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A review b y th e F e d e ra l R e se rv e B a n k o f C h ica g o Business Conditions 195 8 October Contents State-local capital outlays: still high and rising 4 Tough question for cattle feeders 9 Small business investment companies The Trend of Business 13 2-4 Federal Reserve Bank of Chicago OF In contrast to two earlier postwar busi ness adjustments, the transition from reces sion to expansion in 1958 has been crisp and unequivocal. The drop in activity between last fall and last spring was the shortest and sharpest of the past decade. The subsequent recovery has been the most rapid and the most widespread. In short, major indicators have traced a sharp “V” rather than a soft “U” as in earlier adjustments. D u ra b le s join th e u p tre n d As noted in these pages in earlier months, activity in the Midwest, Iowa excepted, had slumped somewhat further than the nation generally and has shown a lesser recovery to date. This situation stems from the fact that Steepest postwar recession has been followed by sharpest recovery per cent, 1947-49*100 june dec june dec june dec BUSINESS the business decline and the recent turn around have been associated with rising out lays for consumer soft goods and services, Government procurement and construction. Despite substantial diversification, the well being of the major industrial centers of this area is tied intimately to the demand for pro ducers’ and consumers’ durable goods — machinery and equipment, autos, appliances and furniture. September brought news which suggests that the downtrend in business plant and equipment expenditures has been arrested and may be reversed in the months ahead. This intelligence comes from a number of sources. The SEC-Commerce survey just re leased indicates that the decline in capital outlays earlier this year was greater than expected, but that a rise may occur in the fourth quarter. The News Week-Conference Board tabulation of “capital appropriations” by manufacturing concerns covering new projects is believed to have shown some im provement in the second quarter after allow ing for seasonal influences. Meanwhile, new orders for various individ ual categories of capital goods are trending upward. The improvement has been most marked in construction machinery, but ma chine tools and a variety of other goods, even including some types of railroad equipment, also are reported to be doing better. The change in the capital goods outlook is in sharp contrast to the view commonly held earlier in the year that business would con Business Conditions, October 1958 tinue to reduce such spending for several more quarters at least. Substantial “excess capacity” in basic industries such as steel, aluminum, glass and cement were thought to make this inevitable. Now it appears that many capital spending programs, shelved temporarily in 1957 and early 1958, are being reactivated and some new plans are being initiated. The indicated rise in capital spending doubtless will be of moderate proportions compared with the 50 per cent gain from early 1955 to early 1957. It will feature proj ects one or more steps closer to the final buyer than basic materials. The emphasis will be on new products, cost-cutting instal lations and better locations. In the case of consumer hard goods, the picture has not firmed as definitely as for producers’ durables. New car deliveries dur ing the summer remained 30 per cent below 1957, about the same as in the year-to-date comparison. Sales of furniture and appliance stores in July remained 3 per cent below year-ago levels. However, production of ap pliances and furniture began to rise markedly in June and July. But in large part this was an inventory phenomenon. Dealer holdings of some items had been allowed to fall below comfortable levels. Nevertheless, there are good reasons to believe that consumers will begin to show a greater willingness to buy big-ticket items in larger quantities. Their hesitation on large outlays has been based upon the same psy chology as that of the businessman — cau tion in making new commitments until clear ing economic skies suggested grounds for a more confident attitude. Their ability to buy is greater than ever. Personal income in August was estimated to be at an annual rate of 356 billion dol lars, 3Vi billion or 1 per cent more than a Consumer buying power at new high, retail sales approach 1 957 record per cent, august 1956= 100 year earlier. Last March personal income was the first major business barometer to reverse its decline, and it moved to new alltime highs in the summer. Few other mea sures have made up much more than half of their 1957-58 dip. Meanwhile, instalment credit has been paid down somewhat on a seasonally adjusted basis since last January. Some reservations Of course, the economic weather forecast, as always, contains warnings of possible squalls. Three principal clouds have been noted. They include the stubborn unemploy ment situation, the sharp advance in long term interest rates which could dampen the upsurge in home building and the possibility that important work stoppages may arise out of current labor-management disputes. Unemployment is estimated to have de clined in July and August but not as much as might have been expected seasonally. In fact, the 7.6 per cent of labor force, sea sonally adjusted rate, for August was the highest for the year. Moreover, new claims 3 Federal Reserve Bank of Chicago for unemployment compensation in August were still 50 per cent greater than last year for the