Analysis 2009: The Financial Crisis Hits IT Hard

By Kurt Cagle
January 6, 2009 | Comments: 16

The recession that started in January 2008 looks to be four phased. The first phase, The housing collapse, actually started in August 2007. The financial meltdown hit in September 2008, and likely will continue through to March 2009 or so. The business firestorm is really just getting underway now, and will be the dominant theme for the next 8-12 months whlie the final phase, currency collapse, will (if it occurs at all) likely not happen for another 12-18 months.

The business collapse itself is taking place in a number of different verticals, which differentiates it from a traditional oversupply recession. In an oversupply recession, the market produces too much of a good or service for the available demand, which usually means that either companies have to cut back on producing goods (and consequently reduce their own profitability) or they fail and fall out of the market. In time, demand rises to meet supply, and the industry in question recovers.

The housing collapse was a classic oversupply recession - too many houses on the market at too high a price, and eventually demand couldn't meet supply. Had the housing market not been fueled by low interest rates when they weren't needed, had the financial industry not done a dice-o-matic on the resulting mortgages, and so on, chances are pretty good that we would be about 2/3 of the way through this by now, IT, except for the specific housing IT vertical, would be relatively unscathed.

We expect to see more of the future--and what to do about it--onstage at the second edition of Money:Tech, happening February 4-6, 2009 in New York. Register today!


The problem now is that risk became baked into the very core of the global financial system like a series of fault lines, and the collapse of the mortgage business was like a deeply buried mortar going off in that mess. This in turn exposed the very ugly truth about finance - that prices are psychological, and when no one knows the value of things, the ability to plan for the future ends.

This fear has manifested in the credit crunch, when banks are terrified of lending money out because they know that the assets that the carry are far below what they should carry in order to stay solvent - and that if they loan out money, they won't have it when the next wave of credit defaults occur (either credit cards or commercial real estate, take your pick - they'll hit about the same time). There's currently an effort to reliquidate the banks by most of the world's governments, though with at best limited success (more on that in future articles).

The business collapse is occurring because of two factors. First companies that had depended upon having readily available lines of credit are finding these lines being cut or dramatically reduced, which makes them much more vulnerable to the variability of incoming contracts ... at a time when everyone else is facing the same problem.

The second is that this has put significant downward pressure on household incomes, as these same lines of credit (in the form of second mortgage refinancing, credit cards and so forth) are now becoming scarce at the consumer level (along with financial investments having plummetted in the last few months). This has resulted in a consumer strike, as people save rather than spend.

For those businesses with a direct consumer face (or those that IT companies who supply services to these businesses) this translates into reduced revenues and shrinking demand, which in turn has a direct impact upon both those people that produce retail hardware and has an indirect effect upon IT companies that produce software to support these retailers. It also means that companies that had projects in the work for FY 2009 are scaling these back or putting them on indefinite hold until they get a clearer read of the economic situation.

One of the problems with recessions is that while there is an underlying economic aspect to most of them (many people just don't have the money in the first place), there is also a psychological aspect. People stop spending (and start saving), in anticipation of two things - first, that when they need the money, they may not have it, and second, that when the economy is receding, the overall price of both goods and services drop. It makes little sense to take on new purchases (whether new projects or new goods) when demand is dropping and the possibility is fairly strong that they can get those things for cheaper in a year or two.

At an individual level, this is a rational response. The problem comes when everyone does it. At that point, demand dries up, companies go out of business, reducing the overall stock of those same goods and services. This happens with all goods. The problem that we face right now is that the goods that are at the root of the problem - houses - tend to have a comparatively long shelf life compared to Tickle-me Elmo dolls or iPods. They can't be inventoried or written off, which means that it will take considerably longer for demand to meet supply, and as capital investments destroying houses and restoring the property to a usable state can be painful at best.

