Loads of Money
The hazy diagram above illustrates the extent to which US consumers leveraged the equity in their houses as compared to their household disposable income in order to raise funds to spend more. The graph for the UK is worse and it shows the extent to which we have dipped further into our equity to fuel the growth of the last 10 years which is why the IMF is predicting Britain has further to fall than the US in this recession, contrary to Government opinion. Real incomes down but spending was up. It was no coincidence that we all saw a glut of Aston Martins on our roads as Britons used their home equity to buy luxury goods beyond their means as 49% of all mortgages at its peak were re-mortgages. No one read the obvious signs of a bubble over-ripe to burst explosively although it has more shrunk due to lack of gas.
But can the car industry be blamed for not anticipating this dramatic downturn in sales? Currently, the US car industry is looking for a collective bail out of $35bn which is small fry compared to the Banks but still an awful lot of money.
So Should The Car Industry Be Bailed Out Too?
My question is - where do we draw the line? The car makers alone are the tip of the iceberg. You then have all the ancillary suppliers, component makers and service industries which are entirely dependent on the car makers keeping their production lines moving. Because the bail out will not be to stimulate the industry it will be to mothball it. Why? Because for a car maker to sell their cars in this climate they will have to at least sell their entire finished stock at cost or below but even then, thrift-minded consumers are going to think twice about buying an expensive item which will depreciate by a minimum of 20-30% within the next 12 months. It is throwing money down a drain so the market will simply stop.
In many respects this is the problem that Gordon Brown faces in the UK over housing. Firstly, nearly half all mortgages up to August 2007 were Mortgage Equity Withdrawals (MEWs) and secondly the market is falling. Just like buying an expensive car, the house-asset will drop the moment you buy it by up to 20% in the next 12 months. So if there is no equity to leverage and the asset is depreciating, even if the interest rate is as low 2% at base, it still makes financial nonsense to buy a new house.
So Which Are Vulnerable Businesses?
What the graph illustrates is that the spending boom over the last 10 years was not created by the average household increase in disposable income in the US or UK - in fact disposable income shrank over the period so we should have afforded less. Income was massively supplemented by a new wealth machine - our own banknote printer and 'Money Creation' device - our houses.
For those who do not believe money cannot created or destroyed and there is zero sum finance listen in. As house prices grew 160% over the last 10 years in Britain, people began withdrawing some of the increased value (equity) by re-mortgaging and effectively issuing bonds or IOUs to themselves. Mortgage Companies were happy to redeem the IOU as cash because it was backed by the equity in their home. We, the consumers, then went on spending sprees buying second homes in sunny climates, new cars, extensions and renovations to our houses, fabulous holidays, far more regular trips to expensive restaurants, lots more clothes and upmarket fashions, and then filled our houses with the most latest mega-flatscreen TVs, Home Cinema set ups and latest wizardry like mobile phones, ipods etc.
So those businesses will get affected by the lack of cash as the house prices decline and that IOU we withdrew on our equity is worth far less and in many cases nothing. In other words, we have borrowed money with a lack of security and in many cases negative security or equity.
Money has indeed been destroyed as value has been destroyed.
Already 75,000 homes have been repossessed this year higher than the number affected in the slump of 1991 - and the figures are terrifying as mortgage providers estimate up to 2 to 3 million households could go into negative equity before the house market starts to recover some time in 2011. With unemployment set to rise to 3 million in the next 2 years, the Government backed scheme to protect those who cannot repay their mortgages from repossession for up to 2 years looks like King Canute in a storm. But the potential liability for taxpayers is huge as we underwrite all the schemes, tax cuts and generosity of these schemes with the sure knowledge we will be paying for them in the future.
The domino effect of lack of equity and capability to spend has already hit the building industry for new homes and many major firms like Barratt have reined in their operations. But all the local tradesmen builders who have benefited from cheap money for extensions and renovations will be affected as will Estate Agents, conveyance lawyers and insurance salespeople who rely on new mortgages going through. Savills reported an 82% collapse in high end house sales in a single quarter while the average Agent sells just one house per week in the South of England.
And what of foreign homes? many countries like Spain, Portugal, Cyprus, Malta, Bulgaria and others have benefited in micro-markets for new homes as Brits and Germans in particular rushed to spend their equity cheques on new homes, many raising mortgages abroad. If you asked the locals, they would tell you they could not afford the prices in these micro-markets so if times get hard and the foreigners have to sell, who will buy their homes? The locals won't at those prices. Such micro-markets are ticking time bombs and could collapse spectacularly at any time.
We have already seen MFI go to the wall - it had a highly discounted selling model which lacked services to underpin it so it was a disaster waiting to happen. But it is indicative of the kind of business right in the firing line as fitted kitchens and bedrooms were prime examples of how leveraged equity was being spent. Perhaps one of the most alarming casualties has been Woolies. The High St low-end specialist had the ideal model of decent goods at decent prices, surely it should survive better than most? But what it shows is that marginally profitable businesses are right in the firing line - it only takes a small decrease in sales to punch a major hole in profits and if you are dependent on high borrowing you are doubly at risk.
How Vulnerable Are You?
Downturns have domino effects. As one industry like the car industry is affected, all those in some way dependent on them will get in some way affected. This is the dilemma Governments face as it is more like the little boy with his finger in the dyke than the domino effect. If the finger is removed the entire dyke collapses. And if that happens, how many industries can we afford to step in to save? We have the banks and car industry so far, next will be insurance maybe - then who? Rumours abound about the steel industry.
For us mere mortals, I have urged everyone to review their sales pipeline and look at their exposure to expected business from companies who are vulnerable already. I have recently spoken to one company who found 60% of their sales pipeline depended on the financial sector - there was no point in believing business from there would carry on, they had to rapidly change the profile of customer and re-mobilise their sales activities very quickly to replace all those opportunities with new ones. Telecoms has already stalled with BT laying off 6%of staff and Virgin Media following suit.
Now is also not the time to be exposed to any single major customer. Woolies' fate might have been avoided because their customer base is so spread but it didn't help them. If any customer in your business represents more than 10% of your revenue and you are a marginal profit based business (i.e. reselling) without a great service business then you are right in the firing line. A dip in sales to a major customer could be the difference between surviving and disaster. So go check your business now, review the pipeline and your current business and do something to protect yourself.
The Road Ahead
What the car Industry collapse has taught us is the speed and effect of a recession is frightening. We have not even technically started the recession to already see the effect because despite what economists have said it started in August 2007 when the credit crunch was initiated. While the sub-prime market showed how daft the lending policy had become, what it did was to expose the flawed business model of not just the financial sector but Governments too. And despite what Mr. Brown says about the current problems starting in the US, it was a good old home grown problem which was far worse in the UK where sub-prime is a minimal issue (barring a few 125% mortgages etc).
We funded an economy on leveraging the increased equity in homes not on the goods we produced, our productivity or endeavours. Now there is only so much we can do to save our industries and it will mean the Government will step in and preferentially save certain industries and businesses - they cannot save them all. And that will cheese off all the rest who suffer by losing their jobs without intervention. It won't be pretty.
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