nation. Michigan, Wisconsin and Indiana reported much larger increases. The unemployment situation usually mod erates slowly as the economy picks up speed. It is in a period such as the present that labor force efficiency and output per man and per man-hour improves most rapidly. Nevertheless, ever since April seasonally adjusted wage and salary employment has been moving up steadily — about as fast as in the same period of 1954 at which time the economy was also recovering from a mild recession. Higher interest rates, thus far, have not slowed the rise in housing starts which hit a two year high in August. In the Midwest, rates on new mortgage loans are on the rise again and FHA mortgages once more are moving at discounts, but mortgage money remains generally available. Meanwhile, there is no evidence that higher money rates have greatly affected the improvement in the prospects for capital expenditures. The possibility of a serious strike in the automobile industry may have been averted with the signing of a new UAW-Ford pact in mid-September. This agreement could presage a less stormy period for labormanagement relations than many observers had expected. State-local capital outlays: still high and rising 4 j / \ ^ t its outset, the now-fading recession commonly was alleged to be a “capital spending recession,” akin to those of pre war years and unlike the two prior postwar declines in business activity. If this proves in retrospect to have been the case, state and local governments have not contributed to the decline. As in the 1948-49 and 1953-54 declines, public agencies on the state and local level have continued to increase their outlays, for both current and capital purposes, posting new records each quarter and each year. By mid-1958, the proportion of the nation’s output of goods and services absorbed by state-local governments had passed the 9 per cent mark, a proportion not seen for more than twenty years. In the immediate future, the rise will continue to be large, in both absolute and relative terms. Capital out lays in particular will climb, as the road building plans stimulated by the 1956 Fed eral legislation increasingly reach the spend ing stage and the record volume of new municipal bonds sold this year are translated into actual construction work. The recession record In the second quarter of this year, gross national product reached a seasonally ad justed annual rate 16.6 billion dollars below its peak level of the summer of 1957. In Business Conditions, October 1958 part, last winter’s pessimism about the course of the economy was due to the pervasiveness of the decline. In contrast to the earlier postwar recessions, nearly all major sectors of the economy contributed to the drop in spending — consumer durables, producers’ durables, business inventories, private con struction and Federal purchases of goods and services for national security purposes. Spending for goods and services increased in only three areas — consumer services, Federal nondefense programs and state and local activities. The latter rose from a sea sonally adjusted annual rate of around 36 billion dollars to around 39 billion. During a short-lived recession, or in the initial phases of a more protracted one, state and local agencies find it easy and advanta geous to accelerate their capital spending programs. Funds are at hand and more bid ders compete, at favorable prices, for the construction work. State-local construction spending since the third quarter of 1957 is Postwar climb in state-local spending faster than in G N P * First half, annual rate. estimated to have increased nearly 1 billion dollars, from a rate of around 9.5 billion to around 10.5 billion. Construction spending thus is a rising share of state-local outlays. Outlays for new construction at the statelocal level are now about nine times as great as in 1946. They are more than twice as high as in 1949, which was probably the first year in which public agencies were fully tooled up with the legislative authority, plans and engineering staffs needed to make a dent on the accumulated needs for new public facilities following World War II. In real terms, construction activity is about four and a half times the 1946 level and about two-thirds greater than in 1949. This is part of the postwar trend in spend ing by America’s “grass-roots” governments. No other major sector of the economy has expanded so rapidly since 1946, in part because no other major sector confronted so large a backlog of unsatisfied require ments at the war’s end. State and local pur chases of goods and services are now running at a rate about four times as high as in 1946, which represents an average annual increase of about 12.5 per cent compounded. Sea sonally adjusted, state-local purchases have increased in every quarter since the begin ning of 1946, save for two — one in which outlays were unchanged and one in which they declined only slightly. The character istic increases have been around 2.4 billion dollars annually. More recently, since mid1956, state-local purchases have been rising at an annual rate of more than 3 billion dol lars, with highway construction outlays ap parently accounting for about 40 per cent of the increase this year. During the postwar years, inflation has boosted state and local government costs a good deal more than those confronting the private sectors of the economy, but even in physical terms the ex- 5 Federal Reserve Bank of Chicago pansion of state-local activity has been large: it more than doubled since 1946, increasing at an average annual rate of