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review by the Federal Reserve Bank of Chicago Business Conditions 1969 November Contents The trend of business Another 1966 for homebuilding? 2 Changing styles in business finance 6 Federal Reserve Bank of Chicago THE OF BUSINESS Another 1966 for Homebuilding? X s 1969 a replay of 1966 in residential con struction? Through most of the first three quarters it certainly seemed to be. But a rise in housing starts in September, coupled with an upward revision of the August figures, ended, at least temporarily, the succession of month-to-month declines that began in Feb ruary. Yet, to judge from the continued slide in building permits and extreme tightness in the mortgage market, prospects are dim for any real resurgence in the final months of the year or early 1970. Even with the downtrend in 1969 starts, it appears that the total for the year will be close to 1.5 million, or about the same as in 1968. This would substantially exceed the 1.2 and 1.3 million totals for 1966 and 1967. One reason, of course, was the high level of activity early in the year when the decline started. Seasonally adjusted annual starts for January were 1.9 million and it was not until June that they slipped below the 1.5 million rate. For the first nine months of 1969, starts were 1.7 percent greater than in the same period a year earlier. A p artm en ts stro ng in e a r ly 1 9 6 9 The uptrend in building of apartments that began in late 1966 continued well into 1969. Indeed, starts of multi-family dwellings in the first nine months were 16 percent greater than in the corresponding months of 1968. Construction of single-family dwellings, on the other hand, was down 7 percent. Credit market conditions undoubtedly were primarily responsible for the divergence in performance by these two sectors of private homebuilding. For one thing, multiple dwell ings typically are financed by developers not subject to interest-rate ceilings imposed by usury laws or other regulations, while single family homes usually are financed by mort gage credit extended within such limitations. Consequently, when market interest rates are high and rising, mortgage credit tends to flow more freely to apartments and other commer cial properties than to the market for single family homes. Another factor is that single-family homes are financed in large part by savings and loan associations and mutual savings banks, and these financial intermediaries are quite vul nerable to the impact of tight credit upon their inflows of funds. During much of 1969, as in 1966 and late in 1967, the inflow of savings at thrift institutions declined as funds were redirected to higher yielding securities available from other sources. Apartments, on the other hand, are fi nanced principally by life insurance compan ies, pension funds, and other large institu tional investors in a position to make the large loans often required for such structures. These lenders have been relatively less af fected by competition from market interest rates than have the savings intermediaries Business Conditions, Novem ber 1969 and, therefore, have been able to sustain apartment lending at a comparatively high level. Adding to the inclination of the life insurance companies and other major insti tutional investors to continue supporting apartment construction (and nonresidential construction as well) has been the emergence of the equity kicker, an arrangement whereby the interest yield on a mortgage loan is sup plemented by a share of project earnings. The equity kicker may be compared to a variablerate mortgage, to the extent that it has the ability to keep the yield fairly well in line with market conditions during a period of rising prices and interest rates. M obile h o m es’ g ro w in g s h a re Even though on-site construction of single family homes has declined substantially dur ing 1969, the total production of single- Uptrend in mobile units sustains single-family share in total housing production thousands 1,000 800 single-family starts m u lti-fa m ily unit starts 1 2 1 2 1965 1966 1 2 1967 h a lf-y e a r totals, not seasonally adjusted I 2 1968 I___ I I 2 1969 family homes has held up, when mobile homes are taken into account. Factory shipments of movable prefabri cated units designed for more or less perma nent sites, as differentiated from travel trailers, have grown substantially. From 318,000 in 1968, shipments are projected at near 400,000 for 1969. Though many of these units become sum mer homes, temporary dwellings for seasonal workers and the like, an appreciable share of the yearly output provides essentially perma nent single-family housing. Indeed, mobile units today are supplying about four-fifths of all new low cost ($15,000 and less) single family homes. Undoubtedly, the pronounced growth reflects primarily the sharp climb in conventional on-site construction costs. Cushioning from tw o sources The impact on housing of credit market tightness in 1969 might have been consider ably greater except for two factors not present earlier. One of these has been the active role of the reconstituted Federal National Mort gage Association (FNMA). The FNMA each week auctions commitments to accept future delivery of Federal Housing Administration and Veterans Administration mortgages orig inated by lending institutions. Mortgage com panies are the major participants in these auctions. Since the inauguration of the present procedure in 1968, the FNMA has consider ably enlarged its operations, giving lenders assurance of an ultimate market for a grow ing share of the loans advanced to real estate developers. While the FNMA has been obliged to step up its own borrowings in order to finance its purchases of mortgages, the existence of this expanded backstop for the market probably has enhanced the ability and willingness of lending institutions to com mit funds to builders. 