With the pallet market down sharply since September/October of last year, and the lumber industry taking it on the chin for much longer than that, everyone wants to know what caused the financial crisis and how the United States can get out of it. This article will summarize the causes, the impact on the forest products industry, and finally recommend actions that could help mitigate the crisis’s effects and build for long-term performance.

            Although the financial crisis bubbled to the surface in August 2007, it has been a long time coming, and unfortunately the current recession doesn’t appear to be going away any time soon. Efforts by the federal government to spur the credit markets have not worked as banks are hoarding money in order to build reserves against future loses.          The Federal Reserve Bank has largely run out of fire power (near zero interest rate and a balance sheet full of questionable collateral), international trade is coming to a standstill as letters of credit dry up, and the deflationary pressures of falling real estate, energy, and equity prices are having an effect on consumers. If bank lending to qualified customers doesn’t come back soon, there will be even more severe consequences to the real economy.

            First, let’s review how we got here, and then look at how it will impact the industry and what companies can do about it.

THE CAUSES

            The financial crisis is global in scope due to the flow of international capital although its acute causes are mainly attributable to the U.S. financial system. There are a number of causes that led to the current financial crisis, including the securitization of credit, negligence of credit rating agencies, deregulation, creation of the housing bubble, and excessive use of leverage. A review of each cause in more detail is presented below.

            The credit crunch started with a loss of investor confidence in securities such as mortgage backed securities (MBS), assets backed securities (ABS), and collateralized debt obligations (CDO), etc. These securities bundled mortgages, commercial loans and other bank loans in order to spread the risk of losses. Many of these securities were given AAA ratings by credit rating agencies, which were paid by the securities issuer (a clear conflict of interest and a departure from historical norms of being paid by the securities purchaser), despite being made up of loans that had an elevated risk of defaulting (i.e.: subprime). Since these new securities were AAA rated, they could be purchased by pension funds, banks, and other investors seeking a “safe investment.”

            These securities were sold by banks and mortgage originators to other banks and investors around the world. Many banks created off balance sheet entities that purchased these securities. In late 2006 and 2007, high interest rates caused adjustable rate mortgages to reset to higher payments, which in turn caused the underlying loans to default, and the securities themselves began to be devalued.

            Some securities lost over 75% of their initial value, and this has led to huge losses for purchasers of these securities. This securitization of credit effectively allowed banks to initiate more loans than their reserves should have enabled them to because they had sold the original loan. These securities failed to mitigate risk and the credit rating agencies that rated them failed to diligently assess risk.

            This type of bank behavior was enabled by the repeal of parts of the Glass-Steagal Act, which regulated commercial banks after the Great Depression. The barrier between commercial banks and investment banks was removed by the law’s repeal, and a new era of deregulation, speculation, and financial innovation was ushered in. Investment and commercial banks merged into behemoths and became too big to fail. The independence of these banks was called into question as the investment side tried to sell the securities produced on the commercial side. The regulation of banks became a lot more difficult as loans were chopped up and sold away.

            The true amount of risk a bank was exposed to was unknown. The use of derivatives grew exponentially, and the Federal Reserve and the Securities and Exchange Commission neglected to adequately regulate these new financial products. At the same time, free market ideology intoxicated the regulators, policy makers, and politicians who were supposed to be protecting the financial system. Deregulation and inadequate enforcement of existing regulations helped create the equity and housing bubbles along with their exotic financial innovations.

            The housing bubble, which has yet to deflate all the way, was characterized by the doubling of housing prices over the past decade. With everyone believing that house prices would always go up, people speculated and hurried to buy in order to get property “while it was still cheap.” This was reinforced by official government policy to help subsidize home ownership through tax breaks on mortgage interest and the activities of government-sponsored enterprises – Fannie Mae and Freddie Mac. Many economists have pointed out that this is terribly wasteful since this subsidy doesn’t increase our competitiveness or improve our productivity.

            There was simply too much investment in housing, which is a non-productive asset. Growth in house prices during this bubble far outpaced growth in household income, so financing had to get creative. Enter adjustable rate mortgages, no down payments, no document loans and securitization of credit. Nearly anyone with a heartbeat could get a mortgage evidenced by the so-called “ninja” loans: No-Income, No-Job or Assets. What happened to 20% down? As interest rates increased, these adjustable rate mortgage loans began to default, and this led to losses on the securitized debts (MBS’s etc).

            The housing bubble also became a way for homeowners to make up for the lack of real income growth. With house prices appreciating, homeowners extracted equity from their homes. Over half of all subprime loans were home equity loans. These new loans and exotic securities only provided the illusion of progress.

