More and more information is coming out about the problems that exist in the banking sector. About ten days ago, Elizabeth Warren, the Chair of the Congressional Oversight Panel, in testimony given to the U. S. Senate Committee on Finance, revealed more than anyone else in Washington, D. C. had done up to the time about the serious problems that existed in the banking sector. (See my post “Elizabeth Warren on the Troubled Smaller Banks”, http://seekingalpha.com/article/215958-elizabeth-warren-on-the-troubled-smaller-banks.)
Now, it seems as if almost every day we learn more about the difficulties still facing the banks.
The problem that goes along with the problems in the banking industry is that there will be little or no real economic recovery in the United States if the banking industry is not present in making business loans. Without any financial support, the economy will just not be able to grow.
My initial concern for the banking industry came from the behavior of the Federal Reserve System. For at least ten months, I have been arguing that the Fed was keeping its target interest rate low because of the problems that existed in the commercial banking system, especially among the smaller banks. Although the Fed stated that the reason for keeping its target rate so low was the fact that the economy was not picking up steam in terms of recovering from the Great Recession, I felt that their policy stance was caused by something deeper within the banking system. I believed that the asset values being carried on the balance sheets of a large number of banks were so inflated relative to market values that there was a major solvency issue within the banking industry, especially amongst the smaller banks.
FDIC data gave us confirming information on this: as of March 31, 2010, the FDIC placed 775 banks on its problem list. With the five banks closed last Friday, 106 banks have been closed this year, a rate of 3.5 banks per week. Expectations are for this rate of closure to continue for at least 12 more months.
Warren stated in her written testimony that quite a few small banks had received TARP funds and, “Notwithstanding the fact that those small banks that received TARP funds were required to prove their financial health, fewer than 10 percent have managed to repay their TARP obligations, and 15 percent have failed to pay at least one of their outstanding dividends.”
Furthermore, in her oral testimony, she admitted that “3,000 small banks faced serious problems in the future related to the residential housing market and the wave of commercial real estate loan resets forthcoming in the future.” One could therefore argue that, given this estimate and the FDIC problem list banks, about 1 out of every 2 banks in the banking system faces “serious problems.”
And Congress is working on a new program that would send $30 billion to “struggling” community banks. (See “Community Bank Bailout: Program Risks $30 Billion to Save Weak Banks”, http://www.huffingtonpost.com/2010/08/01/community-bank-bailout-pr_n_666776.html.) Saturday, President Obama described this new bailout program a “common-sense” plan to help spur on bank lending to small business owners.
This, of course, is the “new” Washington line to justify the help. Give the money to the small banks and they will lend to small businesses.
What about the $1.0 trillion in excess reserves that are currently held by the banking system?
What a weak cover, Mr. President!!!
Further information is coming from the banking system, information on the loan sales that commercial banks have recently made. Peter Eavis has a very insightful piece in the Wall Street Journal this morning concerning some specific loan sales and how these sales have impacted bank balance sheets. (See Eavis’ article: http://professional.wsj.com/article/SB10001424052748703314904575399592715122512.html?mod=ITP_moneyandinvesting_8&mg=reno-wsj.)
The bottom line: a lot of the assets that commercial banks carry on their balance sheets are seriously over-valued. When these assets are finally sold, large write downs take place which are absorbed by a reduction in bank earnings. Eavis concludes his article with this comment:
“More loan sales would be welcome. Not only because they relieve banks of burdensome assets, but also because they might inject more reality into the balance sheets seen by investors.”
What does this say about the state of the banking industry? What does this say about the Federal Reserve’s efforts to keep its target interest rate close to zero? Maybe the Fed doesn’t want commercial banks to sale the over-valued assets from off of their balance sheets?
Furthermore, all this is before the “wave of commercial real estate loan resets” forthcoming in the future that Elizabeth Warren talks about. It is also before another 500,000 foreclosures Realty Trac Inc. expects to occur before the end of the year 2010. And, how many foreclosures will take place in 2011? Historically there have only been about 100,000 foreclosures every year in the United States.
It is very difficult to see the United States economic recovery accelerating if the banking system is sitting on the sidelines. The part of the banking system to worry about is the 8,000 banks that do not make the list of the 25 largest domestically chartered banks in the country. These make up approximately one-third of the banking assets in the United States. About 1 in 8 of these banks are on the FDIC’s list of problem banks, and at least 3 in 8 of these banks are on Elizabeth Warren’s list of banks that face “serious problems.”
And, as we know the 25 largest banks have a lot of cash on hand but are not lending it out. Many of the largest non-financial companies in the United States have a lot of cash on hand but are not currently doing anything with it. It would seem that these organizations are looking to use this cash for something other than economic expansion. Could it be that they see the coming period as one in which there will be major consolidation of industry and a restructuring of the economy. (See my post “The Source of Economic Success”, http://seekingalpha.com/article/216450-the-source-of-economic-success.) This will certainly not result in much economic growth or a reduction in the unemployment rate.
Monday, August 2, 2010
Friday, July 30, 2010
Monetary Targets: The Latest Take
The morning papers contain articles on the newly released paper on monetary policy by James Bullard, the President of the Federal Reserve Bank of St. Louis. The basic thrust of the paper is that the Fed’s efforts to keep interest rates so low and for “an extended period” of time may eventually backfire and result in a Japan-like dilemma of stagnation and price deflation.
The “appropriate tool” in the present situation, Bullard contends, is the use of “quantitative easing.” More specifically, he argues that the Federal Reserve needs to be willing to buy longer-term Treasury issues to expand the amount of Federal Reserve Credit outstanding in spite of the fact that there are more than $1.0 trillion in excess reserves currently in the banking system.
