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Collateral Damage: What the Crisis in the Credit Markets Means for Everyone Else
Credit Markets is also known as :
Credit Markets Collapsing,
Budget Targets Credit Market,
Global Leader in Credit Markets,
Current Credit Market Turbulence,
Inefficient Credit Market Freeze,
Subprime Credit Market,
Credit Market Crunch,
Federal Reserve Credit Market,
Credit Default Swaps Market,
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Credit Markets Regain Record Pace,
Microfinance Ends Hunger,
Definition of Credit Market,
Credit Market Eased,
Boost Confidence in Credit Markets,
Credit Markets Funds,
Unlocking Credit Markets,
Report Unnerves the Credit Markets,
Indicator of Credit Market Health,
Tight Credit Markets,
Credit Markets and Business Cycle,
Market for Corporate Bonds,
Credit Markets Are Thawing,
Credit Crisis Eases,
Calculated Risk Credit Crisis,
Tightening Credit Markets.
Given the dramatic events in the capital markets, everyone is
wondering what will happen next – and what the implications are for the
wider economy. This paper is structured into five chapters. The first
three chapters explain some of the background to the crisis both in the
capital markets and now in the broader economy; the fourth chapter then
explores likely future economic scenarios and the challenges facing
companies outside the financial sector; and the final chapter
highlights some of the actions companies should be taking in order to
respond these challenges.
1. The current Financial and Economic Situation
The week of September 15, 2008 marked the end of America’s
Depression-era financial system. Where some had hoped that the earlier
collapse of Bear Sterns presaged the end of the crisis, it turned out
that it was only an early warning. With Lehman Brothers in bankruptcy,
Merrill Lynch arranging a forced sale, Goldman Sachs and Morgan Stanley
reorganizing as banks and seeking emergency investors, and AIG
accepting a government bailout, the U.S. Financial Services landscape
changed irrevocably – and virtually overnight. The subsequent fall of
Washington Mutual, the takeover of Wachovia by Wells Fargo (or
Citigroup?), and European government intervention in Fortis, Dexia,
Hypo Real Estate and others have only accentuated the gravity of the
moment. And beyond the uncertainties facing the real banks, there is
mounting concern around the rest of the shadow banking system: hedge
funds, PE funds and other alternative investors. What began as a
leverage crisis and a credit crunch has turned into a full blown
insolvency problem as well.
The modern financial system rests on three pillars: capital,
liquidity, and confidence. Unprecedented losses (about $250 billion in
the United States, $200 billion in Europe and $100 billion in Asia as
of August 2008) have depleted financial institutions’ capital faster
than their ability to raise new capital (about $400 billion in the same
period). Illiquid capital markets have made it hard for them to finance
their own debt. Falling confidence has damaged inter-bank lending and
made depositors jittery. Not since the crash of 1929 has the global
financial system been subject to such a severe shock.
Although the financial system is at the centre of this turmoil, the
ramifications will travel throughout the broader economy. The rapid
industrialization of emerging markets, the globalization of supply
chains, and the march of entrepreneurship have all been fuelled by the
easy availability of plentiful capital and cheap debt. Any disruption
to this dynamic will inevitably slow economic growth around the world –
even if debt-burdened consumers, particularly in the U.S. and UK, had
any capacity to spend more to restore growth in the first place. While
no one can predict with certainty the severity and duration of the
global economic slowdown, a recession now seems inevitable, and is
likely to be relatively long.
2. The Roots of the current Crisis
The credit crisis is the consequence of aggressive risk taking by
highly leveraged financial institutions which funded unsustainable
economic growth, particularly in the U.S. Underlying this dynamic were
three widely held misconceptions: that the creditworthiness of
borrowers was strong, that investors were sophisticated and that credit
risk was widely distributed.