Unfortunately, this means that the psychological aspects of businesses far removed from housing will be very much held hostage to the housing cycle. Eventually (for a number of reasons) housing prices will stabilize at a new level of equilibrium (which, if reversion to the mean is any indication, should be about 15% below where most prices are now), though it is also likely that any markets will overshoot this level to about 25% or so below current levels before eventually returning to this mean. While estimates vary as to how long it will take, most economists feel that it will be at least another nine to eighteen months, putting the "bottom" of the recession at or around late 2009 or early 2010.

Yet even that won't necessarily be the end of the troubles. A deep financial depression is a lot like a deep cyclonic depression (a.k.a, a hurricane). In a hurricane, a great deal of damage is done by the winds, as windows break, cars go flying and in some cases houses go sliding into the depths or get turned into kindling. Yet the real damage comes from factors such as storm surges, where large amounts of water start moving quickly in areas not designed for water. Hurricanes knock out power, making recovery efforts difficult, and paradoxically, raises the possibility that fires will start that can't be reached or put out, causing even more damage.

The same thing is happening now - we are within the eye of the financial hurricane, a kind of false calm where the winds and pressures are at an unstable equilibrium, but this only has the effect of relaxing things that had bent in response to the hurricane force winds. Unfortunately, once we enter the eyewall on the other side the forces are just as strong, but going in the other direction (one of the reason hurricanes are so destructive).

When this plays out, many retail companies (and not a few medium to large sized malls) will be out of business, their buildings sitting vacant and often poorly maintained. There will be a significant exurban flight as people are forced to sell their properties (typically at a loss) because of unmaintainable mortgages and either rent closer in to population cores or move to higher density housing (this trend will be exacerbated by the number of baby boomers who are reaching retirement age and are staring at fixed incomes with oversized mortgages and reduced bank accounts), a trend which will result in many "bedroom communities" becoming squalid slums or just abandoned altogether.

Suppliers to these retailers are already starting to disappear as retailers cut back on their inventories, and in areas such as automotive manufacturing the tremors as these highly centralized, monolithic conglomerates continue to shutter plants are causing the extensive supply chains to fragment as companies that weren't sufficiently diversified lose their primary customers and go out of business.

As this happens, it also makes it harder for these same companies to continue to pay their leases, which are typically financed at a much higher rate than consumer mortgages are as most are fifteen year rather than thirty year paper. This will be the next major pressure that a lot of companies, even those outside of the retail sector, will be facing, and software companies in particular are vulnerable to this particular threat, especially as VC financing continues to decline. Expect by the end of 2009 that office buildings will be even more vacant than they were in 2003 at the bottom of the tech recession.

Venture capital, by the way, is also drying up for much the same reason as credit in general - VCs are investors, and they do not in general want to take a loss on a company, even one with a brilliant idea, if they are concerned that economic pressures will never let it get off the ground. Moreover, those same investors already have extant commitments that they are in many cases having to serve as the primary bank for, and this in turn is reducing their willingness to take on new businesses (and will for some time).

A further process that will accelerate is the disaggregation of conglomerates, as companies shed or spin-off divisions that are not profit centers. It's likely that this will hit the big services companies such as IBM, Fujitsu, Siemens and so forth disproportionately, though it might also affect companies such as Microsoft or Oracle. Many of the newly created spin-offs may not make it once cut off from the sheltering effect of the mothership, but others (most notably those that were already successful companies in their own rights) may very well come out stronger in the process.

The next year will be a poor one for mergers, unless they happen to be pure stock exchange mergers (where the two companies agree to on a common stock conversion rate with little actual money changing hands). Acquisition mergers typically require not only cash on hand, but also require access to bonds or other equities that can be used to leverage this cash on hand. With so much uncertainty right now in terms of equity prices, however, raising such funds becomes difficult, even as it seems like we are awash in a sea of junk bonds.

Toward the end of 2009, expect this trend to reverse. Companies with strong cash positions going into this storm will have a much clearer understanding of the shape of the market by the end of the year, and will be able to buy technically sound but financially distressed software companies at bargain rates. If you're vested in a startup, now is probably a good time to discuss acquisition strategies, though probably not at the premium values that many startups tend to value themselves, with an eye towards that sweet spot in the Q4 2009.

