Capital Spending Not Crowded by Federal Deficit

The rise in the 10-year Treasury yield is actually a good sign, maintains a Moody's analyst. Also: Freddie Mack the Knife; downgrades down; uptick in IT budgets?; downtick in board appointments?; and more.


Burgeoning federal deficits, rather than pump up the economy, actually discourage capital spending by crowding financial markets with government debt. That, at least, has been the prevailing post-Reaganomics wisdom.

The most recent period of growth, the longest ever recorded in the United States, was said to be at least partly due to government fiscal discipline and debt paybacks.

Fast forward to mid-2003. The federal deficit is in fact burgeoning — witness the recent rise in the yield of the 10-year Treasury — just as many economists are telling the public that the economy has started to grow out of recession. Is government borrowing a threat to the infant recovery?

Moody’s analyst John Lonski argues against drawing such bearish implications. In his market wrap “Wider Federal Budget Gap Can Help Capital Spending,” he maintains that “the primary driving force” behind the yield increase is not “the very well anticipated widening of the federal budget deficit.” Rather, it results from a return to economic growth.

“Mounting evidence of an improving economy serves as the primary driver behind the latest ascent by Treasury yields,” asserts Lonski. “In part, corporate bond yield spreads over Treasuries have narrowed in anticipation of an enhancement of debt repayment capacity not through lower borrowing costs but rather through an eventual enhancement of cash flow.”

Investors, taking comfort from a sixth consecutive quarter of year-over-year growth for aggregate recurring profits, are bidding down the yield spreads of corporate bonds over Treasuries, notes Lonski. Investors recently bid down the yield spread of Baa-rated industrial company bonds over Treasuries from a June 2003 average of 170 basis points to 159 points, the lowest figure since August 1998, he writes.

A recent single-A industrial company bond yield spread of 115 basis points was the thinnest since July 1998, he adds; the recent Aa industrial yield spread of 83 basis points was the narrowest since October 1997. The yield spread over Treasuries of a high-yield composite recently plunged from its June 2003 average of 625 basis points to 526 points, the lowest figure since February 2000.

Lonski, pointing to the current strong spread performance of all kinds of corporate debt, disputes fears that higher Treasury yields might choke off investment. The reverse, he writes, certainly hasn’t held true lately. Despite the plunge of the average 10-year Treasury yield from 6.03 percent in 2002 to 4.32 percent for the 12 months ending March 2003, the real business investment spending of that 12-month period trailed the spending for calendar year 2002 by 11 percent. Lonski adds that despite a 27 percent increase in investment-grade corporate bond issuance, from $446 billion in 2002 to $565 billion for the 12 months ending March 2003, capital spending sank.

“The ‘crowding out effect’ implies that capital spending declines in response to a widening of the federal budget gap,” he notes. “However, the latest widening of the budget deficit will likely give rise to an increase in capital spending partly in response to the salutary effect of tax cuts.”

“To the degree that fiscal stimulus rouses a soporific U.S. economy, business investment spending will quicken despite what may be a percentage point climb by the 10-year Treasury yield,” he adds. “What happens to aggregate demand matters much more to the economy and capital spending.”

Freddie Mack the Knife

Mortgage finance company Freddie Mac “has used a grab bag of accounting techniques to mislead investors about its results since 2000” writes The New York Times, citing a report prepared by outside investigators for the company.

One U.S. lawmaker reached into his own bag of tricks on Tuesday when he subjected Martin Baumann, CFO of Freddie Mac, to a withering parody of the company’s results restatement, set to the jazz standard “Mack the Knife.”

Criticism of Freddie’s accounting methods was set to the music by Rep. Edward Markey (D-Mass.), who is known for quirky but razor-sharp questioning, during a subcommittee hearing. Freddie Mac, the number-two U.S. mortgage finance company, said last month it would restate earnings for 2000, 2001, and 2002 upward by between $1.5 billion and $4.5 billion, stemming largely from derivative contract accounting problems. The restatement announcement was accompanied by the firing of Freddie Mac’s president, the resignation of its chief executive, and the retirement of its former CFO.

“When those earnings rise on your balance sheet and you want them out of sight, just do a swaps deal, says old Mac’s execs and defer them with all your might,” crooned Markey to the Freddie Mac CFO, according to Reuters.

“You know when the reserve account, with its cash, babe, hides those earnings, it helps the spread. Fancy derivatives has old Mac, dear, so there’s never, never a trace of red,” continued Markey.

Deadpanned Baumann, “I thought the song was excellent, and I thought the tone was very good also.”

Baumann pledged that the company will fully disclose financial information as it remedies the defects in its practices that led to its accounting problems. “We know how to fix these shortcomings — and we will,” Baumann told the subcommittee. “We will emerge stronger than ever, with significantly improved accounting and disclosure practices that will meet the highest standards…. There’s no excuse for Freddie Mac’s accounting problems other than it didn’t have the right controls in place.”

Fannie Mae — a corporate relation of Freddie Mac’s that may face its own accounting difficulties, according to some institutional investors — remains in seclusion.

Downgrades Down, but Not Decisively

Moody’s reports that its downgrade per upgrade ratio has fallen to 2.5 : 1 so far this year. The number is a significant improvement from the 4.9 : 1 ratio recorded by the ratings agency for 2002 and the 2.9 : 1 level of 2001.

While the numbers represent an obvious improvement for corporate creditworthiness, the “ratio has yet to break decisively under 2 : 1, which corresponds to an upgrade ratio of 33 percent,” says the report. Moody’s notes that the last major capital spending recovery occurred as the ratio dropped from 2.9 : 1 in 1991 to 1.7 : 1 in 1992.

Short Takes

  • Uptick in IT budgets? A recent Aberdeen Group study of more than 100 CIOs reveals that they expect their companies to increase their technology budgets by an average of 3.4 percent over the next 6 to 12 months. A similar Aberdeen survey of CIOs, conducted in March 2003, indicated that overall IT budgets would increase an average of 2.7 percent for the 6 to 12 months to follow.
  • Downtick in board assignments? Fully 70 percent of publicly traded companies are limiting the number of additional boards on which their CEOs can serve, according to Christian & Timbers. The executive and board search firm conducted in-depth interviews with 74 CEOs of public companies in May and June. Christian & Timbers also revealed that 77 percent of those interviewed have had a change on their board in the past year, and 65 percent expect further board changes in the next twelve months.
  • Molecular diagnostic group Igen International confirmed that it is in talks to be acquired by Roche Holding. Negotiations were spurred on by a recent U.S. Court of Appeals ruling that set aside $486 million in damages awarded to Igen in its ongoing contract dispute with Roche, reported Reuters, but that upheld a lower court ruling requiring Roche to renegotiate the licensing agreement between the two companies.
  • SonicWALL, a provider of integrated Internet security solutions, announced that Kathleen M. Fisher has been appointed chief financial officer, effective immediately. Fisher, previously chief financial officer of QAD, a provider of ERP and collaborative-commerce software, replaces Michael Sheridan.
  • The Securities and Exchange Commission, writes The New York Times, has reported that it would not spend $103 million of its budget this fiscal year because it “could not hire accountants and investigators fast enough.”

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