The first belief was perhaps the most reasonable—at least on the
surface. For years, credit losses had been relatively limited, so
borrower creditworthiness did indeed appear to be strong. There was,
however, a dangerous circularity to this logic. Lender and investor
perception of healthy homeowner credit drove spreads lower, causing
marginal borrowers to appear to be more financially attractive than, in
fact, they were, and making it easier to justify providing them
financing. This was further fuelled by a belief that any financially
constrained borrowers would be covered by ever-rising house prices via
the home equity release products. The unintended result was highly
imprudent lending to people who could not afford the homes they were
With the bursting of the housing bubble, the problem was there for
all to see. So far, U.S. housing prices have fallen about 20 percent,
not yet bringing the market to long term historic price levels. In late
2006, default rates on sub-prime loans were only 1 percent; a year
later, they were at 10 percent. Today, Moody’s estimates that banks
made in the neighbourhood of 15 million high-risk mortgage loans in the
U.S. between 2004 and 2007 and that a full two thirds will ultimately
end up in default.
The second belief provided even more false comfort. With
unprecedented access to data and analytics, lenders and investors were
assumed to be exceptionally sophisticated. Advanced financial
technology meant that risk could be finely tailored to their specific
needs. Strengthened by credit insurance and blessed by rating agencies,
this risk was assumed to be near bullet-proof. Consequently, the
capital applied against it was minimized.
Finally, market participants believed that risk was widely
distributed among global investors. Even if credit worsened and
analytics failed, absence of concentrated risk would prevent systemic
problems. This belief, more than any other factor, explains why
people—instead of being wary of a market bubble—were under that
impression that "this time, it’s different."
Unfortunately, not only was homeowner credit suspect, but the market
had misread this risk. In the ensuing panic and consequent liquidity
crisis, the safety net of risk analytics and ratings was seen to be an
illusion. When investors realized the risk was largely concentrated on
bank balance sheets, their confidence in the financial system eroded
One might ask oneself why did global capital markets grow as fast as
they did and why were they able to absorb all this – in retrospect –
risky borrowing? The answer lies as much in investor demand for fixed
income securities that offered good returns as it did in the insatiable
appetite of consumers for debt to fuel their spending (see below). By
2000, the total pool of global fixed income securities had reached $35
trillion. It had taken hundreds of years to get there. Yet it doubled
over the next six years. In the early 2000s Alan Greenspan – the former
chairman of the Fed – had publicly asserted that the Fed Funds rate
would be kept low for the good of the economy. This meant that U.S.
Treasury Bonds would offer a low return for the foreseeable future. So
Wall Street filled the void, packaging higher yielding mortgage debt
into (apparently) AAA-rated securities. The problem was that the
incentives driving the mortgage originators and the securities
distributors created a moral hazard: their rewards were not aligned
with sound credit underwriting principles or the distribution of assets
backed by sound collateral. Credit was granted to uncreditworthy
individuals, packaged into securities, and pushed out into the Market.
And seemingly unlimited investor demanded drove this bubble further.
At the same time, the derivatives market for so-called credit
default swaps (CDS) – instruments originally intended to trade and
insure credit risk – exploded from a notional amount of less than $500
billion in 2000 to $62 trillion in 2008 – for comparison, global GDP
for 2008 is also forecasted to be $62 trillion. Now, as part of the
credit risk on which these swaps are written materializes, many of
these CDS need to be settled. This can have severe consequences if the
counterparties who wrote these CDS cannot perform on their liabilities.
Initially, this means that these counterparties will default. But it
also implies that the respective CDS buyers – who bought these
instruments to insure against credit events – will be left without
insurance and so are likely to suffer further losses. Such losses could
then also drive these buyers into bankruptcy. In order to prevent
exactly this from happening, the U.S. government bailed out AIG which
had written $78 billion of CDS on securitized mortgages or so-called
collateralized debt obligations (CDOs). The worrying takeaway is that
the CDS market might conceivably hold an even bigger problem to come.
As of now, the resulting chaos from their misjudgements has forced
bankers to revisit all their flawed assumptions. Driven by spiking
defaults (starting in high-risk mortgages but now spreading to standard
mortgages and likely on to consumer debt, highly leveraged private
equity deals, and corporate debt), banks are tightening lending
standards on all loans. Banks and rating agencies are clamping down on
financial engineering and innovation thereby reducing flexibility of
terms and instruments available to borrowers. Finally, a reduced
ability to place debt with investors implies banks now have to hold
more of it on their own balance sheets. At the same time, the capacity
of their balance sheets is shrinking as they reduce their leverage.
