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F e d e r a l R e s e rv e B a n k o f C h ic a g o

Business
Conditions
1966 Novem ber

Contents

The trend of business—
Construction lags

Bank earnings, 1965:
Banks set fast—and slow—pace

Futures markets and farm finance

Federal Reserve Bank of Chicago

T HE

BUSINESS

Construction lags
^Employment, industrial production and
total spending on goods and services reached
new highs in the third quarter. Construction,
however, continued in the decline evident
since last spring. More than half of the slide
in total construction is attributable to the
residential sector, but private nonresidential
construction and public construction also
have slowed somewhat.
Total construction was at a record annual
rate of 79 billion dollars in February and
March. By September this rate had dropped
to less than 73 billion. Production of con
struction materials and employment in con
tract construction also declined in marked
contrast to substantial increases in most
industries.
The work force in contract construction
was estimated at 3.2 million in September,
seasonally adjusted, about the same as a year
earlier, but about 2 0 0 ,0 0 0 less than the peak

in the spring. The rate of unemployment of
construction workers, however, was 4.8 per
cent in September compared with 5.8 percent
in the same month of 1965. Many construc
tion workers idled by the drop in home build
ing have found jobs in other types of con
struction or in other fields. Industrial and
commercial firms continually advertise their
needs for workers skilled in the building
trades—particularly electricians, plumbers
and steamfitters—for production jobs as well
as maintenance and repair duties.
Construction and th e cycle

Since the early Fifties, construction—in
cluding major repairs and alterations—has
accounted for from 10.5 to 11.7 percent of
all spending on goods and services each year.
The range for the 1960-65 period was re
markably narrow— 10.5 to 10.7 percent. Al
though construction in 1966 doubtless will

BUSINESS C O N D IT IO N S is published m o n th ly by the Federal Reserve B ank o f C hicago, George W . Cloos was
p rim a rily responsible fo r th e a rtic le " T h e tren d o f business— C onstruction lag s," W illia m J. H o c te r fo r " B a n k
earnings: Banks set fa s t— and slow— p a c e " and Ernest T . B aughm an fo r "F u tu re s m a rk ets and fa rm fin a n c e ."
Subscriptions to Business Conditions are a v a ila b le to the public w ith o u t ch arge. For in fo rm a tio n concerning
b u lk m ailings, address inquiries to th e Federal Reserve B ank o f C hicago, Box 8 3 4 , C hicago, Illin ois 6 0 6 9 0 .
A rticle s m ay be reprinted provided source is credited.
Econom ic Fact B oo k:

A n Economic F a ct Book o f th e Seventh Federal Reserve D is tric t has recently been

published. In this 4 9 -p a g e b o oklet have been assem bled considerable d a ta describing some o f th e m ajo r
economic fe atu res o f th e Seventh D is tric t states. Copies m ay be ob tained by w ritin g to th e Research D e p a rt
m en t o f this B ank.

Business Conditions, November 1966

be appreciably higher than last year, the rise
will be much less than for total spending. As
a result, the proportion of construction to
total spending is likely to decline to slightly
more than 10 percent.
Total construction can be divided conveni
ently into three categories—private residen
tial, private nonresidential and public. Each
of these groups will account for about onethird of total construction in 1966, but the
proportions have varied considerably from
year to year.
During the 1947-65 period, the propor
tion of residential building to total construc
tion has ranged from 37 to 54 percent. For
private nonresidential construction, the pro
portion to the total has varied much less—
from 27 to 34 percent—during the same
period. Public construction has tended to rise
relative to the private sector. Accounting for
only 17 percent of the total in 1947, the pub
lic sector has amounted to 31 percent of all
construction in recent years.
Year-to-year changes in residential con
struction have differed widely from changes
in nonresidential private construction. While
residential activity probably will be off about
5 percent in 1966, nonresidential construc
tion may be up about 10 percent. Similar de
velopments have occurred in other years of
prosperity. In 1951, 1956, 1957 and 1960,
residential construction declined while non
residential activity increased sharply. Con
versely, during years of recession or sluggish
growth, such as 1954, 1958 and 1962, resi
dential construction rose while nonresidential
declined or increased much less.
Inverse movements of residential and non
residential construction in periods of busi
ness expansion or decline is, in part, a matter
of cause and effect. Homebuilding is heavily
dependent upon credit availability. The aver
age new home is purchased with a 25-year

Residential construction
has trended downward as
proportion of outlays since 1950
percent of total

p rivate

re sid e n tia l

1966 estimated

o 1

i
'
i
1948 '50

i
i
I
I
I
I
'52
'54
*56

I
I
'58

I
i
'60

i— I— i— I— I
'62
'64 '66

maturity mortgage and a less than 30 percent
downpayment. Some transactions require
only a 10 percent downpayment and are
amortized over even longer periods. When
business expands vigorously, competition for
loanable funds is strong. In such times, funds
that might have been invested in residential
mortgages are channeled to other uses, in
cluding nonresidential construction.
Homes o r facto ries?

