Monday, March 16, 2009

2009 Financial Meltdown

Analysis 2009: The Financial Crisis Hits IT Hard
By Kurt CagleJanuary 6, 2009
The recession that started in January 2008 looks to be four phased. The first phase, The housing collapse, actually started in August 2007. The financial meltdown hit in September 2008, and likely will continue through to March 2009 or so. The business firestorm is really just getting underway now, and will be the dominant theme for the next 8-12 months whlie the final phase, currency collapse, will (if it occurs at all) likely not happen for another 12-18 months.
The business collapse itself is taking place in a number of different verticals, which differentiates it from a traditional oversupply recession. In an oversupply recession, the market produces too much of a good or service for the available demand, which usually means that either companies have to cut back on producing goods (and consequently reduce their own profitability) or they fail and fall out of the market. In time, demand rises to meet supply, and the industry in question recovers.
The housing collapse was a classic oversupply recession - too many houses on the market at too high a price, and eventually demand couldn't meet supply. Had the housing market not been fueled by low interest rates when they weren't needed, had the financial industry not done a dice-o-matic on the resulting mortgages, and so on, chances are pretty good that we would be about 2/3 of the way through this by now, IT, except for the specific housing IT vertical, would be relatively unscathed.

The problem now is that risk became baked into the very core of the global financial system like a series of fault lines, and the collapse of the mortgage business was like a deeply buried mortar going off in that mess. This in turn exposed the very ugly truth about finance - that prices are psychological, and when no one knows the value of things, the ability to plan for the future ends.
This fear has manifested in the credit crunch, when banks are terrified of lending money out because they know that the assets that the carry are far below what they should carry in order to stay solvent - and that if they loan out money, they won't have it when the next wave of credit defaults occur (either credit cards or commercial real estate, take your pick - they'll hit about the same time). There's currently an effort to reliquidate the banks by most of the world's governments, though with at best limited success (more on that in future articles).
The business collapse is occurring because of two factors. First companies that had depended upon having readily available lines of credit are finding these lines being cut or dramatically reduced, which makes them much more vulnerable to the variability of incoming contracts ... at a time when everyone else is facing the same problem.
The second is that this has put significant downward pressure on household incomes, as these same lines of credit (in the form of second mortgage refinancing, credit cards and so forth) are now becoming scarce at the consumer level (along with financial investments having plummetted in the last few months). This has resulted in a consumer strike, as people save rather than spend.
For those businesses with a direct consumer face (or those that IT companies who supply services to these businesses) this translates into reduced revenues and shrinking demand, which in turn has a direct impact upon both those people that produce retail hardware and has an indirect effect upon IT companies that produce software to support these retailers. It also means that companies that had projects in the work for FY 2009 are scaling these back or putting them on indefinite hold until they get a clearer read of the economic situation.
One of the problems with recessions is that while there is an underlying economic aspect to most of them (many people just don't have the money in the first place), there is also a psychological aspect. People stop spending (and start saving), in anticipation of two things - first, that when they need the money, they may not have it, and second, that when the economy is receding, the overall price of both goods and services drop. It makes little sense to take on new purchases (whether new projects or new goods) when demand is dropping and the possibility is fairly strong that they can get those things for cheaper in a year or two.
At an individual level, this is a rational response. The problem comes when everyone does it. At that point, demand dries up, companies go out of business, reducing the overall stock of those same goods and services. This happens with all goods. The problem that we face right now is that the goods that are at the root of the problem - houses - tend to have a comparatively long shelf life compared to Tickle-me Elmo dolls or iPods. They can't be inventoried or written off, which means that it will take considerably longer for demand to meet supply, and as capital investments destroying houses and restoring the property to a usable state can be painful at best.
Unfortunately, this means that the psychological aspects of businesses far removed from housing will be very much held hostage to the housing cycle. Eventually (for a number of reasons) housing prices will stabilize at a new level of equilibrium (which, if reversion to the mean is any indication, should be about 15% below where most prices are now), though it is also likely that any markets will overshoot this level to about 25% or so below current levels before eventually returning to this mean. While estimates vary as to how long it will take, most economists feel that it will be at least another nine to eighteen months, putting the "bottom" of the recession at or around late 2009 or early 2010.