The problem, as Bullard sees it, is a policy dilemma that results from the fact that nominal interest rates include a factor to account for inflationary expectations and that current Federal Reserve operating procedures rely on some form of what is called “the Taylor Rule” to set target interest rates. Bullard contends in his paper (which can be accessed through this article: http://blogs.wsj.com/economics/2010/07/29/feds-bullard-raises-policy-concerns/) that using the Taylor Rule can result in one of two “steady state” outcomes, one with higher interest rates yet more inflation, and the other with low interest rates and outright deflation.
The latter “steady state” position is what the Japanese have experienced. The former is where the United States has been operating. The fear is that by continuing the Federal Reserve policy of keeping its target interest rate close to zero for “an extended period” the United States will migrate from where it is now into the situation more similar to that of the Japanese.
This is why Bullard suggests that the Fed may need to focus more on “quantitative easing” going forward.
The concept of “quantitative easing” was originated early on in the financial crisis that accompanied the Great Recession. When nominal interest rates approached zero, the Federal Reserve (and the Bank of England) argued that it needed to continue to provide more reserves for the banking system (print more money electronically) even though it could not drive nominal interest rates below zero.
Quantitative monetary policy procedures went out-of-fashion in the late 1980s. Paul Volcker had used quantitative measures in the late 1970s and early 1980s to “frame” his efforts to combat the inflation being experienced at the time. However, by the late 1980s, policy makers began to lose confidence in quantitative measures for policy purposes because the various monetary measures that were used did not provide consistent information, at least to those making policy at the time.
As a consequence, policy makers relied more and more on interest rate targets and this is when the Taylor Rule came into usage. Many claim that by adhering to this rule, even implicitly, resulted in a period of relative claim in financial markets and the economy now referred to as “the Great Moderation.”
One reason given for the disenchantment with quantitative monetary measures is that so much reliance has been placed on mathematical modeling within the Fed: monetary measures just did not lend themselves to such a formal process. Hence, quantitative targets were not easy to produce and actual results were even harder to explain because of the divergent movements of the different measures.
We can observe this kind of behavior over the past two years in many of the monetary measures.
For example, if one looks at the behavior of the narrow measure of the money stock, M1, relative to the behavior of a broader measure of the money stock, M2, from 2008 through the present, one can get different signals. In the first six months of 2008, the year-over-year growth of the M1 measure was close to zero. The year-over-year growth rate of M2 was around 6%.
As the financial crisis hit and progressed in the fall of 2008, the rate of growth of the M1 money stock increased dramatically whereas that of the M2 money stock rose only modestly. In the first quarter of 2009 the M1 money stock was growing, year-over-year, at around 17%; the M2 measure had peaked in the fourth quarter of 2008 at about 10% and was beginning to decline.
Furthermore, the behavior of other monetary aggregates seemed all out of line with these money stock measures: Total Reserves in the first quarter of 2009 were increasing, year-over-year, at about 1,850%; the Monetary Base rose by about 110%, year-over-year.
How do you explain these differences? Econometric models couldn’t do it.
Two basic things were happening. First, as the financial crisis progressed, people took more and more money out of less liquid asset holdings and began putting the funds in currency or very liquid bank deposits. Although the M2 measure rose during this time period, most of its increase was coming in the M1 component.
Second, the Federal Reserve was pumping unprecedented amounts of reserves into the financial system. These funds did not go into bank lending so as to expand the money stock: the banks just held onto the money. In August 2008, excess reserves in the banking system totaled less than $2.0 billion. In the first quarter of 2009 excess reserves averaged over $800 billion.
How can you mathematically model these kinds of behavior?
And, the problems of interpretation continue. Money stock growth has dropped off. In the second quarter of 2010 the year-over-year rate of growth of M1 was just under 6.0% while the rate of growth of M2 was less than 2.0%. The non-M1 component of M2 was growing well under 1.0%. People were still putting money into transaction balances and not in savings staying as liquid as they could. The rates of growth in both Total Reserves and the Monetary Base fell dramatically through 2010 yet excess reserves in the banking system averaged more than $1.0 trillion. Banks, too, were acting very conservatively by not lending and keeping as liquid as they could.
The point of this discussion is that the Federal Reserve needs to focus a lot more on the quantitative monetary measures than they have in recent history. But, the understanding of what is going on over shorter periods of time requires institutional understanding within a historical context and not just formal mathematical modeling. The consideration of monetary variables is important for setting and conducting monetary policy!
It is still true that over the longer run, important things like inflation/deflation are still “everywhere and in every time” a monetary phenomenon. Interest rates don’t correlate over the longer run.
Bullard is arguing for a greater focus on the monetary aggregates. By buying Treasury securities in a “quantitative easing” the Fed will be expanding the monetary base. Why would you want to expand the monetary base? Because commercial banks are not lending and if the economy is going to show more life going forward, bank lending is going to have to increase and the money stock measures are going to have to start growing faster again.
Milton Friedman argued that in the 1929-1933 period, the M2 money stock measure declined by one-third. However, the monetary base rose modestly. Freidman criticized the Fed for letting the money stock measure fall. To him, the Fed needed to provide more base money to get the banks’ lending again so that the money stock would grow. Is Bullard saying we are in the same type of situation Friedman described?
The “appropriate tool” in the present situation, Bullard contends, is the use of “quantitative easing.” More specifically, he argues that the Federal Reserve needs to be willing to buy longer-term Treasury issues to expand the amount of Federal Reserve Credit outstanding in spite of the fact that there are more than $1.0 trillion in excess reserves currently in the banking system.
The problem, as Bullard sees it, is a policy dilemma that results from the fact that nominal interest rates include a factor to account for inflationary expectations and that current Federal Reserve operating procedures rely on some form of what is called “the Taylor Rule” to set target interest rates. Bullard contends in his paper (which can be accessed through this article: http://blogs.wsj.com/economics/2010/07/29/feds-bullard-raises-policy-concerns/) that using the Taylor Rule can result in one of two “steady state” outcomes, one with higher interest rates yet more inflation, and the other with low interest rates and outright deflation.