A large share of private nonresidential
construction, about 80 percent, represents
capital expenditures of commercial and in
dustrial firms and public utilities. The re
mainder consists of farm construction and
projects of nonprofit institutions, including
private hospitals, schools, churches, and re
search and recreational facilities.

Federal Reserve Bank of Chicago

In contrast to purchasers of residences,
business firms obtain funds from a variety of
internal and external sources. They have
access to the money and capital markets and
usually are not subject to usury laws and
various conventions that tend to hamper the
resid en tial co n str u c tio n se c to r in th e com
petition for funds.
Another advantage business firms have in
obtaining financing for nonresidential con
struction relates to the lesser significance to
them of interest as a cost. Gross revenues of
an apartment building may be only 10 per
cent of the value of the structure, and inter
est represents, by far, the largest expense of
the owner. For most businesses selling prod
ucts or services, variations in interest expense
are small relative to the cost of payments to
labor and supplies.
Construction costs rise

Availability of mortgage credit has not
been the only factor restraining construction
activity during recent months. Demand pres
sures on available manpower and certain
types of construction materials have caused
wages and prices to rise sharply. This devel
opment has been accompanied by delays in
completion of projects and decisions of some
businesses to defer new projects until firm
bids and more reliable work schedules are
possible.
The Department of Commerce index of
construction costs has risen at least 1 percent
in each year of the past decade. The annual
increase accelerated to 3.6 percent in 1965
and to more than 4 percent in the current
year.
New contracts negotiated by the principal
building trades unions in 1966 commonly
called for increases of 6 percent or more in
total hourly compensation, well in excess of
the average rise for industrial workers. In

addition, heavy use of overtime for some
skills has boosted labor costs by an addi
tional amount. This fact, together with heavy
demand for contractors’ services and uncer
tainties regarding the cost and availability of
materials, has caused many bids to be sub
mitted at levels well in excess of the rise indi
cated by the construction cost indexes.
The Bureau of Public Roads maintains an
index of bid prices on comparable highway
projects. This index rose almost 4 percent in
1965 and a further 7.4 percent in 1966.
In mid-1966 the average price of all con
struction materials was 4.1 percent above a
year earlier. Some materials and components
—such as insulating board, portland cement
and warm air furnaces—were up 1 percent or
less. Prices of certain other materials, includ
ing gypsum products, plate glass and vinyl
floor covering, were as much as 5 percent

Public construction
Has declined only slightly
since early 1966
billion dollars

Business Conditions, November 1966

lower than at this time last year.
At the other extreme, hardwood prices
were up 21 percent, sheathed cable 16 per
cent and copper tubing 39 percent. Most
lumber products moved to lower levels in the
late spring after the initial impact of military
needs had been absorbed and homebuilding
requirements were reduced.
C ontracts a n d plans

Tabulations of building starts and con
struction contracts provide useful “leading
indicators” of future activity in this industry.
Housing starts, an indication of construc
tion in subsequent months, are expected by
most analysts to be 15 to 20 percent below
last year during 1966. Expenditures on new
residential construction will be down much
less, perhaps only 5 percent. There are three
reasons: first, the inclusion in the dollar ag
gregates of outlays on residences started in
1965, second, the rise in homebuilding costs
and, third, the trend toward larger, more
elaborate units.
For many years the F. W. Dodge Corpora
tion has compiled reports of construction
contracts, primarily as a service for sub
contractors and suppliers of materials. The
Dodge seasonally adjusted index of con
struction contracts reached a record high in
April at 161 (1957-59=100). By August it
had declined to 139, about equal to the yearago level.
During the first nine months of 1966, total
construction contracts were 5 percent above
last year for the nation and 7 percent higher
for the Midwest. Until July, year-to-year de
clines for the residential sector were more
than offset by increases for other types, es
pecially factories and commercial building.
Recently an official of the Dodge Corpora
tion forecast that contracts in the final three
months of 1966 would be lower than in the

comparable year-earlier period. The entire
year was projected to show a 3 percent yearto-year rise, somewhat less than the increase
in construction costs.
The recent decline of construction con
tracts does not necessarily mean a drop in
total activity in the year ahead. Engineering
News Record, a publication serving the con
struction industry, reports data on large con
struction projects entering the planning stage.
New plans for the first nine months of 1966
were up from the same period of the previous
year by 15 percent for the nation and 19 per
cent for the Midwest. Plans for apartments
and manufacturing plants were below last
year, but most other categories—especially
schools, highways, sewers and waterworks—
showed substantial gains. New construction
plans were especially strong in September,
exceeding the year-earlier level by 25 per
cent.
W h e n w ill th e d eclin e end?

