Monday, August 31, 2009

The 'Real' Stress test

Greetings good citizen,

Seeing that yesterday was my birthday I gave myself the night off. Given recent events, my biggest ‘birthday present’ this year is being here at all…and I’m not out of those woods yet.

But enough about me, our friend, Mr. Market, in anticipation of the arrival of September, has commenced to ‘retreat’ as Fear has (once again) beaten baseless Optimism to a bloody pulp.

It never ceases to frustrate those of us in the ‘doom and gloom’ crowd that we will never be considered a part of the ‘reality-based community’ (while the Pervasive Pollyanna’s of Prosperity are readily accepted, even while consistently being proven wrong.)

What’s this have to do with the price of tea in China? Well, tonight’s offering returns us to a subject we haven’t visited in quite a while, the topic of cascading systemic collapse.

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James Kelleher at Reuters points up a risk to economic recovery that hasn't been much discussed: the potential drag on the manufacturing sector from the financial toll the recession has taken on smaller companies in the supply chain.

From Kelleher:

Call them zombie suppliers. Analysts say the speed with which major manufacturers cut output in this recession put unprecedented strain on thousands of small manufacturers that supply the industry with critical parts.

That has left the supply chain with an unknown number of suppliers who are dead but do not know it -- companies so undercapitalized and overleveraged they will never raise the money they need to get their idle plants running again.

"Their lenders are going to say, 'Sorry, we're not going to increase our exposure with you because we don't know if you're going to make it or not,' " says Bill Diehl, the chief executive of BBK, an advisory firm that does supply chain risk analysis.

And that, of course, would be a horror show for the publicly traded manufacturers that rely on these suppliers. It could leave them scrambling to secure components once the recovery starts -- and missing some of the rebound's benefits. [There’s a more frightening reality here and that is ‘sole-sourcing’, which is much more common than you’d think/have been lead to believe.]

This will be a big test of bankers' assertion that they're ready and willing to lend money again. Will they balk at extending new financing to many smaller manufacturers even if the companies can show rising orders? This may become a very big issue in greater Los Angeles, given the region's huge base of small and mid-sized manufacturers. [Worse, many of these suppliers are leaning heavily on their ‘sole source’ contracts, which the bankers are ignorant of.]

Japan had the opposite problem in its "lost decade" of the late 1990s and early 2000s: Its banks were under political pressure to keep alive zombie companies that no longer were viable.

As James Surowiecki at the New Yorker wrote in May, the popular recollection is that Japan's economy was held back by zombie banks that were propped up by the government but refused to lend. The reality, Surowiecki noted, was that many Japanese banks engaged in "evergreening" -- they kept pouring money into companies that already had loans with them, even if the companies' prospects were grim. [Were Japanese banks being stupid or are we witnessing the outcome of ‘sole source’ contracts? Where it isn’t worthwhile for the listed ‘alternative source’ to invest in the necessary equipment to produce ‘good’ parts.]

“The practice effectively meant that, instead of making good new loans, [the banks] were constantly throwing good money after bad. As a result, they were never able to earn their way back to health," Surowiecki wrote. [This argument ignores the case of the ‘preferred vendor’ over the ‘alternate vendor’, who isn’t given enough business to make the capital expenditure ‘profitable’.]

The challenge skittish U.S. bankers will face is in identifying which smaller manufacturers have a reasonable chance of bouncing back from the astounding collapse of industrial output that began last fall. The banks will face those decisions as companies ask for more credit to begin ramping up production -- which should happen soon in many industries that need to rebuild depleted inventories.

Kelleher quotes Craig Giffi, head of U.S. consumer and industrial products practice at accounting firm Deloitte:

"Until those companies have to produce something -- and to secure raw materials, to make a part, to hire more workers -- no one will know how weak their balance sheets and credit positions really are."

Once again good citizen there is ‘theory’ and then there’s reality. In ‘theory’, everything has multiple sources but in reality, this is seldom true. Certain components require such rigorous standards that those standards can only be met with highly specialized (and therefore expensive) equipment.

Naturally, it isn’t ‘cost effective’ to purchase such highly specialized equipment if the work for such a piece of capital is difficult to come by. If one were to make such an investment, one would want to be assured that you would receive enough work to at least amortize the investment…this is where ‘sole source’ contracts come in. This is still a gamble but at least, worst comes to worst, you should recoup most of the up front cost, even if you have to return the equipment to the vendor.

Like the parable ‘for want of a nail’, we have a rather similar situation on our hands here. You can’t make a ‘whole’ product without ‘all’ of the parts. The question we face here good citizen is which parts of the puzzle can we afford to do without and still avoid a cascading systemic meltdown?

The bankers don’t know the answer to this question, chances are excellent even purchasing agents can’t provide a satisfactory answer. They have more than one source for everything BUT they have never received ‘usable’ parts from the alternative vendor because they don’t have the right equipment (and sometimes, talent.)

Not frightening enough? Let’s add this tidbit about how only a few financials have ‘dominated’ trading at the NYSE for the past month…

If you think I’m tough on the financial media check out Yves Smith’s take on today’s rather glib report on how taxpayers have ‘profited’ from bailing out the banking system…

Twas a ‘hell of a day’, news-wise good citizen, the bears are just coming right out of the woodwork, again.

What the hell happened to that ‘global economic recovery’ they were all so sure of?

Thanks for letting me inside your head,


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