Thus, the debt available for their customers is constrained and the
price for it is materially higher. Credit spreads have expanded by more
than 100 basis points (bps) for loans rated BBB—and more than 300 bps
for those rated BB. Issuance of asset-backed securities fell by more
than 75 percent in the second half of 2007, compared to the first half
of the year, and has virtually ground to a halt in 2008. And even
issuance of plain debt has fallen more than 75 percent from the steady
levels of 2003-2007.
One feature of the financial system that has been changing over the
years is precisely where the risk is taken. In the past, the
lubrication for many markets came from investors and speculators. These
third parties risked their own cash. By 2007, the increase in
Institutional proprietary risk, supported by their own equity (and
leverage), had shifted a lot of this risk onto the banking system
itself. Historic intermediaries had themselves become major holders of
How bad will the credit crunch be? We estimate that financial
institution losses are likely to reach at least $1.5 trillion worldwide
as losses from personal lending and corporate debt could even exceed
the losses from mortgages. At a 12.5:1 ratio of capital to assets, that
loss would mean a $19 trillion decline in credit capacity—a net
contraction representing about 7 percent of current global credit
levels. Given that roughly four dollars of credit are necessary for
every one dollar growth in GDP, such a contraction would lead to a
massive global economic slowdown directly reducing global growth by
almost 2 percentage points—before any second- and third-order effects.
3. The End of Debt-Fuelled Demand
The credit crunch is taking place against the backdrop of the long
term rise in consumer indebtedness in the United States. For years,
U.S. consumers have been living beyond their means. Between 1972 and
2008, U.S. consumer indebtedness, as a share of GDP, grew from 60
percent of GDP to 120 percent. Even when you exclude mortgage debt,
U.S. consumers are carrying more than $2.5 trillion in consumer
credit—up more than 50 percent from $1.6 trillion in 2000. Indeed, the
explosion in mortgage lending was, in part, driven by consumers using
the boom in housing prices to take on more debt in order to fuel
further consumption—on the theory that still-higher prices later would
pay for money borrowed today.
The wide availability of cheap debt was a key factor in fuelling the
growth of the U.S. economy—and to the degree that that economy has been
an engine of global economic expansion, that of the world economy as
well. U.S. household consumption accounts for an unusually high—and
unsustainable—70 percent of U.S. GDP. As a consequence, the savings
rate of U.S. households, barely above zero, has reached the lowest
level since the Great Depression.
But of course, it is not just consumer debt that has driven the
growth of the U.S. economy. During the same period, corporate and
government debt also grew, causing total U.S. debt to climb from 250
percent to 350 percent of GDP between 2000 and 2007. (By contrast, in
the 30 years between 1950 and 1980, total U.S. debt stayed between 125
percent and 155 percent of GDP.) Financial institutions used debt to
boost returns. (The top 5 U.S. investment banks, for example, increased
their leverage from 21x to 30x between 2000 and 2007 in order to
compensate for a sharp fall in their return on assets; this increase in
leverage allowed them to boost their total asset base from $1.5
trillion to $4.3 trillion.) In parallel, total U.S. financial sector
debt outstanding grew from $10 trillion in 2002 to $16 trillion in
2007. Corporations used debt to fund global expansion.
And of course the federal government increased its debt to increase spending while keeping taxes low.
But debt cannot grow faster than income forever. Now, both consumers
and financial institutions need to deleverage. The days of such extreme
debt-fuelled expansion in the U.S. economy are definitively over.
4. What the Crisis Means for the Real Economy
The combination of less available (and more expensive) credit with
stagnant or even declining demand will hurt even healthy companies.
Corporate financing decisions are typically driven by demand side
factors (e.g., economic growth, capital equipment replacement cycle)
and supply side factors (e.g., cost of money). In the current
situation, both are likely to limit new investment by companies.
On the demand side, unsustainable levels of consumer debt will put a
major dent in demand as people save more both to pay down debt and to
save for retirement. And in the financial sector, where the industry’s
share of total U.S. corporate profits rose from 10 percent in the early
1980s to 40 percent in 2007, de-leveraging will shrink returns
materially and reduce the sector’s contribution to total GDP. The
expected decline in demand and likely fall in capacity utilization will
cause companies to cut back on new investments in capacity and
expansion, stalling growth still further. It will also reduce their
need for external capital.