There's currently a running debate among economists about what happens when the recession ends. Some, primarily Keynesians, feel that economic stimulus is a necessity to get us out of the current liquidity trap, and that for the most part the debt that most countries are taking on now will restore us back to a period of economic stability with perhaps at worst only modest inflation (in the 3-4% rate) for a few years thereafter.

Others, especially those of the Austrian school of economics, expect that all of the money being created in order to finance the stimulus will, once the credit crunch eases, result in significant inflation, possibly above 10% per annum, leading to a similar situation (stagflation) that caused the 70s to be so hard (well, that and disco).

My money is on the Austrians, as they were surprisingly accurate in their predictions of the present economic crisis, and as a central part of the problem facing the economy right now is that real interest rates (those charged by banks to their primary customers) continues to remain far higher than the nominal 0.25% percent rate that the current Fed has set the prime lending rate.

In short, even after the storm abates, money may continue to be in short supply for many months (or even years) to come. Expect that government stimulus packages and government works programs may in fact have to substitute for the private economy for some time (more on that in the next section).


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16 Comments

Informative report.Thanks for sharing
regards
route network analysis

"The recession that started in January 2008"?
One of the main problems of this recession is that it is based on very faulty figures. We've probably had 3 or four recessions that have not been reported as accounting figures were given falsely by companies. The effects of exposing this accounting error/trick will now ripple through the system for a couple of years.
Never, ever, think the US stockmarket should have been anywhere above 7000, and 3000 for the UK market - fractional reserve banking and similar tricks gave company accounts a boost that should never have been there - and this was multiplied by the system.

Why no-one has been done for accounting fraud over this reveals just how deep the desire to believe in the emperors new economics still is.
We were never that well off - we aint got nowhere to go back too!

“This in turn exposed the very ugly truth about finance - that prices are psychological, and when no one knows the value of things…” — how topical for designers, developers and nearly everyone in technology, especially Internet services.

Thank you for your article.

Kurt,
Your writing always astounds me.
You author technical books in such depth and explain the explicit algorithms in fine detail, it is easy to assume you a geek with a very specialized expertise.
With articles like this, it become clear you are one of the best writers (and editors) of our time. Not only do you explain the financial meltdown with readable prose, you research the topic to hit the target right on.
Unfortunately, your descriptive may be a little TOO good - after reading this, I will be looking into shelters and survival skills!

Tom,

Keep in mind that most of the economic numbers that get printed are not "raw". Instead, what ends up happening is that these numbers are estimates based upon surveys that follow a very specific model, in order to develop a model that the statisticians hope reflects a semblance of reality.

For the most part, when economic conditions have been stable for a while, the models are usually pretty accurate, because they rely largely upon previous history. It's when the economy enters an inflection point, however, that things get wonky.

For instance, consider the job birth/death model. Normally its nearly impossible to tell, a month at a time, how many people are actually hired or fired in the economy - the reporting simply isn't that fine grained yet. Instead, the economy assumes that a certain amount of jobs will be created in a given month based upon a running average of the raw numbers over the last six months. Normally, this model is pretty accurate.

However, inflection points cause problems, because they are almost impossible to catch in previous data. If employment falls by 0.3% one month, and the running average has shown unemployment as being steady, then the model may actually show that jobs were created when they in fact were in decline. This becomes a bigger factor the more rapidly change occurs, and it usually means that it may take six months or even a year before the jobs creation model proves accurate.

As another case in point, the economy, according to the BLS "final" numbers, showed a net loss of 450,000 jobs in December, which is stunningly bad, especially when you need approximately 300,000 jobs created a month in order to have sustained growth in the economy. However, other studies that have a perhaps more accurate number because there is less political bias, actually put this number somewhere north of 850,000 jobs lost in December, making it one of the worst since the Depression percentage wise.

On the flip side, however, this also means that the unemployment numbers will likely be higher at the beginning of a recovery than the numbers would indicate. This is why unemployment figures are usually considered lagging indicators.