The latter “steady state” position is what the Japanese have experienced. The former is where the United States has been operating. The fear is that by continuing the Federal Reserve policy of keeping its target interest rate close to zero for “an extended period” the United States will migrate from where it is now into the situation more similar to that of the Japanese.
This is why Bullard suggests that the Fed may need to focus more on “quantitative easing” going forward.
The concept of “quantitative easing” was originated early on in the financial crisis that accompanied the Great Recession. When nominal interest rates approached zero, the Federal Reserve (and the Bank of England) argued that it needed to continue to provide more reserves for the banking system (print more money electronically) even though it could not drive nominal interest rates below zero.
Quantitative monetary policy procedures went out-of-fashion in the late 1980s. Paul Volcker had used quantitative measures in the late 1970s and early 1980s to “frame” his efforts to combat the inflation being experienced at the time. However, by the late 1980s, policy makers began to lose confidence in quantitative measures for policy purposes because the various monetary measures that were used did not provide consistent information, at least to those making policy at the time.
As a consequence, policy makers relied more and more on interest rate targets and this is when the Taylor Rule came into usage. Many claim that by adhering to this rule, even implicitly, resulted in a period of relative claim in financial markets and the economy now referred to as “the Great Moderation.”
One reason given for the disenchantment with quantitative monetary measures is that so much reliance has been placed on mathematical modeling within the Fed: monetary measures just did not lend themselves to such a formal process. Hence, quantitative targets were not easy to produce and actual results were even harder to explain because of the divergent movements of the different measures.
We can observe this kind of behavior over the past two years in many of the monetary measures.
For example, if one looks at the behavior of the narrow measure of the money stock, M1, relative to the behavior of a broader measure of the money stock, M2, from 2008 through the present, one can get different signals. In the first six months of 2008, the year-over-year growth of the M1 measure was close to zero. The year-over-year growth rate of M2 was around 6%.
As the financial crisis hit and progressed in the fall of 2008, the rate of growth of the M1 money stock increased dramatically whereas that of the M2 money stock rose only modestly. In the first quarter of 2009 the M1 money stock was growing, year-over-year, at around 17%; the M2 measure had peaked in the fourth quarter of 2008 at about 10% and was beginning to decline.
Furthermore, the behavior of other monetary aggregates seemed all out of line with these money stock measures: Total Reserves in the first quarter of 2009 were increasing, year-over-year, at about 1,850%; the Monetary Base rose by about 110%, year-over-year.
How do you explain these differences? Econometric models couldn’t do it.
Two basic things were happening. First, as the financial crisis progressed, people took more and more money out of less liquid asset holdings and began putting the funds in currency or very liquid bank deposits. Although the M2 measure rose during this time period, most of its increase was coming in the M1 component.
Second, the Federal Reserve was pumping unprecedented amounts of reserves into the financial system. These funds did not go into bank lending so as to expand the money stock: the banks just held onto the money. In August 2008, excess reserves in the banking system totaled less than $2.0 billion. In the first quarter of 2009 excess reserves averaged over $800 billion.
How can you mathematically model these kinds of behavior?
And, the problems of interpretation continue. Money stock growth has dropped off. In the second quarter of 2010 the year-over-year rate of growth of M1 was just under 6.0% while the rate of growth of M2 was less than 2.0%. The non-M1 component of M2 was growing well under 1.0%. People were still putting money into transaction balances and not in savings staying as liquid as they could. The rates of growth in both Total Reserves and the Monetary Base fell dramatically through 2010 yet excess reserves in the banking system averaged more than $1.0 trillion. Banks, too, were acting very conservatively by not lending and keeping as liquid as they could.
The point of this discussion is that the Federal Reserve needs to focus a lot more on the quantitative monetary measures than they have in recent history. But, the understanding of what is going on over shorter periods of time requires institutional understanding within a historical context and not just formal mathematical modeling. The consideration of monetary variables is important for setting and conducting monetary policy!
It is still true that over the longer run, important things like inflation/deflation are still “everywhere and in every time” a monetary phenomenon. Interest rates don’t correlate over the longer run.
Bullard is arguing for a greater focus on the monetary aggregates. By buying Treasury securities in a “quantitative easing” the Fed will be expanding the monetary base. Why would you want to expand the monetary base? Because commercial banks are not lending and if the economy is going to show more life going forward, bank lending is going to have to increase and the money stock measures are going to have to start growing faster again.
Milton Friedman argued that in the 1929-1933 period, the M2 money stock measure declined by one-third. However, the monetary base rose modestly. Freidman criticized the Fed for letting the money stock measure fall. To him, the Fed needed to provide more base money to get the banks’ lending again so that the money stock would grow. Is Bullard saying we are in the same type of situation Friedman described?
Wednesday, July 28, 2010
Looking at the Dollar Again
As European financial markets seem to be stabilizing, it is time to look again at the value of the dollar. After the heat over the sovereign debt crisis cooled somewhat the value of the dollar, once more, headed south. Over the past two years or so, global markets have seemed to be saying, if the financial world is going to fall apart today, I want to be holding some kind of dollar assets. However, if I am to bet on the value of the dollar over an extended period of time, then I want to hold assets denominated in other currencies.
As one can see from this chart showing a trade-weighted index of the United States dollar against the major currencies of the world, the general drift of the value of the dollar since the early 1970s has been downward. There are two major upswings. The first relates to the tightening of credit by the Federal Reserve under the leadership of Paul Volcker. This is the upswing that goes from about 1980 to 1986. The second upswing came during the federal budget tightening led by Treasury Secretary Robert Rubin which eventually resulted in a budget surplus and lasted from about 1995 into 2001.
