taking place and will continue to take place over the next few years. This, of course, will mean that the economy will not recover real quickly which will mean that it will take just that much longer to resolve the “under-employment” problem.
The evidence of this restructuring can be observed in places like the front page article in the New York Times, “Industries Find Surging Profits in Deeper Cuts”: See http://www.nytimes.com/2010/07/26/business/economy/26earnings.html?_r=1&hp. The gist of the article is that companies are producing very good profits, not through revenue growth, but through the reductions in their cost structure, predominately through cuts in labor costs.
Of course, the real “economies of scale” in this effort are found in the larger companies. Smaller companies can reduce labor costs but they don’t have anywhere near the impact that large companies achieve when they go through a major restructuring.
Rod Lache, of Deutsche Bank: “These companies cracked the code of a successful turnaround. They’re shrinking the business to a size that’s defendable and growing off a lower base.”
Over the past fifty years industry did not downsize in this way because success seemed to come from “hoarding” labor and getting the company positioned for the next surge in sales revenue. This attitude was re-enforced by the federal government that underwrote the “nest surge” in consumer spending through fiscal stimulus programs created through deficit spending and the expansion of the money stock.
The “artificial” underwriting of economic growth by federal government largesse can only go so far. Throughout this period, the question that always lurked in the background concerned the burden of the debt being created, both private and public debt, and the economic mismatch that was being created between where the country should be technologically and where it was both in terms of physical and human capital. The growth in labor under-employment and the decline in capacity utilization over this time pointed to the fact that at some time an economic and financial restructuring would have to take place.
And how are these companies that are doing so well using their profits? They are building up their cash reserves. Jamie Dimon at JPMorgan Chase has indicated that it is not time to pay these profits out in dividends. There are just too many uncertainties present in today’s economy…and there are just too many other possible ways to use the funds in the future. Many other CEOs agree with this assessment.
The New York Times article contains a chart that shows the relationship between “Corporate Cash as a Share of Corporate Assets.” The most recent data show this relationship to be 6.1%. Guess what? One has to go back to the middle of the 1960s to find this figure at such a high level. Through most of the last fifty years the share of cash ran between 3% and 5%. This shift is huge and is taking place primarily in the larger, better positioned companies.
This same thing is happening in the commercial banking arena. The larger, more successful banks are piling up cash reserves. The smaller banks are not the ones with the profits or with the cash resources.
What does all this mean?
It means that the next few years will see a massive restructuring of industry, in manufacturing, financial services, and in other services. Reconsolidation will be in vogue, not expansion. The cash will be used for mergers and acquisitions, for rationalization of industry, for capacity reduction, and for control.
The one caution about this is that these companies cannot get too far ahead of the financial markets for investors will punish those that seem to be “jumping-the-gun”. In the Wall Street Journal we observe the warning, “Markets Say No to Expansionist Companies”: See http://professional.wsj.com/article/SB10001424052748704719104575389172070900184.html?mod=ITP_moneyandinvesting_0&mg=reno-wsj. The economy, in the near term, does not look strong. Profit performance is not seen as coming from increasing revenues, but from continued cost containment or cost reduction. Companies that appear to be moving too quickly in this environment are getting hurt by investors that believe cash should be conserved for use on another day at a different time.
Financial markets seem to want prudence now and not outright aggressive behavior.
Yet, people are getting prepared for the time when action is called for. But, the action will not be toward expansion, but toward containment. In the Financial Times we read of the return of “merger arbitrage funds”: See http://www.ft.com/cms/s/0/d74a2fa6-980c-11df-b218-00144feab49a.html. These funds attempt to profit from the spread between the price of a merger target after a deal is announced and the closing price at the completion of the deal. The funds “smell” something in the wind and they want to be ready when the time is right.
Gerard Griffin of GLG Partners’ event-driven team is quoted as saying: “Companies have built up large cash balances and the economy is not looking particularly strong, so earning growth will have to come through synergies.”
That is, consolidation will have to take place within industries reducing industry capacity and thereby increasing capacity utilization. For the time being, however, this rationalization of industry will reduce the number of jobs that are available and will also result in changing the nature of who is employed in these more technologically advanced and productive firms.