            People couldn’t afford these homes, but they and the mortgages originators fooled themselves into believing that they could. Real progress would be an increase in income, job security, and savings that would really enable higher home ownership.

            The subprime and even prime loans were made available and cheap to nearly everyone by an overabundance of credit supply in the U.S., which was created in part by foreign governments’ appetite for Treasury bonds (in order to maintain their currency pegs), a net savings rate in Asian countries, and a federal funds interest rate that was kept too low for too long by Alan Greenspan. This excess credit availability drove the housing and equity bubbles, and it should have been stopped. Regulators, policy makers, and some economists were aware of it, but they did not do anything to slow it down.

            During this time period (mid-90s to current), investors, banks, and hedge funds were looking to boost returns. They achieved this through the use of leverage. By borrowing money (debt) and investing it, they could achieve higher returns than just investing their own money (equity). This worked quite well for a while. Indeed, the financial industry was responsible for 46% of all earnings in the S&P 500 during the last bull run.

            The financial industry accounted for nearly 8% of GDP in this time period. Now, the financial industry is de-leveraging and having to write down the losses on the loans that can’t be paid back. Because of their extremely high leverage, there isn’t much equity to absorb losses. This is why the government has to come in and bail them out. The bottom line is that the financial industry has gotten too big and must be scaled back to historic proportions. It must serve the needs of the economy and small businesses, not the other way around.

IMPACTS

            The housing slowdown, which began in 2006 and declined rapidly since then, has been impacting the wood industry for a while. The current financial crisis is like the second punch in a powerful 1-2 combo that has knocked many companies out of business.

            Housing starts are down; home prices are down; unsold home inventories are up; non-residential construction and remolding activity have also declined; consumer confidence and builder confidence have decreased, and manufacturing activity has decreased despite dramatically lowered interest rates. These trends have and will continue to have drastic effects on the wood products industry since most of the industry’s demand is driven by construction and consumer demand.

            The recession is already one year old and will not abate for at least another year. This downturn will be longer than normal because there is a housing recession in conjunction with a financial crisis. The credit that drove the housing bubble will not be available to aid in the economic recovery. Also there is a large number of adjustable rate mortgages (ARMs) that reset in 2010 and 2011. These could end up in foreclosure just like the subprime ARMs in 2008.

            There must be a large, effective program to stem the increase in foreclosures in order for the housing industry to stabilize. If banks were willing to give households the option to rent-to-own, this could be beneficial to both parties. Banks would get more than if the house was sold in a foreclosure, and people would get to stay in their home.

            Even with good policies and economic stimulus, this could be the longest recession since the 43-month recession during the Great Depression.    

            Given the policy response of the U.S. government so far, some observers think that the U.S. is headed the Japan route. Japan suffered a long (15 years) no growth period after its asset bubbles burst in 1990. If this is the case, the economy is unlikely to quickly and robustly recover in 2010.

            The recession is also likely to be relentless for the forest products industry. Housing starts will fail to break 1 million units in 2008 and possibly only 800,000 units in 2009. This would be a 61% decline from the 2 million starts in 2005. This steep decline is comparable to the 51% decline over three years from 1972 to 1975. Then, housing restarts rebounded above their long term average (1.5 million units) the next year. We are unlikely to see housing starts rebound that quickly in the current scenario. House prices must fall further and household incomes must rise in order to revert to their long term trends. People must be able to afford houses to purchase them, and until this happens there won’t be a housing recovery. This recession looks to be a long and deep one.

            Companies across the forest products industry, from logging to cabinetry, have already closed operations, some temporarily and some permanently. Since January 2006, according to Bureau of Labor Statistics data, job losses in wood products manufacturing have totaled 126,000 (22% of the total industry employment).

            Production cut backs and consumption declines in nearly every segment of the industry have been significant: softwood lumber down 30%; hardwood lumber down 30%; structural panels down 26%; and engineered wood products (EWP) down 20-30%.

            We have seen a rebalancing of supply and demand in lumber, EWPs, and panels, but this may have to occur again as housing-related demand continues to decrease in 2009 and deflationary pressures further erode prices. The historic low prices of lumber and panels in conjunction with high costs have caused many companies to become unprofitable. The S&P Global Timber & Forestry Index has fallen 55% from its apex in early 2007. In the short term, the job losses, plant closures, and financial losses in the industry will have to continue into 2009 so that supply is brought back in line with demand.

