Those Skyrocketing Interest Rates
Much as Benjamin Franklin might have abhorred the idea, debt has become the 20th century American way of life. The entire U.S. financial system is elaborately geared to keep money moving in vast quantities from lenders to borrowers. Nearly everyone operates on the almost unconscious assumption that there is plenty of money available to borrow at interest rates he can afford: businessmen who launch, expand or modernize enterprises; public officials who schedule the building of roads, schools, parks; consumers who plan purchases of houses, cars, even college educations. Yet in recent months that comforting belief has been shaken by a skyrocketing rise in interest rates to peaks that would have seemed a nightmarish fantasy only two years ago. Some interest rates, in fact, are at levels unmatched since the Civil War. The most startling statistic: the "prime" rate that banks charge to their most credit-worthy business customers has jumped to a level of 11 1/2% to 11 3/4%, the highest ever.
The runaway spiral has already gone far to dim two parts of the American dream: young couples with skimpy savings are finding it all but impossible to buy a" home, and would-be entrepreneurs are unable to get the credit they need to start businesses of their own. Small businesses generally are having trouble borrowing to expand or in some cases even keep going. Most big businesses can still get credit--indeed, their excessive borrowing is a major cause of the present squeeze. But electric-power companies, which must regularly go to the bond market to borrow the funds required to expand and maintain their systems, are in deep trouble as investors demand higher and higher interest rates.
Stretched Out. Savings and loan associations, which supply most of the nation's mortgage money, cannot compete with commercial banks for funds in an era of high interest; some are struggling just to survive. Banks themselves, though collecting handsome interest on loans, are being forced to borrow feverishly--from individual savers, the Federal Reserve, each other--to meet loan demand. Summing up the situation, George McKinney, senior vice president of New York's Irving Trust Co., says, "There is no question that the financial structure is stretched out. There's bound to be an adjustment, and inevitably some companies won't make it."
Some debt-laden companies are already not making it; the high cost of loans has contributed to a sizable increase in business bankruptcies so far this year. The most spectacular case: partly because of the difficulty of getting credit at an affordable cost, Interstate Stores Inc. filed for reorganization two weeks ago under the Federal Bankruptcy Act. It owed $195 million.
Such troubles are not unprecedented. In fact, bouts of scarce credit and high interest rates are apparently becoming a recurrent feature of the U.S. economy. The present one is the third in the past eight years. Rarely if ever, though, have interest rates risen so far so fast. The bank prime rate was 8 1/2% as recently as early March, and below 5% in early 1972. Even the official rate of 11 1/2% to 11 3/4% today understates the real cost of money. Because banks require business borrowers to keep part of their loans on deposit, the effective interest rate on the money that prime-rate borrowers actually get to use is closer to 14%. For many small businessmen without the credentials to get the prime rate, interest charges range up to 15%, 16% or even more--when loans are available.
Exempt Loans. As recently as mid-February, the New York State Urban Development Corporation sold an issue of short-term notes for a 4.74% interest rate. Last week it tried to market $100 million in similar notes to get funds for construction of low-and middle-income housing--and discovered that it would have to pay 8% or more to sell them. That is all the more astounding considering that interest on these loans is exempt from federal income taxes. For a lender who is in the 50% income-tax bracket, an 8% yield on a tax-exempt note is equal to a 16% rate on a taxable loan. Outraged, the state agency withdrew the notes from the market.
As short-term interest rates rocket upward, corporations are also being forced to pay higher interest on the bonds they issue for 20-or 30-year periods. As recently as six months ago, such bonds sold for a rate of 7.9%. Last week Ohio Power Co. tried to sell $150 million in bonds at a 10 1/8% rate but even then had difficulty in attracting lenders.
Just how high these rates are can be appreciated only in historical perspective--and not very long perspective either. Though interest rates in the U.S. have always moved up and down mercurially, their general range has been far below today's. In 1964, for instance, President Lyndon Johnson expressed worry about an increase in the bank prime rate--to 4 3/4%, well under half of today's 11 1/2%-11 3/4% range. Only about a year ago, when major banks raised the prime by half a percentage point, to 6 3/4%. Federal Reserve Chairman Arthur Burns summoned the country's top bankers to Washington for a stern bawl-ing-out and succeeded in getting the increase partially rolled back.
Fortunately, most bankers and economists agree that the present zoom in interest rates is about reaching its apogee. Yet how soon, how far, and even if they will fall again are subjects of sharp dispute. Predictions of where the prime rate will be by year's end range all the way from 6% to 12%. Best guess: rates will gradually trail down to about 8% by year's end.
