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Liquidity: Slip Slidin’ Away - The Economic Recovery Masks Troubling Indicators That Could Make Capital Scarce
By Mark W. Sheffert
August 2004

With the dynamic nature of our economy, writing about economic conditions two months before you’ll read it could land me in a whole heap of trouble. But going where others fear to tread has never been a problem for me.

Now, keep in mind I’m just a transplanted kid from Lancaster County, Nebraska, who struggled through Economics 101. However, while the economy appears to continue its recovery, and everybody is euphoric, there are some things going on out there that just don’t pass the smell test, and they could lead to a liquidity squeeze in corporate America.

Why aren’t more people talking about this? Is it because there’s a pending election and candidates want to gloss over certain issues? Or are we so anxious for good economic news that we’re willing to believe whatever we’re told? I don’t know.

What I do know is that business leaders assess the environment in which they operate, then make assumptions. If those assumptions are wrong, their objectives and strategies will be wrong, too. My intention isn’t to run around the barnyard saying, “The sky is falling!” I simply want to call attention to issues that might affect your business, especially if you are a lender, an investor, a business relying on natural commodities, or a business trying to borrow money – and that covers a lot of acreage.

On the One Hand

Writing this column, I felt like President Harry S. Truman, who said, “Give me a one-handed economist! All my economists say, “On the one hand…, but then on the other hand….’”

Let’s start, on the one hand, with major market trends that indicate the economy is recovering. Consumer spending is at an all-time high and driving the recovery, with personal consumption expenditures representing 71 percent of our gross domestic product. The stock market has been robust, unemployment rates are declining, and it appears that interest rates, while they may go up slightly, will stay relatively low for the remainder of the year.

On the Other Hand

While these major indicators paint a picture of a recovering economy, scrutinize the trends and you’ll see that the recovery remains vulnerable. Specifically, trouble is brewing in excessive consumer debt, less availability of corporate bank debt, an alarming number of risky bond issuances, a less-sanguine private equity market, rising commodity prices, unfunded pension liabilities, and a growing number of business failures. Together, these conditions point to the possibility of liquidity slip slidin’ away. Here’s how it could work.

  • Excessive Consumer Debt – Consumer debt has doubled in the past 10 years to 115 percent of disposable annual income (in a period of record-low interest rates), while the consumer savings rate has dropped to only 2 percent of after-tax income. With the average duration of unemployment at 27 weeks, my sense is that few people have enough savings squirreled away to get through five months without a job. That’s probably why personal bankruptcies have grown at an annual compounded growth rate of 8.5 percent from 1980 to 2003. Large amounts of defaulted debt will shrink lenders’ ability to make corporate loans.
  • Less-Available Corporate Bank Debt – Since 2001, commercial loan portfolio values have declined 19 percent ($200 billion), primarily because of a decline in mergers and acquisitions and an increase in bond financing. So banks are fighting for assets (i.e., loans), resulting in pricing pressure and relaxed covenants. At first blush, that seems like good news for businesses looking for loans. But recently, institutional debt has grown primarily in three sectors: real estate, consumer lending, and the re-emergence of mergers and acquisitions. As a result, less debt is available for commercial lending.
  • Risky Bond Issuances – During the recent recession, bankers worked underperforming companies out of their loan portfolios. Those companies turned to the bond market, and speculative-grade bonds (with ratings of B- or lower) are now at their highest level ever in history, representing about one-third of all bond issuances. If historical patterns are a guide, bond default rates will go up, creating even more potential for a liquidity squeeze.
  • A Less-Sanguine Private Equity Market – Headlines say that improved corporate earnings are causing the M&A market to heat up again, but the transactions are mostly high-end deals funded by debt. In addition, private equity funds established in the ‘90s are reaching their portfolio sundown provisions (i.e., the time when they need to harvest their investments), which could drive up transaction volume and multiples, also sucking up liquidity.
  • Higher Commodity Prices – If businesses think they can pass rising costs on to consumers, they’d better think again. Commodity businesses, like those in groceries and restaurants, have already learned that consumers will resist price increases. If inflation goes up, interest rates will go up on all that debt that consumers are wallowing in. So, commodity cost increases are being funded out of corporate debt. Corporate profits are being further eroded by dramatic increases in energy costs, which have doubled in the past 24 months.
  • Unfunded Pension Liabilities – This is potentially a major calamity. In S&P 500 companies alone, there is approximately $260 billion in these liabilities, which must be paid out of future earnings – while at the same time, such companies try to grow profits and meet Wall Street analysts’ expectations. As General Motors did recently, these large companies will continue to issue bonds and borrow to cover pension liabilities, and this will be a huge squeeze on liquidity.
  • Increasing Business Failures – Business bankruptcy rates have been declining overall – but business failure rates are increasing. Failures are masked by nonjudicial reorganizations, dissolutions, and the sale and abandonment of businesses. In other words, small and mid-sized companies are avoiding the bankruptcy route. But large-company bankruptcies reached an all-time high between 2000 and 2003, with 13 mega-bankruptcy filings aggregating $411 billion in assets. While economists point to the retail sector as one that’s recovering nicely, the growth is principally in stores that cater to an affluent market. Eight of the 21 large-company bankruptcies to date in 2004 have been retailers, most catering to low- or middle-income customers. When failing companies can no longer restructure, lenders have to either write them off or commit further debt to existing loans – tightening a liquidity squeeze.

So What?!

I’m sure you are brighter than I am when it comes to figuring out the implications of a liquidity squeeze for your own business. But at the very least, be aware that the measure of a healthy business is its liquidity, not its leverage. Know that capital could be scarce in the future, and plan accordingly.

While lenders are practically giving away money today, creating a euphoric feeling of safety, let me remind you that in the days of old (i.e., the past two years), a covenant violation could cost thousands of dollars in fees. Suffice it to say that if you don’t have adequate liquidity in your business today, you should darn well figure it out – now, not five years from now – where you’re going to get it.

Oops! I didn’t intend for this to end with a lecture, but here I am giving one anyway. I’m beginning to feel like another president, Lyndon Johnson, who said, “Did y’ever think that making a speech on economics is a lot like pissing down your leg? It seems hot to you, but it never does to anyone else.”


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