Apparently, the demand for new buildings
and other structures remains very strong. But
many plans will not be pushed through to
completion on current schedules if costs con
tinue to rise rapidly. Construction work has
been limited by availability of men, fabricated
components and the effects of these short
ages on costs, as well as reduced availability
of funds. Demand for labor has eased some
what since August. Any further alleviation of
shortages of resources will help promote the
development of additional projects.
Since World War II, the dollar volume of
new construction has declined only once—
in 1960. Forecasts of a prolonged slide in new
building, such as that which foreshadowed
the Great Depression, have been proved
wrong again and again.
Short of direct action by the Government
necessitated by wartime needs, it is unlikely

Federal Reserve Bank of Chicago

that an appreciable portion of the resources
of the construction industry will be idle in
the months ahead. Needs for residential build
ing will rise gradually, as indicated by the
decline in vacancies, growth in the adult
population and the resumption of growth of
the rate of family formation. Many new plans
for commercial and industrial projects are
temporarily “on the shelf.” Some Federal
Government work and grants-in-aid to local
governments have been postponed in line
with the Administration’s desire to hold down
aggregate spending. Certain proposed state

and local government bond issues, intended
to provide funds for construction, have been
withdrawn to await a more receptive capital
market.
Plans for urban transit facilities, slum
clearance, mass housing, airports, interstate
highways and air and water pollution projects
will receive renewed attention when man
power and materials are available. Each of
these programs, whether undertaken by gov
ernment or private firms, tends to stimulate
other types of construction required to serve
a growing population.

Bank earnings, 1965

Banks set fast— and slow— pace
et earnings vary greatly among banks,
even banks that may be similar in size and
certain other characteristics. Small banks,
for example, were widely represented among
both high- and low-earning banks in the
Seventh Federal Reserve District during
1965.
Detailed information is available on costs
and revenues for the 186 member banks that
participated in the functional cost service
provided by the Federal Reserve Bank of
Chicago last year.1 The major characteristics
of the 25 banks with highest net earnings and
the 25 banks with lowest net earnings are
described in this article. For the top group,
net earnings averaged $ 11 per $ 1 ,0 0 0 of
available funds and for the low earners, $4.
Available funds include demand and time

deposits and other liabilities plus those capi
tal funds not invested in banking premises
and other fixed assets. Net current earnings
represents the excess of current operating in
come over current operating expenses after
computed Federal income taxes. State and
local taxes and other nonoperating income or
expense, such as profits or losses on security
transactions and loan losses or recoveries, are
not included in the analysis.
D eposit size and earn in g s

The high-earning banks appeared with
relatively greater frequency among banks of
T h e functional cost service was described in
"Bank Profits— Costs and Returns for Major Func
tions, 1965,” Business Conditions, October 1966.

Business Conditions, November 1966

the 5-15 million dollar deposit size than
among the larger or smaller banks. The dis
tribution of the low-earning banks was
spread more evenly among all sizes.
Net current earnings per $1,000 of avail
able funds ranged from $14.79 to $9.64 for
the top-25 banks and from $5.13 to minus
$2.39 for the low-25 banks. Average net
earnings for the high-earnings group was
$10.83 and for the low group $4.05. The
largest concentration of the high-earning
banks was in the $ 10-11 range and for the
low-earning banks in the $4-5 range.
High-earning banks
Low-earning banks
Net
Net
Number
earnings
earnings
Number
per $1,000 of
of
per $1,000 of
of
funds used
banks
funds used
banks
(dollars)
(dollars)
9-10
5
Under 2
1
10-11
12
2-3
1
11-13
6
3-4
8
13-15
2
4-5
10
Over 5
5

An analysis of the variation in earnings
and deposit sizes by individual banks demon
strates no marked causal relationship be
tween size and earnings. Deposit size, there
fore, is not a major factor in determining
bank earnings as measured by net returns on
available funds.
The b alan ce sh e et

Balance sheets that show annual average
liabilities and assets were developed for each
of the participating banks. The liabilities in
clude deposits and capital—the funds-supplying functions. The assets include loans and
investments—the funds-using functions.
Earnings are generated largely by loans
and investments with some revenue obtained
from activity charges on checking accounts
and fees charged for other bank services.
Banks must hold a portion of their assets in
reserves, cash in vault and other very liquid

High-earning banks tend to be
concentrated in the 5-15 million
dollar deposit-size group
Functional cost service
participants, 1965
Deposit size

Total
banks

High-earning
banks

Low-earning
banks

(million dollars)
0-5

(number)
1

5-15

15-25

25-50

50-100

100-200

Over 200

186

Total

assets (such as short-term Government
securities) in order to meet deposit with
drawals or other sudden or unexpected de
mands on the bank. Since yields on such
liquid assets ordinarily are lower than yields
on loans and longer maturity securities, there
is a constant effort to balance the needs for
liquidity and earnings.
The mix of assets will depend also on the
demands for various kinds of credit experi
enced by the bank and any sizable shift in
bank expenses. For example, in recent years
many banks have boosted their interest pay
ments on time money and have acquired
additional time deposits. Since these funds
normally are less volatile than demand de
posits, it has been possible to offset this addi
tional expense in part by acquiring higher
earning assets with relatively less liquidity
and replacing some of the lower-earning but
more liquid assets.
Differences in balance sheet composition
affect both income and expenses, and, hence,
the portfolio yield and the cost of money.