3 Federal Reserve Bank of Chicago In addition, there has been the relatively aggressive posture of the Federal Home Loan Bank System (FHLB). Twice in the past year, the FHLB has reduced liquidity require ments applicable to member savings and loan associations while encouraging the associa tions to utilize Bank advances to support ex pansion of their mortgage loan portfolios. Home Loan Bank advances to member asso ciations reached the unprecedented level of $8 billion in early October. These advances —a partial substitute in the short run for savings inflow to the associations—oblige the Home Loan Banks themselves to raise funds in the capital market. This additional source of funds probably has supported mortgage lending by the savings and loan associations during a time of uncertainty over their pros pective inflows of savings. Is w h ip lash in e v ita b le ? During any time of tightness in credit markets some prospective borrowers are bound to be disappointed. Some are unwilling or unable to pay higher interest rates. They apparently consider the cost to be excessive in relation to the urgency of their needs. Some others, however, are excluded by the practice of nonprice rationing that supplements the role of interest rates in credit markets. These would-be borrowers may be confronted by increased equity requirements, shortened loan maturities, or stiffer collateral and credit standards that make them ineligible for the full amount of credit they seek—even though they are willing to pay the going rate. Still other factors are at work in times of tight credit. These include such institutional constraints as interest rate ceilings, established by usury laws and administrative regulations, which interfere with market processes and alter the pattern of credit allocation. The effects of tight credit probably are seen more clearly in housing than any other one sector of the economy. Interest costs loom relatively large to many homeowners Federal agency support for housing on a larger scale in 1969 than in 1966 FNM A m ortgage holdings, and its own m arket borrow ings, more than double Seasonal rise in FHLB ad van ces to saving s and loans extends through third q uarter to new high billion dollars billion dollars Business Conditions, Novem ber 1969 and a rise in interest rates often discourages their use of mortgage credit. Moreover, for many purchasers of homes, the amount of credit required is large relative to household income and assets, so that any tightening of credit standards, such as the maximum debtequity ratio or income-to-debt relationship— or rise in house prices—excludes a substan tial proportion of prospective borrowers from the market. Such effects are illustrative of the way the credit market functions, serving to channel the available short supply to those having the most urgent needs or the least sensitivity to the rising cost and who are best able to satisfy lenders of their capacity to meet repayment schedules. The impact of tight credit on housing fi nance is accentuated by certain characteristics of the principal suppliers of mortgage credit. The savings and loan associations and mutual savings banks are alike in that they hold largely long-term assets (predominantly mort gage loans) that are supported by short term liabilities (that is, deposits or share accounts that, in practice, are paid on de mand). A strong rise in yields on alternative short-term assets such as Treasury bills tends to draw away funds that normally would flow to the savings and loan associations and mu tual savings banks. Notwithstanding that in times of tight credit new mortgage loans made by the thrift institutions will bear rates reflecting prevail ing conditions in the mortgage market—the great bulk of the mortgage loans on the books of these institutions were made earlier at the lower interest rates prevailing under easier credit conditions. As a result, average earn ings on mortgage holdings tend to lag the market in a time of rising interest rates, and it becomes increasingly difficult to pay the rates that must be offered if savings funds are to be attracted. In the present circumstances, there prob ably is little that can be done to correct this situation. But a shift to mortgage instruments providing for interim rate adjustments, both upward and dow nw ard depending upon the course of mortgage market conditions, ap pears to have promise as a longer term solu tion. During the immediate future, prospects for the savings institutions will likely depend upon the emergence of easier credit market conditions and lower market interest rates— something that hinges on the curbing of in flationary pressures. 