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May 21, 2010

Finding the Next Economic Bubble: Agriculture and Accounts Receivable

In studying the current condition of our economy, I am finding a number of parallels between present day and 2003.  In 2003, the economy was bouncing off of an economic bottom.  The year 2002 was a rough one in terms of our economy with zero good news.  Money was very easy in 2003 as interest rates were very low.
Now, take the above sentences and replace 2002 with 2009, 2003 with 2010.  Do you see the parallels?
The seeds to an economic bubble are easy money.  The tech bubble of 1999 and 2000 would have been smaller in size had there not been easy money in the system from 1992 to 1994 and the liquidity measures stemming from the 1997-98 Asian financial crisis.  The easy money of 2001-2004 brought about the financial crisis of 2008 and our current recession.
Take a look at the Fed Funds chart and ask yourself when money was easier, 2001-2004 or 2008-present?
I believe that low interest rates cause money supply bubbles, which lead to one of two outcomes.  First, there could be bubbles in various sectors in the economy.  This causes inflation to appear somewhat tame as money is stable in certain parts of the economy but spikes where there is a bubble.  This would explain why inflation never went over 6% after the easy money days of the 2001 to 2004 Federal Reserve.  If the money does not find itself into a particular sector, general inflation would then occur.
I am beginning to believe that the days of “general inflation” could be over.  We have had three bubbles since 1997, and without major changes in monetary policy, the bubble age may only be beginning.  It is important to identify possible bubbles, both as early investment opportunities and as areas to avoid as the market peaks and bursts.
Agriculture concerns me because of the parallels it holds to the financial sector.  I did not think twice about agriculture being the next bubble until I heard comments from Kansas City Federal Reserve Thomas Hoenig.  Hoenig, in a statement quoted on The Street earlier this spring;
"I make no pretense that I, or anyone, can reliably indentify and 'prick' an economic bubble in a timely fashion, the Kansas City Fed president said. "However, I am confident that holding rates down at artificially low levels over extended periods encourages bubbles, because it encourages debt over equity and consumption over savings."
He then added;
"Our contacts within the Tenth Federal Reserve District have shared anecdotal information suggesting that operators and investors in the Midwest are buying farmland and bidding up the price. ... "We've seen this in the agricultural regions of our District in the past, notably in the run-up to the banking crisis of the 1980s."
Applying the bubble principles of high prices, debt over equity, and consumption over savings in the agricultural industry and we have a problem.  Not only that, but this could spill over to the derivatives traded on a variety of agricultural commodities (namely corn).  The biggest factor that separates the prospective agricultural bubble from our financial bubble is that the former involves our food supply.  A crash could cause major disruptions in the United States and with trade partners who are dependent on food from us.
The other area of concern for me is accounts receivable.  This is the portion of a company’s balance sheet were the products/services have been sold, but the sales have yet to be collected.  High amounts of accounts receivables can starve companies of cash.  Imagine selling something and then not getting paid for it.  That is what companies with high amounts of accounts receivable balances struggle with.
One strategy that has been deployed to assist with high A/R balances is to sell these to a collections firm.  For example, if I have $1 million in accounts receivable, I may sell those to a collections firm for $700,000.  I get my cash and the collections company (which specializes in just that) has an opportunity to earn a profit by collecting on all of the outstanding bills.
Unfortunately, accounts receivable balances are going to swell during this decade as a direct result of the health care bill.  I have yet to meet anyone who has a “timely” collections experience with the federal government.  Usually, the federal government pays within 90 days as opposed to 30 days.  Now, imagine a hospital that has increasing sales from the federal government as a result of the health care bill.
The average person might say “increased sales and revenue is good.”  However, from the perspective of the business side of the hospital, this means that the hospital must provide more services (which cost money) and wait longer to get paid.  This means they must use more cash up front and receive the cash (in exchange for the services) later than usual. 
Hospitals will likely turn to collections agencies more as the health care bill is implemented.  How could this potentially create a bubble?  Like the financial services industry, collections involve pushing around A/R assets.  These assets, if not paid for, are worthless.  This is much like the mortgage backed securities market.  In the case of the accounts receivables, the largest debtor to the paper is the federal government.
Like the states of California and Illinois, the federal government is about to become over-burdened with debt.  Like these distressed states, this could lead to slower or defaulted payments.  In Illinois, the state government has defaulted on several hundred million dollars to local school districts.  With this information, let’s present a possible scenario.
A hospital begins seeing increases in its accounts receivables.  Fortunately, they see an opportunity to sell these receivables to a collections company at a good price (80 to 90 cents on the dollar).  The price is good because the government is considered a worthy borrower, with AAA rated debt.  However, the government slips into the same debt and payment conditions as the state of Illinois.
As the defaults begin, the collections companies will begin to downgrade their pricing of the receivables.  Poorly managed collections companies will go bankrupt first.  Then, as collections continue to slow, collections companies will begin to purchase less.  This forces the hospitals to keep the receivables on the books much longer.  If a bank becomes dependent on investing the cash proceeds, there could be serious problems in the hospitals operations, similar to those of the banking industry in the fall of 2008.
It’s a stretch, but it’s possible.  The agriculture and accounts receivable bubbles are two possibilities of what could come about with excessive money in certain industries.  Do you have any possible bubble theories?

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