On the supply side, even those companies that want to invest will
find available credit scarce and more expensive. As financial
institutions focus on rebuilding their depleted capital base and
decreasing leverage, their appetite for making aggressive loans even to
creditworthy borrowers will decline. At a minimum, banks will
differentiate between the highest quality borrowers and everyone else.
The former (mostly large, diversified multinationals and some middle
market companies) should be able to get financing at relatively
competitive levels. Others will get financing selectively and at
significantly higher spreads than they have been used to.
The bottom line: we are facing a very tough environment and, (we
would argue), certainly a recession in many countries. The only
question is: how severe will it be? Some observers have argued that it
will be relatively short and shallow. They point to the relative
flexibility of the U.S. economy and the rapid intervention of the U.S.
government (in contrast to the passive role of the Japanese government
in the 1980s). So, if government intervention in the financial system
proves successful, and if the Fed continues to keep money supply at a
high level and interest rates low (thus helping U.S. consumers cope
with falling home prices, higher unemployment, and slower real wage
growth), then any recession could largely be limited to the United
States and a few other countries facing real estate issues. The rest of
the world economy would be only mildly affected.
In this scenario, the main issue companies will have to contend with
is the increased risk aversion and tighter lending standards of banks.
It might also take a while for confidence to return to the capital
markets. This scenario favours companies with stronger credit profiles
as they will still be able to raise funds not just from banks in home
markets but from global financing sources. They can also look at
acquisition opportunities supported by modest leverage. Having said
this, the cost of credit will be higher for most borrowers, and
therefore it would be prudent for all companies to look at their cash
flow from operating activities as a key source of ongoing financing.
However, we do not find the soft-recession scenario especially
credible. The International Monetary Fund (IMF) has studied more than
100 past recessions around the world, arriving at a clear conclusion:
recessions induced by financial crisis are deeper and worse. According
to the IMF these recessions tend to be "two to three times as deep and
two to four times as long" and, "leading to negative growth of 4.5
percent of GDP". In the current situation the overall high level of
credit, the real estate bubble and the highly leveraged consumers in
the U.S. are the main reasons to be worried. So, realistically,
companies need to be prepared for a serious recession. Firms have to
plan for a situation in which banks continue to fail, decline in
consumer demand persists, and developed economies—not only the United
States and the United Kingdom but also Ireland, Germany, France, Spain
and Japan—fall into recession. Although non-export growth in rapidly
developing economies (RDEs) will be, to a degree, protected, export-led
growth in RDEs such as China could be halved – or more.
So what are the likely specifics most companies in the real economy will face?
- No access to funds: Corporate treasurers face an increasingly
difficult environment for their short term financing needs. Given
record inter-bank borrowing rates, banks are deleveraging, scaling back
open credit lines and seeking to renegotiate lending terms with
corporate borrowers. The ordinarily liquid commercial paper market has
contracted by over $200 billion (11 percent) in just over three weeks,
and securitization of whatever asset class has become nearly impossible
meaning capital markets are effectively closed to most borrowers. Even
some blue chip utilities are currently unable to place new bonds in the
market. Companies therefore need to revisit their financing strategy
and make sure that they can refinance outstanding loans and secure more
credit if needed. In addition they need to close the funding gap (gross
investment less retained cash flow). Overall the funding gap of the
non-financial sector in Europe was 327 billion Euro in the second
quarter 2008. This will need to be reduced. For companies with weaker
credit, all this means difficulties financing even their working
Over the medium term, the $700 billion "Troubled Asset Relief
Program" (TARP) should help. Under this program, banks will be able to
sell illiquid mortgage assets to the U.S. Government. Not only should
this restore some market confidence in banks, it will also inject new
cash and free up their lending capacity. This, in turn, should
ameliorate the stress in corporate lending. But even if some measure of
confidence and liquidity returned to credit markets, banks will remain
highly conservative in their lending practices. They will compete
aggressively for companies with strong credit profiles - over time
bringing down the borrowing cost of such companies. But expect
companies with weak credit histories and high debt to continue to have
difficulty refinancing their debt except at substantially higher cost.