During the last two years or so, there have been two minor upward movements in the value of the dollar. These minor swings came during the fall of 2008 into 2009 and in the spring of 2010 connected with the sovereign debt crisis in Europe. This last upswing seems to have peaked as the dollar, once again, heads downward.
Although the rise in the value of the dollar during the first of these movements was “across the board”, the primary reason for the rise in the value of the dollar in the latter period was the movement of money out of the euro. But, given the actions of the European Union and given the results of the “stress tests” applied to European banks, confidence seems to be returning to the Euro.
So, the long-run trend in the value of the dollar still seems to be downwards.
To me, the price of a nation’s currency is still the most important price in that nation. The fact that the long-run trend of the dollar is down highlights the fact that the international financial community continues to believe that there are still structural problems in the United States that must be dealt with. And, one can add, that these structural problems are not connected with one political party or the other. Both parties have contributed to these structural problems and, until there is a major change in the way Americans think, these structural problems will not go away. Hence, the bet is still on a falling value of the dollar.
What are the major structural problems?
Let’s start with just three. First, is the federal government deficit. Again, this is not a problem that has just occurred. The gross federal debt of the United States has increased at a compound rate of about 7% from 1961 through 2009. “Official” estimates of the deficit over the next ten years are for the deficit to increase by $8 to $10 trillion. I have been a little more pessimistic, arguing that the deficits will be more like $15 trillion. The lower estimate will still keep the growth rate of the debt above 7% a year.
Second, the commercial banking system has over $1.0 in excess reserves! The Federal Reserve is planning an “exit” strategy to remove these reserves from the banking system as the economic recovery picks up steam. However, there is little evidence provided over the past fifty years or so that the Fed can or will be able to keep these reserves from getting into the spending stream especially given the amount of the federal debt that is going to have to be financed over the next ten years.
Third, there are major dislocations in terms of the allocation of corporate assets, of corporate capital, both physical and human, in the United States. (See my post http://seekingalpha.com/article/216450-the-source-of-economic-success.) To correct these dislocations will take a lengthy period of time which indicates that the country will not recover as rapidly as it would if these dislocations did not exist. This will just exacerbate the problems caused by the two situations mentioned above. Again, this is seen as a negative in terms of pricing the dollar in foreign exchange markets.
I have been a dollar “bear” for a long time. The reason is that the general thinking about economic policy in the United States has been wrong since the early 1960s. International financial markets seem to support this assessment. And, this thinking appears in both the Republican and the Democratic leadership. I had hopes that changes were taking place when Paul Volcker was Chairman of the Board of Governors of the Federal Reserve System. I had similar hopes when Treasury Secretary Robert Rubin led the charge to reduce the federal deficits in the 1990s. In each case, “the dark side” eventually prevailed.
There is nothing I see in the future to make me think that the value of the dollar will rise except in times of global financial crisis where there is a “flight to quality”. But, these will eventually run out if nothing is done to resolve the longer-run issues. As far as I can see, there certainly is no leader on the present stage that can bring about the changes that are needed. Therefore, I remain “bearish”.
Tuesday, July 27, 2010
Executive Compensation: A Study
The New York Times’ DealBook edited by Andrew Ross Sorkin recently carried an amazing headline, “Study: Boards Use Peers to Inflate Executive Pay.” (See, http://dealbook.blogs.nytimes.com/2010/07/26/study-boards-use-peers-to-inflate-executive-pay/?ref=business.)
And in this remarkable study we find the following:
“Corporate boards appear to routinely use compensation peer groups to artificially inflate pay for their chief executives, helping to contribute to the cascading increases in executive compensation over the last several years, according to an academic study on corporate governance.”
Well, duh!
This was done in the 1970s and I experienced it first hand in the 1980s and 1990s. Yet the quote above states, with astonishment, that “over the last several years” this behavior took place.
The authors of the academic study being reported on, Michael Faulkender of the University of Maryland, and Jun Yang of Indiana University, ”found that companies usually benchmark their executive pay with peers in their industry group, but that they also choose peers that pay more than others.”
That is, not only did corporation use peer data to determine executive salaries, the peers chosen were generally those that had the highest pay among the similar companies.
“The motivation of corporate boards to consciously chose peers that are more generous than ones that are very similar but are just less generous helps to explain, at least in part, the huge increases in chief executive compensation over the years.”
Huge increases?
Oh, yes, “Executive pay has increased substantially over the last few years. For example, in 1965 chief executives at major American companies earned 24 times more than a typical worker, while in 2007 they made 275 times more,” according to the Economic Policy Institute, a nonprofit Washington D.C. think tank.
Note, we are talking about “major” American companies…the “big guys”. These are large bureaucratic organizations that have huge human resources divisions that are given responsibility for the remuneration and benefits of the employees of these companies.
Now, I am not disagreeing with results of the study and I am not disagreeing that these practices helped to contribute to the substantial relative growth in executive pay when compared to the “typical worker”, whoever that might be.
I am just astounded that the results of this study from the late 2000s seem to be such a surprise.
In the late 1960s and early 1970s, when the United States economy was growing at a relatively good pace and inflation began to become a part of the daily life of Americans, large companies had to seek a way to justify the compensation of their employees…all their employees.
Data from peer groups, companies of similar size and similar industry background, became useful in setting pay scales and in arguing with labor unions about worker compensation. Companies began collecting information from other similar companies that would share data and, as the use of peer data became more generally used, it started to be collected by consultants and agencies that could sell the information to interested organizations.
What could be a more reliable guide to executive, and worker, pay than information on what peer groups paid their executives…and workers.
To me, the use of peer data was ubiquitous in large companies by the end of the 1970s.
But, one must be careful with how incentives are administered. Executives found that pay scales based upon peer data could be very used to their advantage. As a consequence, executives became diligent students concerning the use of peer characteristics and of what items could contribute to higher and higher compensation packages.
