Recent press reports of a record cash hoard on US corporate balance sheets have led to complaints that companies are not investing aggressively enough to pull the economy out of recession. Copious cash appears to be available. Prior to the start of the “Great Recession” (i.e. the third quarter of 2007), total liquid assets on the balance sheets of non-financial corporations totaled $1.5 trillion, and represented 5.3% of corporate assets. Today the cash hoard totals $1.8 trillion, or 7% of total assets on a market value basis. In other words, seven cents of every dollar is held in the corporate “piggy bank” as opposed to being invested in longer-term, (presumably) more productive assets. The longer-term numbers also favor cash. Over the 144 quarters between January 1973 and the fourth quarter of 2008, cash steadily increased as a percentage of corporate capital. Given these trends, critics say capitalists are failing to take risk and act like capitalists.
Companies respond that the frenzy of lawmaking in Washington over the last several months (see the 2400-page healthcare and 2300-page financial regulation reform bills) has them scared stiff. They're paralyzed by regulatory uncertainty. They’re quick to add that the Federal Reserve's bloated balance sheet, the soaring fiscal deficit and moribund bank lending all indicate that the government has done nothing but shuffle the nation's deck chairs. Instead of working to help the economy comprehend the very real losses which precipitated the financial crisis, corporate leaders say policymakers have orchestrated a great game of extend and pretend. Whatever you want to call it, corporations are hunkered down with their cash, even though it earns nothing. It's a perfectly reasonable strategy in an economy suffering from ongoing, grinding deflation.
But a slightly different perspective might help clarify the situation. Let’s recognize that every dollar stashed in a bank account or T-bill is someone else’s liability. And as a short-term liability, it carries risk. Commercial bankers know, for example, that given the ongoing pain in the property markets, the quality of their assets (mostly real estate loans) is suspect. Therefore they keep extra cash on hand to redeem their liabilities (customer deposits). They keep this cash mostly in the form of deposits at the Federal Reserve, and it offsets the risk of further deterioration in their asset base. Home price trends are the best indicator of this risk, and they continue to slowly erode. As a result, banks husband their cash, and won't begin lending until home and office prices stabilize.
The Federal Reserve also has a balance sheet. Its liabilities consist of short-term deposits by commercial banks at the Fed. Its assets consist largely of Treasury and mortgage bonds, many of which in the mortgage category are also of dubious quality. Unlike commercial banks, however, the Fed has no need to keep excess liquid balances lying around. It can create new “base” money to pay its liabilities with the stroke of a computer key, and has in fact done so in large quantities over the past year or so.
The point is that because the cash hoard detailed above represents a call on already existing assets of potentially dubious quality, it may not be as primed for deployment as the critics believe. As money manager John Hussman put it in a recent missive to clients:
What’s preposterous about this is that the cash that companies are holding is primarily in the form of government securities and base money created over the past couple of years, which somebody has to hold at every point in time until those liabilities are retired. This is not money that is waiting to be spent. It is a stack of IOUs representing resources that have already been squandered, and now somebody has to hold these pieces of paper until they are retired.
To illustrate, let’s say Cisco Systems (CSCO) decides to write a check from its $39 billion cash trove for an acquisition. To do so, it can either pass the liability it holds (typically a Treasury bill or bond) along to someone else by selling it, or refuse to roll it over when it matures. In the case of a sale, the buyer credits Cisco's bank account so it can write the check for the acquisition. In the case of maturity, the Treasury needs to sell a fresh T-Bill to someone else to raise the cash to make the payment to Cisco. The point here is that in neither case is the obligation extinguished; it still needs to be funded with real resources. The only way the obligation could be extinguished is if the Treasury ran a surplus, and began paying down Federal debt as was done in the late 1990s. We all know we're a long way from this scenario.
Hussman continues:
In short, instead of directing savings toward investments in real, productive assets that we would observe as physical output, fixed capital and equipment, our economy has been forced to choke down a massive issuance of government liabilities in order to bail out bad debt. For every dollar of debt that should have defaulted, we now have two dollars of debt outstanding (the original debt, and a newly issued government security). What appears to be sideline cash is simply the evidence of past spending.
So we know who holds the newly issued government liabilities: firms like Cisco with their $39 billion "cash" trove (remember … all cash is someone's liability!). Hussman is simply saying that this cash would not exist if it had not been borrowed (and spent) by the Federal government. But who holds the original debt that should have defaulted? It turns out that the mechanism for the creation of the cash that Cisco holds is revealed when we see who bought the bad debt. That's right ... the Federal Reserve! Historically the Fed has purchased only the highest quality Treasury bonds (and typically shorter maturity Treasury bonds) in the process of implementing monetary policy.
Today, however, the Fed owns $1.3 trillion in longer-term mortgage bonds issued by Fannie Mae (FNM) and Freddie Mac (FRE). As noted above, it bought these bonds from commercial banks in return for crediting the bank's reserve accounts at the Fed. This past week the Federal Reserve Bank’s consolidated balance sheet listed nearly $1.3 trillion in mortgage backed securities on the asset side, and offsetting member bank reserve deposits aggregating $1.05 trillion on the liability side. This compares with average reserve deposits of less than $10 billion before September 2008.
Now it gets interesting. What if commercial banks decide they want to begin lending out these reserves? If the banks decide to take down their deposits at the Fed in order to lend them out, what would they be credited with in return? Assuming enough currency was on hand, banks could be provided with Federal Reserve Notes. But $1 trillion in physical cash is a non-starter in the modern electronic economy. Alternatively, the Fed could sell their mortgage backed securities and utilize the proceeds to wire funds to the banks. In this case the Fed would need to find a buyer for $1.3 trillion of securities which they carry at 100 cents on the dollar. But these bonds are not worth par, and any attempt at mass liquidations would drive up mortgage rates, further crushing the housing market. Furthermore, as it stands today, even a 6% loss would wipe out the Federal Reserve Bank’s entire equity of $70 billion!
The point here is that, in practical terms, the reserves which member banks hold at the Fed are very much illiquid, and only technically a cash equivalent because the assets backing them are not worth par. The banks have essentially entered into fictional transactions with the Fed in order to boost their reserves. The Fed bought $1.3 trillion of mortgage-backed securities from the banks at par to preserve both the solvency and capital ratios of the banks, when everyone knows those securities weren’t worth par. Therefore the loss exists somewhere, and at this point it’s on the balance sheet of the Fed. Any attempt by the banks to draw down their reserves (i.e.; increase lending) would force the Fed to either realize the loss (unlikely), or continue to paper it over by further increasing the money supply.
To summarize, if you cannot draw down the funds in your bank account without a material cost hit to yourself or the financial system, you do not have “cash;” you have a loan receivable. The simple mechanism of double-entry bookkeeping reveals the true illiquidity within the system. The massive reserves on the books of both the banks and the S&P 500 aren't being put to work because they aren't all “money good". If everyone tries to invest at once, it becomes like a game of musical chairs. There is not a chair for everyone, and the Fed would have to begin aggressively issuing more “chairs.”
The banks cannot liquidate their asset portfolios at par, so they cannot fund the movement of customer deposits out of cash. The money is stuck there until the banks are nominally solvent. They won’t be nominally solvent until real estate prices reach equilibrium and sufficient new capital has been raised, either via equity issuance or retained earnings. We're not there yet, so we pray and delay. In Japan they're more than 20 years on, and still waiting.
Disclosure: Author long CSCO
