August 23, 2007 - At mid-2007, the mounting turmoil in the financial and credit markets has raised concerns about the impact on the construction industry.  During July and August, the financial stress widened – not just affecting subprime mortgage lenders, but also lenders engaged in more mainstream lending, as well as the stock market.

In August, the fears of a credit crunch picked up substantially, and the Federal Reserve took quick action to shore up liquidity – first by injecting billions of dollars into the U.S. financial system to keep the effective federal funds rate at 5.25%.  The federal funds rate is the rate on overnight loans between banks.  The Fed then lowered the discount rate from 6.25% to 5.75%.  The discount rate is the rate at which banks can borrow directly from the Fed, which under more normal conditions they do rarely, since it may be viewed as a sign that a bank is struggling to raise funds from other sources.  This reluctance seems to have been put aside for the moment, as the four largest U.S. banks (Citigroup, Bank of America, J.P. Morgan Chase, and Wachovia) borrowed $2 billion from the Fed, in a move to help encourage other banks to use the discount rate window.

The action by the Fed shows that it is willing to step in to keep the credit crunch from spiraling out of control.  In its statement following the discount rate move, the Fed indicated that the “downside risks to growth have increased appreciably,” and the Fed will act “to mitigate the adverse effects on the economy arising from the disruptions in financial markets.” A drop in the federal funds rate is now much more likely to take place in the near-term.

Just how severe the credit crunch will be is unclear, but other credit crises in 1987 and 1998 were contained by actions from the Fed.  The impact on the construction industry will be negative, but it will also be varied by major sector.

• The correction for single family housing will be deepened and extended by the current financial stress.  Mortgage availability has been diminished for prime borrowers and those needing “jumbo loans” (greater than $417,000), which will further dampen homebuyer demand.  While single family housing. construction had been expected to show some improvement by mid-2008, that period of strengthening activity has now been pushed back to 2009.  The two-year (2006-2007) decline for single family starts will now be 38% to 40%, with starts down another 3% to 5% in 2008.

• The commercial project types will also be affected negatively, although to a lesser degree than single family housing, with the impact becoming more discernible in 2008.  The year 2008 was already expected to see weaker activity – down 6% in value and 10% in square footage, and these declines may now be 10% to 12% in value and about 15% in square footage.  The cushioning element here is that market fundamentals for the moment are still relatively healthy – office vacancy rates retreated further in second quarter 2007, hotel revenue per available room (revpar) is still rising in 2007, etc.  Marginal projects will be deferred, but projects with sound financials are still likely to go ahead.

• The impact on the institutional structure types will be muted and may not show up until 2009, since much construction here is the result of money already raised through the bond market.  State and local finances are expected to weaken over the next year, but at present they are still relatively healthy, which supports the institutional structure types such as schools.

• The impact on the public works market will also be muted.  Transportation projects are being helped by this year’s 10% increase in the federal-aid highway program.  The renewed attention being directed at infrastructure repairs in the aftermath of the I-35W bridge collapse in Minneapolis will offset a push next year for spending restraint.  The environmental categories. (sewers, water supply, levees, etc.) are showing strength in response to either the need for infrastructure work or U.S. EPA mandates, and will only be modestly affected by the credit crunch.

Overall, total construction starts in 2008 had been expected to edge up 2% in current dollars, following a 6% decline this year.  With the credit crunch further weakening single family housing and dampening commercial building, it is now likely that total construction starts in 2008 will see a current dollar decline of about 3%.