5 Federal Reserve Bank of Chicago Changing styles in business finance Rip Van Winkle skilled in the methods and techniques o f business finance— 20, 10, 6 or even 5 years ago—would find his knowl edge seriously outdated were he to return to the scene today. Changes in practices have been increasingly rapid in recent years. Pro spective vigorous competition for funds by governments, consumers, and businesses in the 1970s suggests that experiments and change in financial management will continue. In the late 1940s, many business corpora tions held large amounts of cash and lowyield government securities. Debts were low relative to assets and earnings. Corporate ex ecutives commonly boasted that their firms were debt free, with neither outstanding bank loans nor bonds. Almost every year since World War II, ag gregate corporate holdings of liquid assets have declined relative to liabilities. Close control of cash positions of U. S. business firms increasingly has become a job for spe cialists. Along with the decline in liquidity more and more corporation executives have set aside their anti-debt scruples. In recent years, an increasing number of these execu tives have begun to point with pride to high indebtedness that leverages upward the earn ings per dollar of equity—assuming, of course, there are earnings. Financial managements in recent years have made extensive use of commercial paper, leasing agreements, convertible debt and preferred stock, subordinated debentures, mortgages or other loans with equity kick ers (participations in earnings), term loans, revolving credits, Eurodollars, and Eurobonds. The pace of change has accelerated under conditions of monetary restraint and the business boom. The explanation is found in the long-continued high level prosperity and the strengthening of inflation. These have reduced the apparent risks and increased the rewards—current and prospective—of inno vation in financial techniques. Significant also has been the slow but steady succession of financial executives in both industrial firms and financial institutions. Those schooled in the adversity of the Great Depression are being replaced by younger men who have known only economic growth and upward pressures on both prices and wages. N e e d e d — $ 5 0 billion Business corporations (other than banks, finance companies, savings and loan asso ciations, insurance companies, and the like) raised $113 billion in 1968 to finance capital expenditures, working capital, and for other purposes. This was a record amount—up 19 percent from 1967 and double the average annual requirements of the early 1960s. In 1969, an even larger amount, perhaps $120 billion, will be raised. About three-fifths of the funds used by these nonfinancial corporations in recent years have been from internal sources, mainly undistributed profits and depreciation. In 1969, about $50 billion will have to be ob tained externally: from security issues, loans, trade debt, and increases in other liabilities. In seeking outside funds corporations, of course, compete in the credit markets with the Federal government, state and local gov ernments, consumers, unincorporated busi nesses, farmers, and foreign borrowers. Business Conditions, Novem ber 1969 When profits are favorable and opportuni ties for expansion appear attractive, corpo rations are vigorous competitors for funds. Interest is typically a relatively small item in their total costs, and, like other expenses, is tax deductible. They pay the going rates, knowing that competitors must do the same. Furthermore, corporations are exempt from usury laws and similar regulations that re strict many individuals and governments in their access to funds. They can obtain funds from a variety of sources utilizing equity financing as well as short- and long-term bor rowings from various lenders. The largest share of corporate funds has always been the cash provided from current operations—taking the form of retained earn ings, depreciation, and increases in reserves, including reserves for profits tax liability. On average, in the postwar period about twothirds of corporation funds have been obtain ed from internal sources. This proportion has tended to rise in years of business reces sion or slow growth, and to decline in years of vigorous expansion when funds from internal sources were supplemented more heavily with funds from external sources. As recent ly as 1965, 66 percent of corporate funds were from internal sources. This proportion has dropped each year since then, probably falling below 60 percent in 1969. In the early postwar years, retained profits were larger than depreciation. But deprecia tion has grown steadily with rising investment in new plant and equipment and with changes in Treasury regulations permitting faster write-offs. Retained earnings have fluctuated with changes in profits. Since 1967, deprecia tion has been more than double retained earnings. In 1969, depreciation may exceed $47 billion and may provide corporations with almost 40 percent of their total new capital funds needs. Corporate capital outlays have outrun cash flow since 1965 b illio n d o lla rs ‘ E stim a te d . ^ U nd istributed p ro fits p lu s d e p re c ia tio n . 