This holds true for inflation and economic growth figures. Frankly at this stage the declaration of a given period as being a recession or a boom is a rather arbitrary exercise to begin with, as it begs the question of how exactly you measure things like GDP and whether those measurements have any relevance anymore. I've seen a number of compelling arguments to indicate that GDP is a lot like IQ - it is an overly simplistic number that exists primarily as a tool for the media to report on a very complex system as if it was temperature guage, and has, at best, marginal real value.

That's not to say that politicians, or government bureaucrats with fixed budgets, aren't above manipulating those figures for their own gains, mind you. Many of these numbers, even as meaningless as they are, still determine tax rates, appropriations, entitlements and other governmental programs, and often also have implications for financial corporations and other businesses.

About the stock market: the long term (200 month) median value is actually about 7350 right now. Most analysts seem to be expecting that there will be an Obama bounce as the market recovers somewhat after the dramatic fall in October/November before heading lower.

My personal belief is that we've HAD the bounce - the market was briefly about 9200 before heaving back down to 8600, and that the overall trend will likely take the market down to 4,000 before finally leveling out around the 200 month average.

Liquidity remains tight, which means that there's not a lot of money available for speculating right now, and overall the volumes that you're seeing in the markets are still anemic even after people return from the holidays.

This means that even strong rallies are deceptive, and volatility is likely to remain high for some time to come (volatility tends to decrease when you have heavy volumes, because the larger number of transactions tend to cancel one another out and give you a fairly quiet index).

The recovery will begin about the point where people have left nearly all markets in disgust or been forced out by losses. That won't happen for several years yet, unfortunately - there are too many people who still see this as an aberration and figure that if they just wait it out a couple more months, that the stock market's near its bottom.

Don't count on it.

Ric,

I'm a systems theorist, and have been pretty much most of my life. Both web programming and economics are systems. It's about that simple.

We're about to face one of the most challenging times that most of us have ever encountered, and that even those who have gone through this before have likely never dealt with at this level. On the other hand, I think that we have the tools and means today to do things at a far higher level than we had eighty years ago, or even forty years ago. I think its important to warn people, to set expectations of what may come, yet at the same time to remind them that we got through our problems then, and we'll get through them now.

-- Kurt

However this ends, the poor and the middle class will be the last to feel the impact of the recovery.

I tried to speak out for the poor in a couple of original Christmas songs I wrote for my CD, Ice and Snow. They were called Billy Wants a Job for Christmas and Long Road to Christmas.

http://www.drblt.net

I wanted to use some of the profits for those most directly impacted by the economic crisis, but little attention was paid to the songs, or to my charitable plans. So I'll try again on Valentines Day with this song:

It’s Valentines Day
Dr BLT
Words and music by Dr BLT copyright 2008

It’s Valentines Day
It’s valentines Day
And Billy and Kay are struggling
Their livin’ on love
They both lost their jobs
They can’t sleep a wink at night

(chorus)
But hey, what can I say
It’s Valentines day
But hey, what can I say
It’s Valentines day

They’re mortgage is due
They ain’t got a clue
About how they
Are gonna make it
They had a yard sale
And sold all their goods
Their cupboard is empty too
(chorus)

Money is tight
But they’ve got tonight
And they are so deep in love
They worry all day
But then stop to pray
They know it will be alright

(chorus)

Wow, this just utterly sucks, give up on singing

The problem with most non-Keynesians is that they don't acknowledge that there are three types of inflation:
- cost push
- wage push
- demand pull

Stagflation occurs, as it did in the mid to late 1970s from cost push; oil in that case. Classic inflation comes from the two other sources. Wages, as measured by median household income, has been, at best, flat since 2000. Since the rich, who've gotten the lion's share of the Bush era "growth", can't seem to spend they're money widely, there hasn't been (nor will there be) demand pull.

Printing money (in the central banking sense) is *not* inherently inflationary, if the commercial banks (broadly defined) just hoard it; as they are currently doing. Only if the print makes it into the hands of consumers can inflation result, and only then if there is no excess capacity in the economy. None of that is currently, or foreseeably true. The Bush/Paulson game is trickle down, yet again. Naturally, nothing is trickling down. So, no effect, positive or negative.

