Corporate Confidence Continues to Wane

I closed my review of the 2012 prospects for mergers and acquisitions with this paragraph: “Let’s hope the boom in M&A business does take place. Let’s hope that the corporate cash and corporate borrowing do not go just to corporations buying back their own stock. Let’s hope that the unwinding and restructuring takes place because that is one prerequisite for business to get back to the capital investment activities that do drive economic growth.”

(http://seekingalpha.com/article/321037-the-outlook-for-mergers-and-acquisitions-in-2012)

However, at the end of January we see the headlines: “M&A volumes at lowest for a decade.” (http://www.ft.com/intl/cms/s/0/f23718f6-4a76-11e1-8110-00144feabdc0.html#axzz1kx2Cicvs) “Dealmaking has had its slowest start to a year for nearly a decade, as companies’ appetite for mergers and acquisitions remains suppressed by the uncertain outlook for the global economy.”

The deal volumes announced so far this year…about half the level of 2011 at this time according to S&P Capital IQ.

Additionally, we read “Hordes of hoarders,” concerning corporate cash hordes…with corporate entities holding onto well over $1.7 trillion at last count. “ (http://www.ft.com/intl/cms/s/0/4cd6cb8c-48e0-11e1-974a-00144feabdc0.html#axzz1kx2Cicvs) “At present, cash accounts for more than 6 percent of US non-financial companies.”

In one specific case, Apple has almost $100 billion in cash on its balance sheet, about level with the market value of firms like McDonalds, or ConocoPhillips, or Cisco Systems.

This pales against the cash holdings of US commercial banks who in January 2012 hold almost 13 percent of their assets in cash balances, up from 9.3 percent at the end of 2010.

I know that this is early in the year, but with everyone looking for positive signs that the economy is picking up steam we need to consider other signs as well. Furthermore, the current situation is not unlike the situation that existed at the start of last year…and the actual commitments never really came about.

The one word that seems to be on almost everyone’s lips concerning this situation is…uncertainty.

There is just so much uncertainty that exists in the world right now that people are unwilling to commit substantial resources to acquisitions…or capital investments.

Where is this uncertainty coming from?

In my mind this uncertainty exists from the lack of economic leadership in the world today.  Europe continues to dither…and so does the UK…and so does the US. 

No one seems to know where they are going…or where we are going. 

How can anyone commit in such an environment?

Who knows what economic policies are going to prevail in these areas over the next year or two…let alone the next three months?

Who knows how the people in these areas are going to react to whatever economic policies are going to be enacted by their governments?

We’ve seen how the governments have acted in the recent past…and these examples cannot give anyone much confidence.

Right now, I am concentrating on factors such as these to try and understand the state of the economy.  Business leaders may be prepared to commit in the future and certainly they have the means to borrow additional funds if they need them.

These leaders still face the following question: “Why should I commit to buy another company now when the economy could get worse and I could buy the same company for a lower price at some time in the near future?” 

Right now, the probability of this happening is still apparently large enough that it is causing these business leaders to hesitate to commit on acquisitions…or capital investment. 

I keep asking people to name one person in a position of political authority in the world that they would apply the title “leader” to…and I keep coming up with silence.

Unfortunately, I don’t believe that business leaders are going to commit resources until some sort of political leadership is forthcoming. 

I still believe that we can look at how corporations are using their “cash” as an indicator of future economic performance. 

For right now, though, the “cash” stays on the balance sheets!

The Outlook for Mergers and Acquisitions in 2012

The key issue in the area of mergers and acquisitions in 2012 is still uncertainty. There seems to be a lot of anticipation that the activity in this area could pick up during the year, but, like last year, there may be little to come of it. (http://www.ft.com/intl/cms/s/0/a29392 10-41d0-11e1-a1bf-00144feab49a.html#axzz1jqA4rKTp)

Many corporations still seem to have a “ton” of cash around.  Furthermore, the corporate bond market is flush; companies “sold $44.2 billion of both high- and low-rated corporate bonds this year, the highest on record for the time period….” Investors are “snapping up bonds…pushing the cost of borrowing for some issuers to record lows.” (http://professional.wsj.com/article/SB10001424052970203750404577171341742782200.html?mod=ITP_moneyandinvesting_3&mg=reno-secaucus-wsj)

“The yield on below-investment-grade, or ‘junk’ bonds fell to 7.93% Wednesday, the lowest since August 5 according to a Barclays Capital index.  An index for investment-grade bonds, which are of a higher credit quality, was at 3.62%.  In comparison, on Thursday the 10-year Treasury note yield rose to 1.972%.”