2N et in cre a se S O U R C E : Flow of Funds, F e d e ra l R eserve B o a rd . Total after-tax profits of nonfinancial cor porations probably will reach a new high in 1969, exceeding last year’s $40 billion total. But with dividends continuing to rise, undis tributed corporate profits probably will only about match last year’s $20 billion total, which was below the record set in 1966. Most corporate managements attempt to maintain or expand dividends, but some have announc ed reductions or omissions in recent months in order to conserve funds for other uses. Money owed on Federal income taxes (and to other creditors) helps to finance business firms until payments are made. Starting in 1967, large corporations have been required to pay income taxes in quar terly instalments in the year profits are made. Underpayments of as much as 20 percent are not penalized, however, and the penalty for larger underpayments is 6 percent per annum. With market interest rates at 8 per cent or more, deferment of tax payments can be a relatively cheap source of funds. Federal Reserve Bank of Chicago Deferred payment of trade accounts is another method of easing the burden on fi nancial resources, especially when cash dis counts are insufficient to encourage prompt settlement of invoices. Since most corpora tions have trade receivables as well as trade payables, the inclination to defer payments works both ways. On balance, attempts to slow payments of trade debts probably in crease the financial burden on corporations, especially large manufacturers, because they commonly finance customers’ inventories in this way. All told, in 1969 internal sources of funds for nonfinancial corporations—depreciation, undistributed profits, and the rise in the tax liability—will probably exceed last year’s total of almost $70 billion. But, because uses of funds are larger in 1969, the need for funds from outside sources has risen. Corporate liquid assets have declined relative to liabilities and sales percent ‘ E stim ate d . SO U RC E: U ses of funds 8 Purchases of new buildings and equipment will utilize about two-thirds of the funds ob tained by nonfinancial corporations this year. This ratio is near the average for the postwar period, but is above the 60 percent average for the early 1960s before capital spending accelerated. In 1969, corporate spending for buildings and equipment may reach $80 bil lion, up about 10 percent from 1968. Most industries have slightly scaled down capital spending plans since the first quarter of 1969. Lower than expected sales, concern over general economic prospects, delays in the completion of construction projects, and slow deliveries of equipment apparently are the major causes. In some instances, spending plans were curtailed because of inability to obtain financing on acceptable terms. Some corporations, however, have raised their spending plans. Important among these are most utilities—water, gas, electric, and com- S e cu ritie s an d Exchang e C o m m issio n an d Flow of Funds, F e d e ra l R e se rve B o a rd . munications—that are finding their facilities increasingly inadequate in the face of sharply rising demand. Some manufacturing compa nies, in efforts to cut costs and improve the quality of products, have also added to back logs of projects, even though there are mar gins of unused capacity. A number of private surveys taken in the early fall of 1969 indicate that capital expen ditures would rise next year—perhaps by 5 or 10 percent. Since prices for capital equip ment are expected to rise by about 5 percent, relatively little increase is indicated for physi cal volume. Experience with these surveys suggests that capital spending plans can be adjusted either up or down, depending on future developments. Next to plant and equipment, the most im portant use of corporate funds has been credit extended to customers—consumers, busi- Business Conditions, Novem ber 1969 nesses, and government. In 1968, receivables rose by almost $17 billion—a record amount. The rise will be even larger in 1969. Inventories rank after receivables among the uses of funds for working capital. Corpo rate inventories rose about $10 billion in 1968—more than in 1967, but less than in 1966 when they rose very rapidly after sales slowed late in the year. Like receivables, in ventories appear to be rising more in 1969 than in 1968. Any slowdown in sales is likely to bring a temporary bulge in inventories be fore adjustments in orders and production can be made. Even if the rise in the dollar volume of business activity were to moderate further in 1970, inventories probably would continue to rise, although perhaps at a slower pace. For competitive reasons inventories must be adequate to accommodate customers who have alternate sources of supply. Corporate inventories have not declined in any calendar year since 1958. Even the recession year of 1960 saw a $3-billion increase. As in the case of receivables, suppliers’ investments in in ventories, especially finished goods, lessen the financial requirements of business cus tomers who would otherwise have to carry larger