Never forget the prime principle: depression (if one chooses to accept that such can be defined; the right wing folk assert that the "market" is just punishing labor for being greedy) was, is, and always will be caused by shifts of income/wealth from the many to the few. The issue is to define "normal" income distribution. In places like India, and your average banana republic, the USofA is still far too generous to the masses of labor. Relative to what existed in 1955, say, the current USofA *is* a banana republic. It all depends on what you define as normal.

I have a very close friend, who graduated from Harvard. Worked for ML for over 8 years, recently he’s been “right sized” too, despite of his outstanding performance and the increasing revenue he generated. OMG, now the banking industry is badly hurt, how long it would take for those financial background guys like him get back to the job market. Banking jobs are not there as much as before as easily seen on http://www.joboutlets.com and other job sites in the region

Thank you for elucidating some difficult financial concepts. I enjoyed reading your article..

In the above 'Analysis 2009: The Financial Crisis Hits Hard', mention is made of a possible scenario of 'currency collapse' occurring...

Can you elaborate more?

Is a 'currency collapse' soley a U.S. phenomenon or are you talking about a world-wide event?

What does this collapse mean for the average citizen in terms of how will it impact on bank savings deposits/assets?

Are any strategies available to citizens to protect their assets and savings and standard of living in this type of eventuality, and to minimize its consequences?

Thank you

The fundamental problem is our having lost control of our companies, allowing their CEOs to run a modus operandi without fear of retribution: 1) pump the short-term profits of the firm, 2) get a huge bonus in cash and stock, and 3) dump the stock at the high.

To regain control of our companies, at the minimum, we must demand from our regulators that brokers and money managers not be alllowed to vote our shares (usually with management) without our consent; compel a company to give proxy access to persons or groups with 10% or more voting power; and to make our regulatory institutions professionally managed by career officials.

Without regaining such control, only fools and gamblers, not investors, will put money in this rigged market.

http://www.youtube.com/watch?v=uwNJmGH6Swo

“The rich, who howl with so much power and money now, will be the most unfortunate. They will be in their knees crying, begging for a dish of food. They will howl like dogs.”

But, There is hope for those that want to overcome. A free gift for humanity is available. No group to join, no money required. Any human being, regardless of color, religion, political or religious position has the potential within. Please ask for a free book at: www.hercolubus.tv. It has the practices to prepare yourself for what is coming. No one can do the job for you. You and you alone can prepare for what is already happening: Floods, Earthquakes, Global Warming, Pandemics, World Wars etc.

This is july 17. I heard that a stock analyst said that the DOW will stabilize, then fall very low. Any Idea when this stuff is going to hit full force?
I mean things like food riots, trucking strikes, mass food shortages, prison camps for 'rebels'. The real 'Wrath of Egomaniac' type stuff.

Wealth and monetary value is created only when a country (or an individual family) sells something to parties outside of that country (or family) in return for a net transfer of gold or currency from other countries to that country (or family). The citizens of that country reflect their real wealth with the accumulation of grain, gold, cattle, jewels, land and/or other marketable products and commodities for reserve use in times of emergency and/or also to raise the standard of living for the citizens of that country.

The people in the country that grew and harvested something from the earth, that extracted something of commercial value from the earth, that provided services (medical, dental, engineering, technology, etc.), and/or that made (manufactured or constructed) something that is consumable (or useful) that was sold outside of that country in exchange for foreign currency (or other commodities to other parties outside of that country) created wealth for that country from the currency received from the sales of those services and products and this increased the real wealth of that country (or family).

If that country bought imported things from outside of their country, but not of more value than the value of the items that they exported to foreign countries, then they would have a net positive foreign trade balance, and that would have increased the value of the real wealth assets of that country (or family). The USA has elected to sell and export title to USA assets in return for foreign manufactured items that US citizens import and consume. The USA is selling our means of creating future wealth in return for imported products. The USA has elected to close our wealth generating businesses, and then lay off US workers for labor cost saving and environmental reasons.

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