BUSINESS/ECONOMY

The high rollers take stock

Lenny Glynn July 8 1985
BUSINESS/ECONOMY

The high rollers take stock

Lenny Glynn July 8 1985

The high rollers take stock

BUSINESS/ECONOMY

Lenny Glynn

For most American businessmen and consumers the reports were a welcome affirmation that the economic recovery is once again swiftly gathering momentum. Last month major U.S. banks lowered the prime lending rate to 9.5 per cent—the first time since 1978 that interest rates have dropped below double-digit levels. Then, on June 20 the U.S. commerce department announced its “flash” estimate of the gross national product, which showed that in the second quarter of 1985 GNP grew at an annual rate of 3.1 per cent, compared with only .7 per cent in the first quarter. Declared commerce secretary Malcolm Baldrige: “We should be back on a higher growth path by summer’s end.” At the same time, however, many economists have begun calling for action to deal with a broad range of potential difficulties that could arise if the recovery eventually begins to falter.

American companies have been borrowing heavily to finance mergers and takeovers or defend themselves against such actions. Consumers have been ac-

cumulating debt at record rates in order to buy cars, houses and furniture. And the U.S. federal deficit has doubled to more than $200 billion this year. According to the Federal Reserve Board, by the end of 1984 consumers, business and the federal government collectively owed $6.1 trillion, a 40-per-cent increase from the $4.4 trillion owed at the end of 1981. In 1985 the debt burden is expected to top $7 trillion. Paul Volcker, chairman of the Federal Reserve Board, declared that debts are rising “much faster than consistent with the long-run health of our economy and financial system.”

Unlike Canada, where the major debt has been created by government, in the United States consumers and business currently are accumlating debt the fastest. When the U.S. economy weakens again, economists say, heavily indebted companies facing declining sales would have trouble meeting interest

payments. That would force them to sell assets, reduce spending and lay off employees. In turn, laid-off employees, many of whom are carrying more household debt than they did going into the 1981 recession, would find it extremely difficult to meet loan and credit card payments. A wave of defaults on loans by consumers and business could easily threaten the stability of lending institutions. Said Robert Irwin, president of the Buffalo, N.Y.-based Niagara Share investment fund: “The next recession may not simply involve a drop in the production of goods but may centre around financial and monetary disorder.” American farmers have already been suffering the effects of excessive debt. Collectively, they are carrying a $200billion debt load, which 2 quadrupled from 1970 to

1 1982. Consumers are also piling up record amounts ? of debt and they current-

2 ly owe a total of $2.1 trili lion. Interest expenses

now cost the average U.S. household 10 per cent of disposable personal income, compared with less than five per cent in 1970. Last week the Washington-based Mortgage Bankers Association reported that in the 1985 first quarter, 6.1 per cent of the 9.2 million homes which it surveyed were at least 30 days in arrears on their mortgage payments—the highest level since the association began tracking mortgages in 1953.

Economists have also begun to express concern that the debt carried by American business—which, like the consumer debt, has reached $2.1 trillion—is rising too quickly. The current wave of mergers, acquisitions and buyouts has caused much of the increase in business debt. In 1984 U.S. companies added $102 billion in debt to their balance sheets, much of it either to fund acquisitions or to buy back their own stock in order to protect themselves from being bought out. According to ' Philadelphia-based Mergers and Acquisitions magazine, in 1984 there were at least 2,994 takeovers, and in 1985 the pace is quickening. Frederick Scherer, an economics professor at Swarthmore College in Pennsylvania, said that takeovers are often attempts to realize quick profits, but that by increasing their debt companies become less able to weather economic downturns.

Companies are also becoming more vulnerable to any future increase in interest rates because the amount of debt held in variable rate loans—in which the interest rate fluctuates in response to market conditions—is rising. Currently, about 75 per cent of all corporate debt is in floating loans, compared with

about 50 per cent in 1977. The major reason, according to some economists: U.S. federal borrowers, by offering high fixed interest rates, have led many firms to risk taking out shorter-term loans of lower, variable rates.

Because of increased merger activity and the trend to short-term loans, many U.S. corporate balance sheets are weaker now than in any past economic recovery, said Stephen Roach, senior economist for the New York-based investment bank Morgan Stanley. Declared Roach: “There are extraordinary vulnerabilities for this stage of the business cycle.” The companies that face the largest potential difficulties are those that compete most directly with foreign imports and those that have not shared in the general recovery, including manufacturing, mining, electric utilities with nuclear power plants, energy, real estate and shipping. In fact, between 1980 and 1984 Standard & Poor’s, a New York-based bond rating service, downgraded the credit ratings of 789 firms but upgraded the ratings for only 496 companies.

The financial stability of U.S. lending institutions should also be examined while the recovery is strong, economists say. The failure in 1984 of 79 banks insured by the Federal Deposit Insurance Corp., including the Continental Illinois bank in Chicago, the country’s eighth-largest bank, was the highest number in any year since 1937. So far this year 51 commercial banks have

failed, and depositors have also been panicked by the near-collapse of a small number of state-insured savings and loan institutions in Ohio and Maryland.

The weakness of American lending institutions has been caused in part by the deregulation of U.S. banking practices between 1970 and 1982. During that time the federal government gradually abandoned ceilings on the interest

rates that banks could pay depositors. Since the last limits were eliminated in 1982, lending institutions have increasingly competed with one another for loans and depositors with a bewildering variety of new debt instruments. They include so-called “junk bonds”—highyielding, risky commercial bonds often used to finance takeovers. Henry Kaufman, chief economist for New Yorkbased Salomon Brothers, told a congressional banking committee hearing last month that the “integrity of credit is being chipped away by a financial revolution that is lowering standards.”

The $200-billion federal deficit is another potential problem that could eventually weaken the U.S. recovery. The competition created by the federal Treasury’s need for funds to meet payments on the country’s total debt is one reason that interest rates remain relatively high. Higher interest rates in turn increase debt service costs for all sectors of the economy and keep the U.S. dollar at record levels relative to other currencies. The strong greenback aggravates the deficit in trade and services—which reached $101.5 billion in 1984—by making foreign goods cheaper and U.S. goods more expensive abroad.

U.S. politicians are considering several actions to slow the growth of debt. Congressman Jake Pickle, a Texas Democrat, has introduced a bill to revoke the right of corporations to deduct interest paid on loans used to finance takeovers. And in his recent tax reform package

President Ronald Reagan proposée mortgage interest payments on incomeproducing rental property. While the country’s debt problems are conceded to be potentially serious by many economists, academics and government officials, most businessmen, on the other hand, are intent on taking full advantage of a recovery that has already turned out to be far stronger than even optimistic experts predicted.^