2010; remember that date.  As of this week, the small business jobs and tax bill (HR 5486), which also provides a $30 billion fund for banks with under $10 billion in assets to increase their small business lending, has finally been signed into law.

So back to 2010.  Since this bill has been grinding around in the Congressional sausage mill for almost a year, it is worth noting that some of the provisions were scheduled to run through 2010.  One example is the extension of SBA’s 90% loan guarantee that had expired in May.  Now that the bill has finally made it out of the grinder, there are barely three months left in 2010.  What happens then?  Are the “through 2010” provisions going to end in three months?  If so, the effects of the bill are going to be negligible.  One thing that will survive is a larger loan limit on SBA loans.  But that limit (up to $5 million) is going to do next to nothing to help the average SBA borrower, and could actually have a negative effect.  If a bank can make a $5 million loan as opposed to ten $500,000 loans, it will almost assuredly opt for the $5 million.

Since now that there is a $30 billion fund available to banks to encourage small business lending, there are a couple of flies in the ointment that need to be considered.  First, there is the timing issue.  A bank doesn’t just take a million or fifty from the government by writing a check and going through the drive-in window to cash it.  And remember, this $30 billion is a loan.  It is going to have to be paid back to the government no matter how rock-bottom the interest rates are, and many banks are still in the process of shrinking and restructuring their balance sheets which still have bad loans on them and assets that have lost value but have not been written off yet.  So they may not be interested in taking on money from the government to make more loans while they are still cleaning up their bad ones.  It is also going to take some time to get the money into the pipeline and be ready to loan – probably at least the first quarter or maybe the second quarter of 2011.  And the economy and all its problems will be just as bad in six months as they are now, so the economic conditions that have constrained small business lending will be almost unchanged.

Now, suppose a bank does decide to take funds.  Who are they going to lend it to?  Bank credit guidelines don’t usually favor companies with declining sales, earnings, or both, and there are probably more small businesses than not that are in this situation today.  Also, to lend it, someone has to want to borrow it.  The National Federation of Independent Businesses (NFIB) does a monthly survey of their membership to determine how they feel about current business conditions, prospects, etc.  For the last several months there have been two consistent themes.  One has been the lack of credit, but the more important has been the lack of sales, customers and confidence.  Many small business owners have no desire to borrow right now even if they could until they see a clearer picture of the economy improving and what new government regulations could mean to their businesses.  So even though the bill is a positive step, it is not going to be likely to have the kind of dramatic results that are being trumpeted.

As bad as the economy is and with any substantial recovery being pushed farther and farther out, there are signs of what we could call foundation building for a recovery; small signs, but nonetheless, positive.  Here are some of them:

  • According to Moody’s Investors Services, the number of U.S. companies at greatest risk of default dropped to the lowest number in two years largely because of increasing liquidity.  And every company that does not default on its debt is one less problem for banks that have financed them.  Losses would have been written off against a bank’s capital, meaning less money to lend.
  • Vehicle sales in the U.S. increased slightly in July, 2010 over July, 2009; only slightly, but in the right direction.  And increasing auto sales means jobs all the way up and down the line – from the worker in the manufacturing plant to the owner of the car wash or gas station.
  • The rise in the personal savings rate to 5.9% in July compared to a 3.3% average since the start 2000 augers well for future spending.  It does not auger well for spending now when the economy desperately needs it, but it’s there and will be supporting economic growth when it finally begins for real.
  • Manufacturing in the U.S. expanded in August, verified by the increase in railcar loadings.
  • New banking regulations forcing banks to strengthen their balance sheets, which in the short term is going to restrict lending and make it more expensive, will benefit the economy in the long run because strong banks are critical to a strong economy.  In many cases, bank liquidity is already beginning to improve.
  • August retail sales were up.  It may have been a blip because of back-to-school sales, but retail sales overall are beginning to show signs of life.
  • Sales of existing homes were up in August.  The housing market is still in a crisis, but any increase helps to bolster the feeling that housing has about reached its bottom.  There is still plenty of sentiment against this point of view, and there are more problems ahead.  But the bleeding has most likely been stanched, and having some ups mixed in with the downs is better than a string of consecutive downs.
  • The Conference Board’s index of leading indicators rose 0.3 percent in August.  July was up 0.1 percent.  Since the leading indicators gauge the prospects for the economy in the next three to six months, positive readings, no matter how small, are good.

