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INC.: But the rages have quieted down. The energy and farm sectors recovered to a large degree, and stocks retraced a good portion of their drop. Now, it looks like business as usual.
SALVIGSEN: It depends on what you mean by usual. One of the market's messages in October was that inflated profitability in the consumption and service sectors is unsustainable. Excessive debt and debt service will bring the curtain down on the consumer goods and service sectors as well. Blaming the October affair merely on program trading and portfolio insurance is like blaming the sacking of Carthage on Hannibal's elephants.
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INC.: The odd thing is, it seems to have been the deep pockets of consumers that stemmed the stock panic and kept business strong -- from new-car sales to upscale yogurt. Obviously, there still are a lot of spenders.
SALVIGSEN: Judging from the activity we see in acquisitions and LBOs in the luxury-goods group, it strikes us that the market is making its usual dangerous assumptions that any anomaly, if it persists long enough, can be embraced as a new standard of normalcy. Half a million dollars for a house in New Jersey is not the new standard. Urban real estate is another sector in danger of collapse.
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INC.: You mean our own homes? What are the signs?
SALVIGSEN: Real estate is the major collateral behind most of the debt out there. Second mortgages have become a widespread means of consumption financing. As debt becomes liquidated -- as we think it will -- the prices of houses behind that debt have to come down. For Sale signs start sprouting up and down the street. It hasn't happened yet in the Northeast, and things are still crazy in California, but there's a high potential for real estate cracking. Look at foreclosures, with a spike where we are right now. And if you plot delinquencies on mortgages, it would look about the same. Real estate owned by banks other than their own premises is exploding. And in the past two or three years, the number of cities in which the average price of homes has turned down has been increasing.
INC.: What would you do if you owned a house that had appreciated by eight- or tenfold, as many have?
SALVIGSEN: If I owed $400,000 on a $600,000 home, I'd sell it and ask the new owner to lease it back to me. Balloons and second mortgages are very dangerous. If I had two homes, I would sell one immediately without a doubt. Of course, you wouldn't do it in Houston, where houses already have crashed.
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INC.: Since it's already happened in Houston, can you take us through the process?
SALVIGSEN: What happened there is when the price of oil went up, it pulled wages up. The person earning the wage goes into the bank, and the bank qualifies him for a lot more loan -- some multiple of his annual wages is now considered safe to lend to this person. So his potential spending power increases as his wage goes up, and that bids up the price of houses. Inflation is credit based, as we see it.
In this case, the credit that was loaned to the wage was tied to the price of oil. Then when the price of oil cracked, it reversed the process. And also deflated the value of the real estate. The only thing it didn't deflate was the loan that was owed. So there goes the home.
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INC.: For many small-business owners, most of their personal net worth is their business. Should they be concerned with their companies as well as their houses?
SALVIGSEN: Especially if they're leveraged. They've got to have something invested for the downside. Invariably, it's leverage that forces people to do the wrong thing at the wrong time. In a recession, there are always guys with perfectly good businesses trying to hang in for one more quarter, but the creditors say sorry, we can't carry you anymore. It seems prudent here to get your business in shape so that during hard times, you're not forced to lose it.
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INC.: If you were a small business and had debt on your balance sheet, would you try to clean it up?
SALVIGSEN: It would depend on what industry you're in, but growth in general for everybody will be something less than currently expected. What we have seen from each of the major accidents in the past six or seven years is that somebody should have said early on, "I'm willing to sacrifice growth to get rid of some of this debt, because if the growth doesn't materialize, I'm dead." The realities of the marketplace are that most of the restructurings take place after you get caught. It seems to be the seizure of assets that sobers people up. They don't change their attitude until they get caught. They will borrow as long as nothing goes wrong.
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INC.: It would take a courageous chief executive officer to do otherwise. Since his function is to keep growing, turning conservative always has to happen after the fact.
SALVIGSEN: That's why it's peculiar advice. We give it, and we know only a very small percentage will take it. Particularly when you see competitors come in and take market share, using leverage to do it. Then you feel if you don't borrow, you'll get squeezed out.
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INC.: If you owned a plant, would you sell and lease back?
SALVIGSEN: It depends on the region. If you were in Texas or Louisiana or some other place that already had had a 40% haircut, you'd probably be better off buying. But if you're in a region that has been unscathed, yes, I'd do that. It makes sense for businesses to do some selling of tangible assets and invest the capital in something that benefits from our scenario of rapidly declining rates.