Additionally, significant uncertainty remains on the actual
effectiveness of TARP. Recessionary conditions are likely to worsen
consumer and commercial credit performance which will constrain
corporate lending by banks. Banks and investors could remain risk
averse for quiet some time preventing any meaningful change in credit
In Europe things are no better. At the time of writing, the
disjointed and inconsistent response of European governments has done
little to ease market worries
- Significantly higher cost of capital: Investors are asking for
hefty risk premiums across all asset classes. In particular credit
spreads have widened and will stay high for the foreseeable future –
with significant volatility. Even for companies with good credit, this
means higher borrowing cost, e.g., the discount rate for investment
grade borrowers has spiked to ~600 bps for 60 days maturities. The
conditions for longer term borrowing are no better. The yield spread on
investment grade corporate debt has widened to a record 487 bps.
Currently companies with a BBB rating pay around 8 percent p.a.
(comparing to 4-5 percent in 2006), while the spreads on some high
yield debt are at 1200 bps, the highest in a dozen years. Under any
scenario, we will not return to the overly cheap debt pricing that
prevailed pre-crisis, when credit spreads had fallen near or to
all-time lows, e.g. to only 250 bps even for junk bonds – which by the
way now require spreads of more than 600 bps over treasuries.
- Weak stock markets: Low valuations (DJIA, S&P 500, FTSE, DAX
and other major indices are down approximately 30 percent for the year
with e.g. the S&P 500 being at its lowest level since October 2004)
make it less attractive and much more difficult to raise new equity.
Companies will be forced to tap alternative funds, e.g. PE firms or
major investors. But: this will be extremely expensive as well. Just
consider the case of Goldman Sachs which agreed to give Warren Buffet
$5 billion of preferred stock paying a guaranteed annual dividend of 10
percent at a discount together with an option on another $5 billion of
stock which is already in the money.
- Bonus for cash: Until the autumn of 2007 companies were under the
risk of being attacked by activist shareholders/PE funds if they had a
significant cash position on their balance sheet. These investors
pressed for special dividends or buy-back programs. The contrary holds
true today: companies get a "safety bonus" for having a solid cash
position. Companies like the Dutch chemical group Akzo have already
suspended buy-back programs and decided to use the funds to pay down
debt. This will be the norm in the coming years.
- Reduced cash flow: All industries and companies will be affected by
the worldwide slowdown. Volumes and prices will come under pressure. We
believe growth will be substantially below the long term trend and turn
negative. Most companies should therefore plan for significant volume
reduction (up to minus 10-20 percent) and additional price reduction
(of between minus 0-10 percent) in their markets.
- Credit losses: Companies who finance their customers will see a
major jump in credit losses because of bankruptcies. This holds true in
particular for consumers but also for industrial customers. Economists
expect default rates on U.S. credit card debt to rise sharply over the
next 12 months, followed then by loans made for electronics and car
purchases. Companies will need to manage much more aggressively both
the extension of credit facilities and their receivables. Remember: in
god we trust – all others pay cash.
- Significant balance sheet risks: The deleveraging by definition
leads to asset price deflation, i.e. assets become cheaper. For
example, U.S. house prices have already fallen approximately 20 percent
and have to fall further if they are to revert back to historical
levels. Asset price deflation does not only pose a major risk for banks
and insurance companies but also for industrial companies. For example,
intangible assets, especially goodwill from acquisitions, could be
devalued. Under current IFRS rules companies have to do an impairment
test every year. This test could lead to reduced values due to lower
cash flows and higher cost of capital. Since impairments of intangible
assets directly reduce book equity, even several blue chip companies
face the risk that their entire equity gets wiped out if they need to
write off their intangible assets.
- Bursting of the profit bubble: Profits as a share of GDP are at all
time highs in the western economies. In Europe profits are currently 40
percent above trend. Experience shows that an "overshooting" beyond
trend, is followed by another below trend. This will mean significantly
lower profit levels for the years to come. Companies should therefore
not expect a return to pre-bubble levels until the next bubble (and
this will come once the generation that experienced the real estate
bubble in the U.S. has moved on).