The evidence is growing that a massive restructuring of industry is taking place. This restructuring will not speed up either economic growth or the reduction of unemployment or under-employment in the near term, only over the longer term. But, the types of things managements and companies are doing are similar to what has happened at other times. However, these restructuring events are captured in the economic writings of Joseph Schumpeter, and not in the economic writings of John Maynard Keynes.
Monday, April 20, 2009
The Banking System and Bank Lending
The headlines in the Wall Street Journal shout out at us this morning, “Bank Lending Keeps Dropping” (See http://online.wsj.com/article/SB124019360346233883.html#mod=testMod.) The bank lending they are referring to is the lending at “the nation’s biggest banks”, the banks that were the biggest recipients of government money. The results: the biggest recipients of taxpayer money “made or refinanced” 23% less in new loans in February than in October, the month the Treasury kicked off the Troubled Asset Relief Program (TARP).
This is just one more piece of information that the banking system still has major problems.
This is the case even though banks are posting first quarter profits. The latest, Bank of America posted a $4.25 billion net income figure for the quarter. (See http://online.wsj.com/article/SB124021187032334351.html#mod%3DtestMod%26articleTabs%3Darticle.) But don’t get overjoyed: Apparently, excluding merger costs, Merrill Lynch contributed $3.7 billion to the posted number which included a $2.2 billion gain related to mark-to-market adjustments on certain Merrill Lynch structured notes. The results also included a $1.9 billion pretax gain on the sale of China Construction Bank shares. What does this mean? I don’t know. Who has any trust in the financial reporting of banks anymore!
What information do we have that indicates that the banks still have massive problems? Let me suggest several bits of information that add up to an exceedingly weak banking system.
First, let it be noted, again, that the Monetary Base, the aggregate money figure that is defined as all bank reserves and anything that can become bank reserves (currency in circulation) has doubled in the past year (97.5% increase year-over-year using non-seasonally adjusted data). This measure was increasing at a 2.0% annual rate in August 2008.
The in-bank component of the Monetary Base, Total Reserves in the banking system, in March, was increasing at a 1,722% annual rate (again, year-over-year using non-seasonally adjusted data). We have never seen figures like this before!
In August 2008, the annual rate of increase was -1.0. Yes that is a negative one percent year-over-year rate of increase.
And, what are the banks doing with these funds?
They are holding onto them!
Excess reserves in the banking system (non-seasonally adjusted) were right at $2.0 billion in August 2008. These are funds in the banking system that are just sitting idle on the balance sheets of banks in the banking system—not earning interest or anything. In the banking week ending April 8, 2009, excess reserves totaled $724.6 billion.
Let me put this in perspective. On September 4, 2008, the assets of the Federal Reserve System totaled about $945 billion. So, in the first week of April 2009, the banking system was keeping, in cash, a little less than the total amount of funds that the Federal Reserve had put into the banking system in the first week of September 2008!
If I look at the Federal Reserve Release H.8, I see that commercial banks in the United States, non-seasonally adjusted, had Cash Assets on their balance sheets in March of $915 billion, again quite close to Federal Reserve assets in early September. One year earlier these banks had Cash Assets of only $300 billion, so Cash Assets rose by 205% in the past year.
Now, the total banking system, in aggregate, is lending some. Total bank credit outstanding rose at an annual rate of 3.2% from March 2008 to March 2009. Within this category, Commercial and Industrial loans rose by 4.3% and real estate loans rose by 4.7%. Consumer credit rose by about 9.0%, of which credit card debt rose by 13.0%. So lending in these categories were increasing, but not by major amounts.
The interesting thing to note, security lending—Federal Funds lending and Repurchase Agreements with brokers—dropped by a third, -33.0% and Interbank loans remained basically flat. Banks reduced their lending to other financial institutions, including other banks, during this time period. Talk about risk averse.
The major story that these data tell is that commercial banks are afraid to lend, especially to their own kind. Delinquencies continue to rise, write-offs continue to rise, and banks continue to increase the provision they set aside for future charge-offs. The banks have gone back to lending only to those that don’t need to borrow, the way banking used to be. They are afraid to lend to anyone else and they are still uncertain about the value of the assets that they already have on their books.
This situation is not going to change overnight. There is not much that the Federal Reserve can do if banks won’t even lend to banks!