approximately 7 per cent compounded, about twice the rate of increase in real gross national product. Although state and local governments con tinued to increase their outlays in this as in the two previous postwar recessions, they did so at the expense of a considerable de terioration in their over-all financial situa tion. In none of the three recessions did total state-local receipts decline. Rather, the rate of increase slackened. Postwar prosperity — and price inflation — together with higher rates of existing taxes and adoption of new tax devices have resulted in large year-toyear increases in state-local revenues, almost but not quite matching the increase in ex penditures. In the recession years, the smaller than expected increases in revenues and the specter of potential declines led to unusually widespread flurries of tax rate increases. But since the recession proved short-lived, these tax rate increases had their greatest impact on revenues in the prosperous months and years thereafter. For example, in 1953, on the accounting basis used in the official national income fig ures, state and local units had an over-all sur plus of about a quarter of a billion dollars. But in 1954, spending increased nearly 3 billion dollars, almost twice as much as re ceipts, and state-local borrowing had to cover an over-all deficit of about a billion dollars. In 1955, expenditures and receipts increased equally rapidly, as economic recovery began to affect state-local revenues. In 1956, however, the impact of renewed prosperity The composition of state-local capital outlays was fully apparent for Change receipts rose almost a 1957 amount1 Distribution since 19! half billion dollars (billion dollars) (per cent) more than expendi Total 12.6 100 + 70 tures, and the over-all Type of outlay: deficit was only half as Construction .................... 10.4 82 + 63 large as in the two Land and existing previous years. 1.2 + 159 structures .................... 10 1.0 8 E q uip m en t........................ + 77 Since the 1957-58 recession proved to be Activity for which spent: Education ........................ 3.3 26 + 93 somewhat deeper than 42 Highw ays........................... 5.3 + 95 the earlier ones, the W ater s u p p ly.................... .8 6 + 92 slackening in revenues .7 Sanitation ........................ + 40 5 has b een s h a rp e r. 4 Electric power systems . . + 140 .5 S ta te -lo c a l receipts — 17 Hospitals ........................... .3 3 Housing and community rose less than 1.5 bil 2 development ............... .3 — 60 lion dollars (at annual All o t h e r ........................... 12 1.5 + 76 rates) from mid-1957 to mid-1958, in con 1 trast to a rise of nearly 4 billion dollars in the U . S . C e n su s B ureau data, which are som ew hat larger than the C om m erce- Labor Departments' estim ates used in the initial part of the accom panying article. Business Conditions, October 1958 Federal highway aids rise rapidly in recent months Steep climb in highway capital spending forecast million dollar* preceding year. Since spending continued to rise rapidly, the over-all position deteriorated greatly — from a deficit, at annual rates, of around a half billion dollars in the third quar ter of 1957 to one of around 2.5 billion in the second quarter of 1958. On balance, the larger deficit faced by state and local govern ments cushioned a significant portion of the decline in the rest of the economy. Land and equipment The share of the state-local capital outlay dollar devoted to nonconstruction purposes — the purchase of sites, right of way, and existing structures and the equipping of new facilities — has grown in the last few years. Site costs were relatively low in the initial postwar surge of state-local capital spending programs, in part because most of the road building activity occurred in rural areas where land acquisition costs are low or took the form of rebuilding old roads along exist ing right of way. Also, some of the new building occurred on sites acquired years earlier, before the war. More recently, how ever, road building has been increasingly concentrated in urban areas, where land costs, particularly for the huge swaths cut by new expressways, are enormous and ris ing. Moreover, land costs in suburban areas, where much of the capital spending for other than highway purposes occurs, have been ris ing steeply. Furthermore, the types of proj ects which have been favored in the last few years entail sizable equipment purchases, particularly for the utility-type activities of state and local governments. In 1957, state-local outlays for capital purposes aside from construction reached nearly 2X A billion dollars. This was more than double the level of five years earlier, in contrast to a 63 per cent rise in construc tion expenditures. Expenditures for equip ment passed the billion dollar mark for the first time. Although state and local govern ments have always been an important ele- 7 Federal Reserve Bank of Chicago ment in the demand for the resources em ployed in construction, in the past they have been a negligible factor in the demand for durable goods. In 1952, for example, expen ditures for the purchase of consumers’ and producers’ durables totaled about 50 billion dollars and state-local equipment purchases about 600 million. Five years later, durable purchases by the private sector of the econ omy had increased about one-third but those by state-local agencies more than threefourths. In mid-1958, with depressed levels of private spending for durables, state-local equipment