- Continued volatility: One silver lining is the likely easing of
pressure on commodity prices – although we expect to see continued
volatility. Current markets have seen oil price swings of more than 40
percent within 6 weeks, the dollar appreciating/depreciating more than
5 Euro Cents a day, raw material prices showing major jumps. Although
we agree that longer term we will see increased raw material prices,
the major deleveraging will lead to big swings and unexpected events in
the short term. For example, one could currently expect the US-Dollar
to depreciate given the major debt crisis in the U.S. But in reality
there were so-called carry-trades, investors who had taken out loans in
US-Dollar. Now they need to repay – and buy Dollars. This does not
imply that the Dollar might not depreciate significantly in the mid
term. But companies have to pay substantial attention also to short
term movements in the current environment and hence be flexible in
their purchasing strategies.
- Protectionism: So far we have seen no visible trend to reduce trade
freedom. But this is likely to come when the recession deepens. It will
become more difficult to export. And companies shifting production to
low cost countries might face issues in re-importing the products.
Politicians like Democratic presidential candidate Barack Obama are
already asking for trade restrictions.
- Wave of industry consolidation: We will see either a wave of
bankruptcies in nearly all industries – or a big increase in
"restructuring mergers". The banks have started this way; it is likely
to happen in other industries as well. Companies do not only need to
investigate and secure their own financial situation but also that of
- More government intervention: We do not believe that the TARP
program is the end of the crisis. It might soften the pressure for a
few months, but it cannot stop the deleveraging and the need for
households in the U.S., UK, Spain, Ireland, France, etc. to restore
their finances. Governments will implement measures to support demand,
e.g. infrastructure investments. Be prepared to see similar measures as
during the "new deal"-policy of President Roosevelt. If you have ever
driven the Route 1 from Monterey to Carmel you will see a lot of
bridges: all these bridges were built in the 1930s…
- Re-regulation: In all industries, not only in banking, we will see
more government intervention. The liberal, free market times will be
restrained for the foreseeable future. Although too detailed for this
paper, the failure of the Regulatory Authorities to manage the
burgeoning bank risk is one of the most salutary lessons from this
- Change in consumer behaviour: Saving will be more attractive than
consuming. Many of the trends we have seen in the past, like trading
up, luxury etc. will be stopped or reversed for many consumers – so
companies must not simply extrapolate the trend of the past 20 years.
The first signs of this are already clearly visible: consumer sentiment
indices have fallen sharply around the world, e.g., in the U.S. by more
than 30 percent from their peak in 2007. Across the High Street, retail
sales are falling, particularly in "non-essentials".
- Every industry will be affected: It is already visible which
industries are affected, but more will be. Banks, insurance and real
estate companies are the most visible ones right now. Retailers are
suffering as customers respond to the bad news with an instant belt
tightening. Theatres, bars and restaurants are reporting a fall in
demand. Companies producing durable consumer goods will be hit hard (as
the automotive industry shows), next will be companies producing
machinery and equipment. For example, German industry overall already
reports a big drop in new orders, with printing machinery producers (a
traditional early indicator) already under severe pressure. But also
"safe" industries will follow. In France the sale of yoghurts has
fallen this year, partly due to a shift to lower priced private labels,
partly due to lower demand. Industries like health care and utilities
will be affected by more regulation and cost saving efforts from public
- A sidebar of good news: The enormous losses described in this paper
are mostly provisions rather than actual realised losses. The
accounting conventions, most notably "mark-to-market", require banks to
carry their investments at market value. In illiquid instruments,
market upheavals can drive down the value of these instruments
dramatically – and out of all proportion to the value that would be
realised if held to maturity. This means that over time the banks
should be able to write back some of their provisions, partially
repairing their capital position. However, this is some time away.
Secondly, the U.S. has actually responded quickly – and in spite of
criticisms, remains the world’s most flexible economy. So unlike Japan,
where dead banks were propped up for years, the U.S. has acted quite
quickly and decisively. In the broader economy, the flexibility of the
labour force means that the painful adjustments can be completed
quickly before growth is resumed on a more prudent basis.
5. How to Deal with the Difficult Times Ahead
Many executives wonder what all of this means for their companies
and which areas now require their special attention. In our view,
companies need to focus on 16 key measures:
- Watch your cash: Install a tight cash management system, reduce and
postpone spending and focus on cash inflow. Have a weekly report on
your cash position and the mid term development based on expected
payments and receipts.
- Reduce trade credit: Customers will try to rely more on trade
financing – but the risks will be too high. Therefore segment your
customers and be directive where you invest.