Federal Reserve Bank of Chicago

The high-earning banks had net portfolio
income (total portfolio income net of all
expenses for loans and investments) of 4.4
percent compared with 3.9 percent for the
low-earning banks. Cost of money for the
high-earning banks was 2.2 percent while the
low-earning banks had a net cost of 2.7
percent. The top earners, therefore, gener
ated more income from their loan and invest
ment portfolios and at the same time secured
deposit funds at lower cost than the lowearning banks.
There are two major differences in the
asset composition of the high- and low-earn
ing bank groups. First, the more profitable
group employed a larger share of total assets
in state and local government securities
(municipals) than the less profitable banks
— 13 percent contrasted with 8 percent. (In
come from municipals is exempt from Fed
eral income tax.) The offset occurs in the
other securities category—largely Federal
funds sold, brokers’ loans and commercial
paper. U. S. Government securities account
ed for 25 percent of total assets in both
groups and total investments accounted for
41 percent.
The second difference in the asset mix is
in the relative share of total assets in real
estate loans and other loans. The more
profitable banks have about 20 percent of
their assets in other loans (mainly, business
and agricultural) and 15 percent in real
estate loans. The less profitable banks had
only 17 percent of total assets in other loans
and 18 percent in real estate loans. Instal
ment loans accounted for 11 percent of total
assets in both bank groups.
Two significant differences also are evi
dent between the two groups in the liability
and capital sections of the balance sheet.
First, time deposits account for 50 percent of
all deposits at the low-earning banks com

Small banks dominate
both high- and low-earning groups
bonk

deposit size (million dollars)
■

150
■

■

125 .lo w -earnin g bonks

•

100

h igh-earning bonks

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6
8
0
12
14
2
4
net eornings (dollars) per $1,000 of funds used

Note: Twelve banks have been excluded to avoid
disclosure of individual bank earnings.

pared with only 40 percent at the more
profitable banks. Time deposits can cost from
2 to 4 times as much as demand deposits
largely because of the interest expense. This
is an important factor and weighs heavily
in the net earnings results. The high-earning
banks have been able to rely more heavily on
demand deposits and have obtained their
available funds at a lower average cost.
Second, the volume of available funds sup
plied by the capital accounts—capital, sur
plus and reserves—also influence the net
earnings on available funds. In the 1965
functional cost analysis, capital funds were
assumed to be free of cost. They were not
treated as a separate function and none of
the operating expenses were charged against
them.2 Banks having relatively large amounts
of available funds from capital, therefore,
had an advantage in this analysis which
would be largely removed if earnings were
2In the 1966 functional cost service, the capital
accounts will be handled as a separate function and
will share in both bank revenues and expenses.

Business Conditions, November 1966

computed on the basis of return to capital.
The capital account provided about 9 per
cent of the available funds of the high-earn
ing banks and about 6 percent for the lowearning banks. Not all of the funds supplied
by the capital accounts become part of the
pool of available funds, however. Funds com
mitted to the bank building and other fixed
assets are netted out since these resources are
not available to the bank to hold as cash or
for use in the portfolio of loans and invest
ments.
Earnings

Competition and management skill largely

Distribution of assets
and liabilities
Functional cost service
participants, 1965
High-earning Low-earning
banks
banks
(percent)
Assets
12

Cash
Investments
U. S. Governments
State and local governments
Other securities

25
13

8
41

Total investments

3Direct expenses include salaries, wages and all
other costs of directly operating the function.

Loans
Instalment loans

Real estate loans
Other loans

Total loans
Other assets

46
1

Total assets

100

Demand deposits

Time deposits

50
2

Liabilities

Other liabilities
Capital and reserves
Total liabilities and capital

determine operating results for individual
banks. Net earnings of the four funds-using
functions are determined by three factors:
income, operating and overhead expenses
and the cost of money.
Direct expenses incurred in each function
are largely the responsibility of the official
in charge.3 In addition, each function shares
in the overhead expenses (business develop
ment and general administrative expenses)
of the bank. These expenses are under the
control of the bank’s management but are
not usually under the jurisdiction of the offi
cer in charge of a particular function.
Each function is charged for the funds that
it actually employs—the cost of money.
Functional cost utilizes the pool of funds
approach, in which each funds-using function
is assumed to draw money from a common
pool and, thus, is charged an identical
“price,” irrespective of the source of these
funds.4
Except for investments, the high-earning
banks had higher gross income in each func
tion than the low-earning banks. The greatest
difference in gross revenues between the two
groups was in the instalment loan function—
$11 per $1,000 of funds used.
The high-earning banks incurred lower