Funds are available. 

Corporate breakups are likely to continue or even accelerate in 2012.  Economic growth is not picking up speed.  Europe looks as if it is in another recession and this does not bode well for the rest of the west.  Companies are finding that the conglomerate structures they built up in recent are not very helpful in times like these, especially for those organizations that are suffering under the burden of too much debt. 

The western world is re-grouping from the excesses of the past ten to twenty years.  Those that still have the time to adjust are downsizing…laying off employees and discarding non-central businesses.  Those that don’t have this time are attempting to sell outright.

Those looking for deals have the ammunition to pull off these deals and they know that this is a “buyers” market with depressed valuations available.  They have the capability of being aggressive.   Whether or not they activate this aggressiveness is another question.

This is because a cloud remains over the M & A market, a cloud that kept many firms on the sidelines in 2011.  First off, a great deal of uncertainty exists with respect to the future of the economy.  Government stimulus policies, both monetary and fiscal, have not worked to any degree and it is debatable whether or not any additional actions will achieve much more.

In addition, Europe appears to be in recession right now and, given its sovereign debt crisis and the state of its banks, any recovery seems to be some way off.  It is uncertain how the situation in Europe might play out in the United States. (http://seekingalpha.com/article/317268-issue-number-1-for-2012-recession-in-europe)

Second, there is the upcoming election in the United States.  The uncertainty surrounding the policies of the American government with respect to business and finance over the past three years has been enormous…and largely uncalculable. At this time, we just don’t know how much the uncertainty in this area has retarded the recovery of American business and economic growth. 

Further uncertainties exist with respect to the impact of other actions of the federal government in areas like health care, the environment, and foreign affairs.  Some people are just learning about the expenses they are going to have to absorb with respect to Medicare, doctors fees, and health insurance.  As people learn more and more how their budgets are going to be affected, adjustments will be made to spending patterns and they won’t be up.

Third, in addition to the uncertainties created by new financial regulations and the complexity of these new regulations, there appears to be a growth in the government’s application of the anti-trust laws.  The recent treatment of the AT&T/T-Mobile merger is a case in point.  The government, ‘feeling its oats’ from this action, will probably step-up its aggressive behavior in this area, leading to even greater uncertainty relative to M&A activity.

Early in 2011, it looked as if there might be a big pickup in merger activity for the year.  Many of the same conditions we see today existed at that time.  And, what happened?

M&A activity did pick up in 2011 from previous years but we did not see the ‘big jump’ that many of us expected.  Instead of buying companies, many firms used their cash on hand or their ability to borrow at ridiculously low interest rates to buy back their stock.  This, of course, helped stock prices but it did not help the economy.

But, even a pick up in M&A activity will not do a lot to help the economy, especially in the short-run.  Buying companies outright or buying pieces of companies will initially result in efforts to achieve greater corporate efficiencies, higher levels of productivity, and will mean more reductions in employment.  This is a part of the “creative destruction” of a market economy.    

And, this should not be surprising.  The American economy has been subject to fifty years of credit inflation.  In such a time, among other things, businesses come to focus more on finance rather than production, they acquire other businesses that are not related to their core operations, and they hoard labor. 

The other side of the business structure created by credit inflation is the need to unwind and restructure what was built earlier.  That is what we face now. 

Let’s hope the boom in M&A business does take place.  Let’s hope that the corporate cash and corporate borrowing do not go just to corporations buying back their own stock.  Let’s hope that the unwinding and restructuring takes place because that is one prerequisite for business to get back to the capital investment activities that do drive economic growth. 

The Worldwide Cash Buildup In Corporations

One of the most wildly optimistic articles I have seen on the economic recovery recently appeared yesterday in the Wall Street Journal: its title, “Corporate Cash Hoards Offer Hope.” (http://professional.wsj.com/article/SB10001424052748704858404576133800157070140.html?mod=ITP_moneyandinvesting_8&mg=reno-wsj) This article begins

“Time to splash the cash? The corporate dash for liquidity that started in 2008 and accelerated in 2009 is starting to reverse. Spending on capital goods, advertising and software is rising. With consumers deleveraging and governments feeling the pinch, corporate spending is key to the recovery. And the conditions may favor acceleration.

There are certainly no capacity constraints on spending. Nonfinancial corporates globally have $4 trillion of cash, up 38% from 2007, according to Citigroup's corporate-finance advisory group. Even allowing for higher liquidity buffers in an uncertain world, some $2.4 trillion could theoretically be surplus to requirements. The profit recovery and rising revenues mean companies are throwing off free cash. Borrowing conditions look good, too: The bond markets are wide open, and banks are lending more freely.”

