FMI: Home Mortgage Market Created a “Perfect Storm of Financial Destruction”

Laura M. Porinchak

January 2009

A Nov. 18 webinar hosted by FMI took a good, hard look at the economy and its effect on the construction industry—and the 2009 picture isn’t pretty, especially for the commercial sector.

The webinar, Current Economic Impact on the Construction Industry, featured FMI President and Managing Director Hank Harris, and Lee Smither, managing director of the company’s consulting practice.

Smither started by talking about what it took to get us here in the first place. He pointed out that the current economic situation is not the result of a "free-market” failure; it is more that the lack of regulation (and common sense) in the home mortgage market created a "perfect storm of financial destruction.” Another factor was the Clinton Administration’s creation of mortgage instruments that required no income and limited employment verification under the banner of "nondiscriminatory lending practices.”

Then, Fannie Mae and Freddie Mac—quasi-governmental enterprises—were guaranteed $1 trillion of sub-prime mortgages and kept $100 billion on their balance sheets. Add to that, rating agencies backed these securities with AAA ratings, and Wall Street sold them.

Consumers, then, were starting to see trouble as they began to realize they were financially overburdened. Approximately 70 percent of Gross Domestic Product growth that has occurred has been the result of increased consumer spending, according to the webinar. The primary source of that spending has been home equity loans and consumer credit card debt.

According to commercial banks, outstanding credit card balances soared by $7.1 billion in the week ending Oct. 15, 2008. Delinquency payments rose to 4.1 percent in 2008; it was 2.5 percent in 2007. Bank of America’s delinquency rate rose to 5.9 percent in 2008.

As of this writing, the federal government anted up $2 trillion in 2008 (Bear Stearns, first stimulus bill, AIG, Fannie Mae and Freddie Mac; Mexico, Brazil, Singapore, Korea; banking and insurance sector; GM, Chrysler; FDIC, proposed second stimulus bill).

The situation now is the subprime debt market has devastated the credit markets worldwide and created a worldwide banking crisis. Financial institutions have lost credibility with investors of all kinds, and getting credit is now very tight.

Taking a closer look at the vertical commercial markets, Harris pointed out that economic cycles come and go. He asked attendees to recall the times in the 1970s, during the Carter Administration, "when everyone thought our problems were so large we couldn’t solve them, and we thought they would last forever. Obviously that is not true.”

Harris said the unique challenges of this cycle include markets going down across the board; public and private market sectors are not offsetting each other this time. So many markets are going down at same time that even if you are in the good vertical market sector, the competition could be going down dramatically. No matter your position, "you will feel the net effects of all this,” he said.

The construction industry mirrors the general economy. Also, the construction employment rate generally mirrors the U.S. employment rate. The U.S. employment rate is now moving up, so the construction industry will follow.

The Bad News
Stating that he is "an optimist by nature,” Harris then gave the bad news:

Commercial construction will decrease 21 percent in 2009 and continue to decline 7 percent in 2010.
• FedEx Kinko’s plans to add only 50 stores in 2009. In the past two years, the company added 500 stores.

• Neighborhood centers with strong grocery anchors and chain drugstores will fare best. All retail is down except Wal-Mart, the only bright spot in a dismal retail setting.

Office construction will decrease 22 percent in 2009.
• Vacancy rates rose in 42 of the 57 markets tracked in 2008.

• New York City had the lowest vacancy rate, Detroit’s rate was the highest.

• Vacancy rates are expected to reach 18 percent by the close of 2009.

Healthcare construction will decrease by 6 percent in 2009.
• Not-for-profit hospitals will account for 70 percent of construction in this market.

• An aging U.S. population, new technologies, increased single-bedroom demand and increased health care consumerism are shaping decisions about new hospital design and location.

The education sector will experience a 2009 drop of 8 percent, then an average annual growth rate of 2 percent through 2012.
• Rapidly increasing student populations, overcrowding and old facilities will keep this market strong.

Manufacturing construction is expected to rise by 4 percent in 2009, then average a 1 percent decline through 2012.
• Dependence on fuel and energy, raw material and labor costs, taxes and a weak U.S. dollar will encourage international relocation of manufacturing operations.

Some other vertical markets are predicted to fare better than the ones listed above, but, unfortunately, they are not related to the ceiling and wall market:
• Transportation will see an increase of 6 percent in 2009 with an average 5 percent growth rate through 2012.

• Power construction will experience an average annual growth rate around 7 percent through 2012. Renewable energy sources provide 7 percent of current power generation.

• Highways and streets will see slower growth through 2012.

• Water-supply construction will continue to increase in construction due to the need for repair, modernization and replacement of current systems. Increased environmental regulations and the population’s growth and mobility will help this sector through the slump.

• Sewage and waste disposal saw 5 percent growth in 2008 and will see an average annual growth rate of 4 percent through 2012, but volume will drop in 2009 by 2 percent.

Overall, construction put-in-place for 2009 shows the following:
• Total nonresidential, down 12.5 percent.

• Commercial and office buildings, down 22 percent.

• Healthcare, down 6 percent.

• Education, down 8.

FMI’s Nonresidential Cost Index, which basically tells FMI what contractors feel when they look at their backlogs, has fallen quite a bit over the last year. At this time last year, the NRCI was 52.6, but it has fallen to 34.1 over the last four quarters. And 71 percent of panelists said they believe that municipal budgets will decrease in 2009. Roughly 50 percent of FMI’s participants have backlogs through September 2009; the big concern is 2010.

One NRCI participant said, "I think we really need to feel the credit crunch as we move into next year. Current projects are moving ahead, but the real risk is there are no new projects entering the pipeline for late 2009-2010.”