purchases were relatively about twice as important as in 1952. The months ahead There are signs that the long rise in statelocal capital spending will accelerate in the immediate future. For one thing, construc tion contract awards for the types of work in which state and local agencies are the most important factors have been running sub stantially ahead of the high levels of a year Record state-local bond sales billion dollars 8.0 f 8 annual quarterly ago. In the first seven months of 1958, con tract awards for all types of public construc tion projects were 15 per cent above awards in the same period of last year. During the summer months, the gap over a year earlier widened — in June it was about 30 per cent and in July nearly 55 per cent. In June and July, increases of more than 25 per cent above 1957 were recorded in contracts for work on roads, sewerage systems, water sup ply facilities, airports and public administra tion buildings. Increases, although of smaller proportions, occurred in nearly all other categories of state-local construction. Since these are contract awards, not work com pleted, it is all but certain that actual con struction activity will rise steeply during the next six months at least. To go one stage further back in the pro cess by which community needs are re flected in finished public works, bond sales by state and local governments to finance new projects have been at record levels this year. Issues sold for new capital in the first three quarters of the year totaled more than 6 .1 billion dollars, compared with less than 5.1 bil lion last year, the previous record year for municipal flotations. The high volumes this year and last have been reached despite the vir tual disappearance of large-scale toll road financing, which had been responsible for the earlier peaks in new issues back in 1954 and 1955. In recent months, school issues have been the pace setters. While school construc tion activity and contract awards have been only modestly above the 1957 levels recently, the bond sales suggest a spurt in the near future. Business Conditions, October 1958 The biggest push will come from the func tion which looms largest even now in statelocal capital spending — road building. Much to the disappointment of the construc tion industry — and motorists — the greatly expanded program of Federal aid for high ways enacted in 1956 has been slow to be noted in increased highway construction out lays. State-local highway construction spend ing rose only about 10 per cent in 1957 and is expected to rise only about 5 per cent this year. In part this is because of the virtual ending of the toll road construction boom, which in 1955 and 1956 accounted for near ly one quarter of all road building work. In 1957, the decline in outlays for toll roads partly offset the increase in work on Federal ly aided projects and this year is expected to completely offset the increase in Federal aid construction work. Also, a substantial por tion of the increased outlays on projects in cluded in the Federal aid program has been for acquisition of right of way and prelim inary engineering work. With much of the preliminary work now done, and with the impetus of the 1958 amendments to the Federal legislation which will induce substantially larger outlays dur ing the next two years than might otherwise have occurred, highway spending is starting its long-awaited steep climb. One symptom of this is expenditures from the Treasury’s highway trust fund. During the twelve months ending December 1957 they totaled less than 1.2 billion dollars. During the year ending this past August, they exceeded 1.6 billion dollars, a one-third increase. In a forecast issued during August, the Bureau of Public Roads estimated total statelocal highway capital outlays for 1959, in cluding those on road projects not eligible for Federal aid, at nearly 6.9 billion dollars, up more than 800 million dollars from this year’s estimated level; construction expendi tures were set at nearly 5.6 billion dollars, up nearly 600 million. By 1962, the Bureau expects highway construction spending by state and local agencies to reach 6.7 billion dollars and total highway capital spending to reach 7.9 billion dollars. In all, it seems like ly that capital spending by state and local governments may show gains averaging close to 1.5 billion dollars annually during the next four or five years. The pressure on state-local fiscal resources and, more fundamentally, the demand for more of the nation’s physical re sources to meet community needs, will there fore continue unabated. Tough question for cattle feeders A vigorous demand for their product and a great abundance of the resources needed to produce it: this is the situation the nation’s cattlemen are facing. What, it may be asked, could be more favorable? Can such an en vironment really present difficult questions? The abundance of the resources needed to produce beef is exceptional if not un precedented. The nation’s major grazing areas have been plush with grass. Nearly all areas are reported to have abundant pas turage, which in September “averaged na- 9 Federal Reserve Bank o f Chicago 10 tionally the best since 1942.” Hay is stacked higher than usual in most areas this fall. The USDA’s hay crop estimate has been in creased to “within 2 per cent of last year’s record tonnage as late cuttings flourished almost to the unneeded stage in many fields.” And the Com Belt’s “golden grain,” al though maturing slowly because of cool weather in some areas, is headed toward an estimated national harvest