inventories. Liq u id ity sq u e e ze Composite balance sheets can give only partial and tentative indications of changes in corporate liquidity. In essence, liquidity is a state of mind, a matter of judgment, and is related to current and prospective cash flows, commitments to spend or lend, and to credit availability. Nevertheless, changes in liquid assets, especially in relation to current liabili ties, provide a clue to the pressures upon corporate financial resources. At the end of World War II, liquid asset holdings of corporations, consisting then mainly of demand deposits and short-term government securities, exceeded 90 percent of current liabilities. Since then this ratio has increased appreciably only in 1949. By the mid-1950s, the liquidity ratio had dropped below 50 percent. The ratio reached a low of 27 percent in 1967 before increasing slightly in 1968. Similar trends are noted when liquid assets are compared to total liabilities or to sales. This year, the liquidity ratio appears to have declined further as many corporate treasurers have reduced liquid assets in the face of high borrowing costs and heavy needs for outside funds. The decline in liquid assets in the postwar period has been a relative decline in most years. This year, for the first time since 1960, there may be a decline in the dollar total of liquid assets. Despite increased needs for funds for all major purposes and higher borrowing costs than in earlier years, corporations were able to increase their liquidity slightly in 1968 on a relative basis and by $9 billion, or 12 per cent, in dollar totals. The buildup in liquidi ties last year is one reason why corporations could increase their investments in capital goods and working capital. Changes in the mix of corporate liquid assets provide insight into the changing finan cial patterns of the postwar period. Demand deposits and currency were more than half of corporate liquid assets until 1963. At the end of 1968, this proportion had declined to 35 percent, and is probably even lower at the present time. Corporate holdings of demand deposits and currency (currency is relatively unimportant) reached a high of $33 billion in 1958. Ten years later the amount was $28 billion, even though the volume of pay ments has increased greatly. The obvious reason for holding demand deposits is to make payments. However, Federal Reserve Bank of Chicago substantial, although unknown, amounts of corporate demand deposits are either com pensating balances under loan agreements or balances held to reimburse banks for other services. The tendency has been to reduce demand deposits under conditions of high interest rates and tight credit. Although demand deposits of corporations have declined in most recent years, their hold ings of time deposits have increased. Rates paid by banks on time deposits increased sharply in the 1960s as banks began to tap this source of funds. In addition, holding time deposits in commercial banks tends to solidify lender-borrower relationships, espe cially in times when banks are unable to com pete actively for funds because of rate ceilings on such deposits. Corporate holdings of bank time deposits exceeded $25 billion at the end of 1968, up from less than $2 billion in 1959. Holdings have declined sharply in 1969, Equity-type securities account for growing share of new issues* billion dollars 18 convertible bonds____ 1 12 — nonconvertible bonds I8% H >3% 9 — 6 — rF W 3 - l 0 _|J I 10 Se cu rity issues rise stock 15 65% l 70% l 60% | 2 I 2 I I I I 1967 1968 I 2 1969 * G ro s s p ro ceeds. S O U R C E : S e cu ritie s an d E x c h a n g e C o m m issio n . partly because banks were not permitted to pay competitive rates, and partly because corporations needed funds for other purposes. Federal government securities continued through the first half of the 1960s as the dominant short-term investment of corpora tions but have declined sharply in recent years. Holdings reached a high of $25 billion in 1959. By the end of 1968, this amount had declined to $14 billion, mainly because of the attraction of higher yielding time deposits, commercial paper, and other short-term in vestment opportunities. Commercial paper (short-term unsecured notes of business corporations and financial institutions) has become a major outlet for surplus corporate funds in recent years. At the end of 1968, corporate holdings of com mercial paper were about equal to their hold ings of government securities. About twothirds of the commercial paper outstanding was held by corporations. Corporations sold a record total of $20 billion of securities in the first nine months of 1969, 25 percent more than in the same period of 1968, and more than in any entire calendar year prior to 1967. Moreover, many issues apparently have been postponed, await ing a more receptive market. (These data include issues of financial corporations as well as domestic issues and foreign issues of nonfinancial corporations.) Refundings of outstanding bonds have been rare in recent years because of prevail ing high interest rates. Thus, virtually all of the gross proceeds of these issues have been for new capital. The net increase in securi ties outstanding is always substantially less than