- Start working capital initiatives: Most companies have poor
processes to monitor their working capital. So it comes as no surprise
that the potential savings from optimizing a company’s working capital
can be substantial and easily reach $1 billion and more for larger
companies. As a rule of thumb, most manufacturing companies can achieve
an additional cash flow of approximately 10 percent of sales from net
working capital optimization.
- Restructure your debt: Secure financing as long as you have access;
reassess dividend and buy-back policies. Look for additional funding by
SWFs or cash rich investors. Leverage ratios have to be conservative.
- Develop a stress test scenario: How would a recession affect your
businesses? Take worst case scenarios (like minus 20 percent volume,
minus 5 percent price) and define countermeasures. Identify early
warning signals for a deterioration of the situation. Simulations show
that even for many currently still very healthy companies with EBIT
margins of around 10 percent a sales drop of 20 percent is sufficient
to turn their profits into huge losses and to send their cash flow deep
into the red.
- Act now on cost and organisational efficiency: Implement all those
measures today which can be executed without risking major
opportunities – in case the recession does not develop as we think.
Delayering and lowering of break-even points is always right! Use the
external market turbulence to justify significant transformational
- Reassess your investment program: Michelin, the French tire
manufacturer, just stopped a major investment program in Mexico. In
most industries capacity will not be scarce in the coming years.
Instead look for consolidation mergers (see below). U.S. capacity
utilization just fell to 78.7 percent and will probably fall even much
lower. Compared with the long term average of 81.0 percent from
1972-2007, there is currently more than enough capacity existent in
most industries and no need for further investments.
- Re-evaluate off-shore manufacturing: The economics of off-shore
manufacturing can change significantly with changing trade directions
(e.g. less U.S. imports) and trade barriers.
- Adapt product portfolio: Purchasing behaviour will change in the
recession. Luxury goods will be used "at home" and less so in a visible
manner. Consumers will shift to lower price alternatives, e.g. private
labels. In the 1930s, there was a huge trend towards cheaper, canned
food in the U.S. A recent example is the 1$ menu of McDonalds which is
highly successful right now. At the same time, GM is about to sell its
Hummer brand while pumping enormous resources into the new Chevrolet
- Look for out of the box pricing: Customers will not be in a
position to pay as before, some might be under financial pressure. In
this context alternative ways of pricing should be considered. It was
during the Great Depression that GE developed its innovative strategy
to finance its customers’ purchase of fridges.
- Divest non-core businesses: companies should not wait for "better"
times to sell non-performing/non-core assets. As BCG research shows the
market reaction to divestitures is very positive, also in recessionary
times. And there are still buyers around. 70 percent of the respondents
in BCG’s recent M&A survey say that disposals, spin-offs, and
demergers are currently a good means to focus the business.
- Engage in selective M&A: The best deals are made in downturns –
this is also shown by BCG research. Downturn merges generate about 15
percent more value – measured as Total Shareholder Return (TSR) –
compared to boom time mergers which on average actually exhibit a
negative TSR effect. This is the best time for consolidation and cost
mergers. Therefore install a close monitoring of your target companies;
especially their financial health.
- Manage financial policies and investor messaging: Some of the banks
have been hit extremely hard because investors did not understand how
toxic or how safe their assets were. In addition, share buy-backs,
dividend policy and TSR management need even more careful attention.
- Look for opportunities: The recession will change many of the
long standing "rules of the game" in many industries. Use the weakness
of your competitors to redefine your industry. An example is the highly
attractive price Citigroup wanted to pay for Wachovia (only $2.2
billion), so attractive that Wells Fargo has stepped in and is now
offering $15.1 billion. This shows that highly attractive deals can be
struck these days.
- Install a crisis monitoring team: A core team should monitor the
key early warning indicators, the development of scenarios, the
competitive landscape and the implementation of measures.
- Plan for the upturn: investments made now in R&D, IT or new
infrastructure by strong companies will only come on stream once the
recession is over. And the cost of these investments will be
correspondingly lower during a period of less competition for resources.
Companies taking these measures will not only be better placed to
master the current turmoil and the likely recession – they will also
have a substantial opportunity to take advantage of the changing
environment, emerging ahead of the competition as the current crisis