of 3.6 billion bushels, 5 per cent more than last year and 14 per cent more than the 1947-56 average. Total production of all feed grains now seems likely to surpass last year’s record by nearly 6 per cent. In addition, the carry-over of feed grains from previous years’ harvests is estimated at 61 million tons, nearly twice the 1952-56 average carry-over. Finally, the supply of high protein feeds — mostly by products of the oil seeds — will be superadequate, as indicated by the record soybean crop and the gains over year ago in output of cottonseed, flaxseed and peanuts. Thus, there is an abundance of feed to support a higher output of beef, and the supply of other resources — including labor, credit and physical facilities on farms and ranches — also is capable of handling a larger number of cattle. The demand for beef has shown every in dication during recent years that American consumers were developing a strengthened and persistent preference for this commodity. Even during the months of rising unemploy ment and pessimistic job prospects in the past winter and spring, consumers continued to spend aggressively for beef and to force prices to higher and higher levels. And now, with business activity picking up and em ployment showing a gradual rise, demand for this luxury protein is expected to continue strong. Yet the present balance in the cattleman’s favor is a delicate one. Although the demand for beef is strong and growing, it is some what inelastic. That is, any sudden increase in supply of beef is likely to be purchased by consumers only with some concession in price, and typically the price concession is greater than the increase in marketings. This means larger marketings bring less total in come and much less net income. Thus, pro duction initiated in response to today’s prices may materialize under a less favorable price and income situation. The problem of price uncertainty is espe cially important to Corn Belt farmers who typically purchase feeder cattle in the au tumn and fatten them for market during the ensuing year. Since the weight of the animal when purchased is usually about two-thirds the weight of the animal when sold, cattle feeders have substantial exposure to price changes, and it is the uncertainty as to pros pective prices and profits which lies at the heart of the tough decisions confronting cattlemen in the autumn, 1958. Modest profits in prospect The profit margin for a typical sevenmonth cattle feeding program last winter and spring was highly favorable. Yearling feeder steers, 500-700 pounds, averaged about $21 per 100 pounds at Kansas City from Septem ber to November last year while choice grade slaughter steers at Chicago brought an ave rage of nearly $29 per 100 pounds from April to June 1958, an increase of $4 from last fall. Thus, the margin (spread between purchase price as a feeder and sales price as a fat steer) of nearly $8 per hundred on the purchased weight of, say, a 650-pound feeder animal would amount to about $52. This assured profitable cattle feeding. Furthermore, feed grains, the major cost in cattle feeding aside from the purchase of Business Conditions, October 1958 the feeder anim als, Financial results of feeding programs were relatively cheap a —"good" 650-pound steer purchased September-November; as compared with the sold the following April-June. price of choice slaugh b— “good to choice" 650-pound steer purchased Septemberter steers. Hence, the November; sold the following July-September. cost per pound of add ing the approximately dollars per head 350 p o u n d s to the total receipts weight of the steer residual-return to during the “fattening” labor, overhead, etc. process was less than the selling price per pound of the fat steer. cost of feed This further augment ed the profit possibil marketing 8r transportation ities for Com Belt farmers and provided high returns — about cost of feeder sfeer $75 per head — from this hypothetical but more or less typical program in the past 1954-55 1955-56 1956-57 1952-53 season. Only in 1949feeding season 50 and 1950-51 were returns more favorable in recent years. farmers expect prices for fed cattle to return Current prospects, however, appear to be to the high level of early 1958, or will lower quite different. Yearling, feeder steers at prices turn the feeding operation into a los Kansas City averaged about $27 per 100 ing proposition? The question is especially pounds the first week in September this year. ominous when cattle prices appear to be at The concurrent price of choice slaughter a relatively high level and, therefore, exposed steers at Chicago was also about $27. This to possible decline, and when feeder cattle unusual price relationship indicates far from prices are high relative to fat cattle at the favorable profit prospects in cattle feeding. beginning of the feeding season. Assuming the same costs for feed, market The price for fed cattle next year depends ing and transportation as in the past year, on a number of factors. Very important is and assuming further that choice slaughter the number of such cattle slaughtered. Pos steers can be sold for $27 per 100 pounds sibly of equal importance is the number of next spring, only about $14 per head would grass cattle slaughtered as these affect the be available to cover labor and overhead total supply of beef although they typically costs. This is substantially below the average do not yield beef of top quality. Important of $33 for the last 10 years. also is the supply of competing meats such A tough question this fall: can Corn Belt 11 