That interest rates should be rising at all now is one of the most dismal surprises of a troubled economic year. Interest basically is the price of borrowed money and, like many other prices, it fluctuates with supply and demand. The more people and companies there are that want to borrow, and the less lendable money there is to meet their demand, the higher the interest rate goes. Rates shot up last year, but that was to be expected in an inflationary boom. At the start of this year, as the energy crisis hit hard, interest rates began to come down (see chart page 78). The almost unanimous view among money-market experts was that they would drop further as the economy slowed.
The economy has slowed all right. In the first quarter, the nation's production of goods and services actually dropped at an annual rate of 6.3%, the steepest fall in 16 years. The general expectation is that the current quarter will show little if any real growth. The reasons why interest rates have gone up, rather than down, constitute a prize example of how persistent inflation distorts all classic economic relationships.
A Plague. Despite the economic slowdown, inflation, propelled largely by a spiral in food and fuel prices, has accelerated to double-digit rates. During the twelve months ended in April, U.S. retail prices rose a blistering 10.2%. Inflation and interest rates are intimately connected; in fact, it would be only a slight oversimplification to say that interest rates are high because inflation is rapid.
The problem is by no means restricted to the U.S. Ballooning prices have become a worldwide plague, driving up the cost of borrowing everywhere. In Italy, for example, the equivalent of the American prime rate is 14 1/2%, in Britain 14%, in France 13%, in Germany 12 1/2%, and in The Netherlands 11 1/2%. "Internationally and nationally, there is danger of money panic and crisis," says Robert Triffin, a member of TIME'S Board of Economists and a specialist in international monetary affairs.
A rule of thumb in U.S. money markets is that the "real" interest rate on loans is 3%; the actual rate charged is 3%, plus whatever lenders expect the rate of inflation to be. Thus, if lenders expect 6% inflation, they will demand a 9% interest rate. Viewed in this light, interest rates have not even caught up with the pace of price increases. If inflation were to continue at 10%, a bank prime rate of 11 1/2% would yield a real return of only 11 1/2%, v. the historic 3%.
Inflation has also prompted businessmen to step up their loan demands, despite the slack in the economy. During the first four months of 1974, commercial and industrial loans made by all U.S. banks rose by $13.6 billion, from $158.4 billion to $172 billion. If continued for the full year, that pace would result in a staggering rise of $45.8 billion in business loans. Many companies have borrowed to meet inflation-bloated operating costs: it takes about 10% more money now to do the same amount of business as in the comparable period of 1973. Others sought funds to pay for new plants, equipment and expensive inventories of metals and other raw materials before prices and construction costs went even higher. Still others decided to borrow money they would not need until later, on the theory that they could always repay the loans in inflation-cheapened dollars.
Rates Down. The final reason for the interest-rate rise has been a determined stand by Federal Reserve Chair-man Burns, the same Arthur Burns who fought last year to keep interest rates down. Six weeks ago he bluntly declared that the Federal Reserve would not pump enough money into the banking system to accommodate the infla-f-T7( tionary "explosion" of loan demand. He acted in full knowledge that holding the growth of the nation's money supply to a relatively tight annual rate of 6% would set interest rates soaring as the surging loan demand bumped up against an inadequate supply of lendable funds. Last week, in a college commencement address, he repeated his position in some of the scariest language he has ever used. "The gravity Up; of our current inflationary problem can hardly be overestimated," he said. "If past experience is any guide, the future of our country is in jeopardy." He added that the potential consequences of continuing rapid inflation "threaten the very foundations of our society."
Without question, Burns' course is risky, painful, courageous and correct. To shovel out enough money to meet the surge in loan demand would indeed be to finance still faster price increases. Past rises in interest rates have provoked outraged screams from Congress and heavy pressure from Administrations on the independent Federal Reserve to pour out more money. Now, Administration policy-makers are leaving Burns free to pursue his stern course, and even some liberal Congressmen have been uncharacteristically quiet.
To some extent, the lack of opposition may reflect a sophisticated public understanding that runaway inflation is an even greater evil than that old bete noire, excessive interest. To a distressing degree, it also reflects a paucity of ideas in the Nixon Administration as to what else to do to fight inflation. That lack has left the Federal Reserve to carry on the battle almost singlehanded. The Administration has let wage-price controls die, and its budget policy has been less than restrictive. Burns, who clearly resents having the main responsibility for curbing inflation forced on the Federal Reserve, pointed out in his commencement address that Government spending in the past five years has increased 50%, and budget deficits over that period have totaled a thumping $100 billion. "In financing this deficit, and also in meeting huge demands for credit by businessmen and consumers, tremendous pressures have been placed on our credit mechanisms," he said.