Yet even that won't necessarily be the end of the troubles. A deep financial depression is a lot like a deep cyclonic depression (a.k.a, a hurricane). In a hurricane, a great deal of damage is done by the winds, as windows break, cars go flying and in some cases houses go sliding into the depths or get turned into kindling. Yet the real damage comes from factors such as storm surges, where large amounts of water start moving quickly in areas not designed for water. Hurricanes knock out power, making recovery efforts difficult, and paradoxically, raises the possibility that fires will start that can't be reached or put out, causing even more damage.
The same thing is happening now - we are within the eye of the financial hurricane, a kind of false calm where the winds and pressures are at an unstable equilibrium, but this only has the effect of relaxing things that had bent in response to the hurricane force winds. Unfortunately, once we enter the eyewall on the other side the forces are just as strong, but going in the other direction (one of the reason hurricanes are so destructive).
When this plays out, many retail companies (and not a few medium to large sized malls) will be out of business, their buildings sitting vacant and often poorly maintained. There will be a significant exurban flight as people are forced to sell their properties (typically at a loss) because of unmaintainable mortgages and either rent closer in to population cores or move to higher density housing (this trend will be exacerbated by the number of baby boomers who are reaching retirement age and are staring at fixed incomes with oversized mortgages and reduced bank accounts), a trend which will result in many "bedroom communities" becoming squalid slums or just abandoned altogether.
Suppliers to these retailers are already starting to disappear as retailers cut back on their inventories, and in areas such as automotive manufacturing the tremors as these highly centralized, monolithic conglomerates continue to shutter plants are causing the extensive supply chains to fragment as companies that weren't sufficiently diversified lose their primary customers and go out of business.
As this happens, it also makes it harder for these same companies to continue to pay their leases, which are typically financed at a much higher rate than consumer mortgages are as most are fifteen year rather than thirty year paper. This will be the next major pressure that a lot of companies, even those outside of the retail sector, will be facing, and software companies in particular are vulnerable to this particular threat, especially as VC financing continues to decline. Expect by the end of 2009 that office buildings will be even more vacant than they were in 2003 at the bottom of the tech recession.
Venture capital, by the way, is also drying up for much the same reason as credit in general - VCs are investors, and they do not in general want to take a loss on a company, even one with a brilliant idea, if they are concerned that economic pressures will never let it get off the ground. Moreover, those same investors already have extant commitments that they are in many cases having to serve as the primary bank for, and this in turn is reducing their willingness to take on new businesses (and will for some time).
A further process that will accelerate is the disaggregation of conglomerates, as companies shed or spin-off divisions that are not profit centers. It's likely that this will hit the big services companies such as IBM, Fujitsu, Siemens and so forth disproportionately, though it might also affect companies such as Microsoft or Oracle. Many of the newly created spin-offs may not make it once cut off from the sheltering effect of the mothership, but others (most notably those that were already successful companies in their own rights) may very well come out stronger in the process.
The next year will be a poor one for mergers, unless they happen to be pure stock exchange mergers (where the two companies agree to on a common stock conversion rate with little actual money changing hands). Acquisition mergers typically require not only cash on hand, but also require access to bonds or other equities that can be used to leverage this cash on hand. With so much uncertainty right now in terms of equity prices, however, raising such funds becomes difficult, even as it seems like we are awash in a sea of junk bonds.
Toward the end of 2009, expect this trend to reverse. Companies with strong cash positions going into this storm will have a much clearer understanding of the shape of the market by the end of the year, and will be able to buy technically sound but financially distressed software companies at bargain rates. If you're vested in a startup, now is probably a good time to discuss acquisition strategies, though probably not at the premium values that many startups tend to value themselves, with an eye towards that sweet spot in the Q4 2009.
There's currently a running debate among economists about what happens when the recession ends. Some, primarily Keynesians, feel that economic stimulus is a necessity to get us out of the current liquidity trap, and that for the most part the debt that most countries are taking on now will restore us back to a period of economic stability with perhaps at worst only modest inflation (in the 3-4% rate) for a few years thereafter.
Others, especially those of the Austrian school of economics, expect that all of the money being created in order to finance the stimulus will, once the credit crunch eases, result in significant inflation, possibly above 10% per annum, leading to a similar situation (stagflation) that caused the 70s to be so hard (well, that and disco).
My money is on the Austrians, as they were surprisingly accurate in their predictions of the present economic crisis, and as a central part of the problem facing the economy right now is that real interest rates (those charged by banks to their primary customers) continues to remain far higher than the nominal 0.25% percent rate that the current Fed has set the prime lending rate.
In short, even after the storm abates, money may continue to be in short supply for many months (or even years) to come. Expect that government stimulus packages and government works programs may in fact have to substitute for the private economy for some time (more on that in the next section).