Let’s see…of course…size, to pick one characteristic, makes a great difference in the compensation received by executives. Bigger companies paid their executives higher salaries.
So, let’s grow the company! Let’s engage in mergers and acquisitions! Let’s move horizontally as well as vertically! Anything to increase the size of the firm! Executives can almost always find reasons to grow their organizations.
Remember the companies we are referring to are the “big guys”!
What about the performance of these companies? That doesn’t seem to matter.
What about the fact that about 3 out of every 4 mergers consummated are unwound in seven years or less? We will just replace those assets with other mergers or acquisitions!
And, the argument can be extended to the “other” special characteristics that apply to the choice of “peers”.
That is, executives could design the strategic plans they used to guide their firms based upon the peer group they had chosen so as to achieve the largest compensation possible.
Could something like this happen? You may express some doubt if you have not read books like “Freakonomics” and “Super-Freakonomics.”
That is, you must be careful of the incentive scheme you choose to stimulate people because that incentive plan will help to determine the behavior of the people you are hoping to influence…and the results you get may not always be the ones you expect.
In this, top executives are no better or no worse than most of the rest of us. They too respond to the reward systems that are presented to them.
And, what about the workers?
Well, they could not choose either their peer group or the design of their company relative to the peer group they wanted to be compared with. Anyhow, ordinary workers competed in a whole different labor market, one that tended to have a lot of substitutes: all peer groups at this level were very similar. Thus, they could not expect much boost in pay from the use of this information.
And in this remarkable study we find the following:
“Corporate boards appear to routinely use compensation peer groups to artificially inflate pay for their chief executives, helping to contribute to the cascading increases in executive compensation over the last several years, according to an academic study on corporate governance.”
Well, duh!
This was done in the 1970s and I experienced it first hand in the 1980s and 1990s. Yet the quote above states, with astonishment, that “over the last several years” this behavior took place.
The authors of the academic study being reported on, Michael Faulkender of the University of Maryland, and Jun Yang of Indiana University, ”found that companies usually benchmark their executive pay with peers in their industry group, but that they also choose peers that pay more than others.”
That is, not only did corporation use peer data to determine executive salaries, the peers chosen were generally those that had the highest pay among the similar companies.
“The motivation of corporate boards to consciously chose peers that are more generous than ones that are very similar but are just less generous helps to explain, at least in part, the huge increases in chief executive compensation over the years.”
Huge increases?
Oh, yes, “Executive pay has increased substantially over the last few years. For example, in 1965 chief executives at major American companies earned 24 times more than a typical worker, while in 2007 they made 275 times more,” according to the Economic Policy Institute, a nonprofit Washington D.C. think tank.
Note, we are talking about “major” American companies…the “big guys”. These are large bureaucratic organizations that have huge human resources divisions that are given responsibility for the remuneration and benefits of the employees of these companies.
Now, I am not disagreeing with results of the study and I am not disagreeing that these practices helped to contribute to the substantial relative growth in executive pay when compared to the “typical worker”, whoever that might be.
I am just astounded that the results of this study from the late 2000s seem to be such a surprise.
In the late 1960s and early 1970s, when the United States economy was growing at a relatively good pace and inflation began to become a part of the daily life of Americans, large companies had to seek a way to justify the compensation of their employees…all their employees.
Data from peer groups, companies of similar size and similar industry background, became useful in setting pay scales and in arguing with labor unions about worker compensation. Companies began collecting information from other similar companies that would share data and, as the use of peer data became more generally used, it started to be collected by consultants and agencies that could sell the information to interested organizations.
What could be a more reliable guide to executive, and worker, pay than information on what peer groups paid their executives…and workers.
To me, the use of peer data was ubiquitous in large companies by the end of the 1970s.
But, one must be careful with how incentives are administered. Executives found that pay scales based upon peer data could be very used to their advantage. As a consequence, executives became diligent students concerning the use of peer characteristics and of what items could contribute to higher and higher compensation packages.
Let’s see…of course…size, to pick one characteristic, makes a great difference in the compensation received by executives. Bigger companies paid their executives higher salaries.
So, let’s grow the company! Let’s engage in mergers and acquisitions! Let’s move horizontally as well as vertically! Anything to increase the size of the firm! Executives can almost always find reasons to grow their organizations.
Remember the companies we are referring to are the “big guys”!
What about the performance of these companies? That doesn’t seem to matter.
What about the fact that about 3 out of every 4 mergers consummated are unwound in seven years or less? We will just replace those assets with other mergers or acquisitions!
And, the argument can be extended to the “other” special characteristics that apply to the choice of “peers”.
That is, executives could design the strategic plans they used to guide their firms based upon the peer group they had chosen so as to achieve the largest compensation possible.
Could something like this happen? You may express some doubt if you have not read books like “Freakonomics” and “Super-Freakonomics.”
That is, you must be careful of the incentive scheme you choose to stimulate people because that incentive plan will help to determine the behavior of the people you are hoping to influence…and the results you get may not always be the ones you expect.
In this, top executives are no better or no worse than most of the rest of us. They too respond to the reward systems that are presented to them.
And, what about the workers?
Well, they could not choose either their peer group or the design of their company relative to the peer group they wanted to be compared with. Anyhow, ordinary workers competed in a whole different labor market, one that tended to have a lot of substitutes: all peer groups at this level were very similar. Thus, they could not expect much boost in pay from the use of this information.
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.
Thursday, July 22, 2010
The Troubled Smaller Banks and Elizabeth Warren
For over nine months I have been expressing my view about the problems being faced by many of the small domestically chartered banks in the United States. Very little has been forthcoming from public officials about the problems of these smaller financial institutions. Well, yesterday, Elizabeth Warren, the Chair of the Congressional Oversight Panel, in testimony given to the U. S. Senate Committee on Finance, provided us with a little insight into what government officials are working with.
