By Richard Michael, CEO, New Zealand Contractors' Federation
Many of you will have heard of the term sub-prime for the first time in recent months. It has already had a major effect on our economy and the construction market. In this article I wanted to give a bit of background to the topic and look at the immediate and ongoing effects on contractors and the wider economy.
As many of you will know, sub-prime is a descriptive term for a class of debt where the risk profile is too high for the normal bank channels. This may be because of the track record of the lender, the level of security or other factors. This is particularly the case where the banks have lent 100 percent or more of the value of the asset.
While the US economy was rolling along and things were good there was no problem. But unfortunately this is no longer the case.
Jobs are being exported from the US to China at an alarming rate. Whole towns and regions are closing down.
In many towns there is one major employer. When this starts to contract and lay off workers, those workers obviously want to sell their houses and move. But of course there is nobody to buy them and their value goes from, say, $300,000 to nothing overnight.
Consequently, the asset backing of the loans is zero or very small and the banks who loaned the money have to write off the debt. So far this has amounted to tens of billions of dollars and continues to grow as we speak.
What the final outcome will be, nobody really knows, but there will certainly be more pressure on the financial markets, business failures and tightening of credit before it’s all over.
The one question that must be asked is how and why did the situation get so bad?
Generally banks and other financial institutions have strict conditions on how much they can lend to avoid just this situation.
The answer of course is pretty simple – greed.
Over the past five years or so the world has been awash with cash looking for a good place to be invested. As this situation has gone on the good investment opportunities have been taken up, but there has still been huge sums of money looking for a good home.
This has led to a relaxation of prudential limits within many organisations, which encouraged the people whose job it is to loan out the money, to take bigger and bigger risks.
While the US economy was going well these loans have paid huge dividends and all involved have got rich.
However, as we know, what goes up must come down and this has now occurred in the US. In fact the situation there looks pretty bleak with some long-term structural issues that will be very difficult, painful and expensive to fix.
This combination of economic down-turn and very high exposure to risk was the mix that ended the party.
Currently there is still plenty of money looking for a place to invest, but the risk profiles that are being tolerated are much lower. Billions of dollars have been lost and financial institutions, both large and small, are failing almost on a daily basis.
The effects on our New Zealand economy can be clearly seen with the more marginal operators, such as some of the finance companies and real estate organisations, going to the wall.
The longer term effects are likely to be less money around to lend and higher interest rates internationally. This will cause a slow down in the world economy.
Fortunately the fundamentals of the New Zealand economy are based on commodity trading and this is a very strong at present, so the slowdown should not be as bad here as in some other countries.
The effect on our industry is already being felt, particularly by those working in the residential property sector of the market. Developers are finding it hard to refinance their projects at any cost and unfortunately good developments and bad are being effected.
It is hard to know how long or how bad things will get. The full extent of the damage has probably not yet come to light. As I mentioned, the New Zealand economy should be somewhat sheltered from the worst of the outfall but things will tighten up here as well for the next year or two.
As usual, cash is king, and contractors who pay careful attention to their financial risk management will come out best in the long run.
Contractor Vol.32 No.3 April 2008
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