Federal Reserve Bank o f Chicago as pork and poultry. While short supplies of pork this year helped boost beef prices, much larger supplies of pork are in prospect next year, possibly on the order of 15 per cent or more. And, poultry supplies are ex pected to continue at high levels. Finally, the demand for beef, as indicated above, is ex pected to continue strong. While Corn Belt farmers may individually decide whether to expand their cattle feeding operation, the over-all supply of feeder and stocker cattle available for feeding is not so clearly within their control. The calf crop in 1958 is slightly smaller than last year and has declined for four years. In addition, the abundance of grass and hay in grazing areas has caused many ranchers to cut back some what on their marketings and has caused other ranchers to purchase cattle for herd expansion which normally would move to feedlots and slaughter. Indeed, the major key to the whole beef supply-price picture next year appears to lie in the decisions of cattle breeders to market currently or to withhold cattle for herd expansion. Restocking u n d e r w ay 12 When the inventory of cattle on the na tion’s farms and ranches is taken next Jan uary 1, it will likely show an increase over the year-earlier number. If this proves to be correct, the recent downswing in number of cattle will have been the shortest on record — just two years’ duration. And the decline will have been the smallest — dropping just 3 per cent — from 97 million January 1, 1956, to 94 million January 1, 1958. By way of comparison, the number of cattle on farms declined 10 per cent in the previous down swing which extended from 1945 to 1949. Once an upswing in the number of cattle on farms and ranches gets under way, it tends to be self-reinforcing and to continue for several years. The withholding of cattle from current slaughter boosts beef prices and encourages further herd expansion. “Be cause insufficient time has elapsed for breed ing herds to be enlarged, cattle slaughter will probably not differ a great deal in 1959 from 1958,” according to the U. S. Depart ment of Agriculture. Old m an w e a th e r holds k e y The turning point of the present upswing can be dated from the drought-breaking rains in the Great Plains in 1957, followed by one of the best grass years in memory in 1958. Thus, old man weather rears his formidable head and further complicates the cattle pic ture. Prices next year, even for fed cattle, apparently will depend heavily on weather and its influence on ranchers’ decisions to re build or liquidate herds. Assuming normal weather and the continued withholding of cattle for herd expansion through 1959, De partment of Agriculture experts say, “Prices of fed cattle during much of next year are likely to be about as high as this year.” In the longer outlook the willingness of cattlemen to expand production is reflected by their current actions to rebuild breeding herds. Their ability to expand production, however, is dependent on two processes of nature — one predictable and the other un predictable. The predictable is concerned with the biology of the bovine. A beef cow retained this year means an extra calf next year which in turn takes eighteen months or more to be ready for market. Thus, if the un predictable processes of weather permit ranchers to continue herd rebuilding, the time schedule imposed by nature means that decisions this year to increase produc tion will not result in any substantial addi tional slaughter of cattle in 1959. Some farmers are delaying the purchase Business Conditions, October 1958 of feeder cattle this fall hoping for lower prices when snow blankets the western graz ing area. And some are making shifts in the kinds of feeder cattle purchased or in the time of year they plan to market their fat cattle, but such adjustments may be largely offsetting. Finally, a few may decide to stay out altogether, and these, along with those who decide to go ahead but on a reduced scale, will help to assure somewhat more favorable results to those who do not re trench. Most farmers, nevertheless, will “do the inevitable” — they have all the resources needed to engage in cattle feeding and will use them, although possibly not so fully as if the profit outlook were more attractive. Small business investment companies T h e session of Congress recently ended has been termed “a high-water mark for legisla tion benefiting the nation’s small business concerns.” This characterization is based on the enactment of a number of individual laws, including those which made the Small Busi ness Administration a permanent agency, lightened the tax obligations of smaller firms and their owners, and liberalized Govern ment procurement procedures on minor pur chases. Greatest interest, however, has cen tered in the Small Business Investment Act which provides for Federal aid to special ized investment companies. In Congressional hearings during the past year, one point of view found expression again and again; namely, that small and growing business firms have adequate access to short-term credit. If a gap in the credit structure exists as regards small business, many statements suggest that it concerns lack of facilities for providing long-term loans and equity capital. This type of capital is commonly obtained by larger firms from the sale of stocks and bonds through the organized capital markets. Virtually every year since the end of World War II, bills have been introduced in Con gress which called for the creation of small business “capital banks” of one sort or