SHORT TERM RESPONSES

            What can we do as an industry to cope with this deep, protracted recession? The necessary responses by the industry aren’t actions that companies like to take, but they must. The list includes cutting production, shutting down temporarily, dramatically cutting costs, conserving cash, finding new markets, diversifying into other markets, and going out of business. We’ll review a number of these actions, but a combination of all of the above is probably necessary.

            First things first, the industry should position itself to take advantage of the coming economic stimulus. The stimulus is likely to be made up of infrastructure investment, state and local government spending, extension of unemployment benefits, and green energy investments. Can your manufacturing facility be retrofitted to produce renewable energy from wood residue? Despite low energy prices, now is a good time to layout a long-term strategy for diversifying into energy production. There has been much research on how to use wood for transportation infrastructure. Does this market fit with your existing capabilities? Finding new markets not tied to housing and diversifying your product portfolio are critical during these times but also make for a good long-term strategy.

            Production decreases and temporary shut downs go hand-in-hand with cutting costs and conserving cash. Fortunately, there has been some relief in the form of decreased energy costs recently along with lower international shipping rates. In order to deal with declining sales revenue and profitability, firms have to cut costs in order to survive. Expenses that seem to be non-essential are the first to get cut, such as the holiday bonus and party, along with postponement of computer and machinery upgrades. More important expenses, such as marketing, research and development, dividend payments, and pay raises, are next in line. The more difficult costs to cut are the large ones: raw materials, labor, energy, supplies, etc. The cutbacks in production help reduce these costs, but they also reduce cash flow, which is critical.

            Without adequate cash flow, companies go bankrupt. Proper management of cash flow is especially important during a downturn. Companies can demand payment up front, decrease their account’s receivables, and try to extend their account’s payables in order to stretch their cash flow. Decreasing costs and conserving cash during a downturn are just as important as trying to increase sales or capture market share.

            There is a natural inclination to look for growing markets overseas for current production as domestic markets shrink. The past few years has seen an increase in exports as the dollar declined and developing countries grew rapidly. Unfortunately, in the current recession there are not likely to be many opportunities. Are there small, niche markets that are growing for some products? Yes, of course, but foreign markets are generally not attractive right now.

            The European Union and developing countries of BRIC (Brazil, Russia, India and China) are in a downturn also. This downturn will be global. China is likely to be harshly affected due to its export and currency imbalances.

            Companies with large debt payments will suffer from tighter cash flow than those with smaller debt payments. Good accounting and financial analysis is especially important when company finances become tight. A close eye must be kept on competitors, especially those that may go under. Will you be able to service their customers or does it make since to acquire their operations? Smart companies can gain market share in this period as less efficient companies go out of business.

LONG TERM RESPONSES

            If the United States wants to be competitive in the future, as a country we must invest in our forest products industry as well as the larger manufacturing sector. Given the global imbalances in trade, specifically forest products, the United States must produce more with our given resources. American companies are going to have to invest in the long-term productivity and sustainability of timber resources. In a couple years, as asset prices reach bottom, those companies looking to acquire forestland may find some good values.

            Wood product manufacturers must figure out a way to reduce lead times, reduce inventory, and shorten the supply chain. American producers can’t make products that people don’t want to buy. Are there new products/services that are needed in the market? Good market research will help answer that question. Companies need to become more responsive to consumers and understand their behavior. Now is the time to get closer to your customers and understand them better. Firms must find out what markets they are competitive and profitable in and produce only the value-added features that customers are willing to pay for.

            Pallet companies should look to opportunities in logistics as shippers try to cut costs and need more than just a shipping platform. This includes everything from reverse logistics, storage, packaging management, grinding services, trucking, re-palletization, etc. Plans by the federal government to invest in roads, bridges, ports and inland cargo facilities could provide opportunities for some companies.

            Companies must correctly position themselves to take advantage of the green building and climate change mitigation trends. If your company owns forestland, are you prepared to benefit from carbon trading? Have you performed a cost benefit analysis on forest certification?

            This economic downturn will be notable, but with good management and good marketing, the wood products industry can emerge stronger, more competitive and more sustainable.

            Brian is a PhD Candidate at Virginia Tech in the Department of Wood Science and Forest Products. He has worked in and studied numerous segments of the forest products industry.  His research focuses on different aspects of forest products business and wood utilization.

            Dr. Al Schuler is a Research Economist with the USDA Forest Service at the Princeton, West Va. Research Laboratory.  Al has also worked as a market expert for Norbord Industries in Toronto and the Forintek Research Lab in Ottawa. His areas of expertise include housing, globalization, the economy, technological changes, and demographic trends impacting the forest products industry.