gross proceeds of new issues. Bonds are paid off at maturity or are purchased for sinking funds, some stock is repurchased by Business Conditions, Novem ber 1969 issuing companies, some businesses are liqui dated, and some securities are retired with the proceeds of bank loans or other funds, espe cially in conglomerate mergers or other finan cial reorganizations. Also, the debt-equity mix is influenced by conversions of one type of security into another, as when convertible debentures are exchanged for shares of a cor poration’s stock. Last year, when $22 billion of stocks and bonds were issued by all corporations, the net increase in outstandings was about $14 billion. In recent years, the net increase in outstandings has ranged from less than 60 percent to almost 80 percent of the gross pro ceeds of new issues. Net security issues of nonfinancial corporations totaled $12.1 bil lion in 1968, well below the $17.4 billion record set in 1967, but more than in any previous year. Net sales of stock have played only a small role in the financing of corporations in recent years. Retirements of common stock last year actually exceeded new issues by about $1 billion, in part because of retirements result ing from merger agreements. In the five years, 1964-68, net funds raised through stock sales by nonfinancial corporations totaled a rela tively modest $4 billion, while sales of bonds netted almost $48 billion. Although the net increases in stock out standing in the aggregate have been small in recent years, many individual firms have acquired substantial sums through sales of stock. Moreover, the amount increased sharply. Sales of common stock increased steadily from the second quarter of 1966, when sales totaled less than $200 million, to the second quarter of 1969 when sales were $2 billion. Even periods of falling stock prices did not halt the trend. Greater emphasis has been placed on the use of bonds convertible into stock, although the uptrend has not been Outstanding debt of nonfinancial corporations billion dollars 240___| | i | | other loans _____ [ bank loans 200— H H | bonds 1948 1953 ------------------ 1958 1963 1968 year-end figures S O U R C E : Flow o f Funds, F e d e ra l R eserve B o a rd . as continuous as the rise for common stock. Only half of gross sales of corporate securi ties, totaling $13.5 billion in the first six months of 1969, were straight (noncon vertible) bonds. In the first half of 1968, 70 percent of new security issues had been nonconvertible bonds and in earlier years the proportion was even higher. The trend to equity, or equity-type, securi ties is related to the strengthening of inflation in the past several years. Many investors are convinced that the best returns on invest ments, current yield plus capital gains, have been from equities, and that this will continue to be true in an inflationary environment. Average common stock prices were down more than 20 percent in late September from 11 Federal Reserve Bank of Chicago the peak level of November 1968. Inflation accelerated in this period, thereby casting doubt on the usefulness of stock as a hedge against inflation. Also, prices of outstanding bonds declined during this period as interest rates rose. In the late 1940s, new high-grade cor porate bond issues yielded about 2.6 percent, while stock yields commonly were 6 to 7 percent. Corporate bond yields did not move above 4 percent until the late 1950s. After continuing on a rather level plateau in the Sources and uses of funds—nonfinancial corporations A v e ra g e 1961-65 D o lla r am ount 1966 P e r cent D o lla r am ount 1968 1967 Percent D o lla r am ount P e r cent 1969* D o lla r am ount P e r cent D o lla r am ount Percent 1 12.9 100 1 21 .0 100 (am o u n ts in b illio n s) Sources Total 6 9 .5 100 101.1 100 9 4 .8 100 U n d istrib u ted p ro fits 15.5 22 2 4 .8 25 21.1 22 2 2 .0 19 2 2 .0 18 D e p re ciatio n 3 0 .7 44 3 8 .2 38 4 1 .2 44 4 4 .3 41 4 7 .0 39 5 .3 8 11.4 11 17.4 19 12.1 11 15.0 12 12 17.0 14 N et se cu rity issues Stocks Bonds 0 .8 1.2 10.2 4 .5 C h a n g e in lo an s 7 .4 Bank loans 2.3 3 .7 11 12.1 - 15.1 12 10.7 0 .8 12.9 11 14.1 6 .9 5 .2 7 .2 3 .9 Mortgages 2 .9 2 .7 3.8 Other loans 0 .8 2 .5 1.7 3 .0 C h a n g e in p a y a b le s 5 .7 8 7.8 8 3.1 3 9.8 8 11.0 9 C h a n g e in o th er lia b ilitie s 4 .9 7 6 .8 6 1.3 1 10.6 9 9 .0 8 Total 6 8 .0 100 9 9 .0 100 9 1 .4 100 1 11.2 100 1 20 .0 100 N e w b u ild in g s a n d e q u ip m e n t 67 Uses 4 4 .5 66 66.1 67 6 8 .3 75 7 2 .5 65 8 0 .0 C h a n g e in in v e n to rie s 5 .4 8 16.2 16 7 .5 8 9 .7 9 16.0 13 C h a n g e in re c e iv a b le s 10.3 15 11.9 12 9 .7 11 16.6 15 19.0 16 C h a n g e in liq u id a sse ts 2 .7 4 1.1 1 0 .8 1 8.9 8 3 .0 — 3 C h a n g e in o th e r a sse ts 5.1 7 3 .7 4 5.1 5 3 .5 3 8.0 7 - D isc re p a n cy : S ou rces less uses 1 .5 2.1 *E s tim a te d . S O U R C E : A d a p te d fro m F lo w o f F u n d s, F e d e ra l R e se rve B o a rd . 