100

4This approach is believed to be a more realistic
reflection of day-by-day banking operations than
the asset-management theory in which special types
o f funds— such as time deposits— are assumed to
be allocated to special types o f assets— such as real
estate— and the function is “charged” at the rate
that the bank “paid” depositors for these funds.
Tying changes in asset composition to changes in
the mix of liabilities is a useful managerial tool for
long-run profit planning, but this approach tends
to misrepresent actual banking practices where the
overall quality of the security or loan in question is
more likely to be the criterion for action than
recent shifts in deposit mix.

Federal Reserve Bank of Chicago

total operating expenses in two of the fundsusing functions: instalment loans and other
loans. In the real estate loan function, the
low-earning banks had lower total operating
expenses— $2 less per $1,000 of funds used
than the high-earning group. Total operating
expenses were the same in the investments
function in both bank groups.
In the instalment loan function, the highearning banks had lower costs than the lowearning group in each of the three expense
categories. The net difference in expenses of
$12 per $1,000 of funds used was the result
of lower costs for salaries and wages, $3,
processing, $4, and overhead, $5.
The difference in total operating expense
in the other loan function was the result of
lower costs for salaries and wages and other
expenses.
In the real estate loan function, the lowearning banks were able to operate with
lower expenses for salaries and wages and
overhead expenses.
These findings suggest that the high-earn
ing banks have more efficient banking oper
ations in the instalment and other loan func
tions. However, the low-earning banks have
a sizable commitment of total assets to real
estate loans and apparently have developed
efficient methods for utilizing their personnel
and other resources in this function.
There was a greater cost of money in each
of the funds-using functions for the lowearning banks—$27 compared with $22 for
the high earners. The low group had approxi
mately 10 percent more time deposits than
the high-earning banks, which partially ex
plains the difference in the cost of money, as
well as higher operating expenses in the de
mand and time deposit functions.
The relative importance of the contribu
tion of gross revenues, total operating expenses and cost of money to the difference

Income,

expenses and
net earnings by function
Per $1,000 of funds used in 1965
Investment
High-earning banks
Total income

InstalReal
ment estate
loans loans
(dollars)
58

Other
loans

1
❖

Expenses
Salaries and wages
Other processing
Overhead
Operating expenses
Cost of money
Total expenses
Net earnings

1
*

Low-earning banks
Total income
Expenses
Salaries and wages
Other processing
Overhead
Operating expenses

Difference1
Higher income

Lower expenses

—2

Cost of money

Net earnings

Cost of money
Total expenses
Net earnings

*Less than $1.
4The difference between high-earning and low-earning
bank figures.

in net earnings varies among the four func
tions. In the investment function, the net
earnings advantage of high-earning banks
was due entirely to the difference in the cost
of money. In the other funds-using functions,
the high earners also had greater gross in
come and—except for real estate loans—

Business Conditions, November 1966

lower operating expenses.
Trust a n d s afe d ep o sit earn in g s

The trust department and safe deposit
rental functions provide specific services on
a fee basis. While these functions can con
tribute to the bank’s net earnings, they are
distinctly different in that neither utilizes any
of the funds provided by the deposit and
capital functions. As a result, these two func
tions do not share in the bank’s expenses to
obtain deposits—the cost of money.
A number of the 186 banks that partici
pated in the 1965 functional cost service do
not have trust departments; only 15 of the
25 high-earning banks and 18 of the lowearning banks offer such services. However,
all the banks in the high-earning group and
24 banks in the low-earning group provided
safe deposit services.
For these two bank groups, the cost data
indicate that the trust and safe deposit func
tions were not profitable operations in 1965.
The trust function in the high-earning group
had net losses equal to 1.5 times the five-year
average gross revenues from this function.
The net loss was even larger in the lowearning group— 2 .6 times the five-year aver
age gross income. Only three of the 15 banks
in the high-earning group and only two of
the banks in the low-earning group had prof
itable trust operations.
A simple cost and revenue analysis of trust
operations can be misleading, however. In
the first place, many banks in the Seventh
District—especially the smaller banks—have
relatively new trust departments. The initial
costs tend to be very high. Usually a highly
skilled trust officer—who can command a
sizable salary—must be hired. In addition,
adequate financial and legal advisory and
reference services must be secured.
Furthermore, most cost accounting pro

grams, including the Federal Reserve func
tional cost service, fail to assign an accurate
amount of income to this function. For ex
ample, trust deposits within the bank are not
assigned a share of portfolio income. Simi
larly, there is no workable method of imput
ing to the trust and safe deposit functions the
income which results from the “cross-selling”
of services. That is, trust and safe deposit
functions may attract or retain customers
who otherwise would not use the bank’s other
services.
Safe deposit boxes are a service that almost
all banks feel compelled to provide for their
customers even if operating expenses exceed
box-rental income. By implication, individual
bankers are apparently making a subjective
estimate of the cross-selling and are assum
ing that there are benefits that offset the loss
on this service.
In the functional cost service, safe deposit
expenses are compared to the current year’s
income. Expenses exceeded income by 21
percent in the high-earning banks, and by 89
percent in the low-earning group. Ten of the
high-earning banks had safe deposit oper
ations that were in the “black” compared to
seven in the low-earning group.
Conclusion