We see that “U. S. May Convert Banks’ Bailouts to Equity Share.” (See the New York Times article, http://www.nytimes.com/2009/04/20/business/20bailout.html?_r=1&hp.) Still the question remains, “How deep is the hole in bank balance sheets?” We cannot provide the answer to this. Ultimately, the bankers, themselves, will have to provide that answer, and my guess is that bank lending will not start to pick up again until these bankers have that answer.
This is just one more piece of information that the banking system still has major problems.
This is the case even though banks are posting first quarter profits. The latest, Bank of America posted a $4.25 billion net income figure for the quarter. (See http://online.wsj.com/article/SB124021187032334351.html#mod%3DtestMod%26articleTabs%3Darticle.) But don’t get overjoyed: Apparently, excluding merger costs, Merrill Lynch contributed $3.7 billion to the posted number which included a $2.2 billion gain related to mark-to-market adjustments on certain Merrill Lynch structured notes. The results also included a $1.9 billion pretax gain on the sale of China Construction Bank shares. What does this mean? I don’t know. Who has any trust in the financial reporting of banks anymore!
What information do we have that indicates that the banks still have massive problems? Let me suggest several bits of information that add up to an exceedingly weak banking system.
First, let it be noted, again, that the Monetary Base, the aggregate money figure that is defined as all bank reserves and anything that can become bank reserves (currency in circulation) has doubled in the past year (97.5% increase year-over-year using non-seasonally adjusted data). This measure was increasing at a 2.0% annual rate in August 2008.
The in-bank component of the Monetary Base, Total Reserves in the banking system, in March, was increasing at a 1,722% annual rate (again, year-over-year using non-seasonally adjusted data). We have never seen figures like this before!
In August 2008, the annual rate of increase was -1.0. Yes that is a negative one percent year-over-year rate of increase.
And, what are the banks doing with these funds?
They are holding onto them!
Excess reserves in the banking system (non-seasonally adjusted) were right at $2.0 billion in August 2008. These are funds in the banking system that are just sitting idle on the balance sheets of banks in the banking system—not earning interest or anything. In the banking week ending April 8, 2009, excess reserves totaled $724.6 billion.
Let me put this in perspective. On September 4, 2008, the assets of the Federal Reserve System totaled about $945 billion. So, in the first week of April 2009, the banking system was keeping, in cash, a little less than the total amount of funds that the Federal Reserve had put into the banking system in the first week of September 2008!
If I look at the Federal Reserve Release H.8, I see that commercial banks in the United States, non-seasonally adjusted, had Cash Assets on their balance sheets in March of $915 billion, again quite close to Federal Reserve assets in early September. One year earlier these banks had Cash Assets of only $300 billion, so Cash Assets rose by 205% in the past year.
Now, the total banking system, in aggregate, is lending some. Total bank credit outstanding rose at an annual rate of 3.2% from March 2008 to March 2009. Within this category, Commercial and Industrial loans rose by 4.3% and real estate loans rose by 4.7%. Consumer credit rose by about 9.0%, of which credit card debt rose by 13.0%. So lending in these categories were increasing, but not by major amounts.
The interesting thing to note, security lending—Federal Funds lending and Repurchase Agreements with brokers—dropped by a third, -33.0% and Interbank loans remained basically flat. Banks reduced their lending to other financial institutions, including other banks, during this time period. Talk about risk averse.
The major story that these data tell is that commercial banks are afraid to lend, especially to their own kind. Delinquencies continue to rise, write-offs continue to rise, and banks continue to increase the provision they set aside for future charge-offs. The banks have gone back to lending only to those that don’t need to borrow, the way banking used to be. They are afraid to lend to anyone else and they are still uncertain about the value of the assets that they already have on their books.
This situation is not going to change overnight. There is not much that the Federal Reserve can do if banks won’t even lend to banks!
We see that “U. S. May Convert Banks’ Bailouts to Equity Share.” (See the New York Times article, http://www.nytimes.com/2009/04/20/business/20bailout.html?_r=1&hp.) Still the question remains, “How deep is the hole in bank balance sheets?” We cannot provide the answer to this. Ultimately, the bankers, themselves, will have to provide that answer, and my guess is that bank lending will not start to pick up again until these bankers have that answer.
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