Here are some of her written comments: “The Panel’s most recent report analyzed the participation of small banks in the CPP (the Capital Purchase Program of the Troubles Asset Relief Program--TARP). Under the program, Treasury put money into 707 banks. The Panel found the experience of small banks differed substantially from that of the nation’s largest financial institutions. Seventeen of the 19 U.S. banks and bank holding companies, with assets totaling more than $100 billion, received the majority of funds (81 percent), most getting their money within weeks of the announcement of the program. Now 76 percent have repaid their TARP funds and returned to profitability. On the other hand, small banks entered the program more slowly, and ultimately most—about 90 percent—stayed out of TARP altogether. Notwithstanding the fact that those small banks that received TARP funds were required to prove their financial health, fewer than 10 percent have managed to repay their TARP obligations, and 15 percent have failed to pay at least one of their outstanding dividends. Their problems are substantial. Small banks face serious difficulties with the coming wave of commercial real estate loans resets. Moreover, small banks do not have the same access to the capital that larger banks have, and investors know that these regional and local banks are not too big to fail. Worse yet, if they cannot exit from TARP in the next few years, they face a TARP dividend that will increase sharply from 5 to 9 percent.
TARP gets its name from the so-called “troubled assets” that were weighing down the balance sheets of the nation’s financial institutions. The meltdown in the subprime mortgage market—and the eventual spillover effects into the prime and alt-A mortgage markets—saddled banks with assets composed of or derived from residential mortgages. These securities became difficult to price and hard to sell. Nearly one year after the passage of TARP, the Panel reported that these same assets continued to impair bank balance sheets. Today, some of these same assets continue to encumber the balance sheets of many banks—especially smaller banks that are also heavily exposed to commercial real estate assets, as the Panel identified in our most recent report. So long as the residential housing market remains weak and homeowners continue to default on their mortgages and fall into foreclosure, these troubled assets will continue to pose challenges for financial institutions.”
In verbal testimony, Ms. Warren provided a number: the number was 3000. She stated that 3,000 small banks faced serious problems in the future related to the residential housing market and the “wave of commercial real estate loan resets” forthcoming in the future.
I presume that this does not include the almost 800 commercial banks that were on the FDIC’s list of problem banks as of March 31, 2010 since these banks are already “problems”.
If her number is added to the number of banks on the FDIC’s list then we have close to one-half of the domestically chartered banks in the United States facing the substantial “challenges for financial institutions.”
One-half of the banks in the United States are facing “serious difficulties” and that ”investors know that these regional and local banks are not too big to fail.”
No wonder that the Federal Reserve is keeping its target interest rate close to zero and expects to keep the rate at this level for an “extended time.” Again, expectations are for this target rate to stay near zero into the third quarter of 2010, a period that goes beyond when most of these large commercial loans are supposed to reset.
The real estate bubble of the 2000s will not go away. It is the gift that just keeps on giving!
Here are some of her written comments: “The Panel’s most recent report analyzed the participation of small banks in the CPP (the Capital Purchase Program of the Troubles Asset Relief Program--TARP). Under the program, Treasury put money into 707 banks. The Panel found the experience of small banks differed substantially from that of the nation’s largest financial institutions. Seventeen of the 19 U.S. banks and bank holding companies, with assets totaling more than $100 billion, received the majority of funds (81 percent), most getting their money within weeks of the announcement of the program. Now 76 percent have repaid their TARP funds and returned to profitability. On the other hand, small banks entered the program more slowly, and ultimately most—about 90 percent—stayed out of TARP altogether. Notwithstanding the fact that those small banks that received TARP funds were required to prove their financial health, fewer than 10 percent have managed to repay their TARP obligations, and 15 percent have failed to pay at least one of their outstanding dividends. Their problems are substantial. Small banks face serious difficulties with the coming wave of commercial real estate loans resets. Moreover, small banks do not have the same access to the capital that larger banks have, and investors know that these regional and local banks are not too big to fail. Worse yet, if they cannot exit from TARP in the next few years, they face a TARP dividend that will increase sharply from 5 to 9 percent.
TARP gets its name from the so-called “troubled assets” that were weighing down the balance sheets of the nation’s financial institutions. The meltdown in the subprime mortgage market—and the eventual spillover effects into the prime and alt-A mortgage markets—saddled banks with assets composed of or derived from residential mortgages. These securities became difficult to price and hard to sell. Nearly one year after the passage of TARP, the Panel reported that these same assets continued to impair bank balance sheets. Today, some of these same assets continue to encumber the balance sheets of many banks—especially smaller banks that are also heavily exposed to commercial real estate assets, as the Panel identified in our most recent report. So long as the residential housing market remains weak and homeowners continue to default on their mortgages and fall into foreclosure, these troubled assets will continue to pose challenges for financial institutions.”
In verbal testimony, Ms. Warren provided a number: the number was 3000. She stated that 3,000 small banks faced serious problems in the future related to the residential housing market and the “wave of commercial real estate loan resets” forthcoming in the future.
I presume that this does not include the almost 800 commercial banks that were on the FDIC’s list of problem banks as of March 31, 2010 since these banks are already “problems”.
If her number is added to the number of banks on the FDIC’s list then we have close to one-half of the domestically chartered banks in the United States facing the substantial “challenges for financial institutions.”
One-half of the banks in the United States are facing “serious difficulties” and that ”investors know that these regional and local banks are not too big to fail.”
No wonder that the Federal Reserve is keeping its target interest rate close to zero and expects to keep the rate at this level for an “extended time.” Again, expectations are for this target rate to stay near zero into the third quarter of 2010, a period that goes beyond when most of these large commercial loans are supposed to reset.
The real estate bubble of the 2000s will not go away. It is the gift that just keeps on giving!