The earnings superiority of the high-earn
ing banks, as sketched in this statistical “pro
file,” would seem to be due to a combination
of three factors. First, the high-earning group
generated greater earnings from their loans—
particularly instalment loans. Second, the
high-earning banks were able to secure their
principal resource—funds for loans and in
vestments— at lower cost. Finally, in many
areas of banking operations, the high earners
were more efficient in the utilization of per
sonnel, equipment and other factors which
contribute to bank costs.

Federal Reserve Bank of Chicago

Futures markets and farm finance*
S ev eral commodities exchanges recently
have undertaken to provide facilities for trad
ing in futures contracts for live meat animals:
Chicago Mercantile Exchange:
Beef steers, beginning November 30,
1964
Feeder steers, beginning November
1965
Hogs, beginning February 1966
Chicago Board of Trade:
Beef steers, beginning October 1966
The Kansas City Board of Trade:
Feeder steers, beginning June 1966

This development is similar to the trading
in grain futures contracts which originated in
Chicago over 100 years ago. It reflects and is
a further step in the trend of United States
agriculture toward vertical integration and
the contract sale of future production.
For some agricultural commodities, large
proportions of the total supply are produced
by vertically integrated firms or under con
tracts between farmers and processors and
marketing firms. These commodities include
broilers, milk for fluid consumption, sugar
beets, seed crops and fruits and vegetables
for processing. For some of these, this type
arrangement is long-standing.
The commodities for which vertical inte
gration or contract production have seen the
greatest development tend to be those pro
duced in small, compact areas that have
fairly specialized outlets and require rela
tively large amounts of labor or cash expense
in their production. The crops and livestock
which are produced over wide areas by large
numbers of farmers and are marketed to a

multiplicity of outlets, thus far, have not par
ticipated greatly in the trend toward vertical
integration or contract production. This
could be because Government programs for
many years have provided relatively high
price support floors for these major crops—
wheat, corn, cotton, soybeans and rice—and
this has reduced any need to seek additional
price insurance.
This, however, is not an entirely satisfac
tory explanation since for 100 years or more
farmers have been able to sell some of their
major crops at firm prices for future delivery
but have made little use of the opportunity.
Yield insurance also has been available for
major crops but is not used widely by farm
ers.1
Government support of prices for cattle
and hogs has been intermittent and largely
indirect. Furthermore, under capable man
agement, production of livestock is less ex
posed than crops to the effects of weather and
other natural hazards. Farmers may be con
cerned more, therefore, about the risk of
price decline for livestock than the risk of
“crop failure.”
Futures m a rk e ts com pared

The livestock futures market represents a
somewhat different use of futures contracts
than the long-established and familiar trad*Summary of a speech given by Ernest T.
Baughman, Vice President and Director of Re
search, Federal Reserve Bank of Chicago, before
the 80th Annual Convention, Iowa Bankers Asso
ciation, Des Moines, Iowa, October 17, 1966.
’See “Crop
May 1966.

Insurance,” Business Conditions,

Business Conditions, November 1966

ing in grain futures.2 In grains, the major
function of the futures contract has been to
enable a holder of grain to “hedge,” that is,
to shift the risk of possible loss caused by
price decline to someone willing and able to
carry that risk. (In transferring such risk, one
also transfers the possible gain from price
increase.)
However, farmers or others, if they de
sired to do so, could sell grain for future
delivery at any time whether or not they were
holding grain in storage or were growing a
crop. Sale of a futures contract before the
grain is produced provides insurance against
possible loss from price decline but increases
the risk of loss from crop failure. The con
tract must be honored either by actual de
livery or by purchasing a comparable con
tract before the date for delivery. If a farmer
undertook to insure against price decline by
selling for future delivery and failed to pro
duce a crop, he would have increased, not
reduced, the risk.
The livestock futures, from the farmer’s
point of view, provide a means of contracting
future production at firm prices. This is simi
lar to a grain farmer selling future delivery
of a crop not yet produced.
From the point of view of livestock
processors, the futures markets in beef cattle
and hogs make it feasible to enter into con
tracts for future purchase of livestock at firm
prices. This may enable processors to assure
a more stable supply of livestock. Their
“long” position in these contracts (and ex
posure to risk of loss due to price decline)
can be offset by taking “short” positions on
futures contracts. At least one large meat
T o r a description of the technical features of
futures markets see “Beef Futures,” Business Con
ditions, March 1965; for information on current
contracts and fees make inquiry to the respective
exchanges or boards of trade.