another. These institutions were proposed to improve the availability of equity capital and long-term credit to small businesses. In some cases, the institutions proposed would have broadened the scope of the lending and in vestment function performed in recent years by the SBA and by its predecessor, the Re construction Finance Corporation. Following competition for loanable funds in the 1955-57 period, interest in the pro posed capital banks for small business reached a new high during the past year. Numerous bills were introduced, some of which contained novel departures from exist ing financial arrangements. The act The provisions of the act finally adopted 13 Federal Reserve Bank of Chicago place relatively less emphasis on Government aid and relatively more upon private enter prise and local initiative than many of the other proposals considered. Nevertheless, it marks a significant departure from the small business legislation of the past in that it makes a definite although indirect attempt to augment ownership capital. As is common with new legislation, it will be some time before the full ramifications of the act are clear. Responsibility for its ad ministration is lodged with the SBA which must formulate administrative regulations. These regulations will determine the actual character of the program to a considerable degree and will help to clarify many of the features not spelled out in detail in the law. Essentially, the act provides for making Federal money available to investment com panies which will in turn lend to small firms. Federal charters may be issued to such in stitutions, but only if it is determined that a charter cannot be obtained in the individual states. Whether state or Federal charters are em ployed, the SBA will issue licenses to ap proved institutions. These licenses are re quired not merely to obtain Federal money under the program but also to receive the benefits relating to taxes and regulation of securities which are provided by this act and other new legislation. According to the SBA, application forms and copies of regu lations will be ready about mid-November. It is expected that some investment com panies will be functioning by year end. O btaining funds 14 Investment companies must have paid in capital of at least $300,000 to operate under the act. Half of this amount must be pro vided by the stockholders of the enterprise. The SBA may then invest another $150,000 in the form of subordinated debentures — long-term debt which will rank ahead of common stock but behind other indebted ness in case of liquidation. These debentures are to be considered cap ital for the purposes of the act, although they will bear a stated rate of interest — 5 per cent according to an SBA announcement. In addition to supplying half of the $300,000 capital, the SBA is authorized to lend up to $150,000 to these firms. It would be conceivable, therefore, for an investment company to have $450,000 to lend, of which two-thirds was supplied by the Government. It could obtain additional funds by selling more stock or borrowing from other lenders. Government loans to individual invest ment companies will have to be repaid in time. The $250 million made available to the SBA for lending to investment com panies is intended to operate as a “revolving fund.” W ho m ay o rg an ize? A minimum of ten stockholders may or ganize a SBIC. There is no requirement, however, that each individual or corpora tion stockholder contribute any minimum sum to the enterprise. Thus, one stockholder apparently could supply virtually the entire $150,000 required to start a SBIC. Thousands of inquiries have been received by the SBA from parties interested in the new plan. Many of these have come from banks, savings and loan associations, in surance companies and other financial in stitutions, as well as chambers of commerce and similar local promotional groups. National banks and state-insured banks, unless prohibited by state law, are permitted to invest 1 per cent of their capital and sur plus in the stock of one or more SBIC. Thus, a bank with capital and surplus of $15 mil Business Conditions, October 1958 lion might organize such a company as a subsidiary. It has been pointed out that the act modi fies in some degree the terms of the divorce of commercial and investment banking which was decreed by Federal statute 25 years ago. Presumably, a commercial bank will be authorized to lend to a SBIC subsidiary sub ject to regulatory restrictions. Through this institution it could, in effect, invest in the stocks of eligible, small business corpora tions, which it could not do otherwise. It is to be expected that existing financial institutions, commonly, will be the organizers of investment companies. Financing small business is a difficult process which can be both time consuming and costly. Existing financial institutions are equipped to handle the overhead of investigation and adminis tration along with their regular operations. Moreover, they will often be in a position to know which firms can benefit from the type of financing which the new investment com panies are expected to provide. Various restrictions are placed on invest ment company lending by statute, and others can be imposed by SBA regulation. The total funds which can be made available to a single firm, for example, cannot exceed 20 per cent of an investment company’s capital and sur plus. Also, funds can be made available only in the form of loans or through the purchase of convertible debentures. In addition, the SBA is empowered to place interest rate