By-the-way, did you see that Microsoft, a company that has tons and tons of cash, issued more bonds on February 4, 2011. It raised another $2.25 billion (over $6.0 billion offered) which goes along with the $3.75 billion raised in May 2009 and the $4.75 billion was raised last fall. That is almost $11.0 billion!

Our author states that corporate spending is now going for “capital goods, advertising, and software.”

Really...

Microsoft has continually stated that the funds it raised could be used for “stock buybacks, building up working capital, or corporate acquisitions.”

People who have read my posts before know where I stand.

I believe that a large portion of this cash buildup is going to be spent on...”corporate acquisitions.”

And, the phenomenon is worldwide. The following chart accompanied the Wall Street Journal article. As we can see, the buildup in cash is not just a United States thing. And, the acquisition binge we have started on is global, not regional or national. A lot of acquisition have already taken place or are in the works. Many more are on the way. Acquisitions to take advantage of the rise in commodity prices. Acquisitions to get into new markets. Acquisitions to get into major nations. Acquisitions to build scale. And, so on.

This is a time of transition...worldwide. The emerging nations are becoming stronger relative to the developed nations. The middle east is facing major upheaval. We are transitioning from a manufacturing world based on the worker to an information world based on knowledge. Old thought patterns are changing. The way to run governments is changing. Literature is changing. Political commentary is changing. Religions are in turmoil. We communicate by twitter, chat, and text. Nothing is settled.

Information is spreading, as it always has, only the speed is accelerating and this is causing major adjustments in the way people live and do business and govern. And, it is changing the way businesses are structured and organized.

Can you imagine a non-American organization owning the New York Stock Exchange! Can you imagine a Chinese bank owning an American bank! Part of the re-structuring of the world is that the barriers are really breaking down and in a way that has never happened before. And, so on and so on.

When I discuss the subject of corporate cash I always get comments regarding the amount of corporate debt that is still outstanding with the argument that the corporate debt is just the other side of the balance sheet from the cash that is being accumulated. Therefore, the buildup is just a lot of noise.

I would argue that non-financial businesses, as well as financial businesses, are divided into those that are still overly leveraged and are not doing so well and those that are doing very well, thank you, yet are issuing debt that costs them very little, so as to build up cash treasure chests.

The question I ask those that are doing very well is, “why are you issuing debt if you are just going to buy back your stock or build up your working capital.” These companies are profitable and are generating sufficient cash to buy back their stock or build up their working capital. They don’t need to issue debt to do these things.

The companies that are not doing very well and are highly leveraged are another story. They are not generating sufficient cash flow to de-leverage or they cannot raise any cash to reduce their leverage.

The picture is simple. There are a large number of the latter firms that are not going to be able to re-structure their balance sheets in such a tepid economic recovery. These firms will eventually succumb to the need to seek buyers in order for the existing organization to have any chance in the future, even as a part of another company.

And, a lot of the cash rich companies or organizations are “off shore”…that is, these potential acquirers are not American companies; yet they are seeking to purchase American enterprises.

And, whether or not you like it, a lot of organizations are going to get a lot bigger and everything is going to become more global. The most direct way this is going to happen is through mergers and acquisitions. But, M&A will not add jobs nor will it result in faster economic growth immediately. In fact, they will do just the opposite.

Whither Economic Policy? Whither Investments?

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!

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!

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.

Commercial Banking: Still Hanging On

The commercial banking system continues to contract. Loan volumes keep falling.

Total assets in domestic commercial banks in the United States fell again over the past four weeks as the banking system continues to contract. From May 5 through June 2, total assets declined by about $105 billion while Loans and Leases dropped by $48 billion over the same period of time. This is from the H.8 release of the Federal Reserve.

In the past month, Securities held by domestically chartered banks declined by over $42 billion as Treasury and Agency securities at these institutions fell by almost $22 billion and other securities fell by $20 billion.

An interesting aside is that cash assets at foreign-related financial institutions fell by over $54 billion during this four-week period. Institutions took funds from the United States and parked them back in Europe where more liquidity was needed to weather the crisis taking place there.

Splitting this up we find that the total assets of large domestically chartered banks fell by about $86 billion whereas total assets fell at smaller banks by only $19 billion.