All of these facts and statistics are almost tiny changes, but a plant can’t blossom until a seed starts to grow, and little by little, the seed is starting to grow.

“Noise” can be described as competing or contradictory signals creating all sorts of information useless to seeing the correct answer.  It can be masses of conflicting evidence that support alternative and equally reasonable hypotheses.  It is well-known that before the D-Day invasion in World War II, the Allies created a massive deception plan called Operation Fortitude.  It was designed to create the impression among Axis planners that the allies were going to invade at the Pas de Calais and/or Norway.  They used everything from dummy planes, buildings, tanks, boats, etc. to fool German reconnaissance flights.  But they also used fake radio traffic which created “noise” that obscured the true Allied invasion plans; as was said above – masses of conflicting evidence that supported alternative and equally reasonable hypotheses.  Pas de Calais and Norway were both reasonable hypotheses, so the Germans could not leave them undefended.  Consequently, troops and armor that might have been at Normandy were not.

At Pearl Harbor, the noise took on a different form in that it inadvertently worked against the Americans.  The Japanese contributed very little to America’s noise problems.  In those days, communications between Washington and Honolulu were light-years slower when compared to today.  So there were warnings, decodings and other information that did not get back and forth from Honolulu to Washington instantly, causing the loss of precious time.  There were also the problems that the Army and Naval intelligence services did not fully cooperate with each other in terms of sharing intelligence, partly because they were assigned different security assignments – the Navy on the waters around Pearl Harbor and the Army on land to guard against sabotage.

Also at this time, America and Japan had been negotiating for some time to avert a war, but war was becoming more of a reality.  So there were several interested parties engaged in Washington, and the right to know certain classified information was possessed by only a few.  Each interested party had their own take or interpretation of the situation, then there was Roosevelt whose style was often to keep his advisors somewhat in the dark as to his intentions.  So in a sense, Washington was creating its own noise before it even got to Pearl Harbor.  Also, as a result of the growing alarm with Japan, there had already been several false alerts sent to Pearl Harbor, so in themselves these began to create a certain level of noise.  There had been various signals picked up from the Japanese, especially since America had broken Japan’s diplomatic codes, that had a central set of analysts existed that could see all the different intelligence information, a pattern of anomalies might have been picked up leading to the conclusion that something big was going to happen, maybe to Pearl Harbor.  But such an operation did not exist, an attack did not seem like a reasonable hypothesis, and as a result the Japanese achieved complete surprise with their attack.

So what does the idea of noise have to do with small businesses?  There is the continuing drumbeat of the negative side of much of the economic news that creates the impression that things will almost never get better before it’s too late.  But look through the noise and there is information in certain places that could lead a smart business owner to a different conclusion.  For one thing, as bad as the unemployment rate is, there are still four out of five people who have jobs, and they are spending, more carefully perhaps, but they do spend.  There are signs here and there that things are improving.  One small example is railcar loadings.  If manufacturing is increasing one of the first places it shows up is in railcar loadings, and the 26-week moving average of railcar loadings just hit a 19-month high at the beginning of September.  There are other signals as well.

The small business owner who is going to succeed needs to cut through the negative noise and look for the information to tell him or her that their business can succeed if certain actions are taken.  If the information is not positive, then it may be a signal to get out before it’s too late.

New bank regulations designed to strengthen bank capital requirements will be good for the economy in the long run because a strong economy cannot function without a healthy banking system.  But as beneficial as this is for the economy in the long run, it is going to place even more pressure on small businesses.  The regulations are going to fade in gradually, but knowing that it is coming is almost certain to make some banks start to curtail lending to more risky borrowers, and one of the most risky for banks is small business.  So lack of credit (read lack of funding for growth, new hiring, etc.) is going to continue  to hinder small businesses well into the future.