packing firm has announced that it will enter
into such contracts—to purchase hogs and
cattle for future delivery— and hedge such
contracts through sales on the futures mar
kets. The prices at which processors will be
willing to purchase livestock for future de
livery will be determined largely by the prices
at which such contracts can be hedged, that
is, the price at which speculators are willing
to purchase futures contracts.
Livestock futures prices and cash prices
must converge when futures contracts ma
ture, but there is no necessary relation at
other times. Furthermore, there is no neces
sary linkage between livestock futures prices
in the various delivery months. Livestock are
produced throughout the year and are not
“storable” except for fairly short periods, and
there is no large inventory of the contract
grades and weights ready for market at any
given time. This is in contrast with grains,
for example, where the commodity is stora
ble, relatively large inventories are available
and most of a year’s production is consum
mated within a relatively short time span.
Marketings of livestock probably are suf
ficiently flexible and responsive to prices to
assure that deliveries can be made on any
futures contracts where delivery is desired.
The usual practice (as in grain futures) is for
such positions to be liquidated by offsetting
purchases or sales of contracts, not by mak
ing delivery of livestock. It is essential, never
theless, that delivery be possible. The con
tracts now in use appear to be functional in
this respect; they provide for delivery of
identifiable quality and quantity of widely
produced commodities at convenient loca
tions at prescribed times. Only 20 August
contracts for beef steers on the Chicago Mer
cantile Exchange were satisfied by deliveries
from a total of 22,369 such contracts. Deliv
eries of beef steers generally have been con-

Federal Reserve Bank of Chicago

summated without difficulty.
W h y th e re n e w e d in te re s t now?

It must be presumed that much of the re
cent interest in the possibilities of contract
ing the sale of future production reflects con
siderations other than a desire to raise the
general level of livestock prices. Any belief
that a change in market mechanisms and
practices can raise prices substantially with
out imposing effective control on supply is,
of course, a figment of the imagination. The
interest appears to have developed largely as
a result of changes in recent years in some of
the basic characteristics of agriculture which
affect risks in that industry.
While it has become trite to observe that
agriculture is a rapidly changing industry, it
is necessary to understand the general pattern
of changes transpiring and the forces bring
ing them about if developments in individual
facets of the industry are to be interpreted
meaningfully. A number of these develop
ments affect risk and, consequently, credit
arrangements—current and prospective.
Farmers have incorporated a tremendous
amount of new technology into their busi
nesses in the past 15 years. This has in
creased greatly their ability to produce crops,
livestock and livestock products. Total pro
duction of agricultural commodities last year
exceeded output in 1950 by 35 percent. How
ever, the tremendous impact of this tech
nology is demonstrated even more emphat
ically in the effects on farm population. The
population living on farms declined 46 per
cent to 12.4 million during this period or to
6.5 percent of the nation’s total. The man
hours of labor utilized on farms declined by
about the same proportion as population.
Total acres of cropland harvested de
clined 13 percent (reflecting largely the
Government programs to curtail production

and raise prices) while the amount of live
stock for breeding purposes remained essen
tially unchanged. However, these acres and
herds were divided among only 3.4 million
farms in 1965, 27 percent fewer than in
1950. The average size of farm, therefore,
has increased substantially in terms of crop
land harvested, breeding animals and total
production.
Farms have increased also in terms of
value—both the total and value per farm.
Total value of agricultural assets increased
80 percent during the past 15 years—to 238
billion dollars. This sharp rise has boosted
the amount of credit required to finance
transfers of ownership of farm assets. Farm
real estate debt, for example, increased 250
percent during the period—to 2 1 .2 billion
dollars.
Farmers’ annual production expenses have
increased substantially— 56 percent since
1950—to 30 billion dollars. This, too, has
boosted agriculture’s credit requirements.
Farmers’ non-real estate debt rose 190 per
cent—to 20.4 billion dollars. Total farm
debt, therefore, exceeded 40 billion dollars
at the end of 1965, compared with 13.1 bil
lion 15 years earlier. Owner equity has in
creased also— 6 6 percent— and, while still
large, has declined as a proportion of the
total value of agricultural assets.
Along with these trends, there has been a
trend toward greater specialization of pro
duction on individual farms, also a result of
the improvements in technology and mecha
nization. While many of these trends have
been evident for many years, the pace of
change in American agriculture appears to
have accelerated after World War II.
An important point, then, is that these
trends, by and large, are the result of im
provements in technology and progress in
mechanization, and there is no reason to be-

Business Conditions, November 1966

achieved by contract
ing commodities for
future delivery, this
also eliminates possi
bilities of any windfall
gains from price in
creases.
Historically, farm
ers have preferred to
be in a position to
benefit from any in
crease in price that
might occur during the
period when crops or
livestock were being
produced. In general,
farm ers have been
good risk bearers; they
have been usually un
willing to pay a sub
stantial premium in order to avoid risk of
price decline or low yield. This preference is
demonstrated for yields by the limited, al
though growing, participation in the all risk
yield insurance offered by the Federal Crop
Insurance Corporation and for prices by the
apparently limited use made by farmers of the
markets in grain futures. But this situation
may be changing. Price certainty may be in
creasing in importance relative to price level.