limitations on loans and upon the size of borrowers. Also, it may make examinations of the investment companies and require them to file reports. SBA officials indicate that they will be as liberal as possible in regulating investment company operations. A boon to b o rro w ers? The Small Business Investment Act is in tended to stimulate “the flow of private equity capital” to small business. However, it does not provide for direct equity invest ment. Rather, the investment companies may purchase debenture bonds from small busi ness concerns which are to be convertible at a later date into common stock. It is possible, of course, that the additional provision for debt financing might also help attract owner ship capital to a small firm from other in vestors. Before providing “capital” to a small busi ness concern, the investment company may require that any or all of existing indebted ness should be refinanced. Prior approval is to be obtained before a firm can incur addi tional indebtedness. Investment companies are also authorized to make loans to small business concerns. In addition, they may participate in loans made by other lenders. Maturities on loans may range from 5 to 20 years with a possibility that a 10-year extension may be obtained at the end of that time. These loans will be “of such sound value or so secured as reasonably to insure repayment.” It would seem that many small firms would prefer outright loans to the sale of convertible debentures. The convertible fea ture is mainly of value to the investor. Con version would take place only if the firm became successful. At such a time the orig inal owners of the small business might be averse to sharing ownership and control. In case of financial difficulty, the debentures constitute debt which must be serviced and eventually repaid. Unless the interest rate on loans is sub stantially higher than the rate on debentures, small firms probably would tend to avoid the latter, assuming the alternative is available to them. Another consideration springs from the difficulty of determining the value of the 15 Federal Reserve Bank of Chicago stock of a firm which does not have a ready market. Recently the administrator of the SBA stated that there was no immediate intention to restrict the charges to be made by invest ment companies and implied that existing state usury laws would set the maximums. But it would appear that these rates would have to bear some relation to the 5 Vi per cent charged by the SBA itself on loans to small businesses. The SBA continues to have the power to lend money to small firms. It can grant loans which range up to 10 years in maturity and these can be extended an addi tional 10 years if conditions warrant. In practice, the SBA has usually kept maturities well below the 10-year maximum. Can loans other than mortgage loans be extended for 10, 20 or 30 years to small firms without undue risk even at high rates of interest? Can restrictive covenants and provisions which accelerate the maturities of loans be held to a minimum that will not hamper the freedom of movement of the debtor or, indeed, break down the dividing line between short-term and long-term debt? Satisfactory answers to these questions must be visualized if the new program is to be come an important adjunct to the existing financial institutions and practices. An e x p e rim e n t 16 The contribution which the Small Business Investment Act may make to a more efficient financial mechanism will be determined only with the passage of time. From the stand point of small firms seeking funds, the pro gram can be helpful since it adds an addition al source of funds. For the potential investor the SBIC plan offers a new outlet for funds. Of course, it has been and continues to be possible to set up investment companies independent of the recent authorization. If the object of an investor is profits rather than building good will or promoting local expansion, he must decide whether the advantages of the plan, including tax benefits and the availability of Government money at relatively low rates, outweigh the disadvantages. These include the restrictions on lending methods and the selection of borrowers, together with the possibility that interest rates may be con trolled and that other restrictive SBA regula tions may be forthcoming. The ability of investment companies to obtain additional debt financing will deter mine to a large extent the profit potential of these enterprises. Finance companies in good standing can borrow two or three times their capital, including subordinated debentures. SBIC’s operating in a new medium of busi ness finance may have to be content with far less leverage than this. Their ability to attract additional outside funds will be determined largely by the confidence of lenders in the management of individual institutions. The SBA in formulating its regulations will attempt to encourage investment in the proposed investment companies by avoiding unnecessary restrictions. Nevertheless, lend ers whose operations are based in part upon Federal money must expect some limitations on their activities. Business Conditions is published monthly by the federal reserve bank o f Chicago . Sub scriptions are available to the public without charge. For information concerning bulk mail ings to banks, business organizations and edu cational institutions, write: Research Depart ment, Federal Reserve Bank of Chicago, Box 834, Chicago 90, Illinois. Articles may be re printed provided source is credited.
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