Corporate America's New Achilles' Heel

Overreliance on profits from finance units may be setting companies up for a fall

America is no longer a nation of manufacturers. But it isn't quite a health-care or even a tech economy, either. Instead, America is quietly and quickly becoming a nation of financiers. Finance supplies 30% of all U.S. company profits, as of last Sept. 30, up from 21% a decade ago, according to federal government data. And some of those profits don't come from banks or other financial companies, but from manufacturers and retailers that rely on their financial activities for a big chunk of their earnings. At Deere & Co. (DE ), the farm-equipment company, finance produces nearly one-fourth of earnings. Retailer Target Corp. (TGT ) usually gets about 15% of its profits from its credit cards. And while General Motors Corp. (GM ) is having trouble selling cars, its mortgage business is going great guns. GM's financing operations earned $2.9 billion last year, while GM lost money on cars. If GM earns any money this year, it will again come from finance.

With finance dominating the corporate landscape, any threat to financial earnings has a magnified impact -- and now several threats are gathering. Since the Federal Reserve started raising interest rates in June, finance businesses have paid higher short-term rates on the funds they use to make loans, but the rates they charge customers for longer-term loans haven't been rising nearly as fast. That's starting to squeeze profits.

What's more, lenders have been running more risks than ever as the competition for borrowers heats up, according to a report by Bridgewater Associates Inc., which manages $92 million in investments. So more defaults may be on the horizon. Meanwhile, auditors and regulators are applying accounting rules more strictly, which could dent the reported profits of some finance operations. This has already happened at mortgage giant Fannie Mae (FNM ) and at insurers MBIA Inc. (MBI ) and RenaissanceRe Holdings Ltd. (RNR ). "As a result, you'll see much slower earnings growth for Corporate America," says David A. Rosenberg, chief North American economist at Merrill Lynch & Co. (MER ). In fact, Standard & Poor's (MHP ) expects earnings at financial-services companies in its S&P 500-stock index to grow just 6% this year, down from the 27% jump in 2003.


Indeed, slowing growth in financial earnings threatens to break a three-year streak of double-digit profit growth for S&P 500 companies. The financial sector -- which doesn't include the finance arms of manufacturers and retailers -- has become the biggest engine of profits for the S&P 500, contributing 28% of earnings by companies in the index last year. By contrast, the next two most significant sectors, health care and information technology, kicked in just 12% and 11%, respectively, while industrial concerns ponied up 10%. Ten years ago, financial companies provided 19% of earnings.

At the same time, earnings from finance have become dramatically more important for many nonfinancial companies. General Electric Co.'s (GE ) finance and insurance units kicked in 49% of its $16.6 billion profit last year, up from 37% in 1995. Last year, H&R Block Inc. (HRB ) made $678 million in pretax profits from mortgages -- more than it did from tax returns. A decade ago, financial services weren't even a tenth of Block's revenues.

The trend is sobering for the stock market. That's because Wall Street tends to pay lower prices for each dollar of finance earnings, apparently viewing them as of lesser quality than other profits. GE, mindful of this, is paring back by selling most of its lower-return insurance businesses. But Chief Executive Jeffrey R. Immelt has said he still expects 40% to 45% of earnings to come from GE's commercial and consumer finance units.

Sometimes the impact of a finance business on the bottom line is difficult to ferret out. Electronics retailer Circuit City Stores Inc. (CC ), for example, does not disclose how much money it makes from selling extended warranties on its products. But analysts estimate that the company would have lost money in the year ended February, 2004, if it didn't offer warranties. The company says it gives "appropriate" information.

The most obvious threat to this earnings parade is the sharply narrowing gap between short- and long-term interest rates that market mavens call the spread. Last April the spread between the 2-year and 10-year Treasuries -- used as benchmarks for pricing finance deals -- was an exceptionally high 2.4 percentage points. It's now down to 0.8 point, making lending much less profitable than before. "Financial institutions will feel that," says James W. Paulsen, chief investment strategist at Wells Capital Management.

Of course, financial companies now insulate themselves better from interest-rate changes with derivatives and by quickly packaging loans and selling them to hedge funds and other institutional investors. That way they earn more in fees for arranging the transactions and collect less in interest payments. Financial companies now get about 42% of their revenues from fees and only 58% from interest, compared with 20% and 80%, respectively, in 1980, according to Bridgewater.

Maybe so. But with thinner margins, there could well be fewer loans on which to collect fees. That's what would happen if the spreads were too narrow to attract institutional investors, who borrow short-term money to invest in longer-term paper in what's called the "carry" trade. "Client after client tells me these trades carry well, but they're going to carry less well in coming months," warns Merrill Lynch's Rosenberg. The most noticeable impact could be on mortgages, says Peter Thiel, president of Clarium Capital Management LLC, a hedge fund that is betting that the housing market is about to crack. That's because mortgages are now the biggest part of the U.S. debt market.

Rising rates also hurt financial companies because the risk of loans going bad increases. These days, lenders are especially vulnerable to defaults as they have become a lot less choosy about whom they lend to. Credit analysts at Moody's Investors Service are predicting an increase in defaults of junk bonds to 3.2% of issuers over the next year, from 2.5% as of last month. They also foresee a significant risk that companies will not be able to refinance junk bonds maturing over the next three years when a glut of exceptionally low-quality debt comes due. Home mortgage debt, too, has been climbing faster than home prices the past four years.


Rising rates and defaults always pose a risk to finance profits, but now there's a third hazard: tougher scrutiny of accounting practices by regulators and auditors. Last fall regulators uncovered a plethora of accounting maneuvers at Fannie Mae allegedly aimed at dressing up its earnings. Fannie's results are now undergoing wholesale restatements. On Mar. 15 an investigation into whether American International Group Inc. (AIG ) distorted its results resulted in the resignation of its longtime CEO, Maurice R. Greenberg. Regardless of whether AIG broke the law or must report lower earnings for past periods, the case likely will prompt executives at other financial companies to be more conservative in tallying their numbers.

Of course, it's possible that none of these scenarios will turn into painful reality. Perhaps stronger demand from borrowers will lift long-term rates and spreads. Perhaps the recent buildup of cash on corporate balance sheets will offset losses from defaults. In an economy that increasingly revolves around finance, however, the triple threat is certainly unsettling.

By David Henry in New York

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