The Current Performance of Commercial Banks
Commercial bank profits are OK. Commercial bank lending is practically nil.
The prognosis for the future?
If commercial bank lending does not pick up, commercial bank profits will fall.
When will commercial bank lending pick up?
Good question, but the answer is not an easy one. Also, to get an answer, it seems as if we need to go to both sides of the desk: to those that are demanding loans and to those that are supplying loans.
There seems to be four factors that are keeping loan demand from growing. First, of course, is that a lot of people and companies are still trying to climb out of the economic hole in which they have found themselves over the past three years. We still have foreclosures and bankruptcies continuing at a very rapid pace even though below record levels. We still have massive amounts of unemployment as well as underemployment. And, we still have large numbers of the American families and businesses with extremely poor credit records.
Second, there is a great amount of uncertainty about the future of business. And, confidence is not built when the Chairman of the Board of Governors of the Federal Reserve System announces before Congress…and the whole world… that the business outlook is “unusually uncertain.” If Mr. Bernanke believes this to be true, what are the people “in the trenches” expected to believe?
Third, there are a large number of companies, mostly big companies, that are sitting on a large amount of cash. These companies are not ready to commit at the present time, but they are poised to put these funds into play, either in an expansion off-shore, or in purchasing other companies. These big companies have been profitable, much like the big banks, but they are not yet ready to put these funds to a business use. As far as wanting bank loans, that will depend upon the strategies these companies want to pursue and the cheapest way to finance them.
Fourth, consumers that have the income flow or wealth continue to pay down their debt in an effort to re-balance their balance sheets. At a time like this with all the evidence around that too much financial leverage is not “the place to be”, individuals and families are not seeking credit and are even reducing the amount of credit that they do have outstanding.
From the demand side we see the reality that the people that have the income and the cash assets are not real anxious to borrow and the only ones that really want to borrow have neither the cash flow nor the cash assets to get a loan.
This gets us to the supply side. Commercial banks, in recent months, across the board, say that they have not changed their credit standards. I take them at their word. Yet, if one compares current bank lending standards with those that were in place one, two, or three years ago, the bar is set much higher than it was. This tightening of standards was to be expected as credit standards are always raised during an economic down turn. They were raised to current levels due to the severity of the 2008-2009 financial crises and to the pressures that were brought on the banks by the regulatory agencies. Although these standards will not get tougher, they will not be eased appreciably any time soon.
The commercial banks are also hit by the uncertainty of the current economic situation and by the coming imposition of new financial reform legislation. In terms of the economic situation, loan officers have to be skeptical of business projections of future cash flows. Since the economic outlook is “unusually uncertain” banks have to be extremely careful about basing the extension of money to a borrower upon “optimistic” forecasts. Even “prudent” forecasts are suspicious because of the uncertain nature of the business environment right now.
Plus, bankers, in general, and lending officers, in particular, are “debt guys”. (Please excuse the gender specificity here, “guys” refers to all bankers and lending personnel.) “Debt guys” are taught that forecasting just on cash flows is a tricky business and so it is wise, extremely wise, to require a borrower to put up collateral behind the loan. And, if cash flows projections become even more uncertain than in the past, more collateral should be required.
But, in a very uncertain economic environment, another problem rises to the surface. This problem has to do with the “value” of the collateral. In a very uncertain economic climate and uncertain secondary markets, how can you get a good estimate of what the value of “physical” capital might be? Hence, commercial banks extend their requirements for the collateral backing of loans, now requiring financial instruments, bank deposits like CDs, compensating balances, or other cash demands. Banks are getting back to the “good old days” when to qualify for a loan, a potential borrower had to prove to the bank that they did not need the loan in order for the bank to extend the money to them.
There is another uncertainty now in play. The passage of the financial regulation reform bill introduces more unknowns into the banks’ decision making. Just the concern over higher capital requirements causes the commercial banks to become more conservative in their lending practices. Furthermore, it is unclear how other rules and regulations, some of them not even written yet (the regulators have several months to write up some of the new provisions), will affect bank policies and procedures. How can commercial banks be aggressive in their lending practices it they don’t know what the “playing field” is going to look like in the future?
Finally, there are still many commercial banks that have solvency problems. As I continually quote, about one in eight commercial banks is on the list of problem banks put out by the FDIC. This list was as of March 31, 2010. Soon there will be a new list out relating to June 30, 2010. It is anticipated that the number of commercial banks on this new problem list will be greater than was the case at the earlier date.
My estimate that another two or three commercial banks out of eight still have problems pertaining to capital requirements, or, pertaining to major credit problems in the areas of consumer or commercial real estate loans. To me, this latter problem is one of the major reasons why the Federal Reserve is keeping short-term interest rates so low and will continue to do so, as Bernanke reiterated in his testimony yesterday, for “an extended period”. Market estimates for when the Federal Reserve might increase its target rate of interest now go until at least the third quarter of 2011. This says to me that there are still many, many problems in the commercial banking industry and these problems are not going to be resolved for “an extended period.”
This situation can only result in a large consolidation in the commercial banking industry in this country. Right now there are about 8,000 domestically chartered commercial banks in the United States. I remember when this number was 14,000 and this did not include an extensive Savings and Loan industry. One could see a drop by one-half or more in the number of banks in the country. And, this doesn’t even take into account the effects information technology is going to have on the banking industry in the next five to ten years.
This does not bode well for the supply of bank loans. With the changing financial regulations, the uncertain economic environment, and the changing structure of the banking industry itself, commercial banks are going to concentrate on “high quality” loans. And, if the big banks cannot find them in existing markets they will invade the local or regional markets of other banks. In fact, many banks are now talking about how the big banks are becoming more aggressive in their markets. This will not result in an increase in loan supply, but it will contribute to the consolidation in the commercial banking industry.
In short, there doesn’t seem to be much reason to expect a pickup in bank loan volume in the near future.