3 .4 1.7 1.0 Business Conditions, Novem ber 1969 early 1960s, bond yields began to rise sharply in 1966. In September and early October 1969, new top-quality corporate bonds yielded 8 percent or more—the highest in modern times. Common stock yields in recent months averaged about 3 percent. For many firms, funds obtained through sales of stock are cheaper than funds obtained through sales of bonds, even though interest on bonds is a deductible expense in comput ing corporate income taxes. Dividends on stock, on the other hand, are not a deductible expense. Therefore, with the tax rate on cor porate profits approximately 50 percent, the net cost of capital raised through bond issues typically is about one half the market yield, when comparisons are made with the cost of capital raised through sales of stock. The rise in interest rates relative to stock yields doubt less has encouraged some corporations to raise funds by selling additional stock. Bonds carrying conversion privileges, or accompanied by stock purchase warrants, offer lower yields than bonds without such features. These “hybrid” securities have ap peal to investors who desire the safety of debt against substantial declines in price while ob taining a chance to share in the gains if shares of the issuing corporation’s common stock rise appreciably in value. Another method of sweetening bond issues is to provide that the securities will be non-callable for redemption for a period of five, ten, or more years, thus allowing holders an opportunity to benefit from capital gains if market interest rates decline. The tendency has been to strengthen non-callable features in the past two years. In recent years, corporation bond issues have been sold in an increasingly competitive market, which is tapped also by banks and finance companies, foreign borrowers, and most important, federal government agencies. Liquid assets of nonfinancial corporations billion dollars S O U R C E : F lo w o f F u n d s, F e d e ra l R e se rve B o ard . Nonguaranteed agency issues and loan partic ipation certificates marketed by such organi zations as the Federal National Mortgage Association, the Home Loan Banks, and the Commodity Credit Corporation are not ac corded the same market status as direct obli gations of the Treasury. (Some financial insti tutions classify holdings of agency issues with corporates, rather than governments.) In 1968, agency issues outstanding rose by a record $5.7 billion, and the prospect is for an even larger rise this year. In the five years, 1964-68, when net funds obtained through bond sales by nonfinancial corporations to taled $48 billion, agency issues totaled $18 billion—far more than ever before. In the same period, net sales of bonds by banks and finance companies were $8 billion and sales of foreign issues were $4 billion. Credit market borrowings of nonfinancial corporations outstanding at the end of 1968 totaled almost $260 billion, up 70 percent in five years. In the aggregate, these debts have 13 Federal Reserve Bank of Chicago increased every year since 1945. More than half of corporate credit market debt consists of bonds. This proportion has been stable at 53 percent since 1964. In the early 1960s, more than 60 percent of cor porate debt was bonds, the decline in this proportion was associated with a rise in other debts, especially mortgages. Lo ans an d m o rtg ag es 14 Bank loans, other than mortgages, account for 26 percent of total corporate debt, mort gages 15 percent, and other loans 6 percent. Loans from commercial banks have always been a major source of corporate funds, espe cially in the early stage of a rapid business upswing. In years such as 1947, 1956, 1959, and 1965 the proportion of bank loans to total corporate credit market borrowings has increased. In the later stages of an expansion, or in periods of reduced activity, some of these loans are either repaid or refinanced as long-term debt or equity. Large commercial banks typically consider commercial and industrial loans their main lending activity, and their major source of earnings. They are ready to de-emphasize investments and other types of lending when business customers, especially those with established lines of credit, need funds. Prior to the 1930s, almost all bank loans were short term (under one year), usually with maturities of only a few months. Since World War II, more and more banks have made longer maturity term loans, often three to five years in maturity, and have offered revolving credit agreements that are renewed or modified periodically. Bank loans of nonfinancial corporations outstanding totaled $68 billion at the end of 1968, up 12 percent from a year earlier, and up almost 90 percent in five years. At times of extremely heavy demands for funds, espe cially in 1966 and 1969, banks have been hard pressed to satisfy all loan demands from high-grade corporate borrowers. After rising rapidly in the first half of 1969, bank loan growth slowed in the third quarter. Pressure of bank loan demand in 1969 is indicated by the fact that the prime rate charged by large commercial banks on un secured loans to highly rated corporations was raised three times in the first half, reach ing 8.5 percent in June. For some prime rate customers, the effective rate on such loans is 10 percent or more if allowance is made for compensating balance requirements. The prime rate was 4.5 percent in the late 1950s and 2 percent in the late 1940s. Even in 1929, top-rated customers paid only 6 percent. Some