The new rules mandate that by 2013, a bank’s strongest capital, known as Tier 1 capital, would increase from 4 to 4.5% of assets.  Added to this would be an emergency reserve of 2.5%.  So by 2013 – three years from now – a lot of smaller banks that may be short of this number now are probably going to be curtailing their lending somewhat as they build up their Tier 1 capital.  Plenty of banks, including most of the large ones, meet these requirements already.  But more smaller and community banks may not, and this is where the bulk of small business lending comes from.

A second consequence of these new regulations is that they are going to have a negative effect on bank profits, which will then make loans more expensive.  Loans are the main income-producing assets for a bank.  How much a bank can lend is based on their capital.  So for example, if a bank can lend $5 for every $1 of capital, every dollar taken out of the loan pool is $5 that can’t be put out in income (and profit) producing assets.  So the options for a bank are to either curtail lending because they don’t have sufficient capital, in which case their profits will suffer, or charge more for what they can lend to maintain their profits.  Either way, it is either going to mean less money available or more expensive money if it is available.

Because of the recession, most of the normal lending dynamics are already working against many small businesses.  Sales and profits may have declined, and banks usually will not lend to companies with declining sales and profits.  Yet this is becoming more and more the scenario that banks are going to be seeing even if the business owner has done a brilliant job of keeping the business going.  So even aside from the new banking regulations, the economy has already made it more difficult for small businesses to find financing, and adding this new level of bank regulations will just make it harder

Jobs are the key to any kind of economic recovery, and everyone is trying to figure out a way to get the high unemployment rate down.  One major problem that the job market faces in the future is jobs that existed before the recession started that may never return to pre-recession levels.  Here is a brief look at two more industries that are not going to reach previous employment levels for a very long time after the economy recovers.  They are pharmaceuticals and construction.

“Off patent” probably best describes the situation facing the major pharmaceutical companies today.  Some of the biggest money-making drugs in the industry are about to lose their patent protection.  One almost-household name that people might be familiar with is Lipitor, which is owned by Pfizer.  Lipitor accounts for approximately $10 – $11 billion in sales, and Pfizer’s patent expires in November, 2010.  Merck is another pharmaceutical giant that is going to lose patent protection on drugs that account for about $2.5 billion in sales.  Neither of these two companies has anything in their pipelines to even remotely approach these drugs in terms of sales.  And by 2014 Eli Lilly, the third of the big three, faces the loss of patent protection on drugs that account for almost 60% of its revenues.

Because of this threat of lost revenues, two of the big three have purchased other drug companies.  Pfizer purchased Wyeth Labs for $68 billion, and Merck purchased Schering-Plough for $41 billion.  Mergers and acquisitions usually result in cost-cutting as the firms combine and jobs are consolidated.  Pfizer has eliminated 30,000 jobs since the start of the recession and Merck has eliminated 25,000.  Very few of these jobs will be back any time soon, if ever.

Next, to the construction industry.  As of August 10, the Bureau of Labor Statistics reported an unemployment rate in the industry of 17.0%.  Put very simply, there is too much of everything, both homes and commercial.  You can still see new houses being built, but very selectively and nowhere near the volume necessary to begin to put people back to work.  And the problems in the housing market are getting worse.  There are projections of up to 3 million new defaults or foreclosures projected for the coming year.  There is a very large supply of houses on the market that aren’t selling.  And there are probably an even larger number of houses owned by banks that have foreclosed on them but have not yet put them back on the market.  All of these factors effectively put a lid on any sizeable increase in residential construction.

Commercial construction is no better off.  All you have to do is ride around where you live and look at the empty stores, offices, warehouses, restaurants, etc. to see that there is a large supply of commercial space available just like in the residential market.  Until a substantial amount of this inventory is worked down, there will be very little new construction taking place.  Also, commercial projects and buildings take a lot more money than residential, and the financing for most of it is simply not there.  So the level of unemployment in the whole construction industry is likely to stay high well into the future.

