The September 2008 credit crunch severely reduced construction starts and jobsite spending last fall and into the winter. Then it subsided to a more modest, lingering constraint on only some sectors of construction by last spring. The evidence for this is the sharply reduced “spreads” or interest rate premium now being asked for less than prime loans, says Reed Construction Data chief economist Jim Haughey.
The September 2008 credit crunch severely reduced construction starts and jobsite spending last fall and into the winter. Then it subsided to a more modest, lingering constraint on only some sectors of construction by last spring. The evidence for this is the sharply reduced “spreads” or interest rate premium now being asked for less than prime loans. By then the recession set off by the credit problems had a bigger negative impact on construction than did the original capital shortage at major lenders.
Currently, credit denials for construction stemming from the credit crunch a year earlier are significant only for some financially marginal homebuilders and commercial developers. Lack of construction credit now is far more likely to be due to recession damaged balance sheets or recession induced declines in demand for building space or facility capacity than it is to the inability of lenders to finance loans that they otherwise would choose to approve.
But the damage to construction from the September 2008 credit problem is not yet finished. Loan demand is now depressed to the lowest level in this economic and building cycle, both in the US and in other major countries. This is masking the inadequacy of the credit supply. Loan demand will grow quickly as the economy in mid 2009 and the construction market in early 2010 resume expanding. Capital goods purchases, including construction, expand more rapidly than the balance of the economy early in a recovery period. What appear to be an adequate supply of credit in October 2009 will be increasingly strained by the recovering economy requiring credit rationing beginning in the second half of 2010 and becoming more serious beyond.
Where did all of the credit go? Several trillion was destroyed by unpaid loans. Initially, the unpaid loans were almost entirely sub-prime residential mortgages but later included commercial mortgages and a long list of other loan types. The lost capital had to be written off by lenders with a sizable share covered by various federal agencies. This was borrowed money so it was not additional capital available to lenders in the aggregate. Some capital was also consumed by greedy fees pocketed by lenders.
In addition two other factors reduced available credit to construction borrowers. Aggressive new federal spending plans, including mortgage payment assistance consumed over a $1 Trillion. And lenders cautiously reduced their financial leverage. Each dollar of lender capital or deposits can now support less lending than before September 2008. The conversion of large investment banks to commercial banks reduced their leverage ratio from as high as 30:1 to about 10:1.
As the economy and the construction market expand over the next year and credit demand expands even quicker, the financial constraint will become more binders which will force credit rationing. The rationing will take the form of both tighter lending standards and higher lending rates. Borrowers will be asked for more collateral. Some balance sheets that would have been creditworthy in 2005 — a similar point in the economic and building cycles — will not be creditworthy.
Three other factors will also be pushing up credit rates and tightening lending standards. Inflation will be rising from near 0.0% to 1-2% a year ahead and will add proportionally to credit rates. And additional large federal spending programs may be enacted. This includes the $700 Billion federal budget expansion requested for FY 2010 as well as healthcare expansion and the green initiative to cut carbon emissions. These two would add as much as $200 billion a year to federal borrowing. Finally, the several trillion dollars of added liquidity injected in the economy by the Federal Reserve Board have to be taken back to avoid serious inflation problems in 2011-12 and beyond. As of now the FRB plans to begin doing this slowly in mid 2010. It has to be done quickly enough to avoid over stimulation and the inevitable boost inflation but slow enough to avoid halting the economic recovery. Expect that removing the liquidity injection will contribute both to keeping the economic recovery sluggish and inching up credit costs.
Washington has made it very clear that housing has priority access to credit. The federal government is currently borrowing — printing money — to finance far more than half of the residential mortgages issued in 2009. Other construction borrowers will have to pay higher lending rates and get less credit to accommodate housing.
Unfortunately, there is yet another risk to the cost and availability of construction credit which US investors have not had to seriously consider for more than 70 years. The US is a new importer of capital. This is good. It permits the US economy to expand faster. But the willingness of foreign investors to send money to the US depends on their expectation that we use the money wisely so that we are able to repay them in non-depreciated dollars.
This expectation is now not as solid as it used to be. Recall in the past year that there was a brief period that foreign investors shunned Freddie Mac and Fannie Mae bonds. And there was also a brief period when foreign investors in US bonds bought bond repayment insurance for US Treasury bills, just as they often do for private bonds.
While the foreign capital risk to US interest rates is now much larger we are likely to muddle through with little interest rate premium because of foreign views of our ability and willingness to repay loans. Little but not none. Our largest creditors in both Europe and Asia are slowly diversifying their foreign investment away from the US and making contingency plans to speed up this process if necessary.