“Happy 2nd Birthday, U.S. Economic Recovery!” read the cheeky headline from a recent article in SmartMoney, which noted that, according to the National Bureau of Economic Research, the expansion turned two years old in June. Since the recovery began in 2009, the gross domestic product has inched up every month, banks have begun to lend again, layoffs have subsided, corporate profits have broken records and the manufacturing sector has experienced the strongest growth spurt in seven years.

Then there are the other numbers, such as an unemployment rate holding steady at 9% and home prices treading water at their 2003 levels. But the recovery story has more to do with psychology than statistical analysis. When I talk to my contemporaries in equipment finance, their mood is far from celebratory. Despite some encouraging data, most feel that our industry is just scraping along the bottom. Businesses may have more cash, but they lack the confidence in the economy’s sustainability to pull the trigger on growth investments. Unprecedented bank liquidity has spawned new market entrants and intense competition, resulting in thinner margins, increasingly more aggressive terms and higher asset prices.

All in all, it’s not a pretty picture — certainly not one you’d expect to see after reading the government reports. I’m an optimist by nature and don’t want to create the impression that everything’s doom and gloom. Without question, there are plenty of good lending and leasing opportunities out there, which was why I came to CapitalSource in early 2010 to head its new Equipment Leasing and Financing Group, and nothing has swayed my opinion to the contrary.

But, I’m also a realist — we have to play the hand we are dealt. From my point of view, today’s market seems to be heading in a direction that’s all too familiar. The reality is that if we continue down this path, we’re going to find ourselves in the same predicament we left behind only several years ago.

This One’s Different
I’ve been through five recessions during my 30-plus year career and the last one was the worst. I never thought I’d see the day when Goldman Sachs and General Electric would be going to Warren Buffett for money. The recovery has also been different. In the past, it was obvious to everyone when the economy snapped back. You didn’t need a government report to tell you things were getting better.

If you believe statistics, the average economic recovery since 1945 has lasted about five years, which means we’re almost halfway through this expansion. But, it just doesn’t feel like much of a recovery. What’s worse, many question whether it’s sustainable. At a recent ELFA funding symposium, I asked 20 people the same question: What kind of equipment deals are you seeing — replacement or expansion? Only one person said the latter.

It’s no different than what’s happening in the broad economy. Both companies and consumers make their decisions based on their “reads” of the market and right now they’re seeing mostly gray. And when you’re unsure, you don’t do anything. No big mortgages for consumers, no big growth capital investments for businesses.

Unprecedented Bank Liquidity
As companies continue to run lean operations, banks are piling up their cash reserves. They have an unprecedented amount of liquidity that they need to deploy and equipment finance has been one of their prime targets.

Only a year ago, the Monitor 100 reported that 2009, “was a year where lenders and lessors felt the pinch of limited liquidity.” How quickly things can change. Today, everyone wants to be in equipment finance, and far more capacity is coming online than warranted by the volume of capital expenditures. New business budgets for existing players have been increasing exponentially faster than the economy or market growth in capital expenditures.

I expect this trend to continue, and we all know what happens when too many dollars chase too few deals. In a stagnant but highly competitive market where volume rules, the only way to gain market share is to lower rates or make other concessions. It’s no surprise that margin spreads over the last two years have been compressed by more than 200 basis points and may be heading toward pre-recession lows.

Loan and lease structures also have quickly deteriorated as the market seems to be returning to “covenant light.” We’re seeing longer terms, requests for more “stalking-horse” proposals and pleas for “last looks.” Higher asset prices, relaxed terms and no pre-payments are becoming commonplace in many contracts.

In just a short time, the pendulum has swung to give the borrower or lessee the upper hand. I don’t see this changing much through 2012.

Confidence Issues
Don’t get me wrong. I’m not being negative about the state of the market, which is much better than it was in 2008 to 2009 — but it does appear to be getting overheated. When you also consider the fact that businesses are reluctant to spend because of so much uncertainty about the economy and how the country will deal with its mounting debt, there’s good reason to be cautious.

I know many of my colleagues share this opinion, as evidenced by the May 2011 Monthly Confidence Index for the Equipment Finance Industry (MCI-EFI) from the Equipment Leasing & Finance Foundation. Its report indicated that overall confidence in the equipment finance market is 63.2, down from the April index of 70.3. In addition, 30% of key executives in the equipment finance sector said they believed business conditions will improve over the next four months, a decrease from 54% in April. Only 22% believed demand for leases and loans to fund capital expenditures will increase over the next four months, compared to 65% in April.

The market is what it is and there are only three possible scenarios for our economic future. We could slip into another recession (which I don’t believe will happen), stumble along for a while with slight improvements (my choice) or begin real expansion. A host of interrelated variables will determine how and when this plays out, and I’m not smart enough to make any predictions. But, I do think that before the recovery gains traction and starts to build real momentum, the government has to regain the business community’s confidence.

What will this take? The most productive thing the government can do to boost confidence is come to a meaningful conclusion on the budget deficit. I’m not talking about any specific policies or Republican or Democratic proposals. It’s just important to reach some sort of agreement, because right now everything’s up in the air. Business owners are like deer in the headlights, wondering if they’re going to get hit by tax policies or regulations and immobilized by a lack of information. An agreement would have a huge positive impact on every business owner and help the economy move forward.

Dislocation Means Opportunity
Markets are rarely in a state of equilibrium where the right choices and profitable actions are obvious. When housing prices keep going up, you can sell your home for a tidy profit, but you’ll also have to pay a lot more for your next one. There never is an easy way.

And that’s good, because dislocation presents opportunities. The Equipment Financing Group at CapitalSource is the fourth time I’ve been involved in a business startup at the end of a slowdown or recession (the others were Heller Financial’s Commercial Equipment Finance Group, RBS Asset Finance and Tygris Commercial Finance). As I mentioned during an interview with the Monitor (May/June 2010, Vol. 37, No. 3), we are so confident in the industry’s growth potential that our aspirational goal is to see equipment financing accounting for up to one quarter of CapitalSource’s balance sheet by 2014.

Regardless of economic conditions, the market will always be a moving target. Companies that succeed in equipment finance — now and five years from now — will be nimble and adaptive. They will become experts in a variety of niches, which will allow them to ease into specific markets as they open up and exit others as they overheat. Operationally, they will need a reliable, competitive cost of funds, as well as a low-cost platform, especially when margins are so compressed.

Even if the so-called recovery doesn’t pick up, I foresee continuing opportunities for lenders and lessors unafraid of taking risks. That doesn’t mean adding feet to the street to pump up volume in a flat market. Those that flourish will be adept at adjusting their business models to new realities, maintaining credit quality discipline and minimizing the downside losses of any “risk” mistakes.

Although it would be sheer folly to make any bold forecasts, it seems likely that market conditions in the equipment finance sector will remain cloudy for the near future. There will be silver linings, each undoubtedly tinged with a touch of gray. But, I also know from my experience that our industry is vibrant and resilient. I’m excited about what lies ahead, for, as Winston Churchill once said, “The future is unknowable but the past should give us hope.”

Laird Boulden, a 30-plus year veteran of the leasing industry, is president of the Corporate Finance Group at CapitalSource. In this capacity, he manages all aspects of the Asset Finance and Leveraged Finance businesses including strategic direction and business development.