Smither reminded webinar attendees that nonresidential construction typically lags residential market by 12 to 18 months, but that commercial always follows residential. Therefore, we can expect that commercial starts will continue to decline through 2009.

What Should Contractors Do?
FMI says there are early warning signs that you should look for:
• An increase in the number of project delays and cancellations.

• The number of new contracts versus new contracts in the previous year.

• Rate of backlog fill.

• Fewer large jobs.

• Slowing collections.

• Backlog at A&E firms. (Keep an eye on the AIA Billings Index.)

• Site contractor backlogs.

If you are noticing any of these signs, there are many options for you to consider and then plan for accordingly.

First, take a good, hard look at your demographics. What is the consumer demand? Where are people spending money, and where are they not spending money? Position your business accordingly.

Contractors also should examine their external economic and market data. They should challenge their business planning assumptions and strategies. Contractors should also look past their backlog report.

Do some contingency planning for the next six to 12 months. Look at your key metrics, the incremental economics of your business: What are they?

Key metrics to watch are these:
• Backlog gross profit to overhead—look ahead 12 months.

• Trends in gross profit per employee, project manager, field supervisor, crew member, etc.

• Overhead to revenue. • Labor productivity.

• Cash flow on projects.

• Liquidity ratio.

• Age of receivables/retention.

Examine your key metrics and put a plan in place should you have a 10 percent shortfall in revenue, or worse.

Understand your incremental economics:
• What is the amount of volume that must be performed in order to cover the cost of staying in business? What does it take to cover your costs? What is your break-even volume?

• Do you have too much equipment? Sell your under-recovered equipment and rent as needed.

• What about non-billable expenses? Any nonessential expenses should be fully scrutinized. Delay noncritical capital expenditures.

If the recession lasts longer, FMI suggests developing a long-range plan with critical actions that you can take that will ensure your survival.

Possible actions you can take are these:
• Make informed, fact-based decisions.

• Merge branches and eliminate marginal locations.

• Slow or stop hiring.

• Delay capital expenditures and lease to conserve cash.

• Reduce nonessential spending. • Communicate the actions to be taken, and act swiftly.

• Stay positive to increase the morale of your people.

• Keep your bank and bonding company informed.

Finally, you can establish a cost-cutting hierarchy. Look at both products/services and people, and decide which should be cut first (if the need arises) and what should be cut last.

Also consider the following questions: Does your organizational structure work? Does it work based on what you see in the future? Is it organized in a way that will be effective? Is there too much redundancy in places that were once needed but now are no longer necessary?

A cost-cutting hierarchy may look like this:

• Tier 1 (Non-HR)
• Capital purchases
• Delay IT or vehicle replacements
• Office relocations
• Meetings and travel
• Entertainment events

• Tier 2 (HR)
• Office personnel

• Tier 3 (HR)
• Office, professional and field

Develop a Contingency Plan
Consider the key metrics mentioned above, and then develop your contingency plan.

Revise your business plan. Undertake scenario plan-based business planning. Gather information from all senior management and from outside perspectives for a "reality check.” Then have a planning session with senior management to discuss the possible best-case, expected-case and worst-case scenarios. Each major function or department should present their own best/expected/worst-case budgets based on guidelines that have been set by senior management.

"Have some good debate about what the future may hold,” Smither said. "It takes a month to go through it, but it is well worth it.”

Actions you can take to get work (i.e., business development):
• Proactive companies can intensify marketing, sales and customer-service efforts to gain market share and increase their relative market position.

• Develop "win strategies” on key sales opportunities.

• Refocus estimating departments on creative bid strategies that create a competitive advantage. Get creative.

• Be the best at presenting your proposal and the companies’ competitive advantages.

Actions you can take to do work (i.e., operations):

• Reinvigorate productivity and project management best practices. Get lean again.

• Reward margin-aggressive behavior.

• Cash, cash, cash—implement proactive invoice and collection processes.

• Finish strong—close out projects aggressively.

• Fix or eliminate marginal locations (if applicable).

Actions you can take to keep score (i.e., accounting):

• Intensify efforts to verify project funding capacity for new work.

• Pay attention to risk management procedures: signed subcontracts, insurance certificates, safety programs.

• Ensure your financial protection plan (bonding).

• Verify key subcontractor solvency and backlog health and capacity.

What Happens Next?
FMI predicts that house prices will bottom out in 2009, and banks will begin to lend again … slowly.

Taxes will have to wait, according to FMI, or the recession will be deep and even longer. The FDIC and the Obama Administration will delay foreclosures and help defaulting homeowners. Obama will be conservative and deliberate about taxes.

When all is said and done, FMI predicts this will cost the U.S. taxpayer between $3 trillion and $4 trillion. And new regulations and clearing mechanisms for derivatives will be necessary to restore confidence.

U.S. savings will increase, but debt will be more expensive.

The big question from a nonresidential construction standpoint is, "How long will the recession last?” Past history has shown, Harris said, that if you have 10 good years and then hit a recession, the recession will take 10 years to recede. Basically, the good times equal the bad times.

"If that’s the case here,” Harris said, "this recession could go for a long, long time because the construction markets, on a national level, have been bullish for 16 years.”

Still, that’s a long time, and because so many demand drivers and sectors are involved, it is hard for FMI to predict exactly how long the downside of this cycle will last.

"This, too, will pass. It is obviously just a question of when,” Harris said. "In the meantime, run the best business you can.”

Laura M. Porinchak is AWCI’s director of communications and editor of AWCI’s Construction Dimensions. She can be reached at porinchak@awci.org.