Driving this decline was a drop in purchased funds at the larger banks with a fall of $34 billion in borrowing from banks other than those in the United States and from a decline in net deposits due to related foreign bank offices. This would seem to mirror the turmoil taking place in Europe and indicates a reduction in the reliance in funds coming from elsewhere in the world.

Other deposits at these large domestically chartered banks rose by almost $21 billion to offset some of the decline in other sources of funds.

At the smaller banks, deposits continued to run off, declining by about $11 billion while borrowings from banks in the United States also fell, declining by over $5 billion.

Commercial and Industrial Loans (business loans) held roughly constant over the past month although they dropped by about $37 billion over the last 13-week period. Real estate loans continue to drop. They declined by almost $12 billion at the larger banking institutions and fell by over $10 billion at smaller banks. The drop over the past thirteen weeks was about $30 billion.

In addition, consumer loans dropped by over $11 billion at the larger banks over the last four weeks while they stayed roughly constant at the smaller banks.

Year-over-year total assets in the banking system dropped by $256 billion, year-over-year, from May 2009 to May 2010. Loans and leases fell by $222 during the same time period.

Commercial bank lending has declined for more than a year and shows no sign of stopping!

This, of course, is the type of situation that the economist Irving Fisher was worried about when he discussed a debt deflation. Loans that are being liquidated are not being replaced by new loans, hence the decline in loan balances. This is a difficult environment for a central bank. The monetary authority may be injecting funds into the banking system but since banks aren’t lending it feels like the central bank is “pushing on a string.” ( See http://seekingalpha.com/article/209463-the-fed-pushing-on-a-string.)

The concern is whether or not the “lending problem” is a demand problem or a supply problem. That is, if the problem is a demand problem, businesses are not going to their banker to borrow money. If the problem is a supply problem, commercial banks don’t want to make loans.

My belief is that the current dilemma has been created by both sides and this is consistent with Fisher’s concern about debt deflation. In the credit inflation, everyone, banks and non-banks alike, increase their use of leverage. In Fisher’s terms, the granting of new loans exceeds the liquidation of loans so that loan balances increase. In the debt deflation period, loans are being paid down.

And, how is this showing up?

Commercial banks are holding roughly $1.2 trillion in cash assets. Non-bank companies are holding about $1.8 trillion in cash and other liquid assets. This latter number comes from the Wall Street Journal article by Justin Lahart, “U. S. Firms Build Up Record Cash Piles,” http://online.wsj.com/article/SB10001424052748704312104575298652567988246.html?KEYWORDS=justin+lahart.

From the article, “U. S. companies are holding more cash in the bank than at any point on record…” The total of $1.8 trillion is up 26% from a year earlier and is “the largest-ever increase in records going back to 1952.”

The reluctance to borrow/lend is coming from both sides of the market as both banks and non-banks attempt to re-position their balance sheets to protect against further bad times and to be prepared for when the economy really begins to pick up speed once again.

In addition, there is still the concern over the health of the smaller banks in the banking system. The largest 25 banks in the banking system make up about two-thirds of the assets of the banking system. The other 8,000 banks still seem to have plenty of problems. About one in eight of these “smaller” banks are on the problem bank list of the FDIC and between 3.5 and 4 banks have been closed every week this year. This number will probably grow over the next 12 months.

Furthermore, the Federal Reserve continues to keep its target interest rate close to zero. This has been a boon to the larger banks, but is seemingly in place to keep the situation with respect to smaller banks from deteriorating even further. Many analysts believe that the Fed will keep its target interest rate low into 2011. This reinforces my belief that the “smaller” banks in the United States are still in serious trouble. Federal Reserve officials will not confess that the low target rate of interest is to keep as many “small” banks open as possible. To do so would be disturbing to depositors and other customers of these banks.

The question is, are we really in a period of debt deflation? Certainly the loan figures discussed above could be interpreted that way. But, is this all that is going on.

The interesting thing to me is that the economy seems to be bi-furcating in several ways. For one, there are a large number of people that are under-employed and seem to be facing an extended period in which they will be living off of their accumulated wealth, if they have any, or on government welfare. Yet, there are a lot of people that are doing very, very well.

The “big” banks are doing very, very well while the “smaller” banks are scraping by, at best.

The Wall Street Journal article referred to above indicates that businesses, especially larger companies, have a lot of cash on hand and are doing better than OK. We know, however, that there are a lot of other businesses that are not doing so well and still face bankruptcy or restructuring.

One could seriously argue that when the economy really does begin to pick up there will be a tremendous shift in the structure of United States banking and industry. And, if I were to choose, I would bet on the “big” guys! Sorry, little guys!