Volum e of slaughter beef contracts
traded on the Chicago Mercantile Exchange
thousands

22
20

lieve they have “run their course” or that
they can be moderated, except at great cost.
The feasible practice for farmers, bankers
and public officials, therefore, is to adjust to
such changes, not resist them.
The renewed interest that farmers display
in exploring more fully the possible benefits
to be derived from marketing arrangements
in which they contract the sale of future pro
duction appears to spring in large part from
changes in risks associated with changes in
the structure of agriculture and the costs of
producing agricultural commodities. With
larger farms, increased production per farm,
greater specialization of production, higher
cash costs of production and increased reli
ance upon credit as a source of capital, farm
ers’ equity in their products at the time of
marketing has declined. Therefore, even a
modest change in price has a large effect on
net income. To the extent this has occurred,
farmers have a greater interest in the possi
bilities of shifting risk of price declines; if

Futures, a risk s h ifte r

The experience to date, although limited,
suggests that futures markets for cattle and
hogs are workable. Their role will be deter
mined largely by the need for a mechanism
to shift risk. If farmers find they have greater
and greater need to shift risk of price change,
some form of arrangement to accomplish this
will come into widespread use. It is not neces
sary that farmers make widespread direct use
of futures markets for cattle and hogs in order
for such markets to serve their need. Farmers

Federal Reserve Bank of Chicago

could contract future production largely with
processors who, in turn, would hedge such
purchase contracts in futures markets. It is
essential, however, that there be broadly
based futures markets to accommodate the
hedging of the processors. Such markets must
have a broad range of speculators to assure
consistent and effective performance of the
risk-bearing function. Farmers are not ex
cluded from serving as speculators as well as
using the markets to establish prices for
future production. But the one role should
not be confused with the other.
C red it loins m a n a g e m e n t and cap ital

The perfection and widespread use of
futures markets for livestock would appear
to make it possible to extend greater amounts
of credit to some farmers, feeders and pro
cessors. Such customers will have demon
strated ability to perform their usual func
tions efficiently but may have inadequate
capital to make full use of their other re
sources — largely labor and management.
When such farmers, for example, can show
firm contracts in the futures markets or with
established buyers for the sale of future pro
duction at profitable prices, the risk in ex
tending credit to finance the production will
be reduced. Such customers, on average,
will earn less profit per animal, because of
the cost of shifting risk, but they will be less
likely to suffer catastrophic loss. Because of
the larger volume that can be financed, they
may make faster financial progress overall
than if they had to carry the risk themselves.
Young farmers who are well endowed with
labor and management but short on capital
may be able to use such markets effectively;
also for farmers who are heavily specialized,
whether or not large enough to provide a
fairly steady flow of livestock to markets.
The “typical” Midwest livestock farmer

probably will continue for some years to
carry most of the production and price risks
himself. But as farms are transferred to new
owners and farm debt rises relative to farm
assets and as the effects of recent and pros
pective technological developments percolate
further through the agricultural fabric, the
necessity and desire to transfer risk may be
come stronger. In this event, markets in live
stock futures would be expected to attract
widespread participation.
Interest may strengthen also in other facets
of risk transfer and means to avoid risk. Debt
can be minimized, for example, by renting or
leasing land instead of owning it. The same
applies with respect to certain machinery and
even buildings and livestock. Farmers’ and
farm managers’ major focus may shift grad
ually from the now almost universal goal of
acquiring ownership of agricultural resources
to that of acquiring the use of agricultural
resources owned largely or entirely by others.
The problems of providing credit service to
farmers (and to the owners of agricultural
resources and the purveyors of specialized
services sold to farmers) under these condi
tions would become increasingly complex.
Risk insurance and credit arrangements of
types not yet visualized may be needed and,
if so, will certainly be developed. The recent
initiation of markets in livestock futures may
be a harbinger of trends not yet evident to
either farmers, bankers, marketing firms or
public officials. The essential service to be
provided by credit will continue to be that of
helping competent managers to acquire the
use of resources needed to enable them to
utilize fully their labor and management in
producing commodities desired by consum
ers. Futures markets, contract sale of future
production and other arrangements for trans
ferring risk can serve a useful role in achiev
ing efficient production.

Full text of Business Conditions (Federal Reserve Bank of Chicago) : November 1966

FRASER