Here and in the next two or three posts is a look at certain jobs in the economy which will not come back with anywhere near the number of jobs that existed only a few years ago.  Some industries have been affected by the internet and some, more by structural changes in the economy.  Both of these mentioned today have been affected by the internet.  Look first at the postal service. 

The mail delivered by a postal carrier is what we all grew up with.  A letter was written by somebody (a novelty now), it was dropped in a box, and it was picked up by someone driving a truck and taken to a central processing office where more people sorted it to be delivered by each carrier.  Today you often would just send an email.  On the commercial mail side, a manufacturer or store wanted to send you a color advertisement in the mail.  Someone created it then took it to a printer to be printed by people running expensive printing machines.  Then a different set of people delivered them to a post office where the sorting and delivery was carried out.  Today, advertisements for more than you could ever dream that you wanted are all over the internet.  Stop and think through that path of events and think about the people that are either no longer needed or needed in far smaller numbers.  There is also the collateral piece to that of equipment and machinery that did not have to be made because of the decreased demand, and all the people on that side of the equation who made them and ran them.  You can do commercial/industrial archaeology back farther in the chain to see how many other industries and jobs were involved in getting those pieces of machinery and equipment to produce those mailings.

Now look at telecom – telephones, to be specific.  How many people around the country have given up their land lines in favor of cell phones?  Until wireless technology became commonplace and cheap, a lot went into getting a phone call from one place to another.  A company had people to produce wires in a factory using really big equipment.  Then it had to be shipped by truck to a phone company.  Then the phone company broke it up into smaller amounts and sent it, by truck, to where lines were being put up to serve phone customers. They needed equipment to dig holes to stick poles in and guys to climb the poles to hang the wires so that simple phone call could be made.  Don’t see much of that any more, do you?  You grab your cell phone wherever you happen to be at the moment and make a call to anywhere in the country.  It takes nowhere near the number of people necessary for you to make that call now as it did when you had to have a land line.  To prove the point, Verizon recently announced that it would eliminate the jobs of 13,000 people in their land line operations.  Those jobs won’t be back.

These are the types of headwinds that the economy is fighting now and will continue to have to fight in the coming years as we try to bring down the unemployment rate.  New jobs are going to get created, wherever they are, but some of them are going to be offset by jobs being lost to changes in the way different industries do business. The trajectory will not be straight up.

The dreaded Memorandum of Understanding, or MOU, is a voluntary agreement between a bank negotiated with a supervisory agency, such as the FDIC, to refrain from a particular activity deemed by the regulatory agency to be an unsound banking practice.  An MOU is not necessarily an admission of wrongdoing, but indicates a willingness to take corrective action in the future.  The phrase “… is not necessarily an admission of wrongdoing ….” is a nice way of saying “We may have been a little over-aggressive, but we didn’t really do anything wrong.”  When a bank makes such an agreement, it is generally going to stop making all but the least risky loans especially since the regulatory agency is watching them so closely.  And since local banks usually have a pretty good idea of each others’ lending practices, if one sees a competitor go under an MOU, it might also become more cautious even if they are in no danger.  Small business loans are generally not considered the safest types of loans.

The latest report released by the FDIC of their Problem Bank List shows 829 problem banks as of June 30, 2010.  That’s over 10% of all banking institutions.  The Problem Bank List contains the names of institutions that have weak capital positions caused by large loan losses or operational deficiencies that usually lead to failure.  Compare the June 30 list to the third quarter of 2006, the historic low for the Problem Bank List, when the number was 47.  There you see one of the most perfect indications of why we are in the mess that we are in now.  Bank regulators have been breathing fire at banks now for the last two years.  The large banks can handle it even though it has decreased their earnings, but the smaller banks, especially the community banks, are a lot more at risk because they generally can’t afford to take significant hits to their capital base because it could cause them to fail.

With more banks failing and more banks signing MOU’s, overall lending, especially to small businesses, is going to be constrained for years.  The longer the economy stays stagnant, the higher the risks to many small businesses that cannot afford to stay stagnant but cannot get financing to grow.  Bank examiners are taking a bad situation and making it worse.