Though frightening, Burns' remarks are accurate in describing the strains resulting from the present money pinch and interest surge. As always, housing is being hammered hardest, because both the building and the sale of houses are financed almost entirely on borrowed money. In the first four months of 1974, housing starts limped along at an average annual rate of 1.6 million, 30% below a year earlier, and prospects for a recovery are getting steadily dimmer.
As banks conserve cash for loans to their biggest corporate customers, home builders are among the businessmen who have the most trouble getting loans and have to pay the most for them. Unable to meet their bills, 440 builders in the U.S. failed in the first quarter, leaving unpaid debts of $131 million--more than double the liabilities of bankrupt builders a year earlier. More recently, Woodmoor Corp., builder of a 3,200-acre development outside Denver, filed for a bankruptcy reorganization with 32 town houses and a golf course completed. A few years ago, Woodmoor had arranged financing at a rate 5% above the bank prime rate, which seemed tolerable then. With the bank prime rate now 11 1/2%, it has become a price the company simply cannot pay.
Higher Yield. For many would-be home buyers, mortgage money is becoming unavailable at any price. Reason: savings and loan associations and savings banks, two prime sources of mortgage loans, are running out of money to lend. For complex legal and technical reasons, these "thrift institutions" cannot usually pay more than about 6% in order to attract deposits. Depositors have been pulling out their money in order to buy higher-yielding investments, such as Treasury bills, which recently have paid up to 8 3/4%.
In April savings banks lost $650 million in deposits, and S and Ls $335 million. Withdrawals probably continued through May at about the same rate. James Kemp, counsel to the Illinois Savings and Loan Commission, estimates that half of his state's 500 S and Ls are refusing to make any new mortgage loans with less than a 30% to 40% down payment. For small S and Ls, the money drought is a disaster. Dalton Long, loan officer at Atlanta's Decatur Federal Savings and Loan, is convinced that "some could be wiped out."
Typical of the home-buying victims is Dick Santos, 25, a payroll clerk for Honeywell in Boston. For years he operated a small business after work to bring his income to $10,000 a year and scrape together $2,000 in savings. He and his wife Patty hoped to use that as the down payment on a house costing about $23,000 that could be bought on a Veterans Administration-guaranteed mortgage with monthly payments of around $200. The family finally found a likely house, and then went to eight lending institutions for financing. Only two of the lenders even bothered to let Santos fill out an application, and those two rejected him. Embittered, Santos remarks, "It's like we're on the outside of this country looking in."
Running Out. Banks' stringent home-loan policies are also demolishing the plans of real estate speculators like Bostonian Clark Frazier, a 33-year-old computer programmer who bought a brownstone cheaply, spent heavily to renovate it, and ran out of money after rendering only three of the four apartments livable. Now he cannot get a loan to complete the renovation and has piled up $13,000 in unpaid debts. "I don't know what I'm going to do," he says.
Interest rates on car loans, vacation loans, personal loans and the like have always been high (up to an effective 18% or more), and most banks say that they are not turning away borrowers--at least, not those who have savings accounts at the bank from which they seek a loan. Still, some banks are tightening up their consumer-loan standards. In Atlanta, Trust Co. of Georgia has stopped making new revolving credit loans, the kind that enables a consumer to borrow up to a certain amount, repay part of the loan, then have the amount he has repaid become available to be borrowed again. A year ago, the bank required a car buyer to have a monthly income six times as large as the loan payments. Now his income must be eight times the payments. David A. Brooks, vice president of First National Bank of Chicago, reflects the attitude of many bankers toward consumer loans: "We are not aggressively seeking new relationships at this time."
Any problems that consumers have in getting nonmortgage loans are small in comparison with the difficulty of borrowing to launch a small business, expand it or keep it going. In Troy, Mich., Mrs. Alisha Fall, a onetime teacher who now directs a day-care center for a national chain, has had to put off her ambition to open her own day-care center for the children of working parents. "I'd need $60,000 for the building, installations and the rest," she says. "That translates to about 30% down in today's market and, with an 11%-plus interest rate, it's just an impossible dream." Bernard Zvirman, co-owner of a restaurant-hardware business in Pittsburgh, says, "It is just about impossible for a chef to leave his place of employment and open his own restaurant." With high interest rates piled on top of other costs, he estimates that it now requires $3,000 a seat to open even a modest dining room, double the cost ten years ago.
Ronald Sienko, president of Sienko Consultants in Newton, Conn., recently designed a device that substantially cuts the cost of measuring water levels in reservoirs and pipelines. Early this year he borrowed $20,000 on a personal note at 11.43% interest, built ten machines and sold them all. Since then, he has had 220 inquiries about the device from cities and towns round the country, but he cannot raise the money to make more than about 20 additional machines, except at prohibitive cost. "I tell the banks I need $50,000 to $100,000 to get this thing going, and I tell them it will take about two years to make it profitable," says Sienko. "The banks tell me it is not even worth looking for credit."
