Notes from Jim Haughey

Aug 13 2007 8:36AM | Permalink | Email this | Comments (2) |
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By Jim Haughey

Financial markets remain in turmoil around the world as the fallout from the US subprime mess spreads. This is now the biggest risk to the investment spending that finances the construction industry. While it is likely that markets will calm quickly before serious damage occurs to construction funding, the risk continues until this happens.

The major central banks pumped $100 billion into commercial banks in the last few days to assure that there was enough liquidity to permit banks to meet loan commitments and investment funds to honor withdrawal requests. The worst nightmare for any central banker is having to cope with a perception among investors that they can not get their money when the want it.

The current crisis developed slowly over the last year as the holders of bonds backed by subprime mortgages sparred with mortgage brokers and the wholesalers that packaged pools of mortgages and issued the bonds over who would take the losses from mortgage defaults. The stakes got higher as the default rate increased and expectations for future default rates rose with the progressively weakening housing market.

This turned into a high stakes games of musical chairs — hence the current crisis — when investors decided all high return/high risk investments needed to be reassessed as the long worldwide business expansion moved closer to its inevitable end. This included corporate junk bonds, syndicated loans for acquisitions and debt and equity investments in developing countries. The result was an abrupt drop in the prices of many assets so that investors could realize a higher rate of return on assets now judged to be more risky.

The consequence was that leveraged borrowers got margin calls to provide more cash or collateral. Subprime mortgage companies could not meet the margin calls and shut their doors. Their lenders took huge losses and immediately tightened lending standards for risky borrowers. Some loans expected to close did not or closed only with a much higher interest rate for the borrower. This included some construction loans and commercial mortgages.

Now that all risky investment worldwide are involved, the US construction industry can only wait and see what happens. The resolution of the mortgage-initiated financial crisis is in the hands of central bankers. So far they appear to be handling it well. They will either solve it within a few weeks or we will all endure an abrupt end to the long worldwide economic expansion.

Here is what to watch for. Ignore reports of the bankruptcy of more mortgage companies. This is inevitable and is part of the therapeutic process of weeding out investment projects that were too late in the cycle to be needed or never were good investments — they could not generate enough income to repay the loan. Similarly, ignore reports of “no access to credit” by other investors, both here and abroad, by developers or companies whose ideas were either too late or not good enough to get a loan in any financial environment.

But pay close attention to reports that developers who expected a market rate loan for a solid project can not get the loan because the lenders do not have the cash or credit to close the loan. Pay especially close attention to reports that ongoing operations that had market rate operating loans have to scale back or close. This is what could cut spending and investment confidence abruptly and reduces demand for building space and facilities.

This has not happened yet and probably will not. If it does it is most likely to be in a small Asian country. It could take the form of a major currency adjustment, factory shutdown due to lack of credit to pay for supplies or import restrictions due to insufficient foreign exchange to pay for imports. This happened in Thailand in 1997 and quickly caused factory production cutbacks and investment cancellations worldwide.