Businomics Blog

Small Business Advocate Interview

Bank Losses: Not as Bad as We Feared

The FDIC now has the scoop on the banking industry's third quarter results.  They aren't as bad as I had feared.  Not that they are good, but it's not catastrophic.  Some key points:

• The industry earned money third quarter, though a huge amount less than in the third quarter of 2008.  Still, 76 percent of all banks were profitable.

• Net interest margin increased, providing a little cushion against the bad news.

• Capital ratios increased at about half the banks.

The critical issue is not the past, but the present and the future.  Third quarter loan delinquency rates were up in all categories, and the fourth quarter, with very weak GDP, will certainly prove even worse for loan quality.  The bankers with decent financials are worrying that they, too, will be caught up in the credit difficulties.  Good news: write offs of mortgage-backed securities have probably been taken, so won't add on any further problems.

The credit crunch outlook: I think that the government's capital infusion will help end the credit crunch, bringing credit down to the tight end of the normal range.  However, I'm not real confident about this forecast, because of the bank examiner behavior I wrote about here.

Bank Regulators Sending Mixed Messages

The newspapers report that the chief banking regulators are urging banks to lend money.  But the front-line bank examiners, the men and women who work face to face with actual bankers, are giving different orders.  They are telling banks to build up capital and liquidity, which can only be done by SLOWING lending.

The Wall Street Journal reports the phenomenon with this quote:

"It's so incongruous when the four regulators publish a joint press release imploring banks to lend and saying they should do their duty under their charter, when at the same time the regulatory field forces are bludgeoning community banks to death," said Camden Fine, chief executive of the Independent Community Bankers of America.

I'm a skeptical guy, and I read quotes like that and wonder if it's just political posturing.  However, this fall I've talked to dozens of bankers.  I've spoken to three conferences of bank associations and met with the top executives and directors of several other banks.  I'm hearing conclusively that their regulators want them to build up capital and liquidity, even if that means cutting back on lending.

The pronouncements of the top regulatory dogs don't match the behavior of the regulatory pack dogs.

This is important, because if regular Main Street businesses, (NOT involved in real estate development) are suddenly cut off from the capital they are used to having, then the recession becomes deeper and lasts longer.

Good Oil Forecast, Bad Oil Forecast

Here's the good oil forecast:  back in the fall of 2005, I predicted oil prices going back down to $35.

Here's the bad forecast: I said it would happen by the end of 2006.

Right price target, wrong time span.  So what went wrong?

The process behind the forecast is still sound, I think.  World demand for oil can change quickly as the economy grows.  World oil supply cannot change quickly, because of time lags in exploration and development (which means putting in the production wells, laying pipeline, building terminals and docks).  So oil price rises in the face of growing demand and slow supply response.  And oil prices have to rise a lot, because in the short-run demand is not very sensitive to price.  Changing oil demand because of price requires changes in equipment and usage patterns, which does not happen quickly.  So it takes a big oil price change to bring demand down to current supply.  But so far we're in the short run.

In the long run, supply increases.  It takes a few years, but supply increases.  Demand relative to output slows down.  Again, this response takes a few years.  That by itself would be enough to bring prices down.  My mistake: I expected this process to occur over the course of two to three years.

How was I wrong?  Two possibilities:  1) I was mistaken about how long the supply response to price would take, and how long the demand response to price would take; or 2) I misjudged the additional increase in demand from the strong world economy.

I don't know the relative importance of these two errors, but I suspect they are both major contributors to my (and others') forecast errors.

So what's the outlook?  I don't know.  We're much closer to an equilibrium in which the price at which new supplies can be brought to market matches the price that people are willing to pay.  But the market is tremendously volatile.

Business strategy for dealing with oil prices:  don't bet your business on a forecast.  Not mine, not anybody else's.  I don't know of anyone who predicted both the rise to $140 and the drop back to $35, and made the predictions publicly with dates attached.  (It's easy for me to say oil will go back over $100 if I don't have to commit to a time period.  Maybe 2045?)

If energy costs are critical to your business, look for ways to hedge.  Certainly continue to look for cheap ways to become more energy efficient, but keep in mind that a large capital expenditure to lower energy costs is a big, big bet.  If betting on energy is not your core competency, don't do it.

What will the next forecast error be?  Someone will ask, so let me say now, that's a stupid question.  It's asking for a self-defeating prophecy.  If I knew what my next mistake would be, I wouldn't make it.

The End of Chinese Quality Products?

I've written several posts about the end of the "China Price," which was the price that undercut old-line American producers by 30 percent or so.  (here, here and here).

Now I'm pondering whether we're also seeing the end of Chinese quality.  This seems odd, given the various scandals about lead and melamine in various products.  We all (or at least I alone) expected China to work on improving quality.  But Dan Harris over at China Law Blog has a couple of stories about companies receiving sub-standard products from Chinese vendors they've done business with for years.  Perhaps the economic downturn is leading many Chinese producers to cut corners.

Dan's legal interpretation: in a booming economy you can get away with some careless business practices, but they will come back to haunt you when times turn hard.