Fire Sale. Small businessmen who need to borrow to keep going at all are increasingly turning to underworld loan sharks for credit, reports Ralph Salerno, chief rackets investigator for the district attorney of Queens County in New York City. The "vigorish," or interest rate, on these loans makes the bank prime look like a fire-sale bargain: $300 on $1,000 borrowed for 13 weeks, or 120% a year; $150 a week on a $5,000 loan, or 156% a year. The loan sharks are sophisticated operators who keep close tab on the legitimate money markets and often cite the latest jump in the bank prime or in bond-market rates in order to convince reluctant customers that they cannot get credit elsewhere. The loan sharks will take on poor risks; but if a customer falls behind in his payments, he faces a lot more than a dunning note.
If interest rates stay at their present levels for a long time and the credit pinch intensifies, much more serious strains on the economy could result. Already the cash ratio--money available compared with debt--of U.S. corporations is down to its lowest level since World War II at least. In this year's first quarter, corporations had only 17c in cash for each $1 of current debt, a drop of 3-c- from the end of 1972. As yet, no bankruptcies as spectacular as the 1970 crash of the Penn Central are in sight; but if the squeeze continues, even big companies could have trouble paying their bills.
A more subtle but very real threat is that companies will be unable to raise the vast sums of capital they will need to expand capacity so that they can relieve shortages of oil, steel, paper and other products. For that, corporations need not the short-term funds they can borrow at the bank prime but the long-term money raised by selling new issues of bonds or stock. But as towering interest rates make bond issues costly, they also depress the stock market by luring money away into such high-yielding investments as bank certificates of deposit. The Dow Jones industrial average last week fell below 800 for the first time in five months and closed at 802.17, down 24% from its January 1973 peak of 1050.
The troubles of the electric-power companies are a prime illustration of what could happen to other industries if there is a further general drying up of credit. The utilities are in constant need of capital because by law they are required to expand their systems continually to serve the needs of a growing population. By one estimate, they will need $66 billion in new money between now and 1978. But the utilities have been pinched by soaring fuel costs and energy-conservation programs, and are having trouble selling bonds at interest rates they can afford. Two weeks ago, Florida Power & Light could sell only about half of a $100 million issue that paid interest at 8 3/4%. Nor do utilities have much chance of successfully selling new stock issues. When Consolidated Edison of New York skipped its first-quarter dividend, its action depressed the prices of all utility stocks. Robert Nathan, a consultant to utilities and member of TIME'S Board of Economists, suggests that if utilities are not allowed to raise their rates faster, their financing problems could become so severe that the only way out would be to turn over their systems to state and local governments--a course that Chairman Charles Luce does not rule out for Con Ed.
Delicate Line. Happily, the chances are that the nation can escape a long, intense money squeeze. Arthur Burns well knows that the Federal Reserve must walk a risky and agonizingly delicate line, keeping a rein on credit tight enough to avoid feeding inflation while still putting out enough money to keep the economy from tumbling into recession. He has pledged to avoid a "credit crunch" (a situation in which loans become unavailable for any purpose) and to bail out any banks that get into trouble, even if that means increasing the nation's money supply faster than he would like. In the past few weeks, in fact, the Federal Reserve has lent $1 billion to Franklin National, a New York bank that had to omit its dividend because of heavy losses it had suffered speculating in foreign currency.
Moneymen are also cheered by a recent sharp plunge in some commodity prices. Wheat, for example, dropped from $6.11 per bushel in February to $3.62 last week, beef cattle from $46.25 per hundredweight to $38.90, and steel scrap from $115 per ton to $100. If these drops continue, economists believe, corporations will stop scrambling to borrow in order to stockpile raw materials. Indeed, they may sell off some of their present inventories and start repaying their loans.
The U.S. could take other steps to ease the pain and strain of high interest rates and credit scarcity. More banks could and should start saying no to large companies that seek loans they do not really need, rather than pinching off credit to small businesses and scrambling to come up with the money to satisfy the big borrowers. Congress should enact an Administration-sponsored bill that would enable savings and loans to make consumer loans and enter other fields now reserved to banks. If they could make money from a broader range of services, S and Ls could compete more effectively with banks for funds.
These are at best palliative measures though, and an 8% prime rate by year's end would still be high by any standards except today's. A real and lasting drop in interest rates must await the discovery of what no industrial nation has yet been able to find: an effective strategy for fighting inflation that does not run the risk of producing intolerable unemployment. The lesson of the current interest troubles could not be more painfully clear: double-digit inflation equals skyrocketing interest rates; and until inflation goes down, rates will stay up.
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