Insight Line—May 21, 2007

Despite recent headline concerns about credit quality on the books of many of the nation’s leading lending institutions, the banking business—that is, the business of making loans—is arguably a very profitable undertaking. With the industry’s return on assets measuring slightly above 1 percent, gross margins around 3 percent, and a return on equity that is only slightly higher than the long-term returns of the stock market, how else would one explain that banking, at least by these profitability metrics, is a viable business franchise? After all, many other industries operate with much higher margins but generate considerably lower total profits.¹

The simplest, most straightforward answer is: make a little on a lot and do it over and over again. However, I believe the more informed answer relies more on the legal system than the nation’s capital markets. More specifically, my position is that without bankruptcy laws offering the protection of the courts to both parties, borrowers would be less willing to borrow and lenders would be less willing to lend. Simply put, while money makes the world go round, bankruptcy laws make sure it keeps spinning.

When assessing investment risk in the United States and abroad, investors often overlook the role of bankruptcy laws—despite the fact that they are integral to the completion of the capital allocation process. You see, part and parcel to the selection of the optimal capital structure of a corporation is preference of funding sources. A larger reliance on debt funding garners increased financial controls to the lender, whereas a larger reliance on equity funding places control in favor of the corporation. Thus, in a behind the scenes manner, more often than not the ultimate funding decision rests not on interest rates or stock price, but rather on the applicable liquidation codes. My contention is borne out in recent research from the London Business School and New York University’s Stern School of Business which suggests, “This means any comparison of capital structures across bankruptcy codes must include a non-trivial role for the liquidation value of the firms’ assets,” [bold mine].² In essence, the final capital structure does not occur before lenders are given the opportunity to fairly assess—and price—their expected recovery in the event of default or bankruptcy. In other words, lenders take a calculated risk in extending credit based on what could go wrong rather than what could go right.

Though such an approach appears counter to the hopes of those receiving the funding, it is nevertheless very logical. In that most lending is secured by tangible assets, the lender must take into consideration the worst case scenario—liquidation— and the prospect of recovery through workout plans or court proceedings in order to accurately price expected risk parameters. That said, and despite such precautions, the lending process is not without risk. The potential for defaults is an ever-present part of the lending decisions. However, the worst case scenario—total loss—as the chart below attests (as of 12/31/2006), is but a small fraction of the total bank loans and, in my opinion, as we close the loop on my initial query, total bank profits.³

Granted, I acknowledge that the profitability of the nation’s banking system is not solely dependent upon lending activity, but lending is its main line of business. And despite the inherent credit and default risks involved, banking, in general, and making loans, specifically, appear by most generally accepted metrics to be a very profitable and growing business that is arguably built more on a legal footing than a financial one.

¹ Ned Davis Research, Inc. Chart GIX4164, ©2007

² “Cross Country Variations in Capital Structures: The Role of Bankruptcy Codes,” by Viral V. Acharya, Rangarajin K. Sundaram and Kose John, October 1, 2005.

³ Ned Davis Research, Inc., Chart GIX 4185, ©2007

Factors Driving the Economy

Economic Acceleration

Economic Deceleration

Latest Available Information
(as of 05/18/07)

Employment
^{(Source: Bureau of Labor Statistics)}

Up

Down

The April employment data raised more questions than it answered. Measured shifts in the labor force, that is those entering and leaving—essentially clouded the picture. Granted, the unemployment rate ticked up to 4.5 percent, but only because the size of the labor force contracted in excess of job losses. Payroll gains, while less than the consensus forecast, continued the recent pattern of upward revisions to earlier month’s data offsetting weaker current month data. That being said, total household and payroll employment remains near record levels seen earlier in the year. In summary the overall data, including hours worked and wages earned, suggests to me the consumer continuing to be a force for economic growth in the second quarter of the year. As such, I suggest the appropriate action on the table is to circle Up.

Personal Income
^{(Source: Bureau of Economic Analysis)}

Up

Down

Personal Income growth in March 2007 registered a .7 percent increase for the second consecutive month. Wage and salary levels once again set new records at $6.289 trillion. The personal income data remains, I believe, supportive of future economic activity. Please circle Up on the tablet.

Retail Sales
^{(Source: Department of Commerce, U.S. Census Bureau)}

Up

Down

The nation’s measure of retail sales activity in April 2007 reflected inclement weather and a calendar shift splitting the Easter holiday shopping patterns between March and April. Total sales slipped .2 percent. However, once prior month revisions are considered the levels were essentially unchanged. Though weather and holidays can and will obscure the true nature of consumption outside of services, I remain of the opinion that while the consumer is indeed spending, the level is not sufficient enough to shift Gross Domestic Product growth closer to long-term trend. As such, I suggest the appropriate action is to circle Down.

Durable Goods
^{(Source: Department of Commerce, U.S. Census Bureau)}

Up

Down

The story in new orders for durable goods in March 2007 remained heavily influenced by swings in net aircraft orders. Outside of transportation orders, the overall data remains lackluster as manufacturers continue to work down inventory. As such, the component calculations from the report featured in the Gross Domestic Product accounts show little acceleration over that seen in the fourth quarter of 2006. Please continue to circle Down.

Inflation
^{(Source: Bureau of Labor Statistics)}

Low

High

Inflationary pressures remain evident but not elevated. The Federal Reserve’s preferred measure, Personal Consumption Expenditures ex- food and energy price changes, as of March 2007 rested at 2.1 percent year-overyear. Though the Federal Open Market Committee (FOMC) policy directive continues to highlight inflation concerns foremost in the minds of FOMC members, I now expect the incoming data to highlight a downward shift in the trajectory of this widely watched metric. Therefore, I now suggest the appropriate action is to move the circle from High to Low.

Government Spending
^{(Source: Congressional Budget Office, U.S. Treasury)}

$In

$Out

The federal government recorded a budget surplus for April 2007 of $177 billion. Total receipts from the April tax payments posted a record $384 billion thereby pushing the rolling 12-month fiscal deficit down to just 1.1% of the nation’s Gross Domestic Product—a level not seen in five years. Interestingly enough, though unlikely, there is a rising probability that if the receipt and expenditure patterns of the first seven months of the fiscal year follow suit in the remaining five, the fiscal budget could be in balance on September 30. Please circle $In on the chart.

Monetary Policy
^{(Source: Board of Governors, the Federal Reserve System)}

$In

$Out

The Federal Reserve’s Open Market Committee continues to set the overnight interbank lending rate at 5.25 percent. In that the Committee did not reinstate any tightening bias to the policy directive of May 9, 2007, I suggest the appropriate action on the table is to circle $In.

Yield Curve
^{(Source: Bloomberg, LP)}

Positive

Negative

The difference between the three-month Treasury bill yield and the 10-year Treasury note yield was 8 basis points on May 18, 2007.

The inversion in the most popular measure of the yield curve, the discount yield on 90-day U.S. Treasury Bills and 10-year U.S. Treasury Notes, so prevalent for the last year, reverted to a positive spread over the last thirty days. This swing suggests investors sense the FOMC moving to acknowledge, sooner rather than later, inflation levels remaining within their preferred range. Please move the circle to Positive.

Gross Domestic Product
^{(Source: Bureau of Economic Analysis)}

Above

Below

Midway through the second quarter finds anecdotal and reported measures of economic activity confirming little change to the below trend growth seen in the first quarter of the year. Corporate capital expenditures and residential investment continue to represent the lion’s share of the sluggishness. On the other hand, the picture on the consumer side of the ledger is far from robust. However, they are holding their own. All in all, in that trend real GDP growth over the last five decades has centered around 3.3 percent I continue positioning the appropriate circle as Below.