The prognosis for the future?
If commercial bank lending does not pick up, commercial bank profits will fall.
When will commercial bank lending pick up?
Good question, but the answer is not an easy one. Also, to get an answer, it seems as if we need to go to both sides of the desk: to those that are demanding loans and to those that are supplying loans.
There seems to be four factors that are keeping loan demand from growing. First, of course, is that a lot of people and companies are still trying to climb out of the economic hole in which they have found themselves over the past three years. We still have foreclosures and bankruptcies continuing at a very rapid pace even though below record levels. We still have massive amounts of unemployment as well as underemployment. And, we still have large numbers of the American families and businesses with extremely poor credit records.
Second, there is a great amount of uncertainty about the future of business. And, confidence is not built when the Chairman of the Board of Governors of the Federal Reserve System announces before Congress…and the whole world… that the business outlook is “unusually uncertain.” If Mr. Bernanke believes this to be true, what are the people “in the trenches” expected to believe?
Third, there are a large number of companies, mostly big companies, that are sitting on a large amount of cash. These companies are not ready to commit at the present time, but they are poised to put these funds into play, either in an expansion off-shore, or in purchasing other companies. These big companies have been profitable, much like the big banks, but they are not yet ready to put these funds to a business use. As far as wanting bank loans, that will depend upon the strategies these companies want to pursue and the cheapest way to finance them.
Fourth, consumers that have the income flow or wealth continue to pay down their debt in an effort to re-balance their balance sheets. At a time like this with all the evidence around that too much financial leverage is not “the place to be”, individuals and families are not seeking credit and are even reducing the amount of credit that they do have outstanding.
From the demand side we see the reality that the people that have the income and the cash assets are not real anxious to borrow and the only ones that really want to borrow have neither the cash flow nor the cash assets to get a loan.
This gets us to the supply side. Commercial banks, in recent months, across the board, say that they have not changed their credit standards. I take them at their word. Yet, if one compares current bank lending standards with those that were in place one, two, or three years ago, the bar is set much higher than it was. This tightening of standards was to be expected as credit standards are always raised during an economic down turn. They were raised to current levels due to the severity of the 2008-2009 financial crises and to the pressures that were brought on the banks by the regulatory agencies. Although these standards will not get tougher, they will not be eased appreciably any time soon.
The commercial banks are also hit by the uncertainty of the current economic situation and by the coming imposition of new financial reform legislation. In terms of the economic situation, loan officers have to be skeptical of business projections of future cash flows. Since the economic outlook is “unusually uncertain” banks have to be extremely careful about basing the extension of money to a borrower upon “optimistic” forecasts. Even “prudent” forecasts are suspicious because of the uncertain nature of the business environment right now.
Plus, bankers, in general, and lending officers, in particular, are “debt guys”. (Please excuse the gender specificity here, “guys” refers to all bankers and lending personnel.) “Debt guys” are taught that forecasting just on cash flows is a tricky business and so it is wise, extremely wise, to require a borrower to put up collateral behind the loan. And, if cash flows projections become even more uncertain than in the past, more collateral should be required.
But, in a very uncertain economic environment, another problem rises to the surface. This problem has to do with the “value” of the collateral. In a very uncertain economic climate and uncertain secondary markets, how can you get a good estimate of what the value of “physical” capital might be? Hence, commercial banks extend their requirements for the collateral backing of loans, now requiring financial instruments, bank deposits like CDs, compensating balances, or other cash demands. Banks are getting back to the “good old days” when to qualify for a loan, a potential borrower had to prove to the bank that they did not need the loan in order for the bank to extend the money to them.
There is another uncertainty now in play. The passage of the financial regulation reform bill introduces more unknowns into the banks’ decision making. Just the concern over higher capital requirements causes the commercial banks to become more conservative in their lending practices. Furthermore, it is unclear how other rules and regulations, some of them not even written yet (the regulators have several months to write up some of the new provisions), will affect bank policies and procedures. How can commercial banks be aggressive in their lending practices it they don’t know what the “playing field” is going to look like in the future?
Finally, there are still many commercial banks that have solvency problems. As I continually quote, about one in eight commercial banks is on the list of problem banks put out by the FDIC. This list was as of March 31, 2010. Soon there will be a new list out relating to June 30, 2010. It is anticipated that the number of commercial banks on this new problem list will be greater than was the case at the earlier date.
My estimate that another two or three commercial banks out of eight still have problems pertaining to capital requirements, or, pertaining to major credit problems in the areas of consumer or commercial real estate loans. To me, this latter problem is one of the major reasons why the Federal Reserve is keeping short-term interest rates so low and will continue to do so, as Bernanke reiterated in his testimony yesterday, for “an extended period”. Market estimates for when the Federal Reserve might increase its target rate of interest now go until at least the third quarter of 2011. This says to me that there are still many, many problems in the commercial banking industry and these problems are not going to be resolved for “an extended period.”
This situation can only result in a large consolidation in the commercial banking industry in this country. Right now there are about 8,000 domestically chartered commercial banks in the United States. I remember when this number was 14,000 and this did not include an extensive Savings and Loan industry. One could see a drop by one-half or more in the number of banks in the country. And, this doesn’t even take into account the effects information technology is going to have on the banking industry in the next five to ten years.
This does not bode well for the supply of bank loans. With the changing financial regulations, the uncertain economic environment, and the changing structure of the banking industry itself, commercial banks are going to concentrate on “high quality” loans. And, if the big banks cannot find them in existing markets they will invade the local or regional markets of other banks. In fact, many banks are now talking about how the big banks are becoming more aggressive in their markets. This will not result in an increase in loan supply, but it will contribute to the consolidation in the commercial banking industry.
In short, there doesn’t seem to be much reason to expect a pickup in bank loan volume in the near future.
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