commercial banks have been experi menting with equity participations on busi ness loans and mortgages. Such participations are authorized under the Comptroller of the Currency’s ruling #7312 which was pub lished in November 1966. Apparently this practice has not become widespread. Corporate mortgages include mortgages on industrial, commercial, and residential prop erties. Although some of these mortgages are relatively large, most reflect financing of small- or medium-size business. Business mortgage funds have been obtained princi pally from life insurance companies, but banks, savings associations, pension funds, and individual investors also are important lenders in this area. Corporate mortgages have provided a flex ible source of funds for many firms with properties offering suitable collateral. These loans typically are exempt from state usury ceilings—unlike mortgage loans to individ uals. In addition, terms can be arranged with variable returns to the lender. Increasingly in the past year or two, contracts have pro vided escalation clauses adjusting payments Business Conditions, Novem ber 1969 periodically to changes in the commercial bank prime rate or some other market interest rate. Also, equity participation features com monly have been included giving lenders stock purchase warrants, a proportion of the gross rentals, or a share of profits associated with the structure bearing the mortgage. Corporate mortgages outstanding totaled $38 billion at the end of 1968, up 15 percent from a year earlier and up 80 percent in five years. Loans to corporations, other than mort gages and bank loans, totaled only $ 16 billion at the end of 1968. Part of these loans are owed to sales and commercial finance com panies, an important source of funds for small- and medium-size businesses. The most dynamic factor in the rise in other loans in the past two years, however, has been commer cial paper—the short-term unsecured notes of large firms with excellent credit rating that are sold to the public. Commercial paper of corporations placed through dealers (other than bank-related paper) exceeded $10 billion at the end of August 1969—an increase of more than 40 percent from the start of the year. This year, bank holding companies and bank affiliates have begun to market commercial paper. A large portion of these funds are re-lent to business corporations. Another rapidly growing method of busi ness finance is equipment leasing. Computers, motor vehicles, and virtually every other type of equipment can now be leased; and leasing is used by all types and sizes of business, including large corporations. Leases take the place of equity or debt financing, but do not appear as a liability on the balance sheet. Reliable data on the current volume of leas ing is not available, but it probably amounts to several billion dollars. Rising working capital needs spur bank loan growth The rapid developments in corporation finance of recent years have not exhausted the possibilities for further change. Corpora tions will probably find ways to reduce liquid reserves still further, whenever these funds can be profitably used in operations. Chan nels may be developed to sell bonds and notes to individuals of relatively modest means. Equity participation features in debt issues may become even more widespread, espe cially if the public’s fears of accelerating in flation are not overcome. Past standards of sound finance covering debt-equity ratios, interest as a proportion of total expense, and the adequacy of liquidity reserves may be adjusted further. The imag inative innovations of corporate financial management have been matched, and often suggested or encouraged, by financial insti tutions. Most changes in recent years have been in the direction of greater risk exposure. billion dollars * E s tim a te d . S O U R C E : F lo w o f F u n d s, F e d e ra l R eserve B o a rd . Things to com e 15 Federal Reserve Bank of Chicago Continuance of general prosperity, therefore, is a requisite to continued success, and wider adoption, of the new methods of finance. Most financial analysts anticipate some leveling or easing in interest rates in the months ahead, but no sharp decline. Needs B U SIN ESS C O N D IT IO N S is p u b lish e d for funds to finance new plant and equipment, and increases in working capital are expected to continue large. Moreover, many corpora tions would like to lengthen the average ma turities of their debts and somewhat restore their liquidity positions. m o n th ly b y the F e d e ra l R ese rve B a n k o f C h ic a g o . Lynn A . Stiles w a s p r im a rily resp o n sib le fo r the a rtic le "T h e trend o f b u sin ess—a n o th e r 19 66 fo r h o m e b u ild in g ?" a n d G e o rg e W . C loos fo r "C h a n g in g styles in b u sin ess fin a n c e ." Su b scrip tio n s to Business Conditions a r e a v a ila b le to the p u b lic w ith o u t c h a rg e . For in fo rm a tion co ncern ing b u lk m a ilin g s , a d d re ss in q u irie s to the F e d e ra l R ese rve B a n k o f C h ic a g o , Box 8 3 4 , C h ic a g o , Illin o is 6 0 6 9 0 . 16 A rtic le s m a y be re p rin te d p ro v id e d source is cred ite d .
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