(By the way, I don't have a lick of interest in Chinese law, but I find China Law Blog the best-written blog about the Chinese economy.)

Getting Consumers to Buy Cars from a Bankrupt Company

The auto industry says that if they have to declare bankruptcy, no one will buy their cars for fear of warranty failure and lack of parts.  A recent Wall Street Journal story casts some doubt on that assertion, but the logic makes sense.

I was listening to the great Clark Howard radio show yesterday and he mentioned that a big box retailer may go belly up after Christmas.  That would make me nervous about shopping there even before it filed bankruptcy.  It seems that the risk of GM and Chrysler going bankrupt would have as much of an effect as an actual bankruptcy filing.

Here's how they could avoid that problem.  (An attorney might want to tweak this suggestion.)

• Form a warranty trust, funded with a portion of the sales proceeds of each car.  Right now GM (and I think the others) show a liability for warranty reserves, but in a bankruptcy the liability is just another unsecured claim.  Instead, form a trust that can only use its funds for warranty claims.  You might want a separate one for each model year.  If there is extra money left over at the end of the warranty period, because warranty claims were low, that money would revert to the company.  If there were insufficient money to pay all claims, the deficit would be another liability of the company.  But the trust would be separate from the company in a bankruptcy.
• Add a clause to each car sales agreement regarding replacement parts.
  1. If the company or its contractors stops (for a specified length of time) making a part needed for repairs, the patent on that part becomes public domain.
  2. If a part goes out of production, the tooling to produce the parts must be sold at auction.

(There are similar clauses in book publishing contracts.  If the book that I wrote goes out of print for a specific length of time, I can ask the publisher for the rights back.  Then the publisher must either get the book into print or return the rights to me.)

These changes would probably make sense as soon as bankruptcy talk begins--which means already.

Is This Recession the Worse Than Other Post-World War II Downturns?

There's too much doom and gloom in the air.  Yes, the economy is in recession.  Yes, I think that the downturn will continue for a few more months.  Yes, we'll be a flurry of bankruptcies in the coming months.  But current attitudes are worse than the fundamentals dictate.  Let's compare the current recession with the two worst downturns of the post-World War II era:

 

The specific indicators I looked at are the ones the "official" recession determining group uses (detail below).  I looked at each concept's own peak and trough, which are often a month or two offset from the overall recession's peak or trough.  So far, this recession is milder than the worst we've seen since World War II.

The big "if" is that this recession is probably not over yet, so things are likely to get worse.  (However, two of the four coincident indicators turned up in the most recent monthly data.  Probably a blip, but you never know.)  My own prediction: this will end up in the neighborhood of those two other harsh recessions.

Business Planning Implications:  Start your contingency planning for the upturn.  Will you have the staff, equipment, resources and financing that you'll need to accommodate increased business?  Are your sales people charged up and energetically looking for customers (or have they become dejected order-takers)?  There are huge shifts in market share when the economy turns; make sure that you're on the upside of that shift.

Note on business cycle determination:  There is no government agency involved in declaring a recession.  The private non-profit foundation, the National Bureau of Economic Research, has a Business Cycle Dating Committee that determines the peak and trough of each business cycle.  This is a continuation of an academic research program that dates back to the 1920s.  They primarily examine the four indicators shown above.  Hit their website for the complete list of business cycle dates or their latest announcement.

Did Government Cause the Housing Crisis?

I interviewed Russ Roberts of George Mason on this topic.  Listen here.  He makes a good argument that government was part of the problem, but acknowledges a role for good, old-fashioned private sector mistakes. 

Officially a Recession, and Why Did It Take So Long to Determine?

Welcome back from your long holiday weekend. We're in recession.

The Business Cycle Dating Committee of the National Bureau of Economic Research, a non-profit foundation, announced that the last economic expansion peaked in December 2007.  Read the full report.

I've been asked frequently why it takes so long for an official determination.  Here's the story.  The government does not define recessions.  Back in the 1920s, the NBER began a research program into our economic history, resulting in a set of dates of economic peaks and troughs.  NBER has continued to update this chronology.  NBER is an academic organization, and its business cycle dating program is a service to the scholarly research community.  It is not meant to be a current commentary on the economy nor a forecast of future activity.

The committee wrestles with two issues when it sees a decline in economic activity.  First, it asks if the downturn we're seeing will survive the inevitable data revisions.  Second, if economic activity turns up tomorrow, will the downturn be significant enough that we will call this event a recession.  Although it has seemed obvious to many that this is a recession, that's because no one expected a sudden turnaround.  However, the committee does not use such a forecast in its determination.  And being academics, there's really no hurry.

While wrestling with these two issues, the committee also deals with data that may be telling different stories.  One reason it has not been obvious to me that we're in recession is that first and second quarter GDP growth were positive, with Q2 pretty strong.  It's hard to see such strong growth in the middle of a recession.  However, the monthly data that the committee focuses on all showed pronounced peaks.

So, when will the recession end?  My current forecast is that we hit bottom around March 2009.  If that's the case, the recession will have lasted 15 months, making it the third longest of the post-World War II era.  It would only be one month shorter than the two longest recessions of that time period (1973-75 and 1981-82).