Catch-22

Many of you have been asking for an update on the Florida housing scene from Mike Morgan at Morgan Florida. Although we chat several times a week, it has been hard to come up with a new angle, given the steady deterioration in things. Hopefully, the following post accomplishes the mission. It is an attempt to look at things from the perspective of the homebuilder rather than the homebuyer, with a brief preliminary discussion on stock prices. Here goes…from Mike Morgan:

“Chicken Little

“I’ve been receiving quite a few calls regarding the surge in homebuilders’ stock prices. Well, first off, I am not a financial adviser. My research and consulting services are purely information for the end users to incorporate into their financial analysis.

“I think that what’s going on nationwide in housing will affect the country to levels we have not seen since the Depression. Some of you may be equating me with Chicken Little. After all, Cramer is bullish on the homebuilders and so is Bill Gates. Well, it’s not Bill Gates making the call. It’s his financial advisers that run the foundation that are making the call. Second, even if it were Bill Gates, he’s been wrong more than right for the last few years. Bill Gates is not Warren Buffett. As for Cramer, I have no comments except to say that his show speaks for itself. I think you can read between the lines. Finally, the market seems to have bought into the ‘Goldilocks’ soft landing theory. Well, housing has never seen a soft landing ever, and I fail to see how this time can possibly be different, given the affordability problems and the disparity between housing prices and rents — not just in Florida, but pretty much nationwide. With that comment, let’s now turn our attention to the situation facing the homebuilders.

“Catch-22

“Following are the three business strategies builders are using to survive the downturn in home building:

“1) Reduce Inventory

“Housing inventory is at the highest level we have ever seen since the beginning of time, and growing daily. Back in early 2005, Centex was the first to realize the market was in trouble. It quietly contacted real estate agents and offered double commissions and huge discounts on inventory that would close prior to their fiscal year end of March 31, 2006. As this program grew, the other homebuilders initially ridiculed Centex, but in their own board rooms, they quickly started cooking up competitive discounts, incentives, and commission bonuses. Now it’s a free-for-all to see who can leap-frog the other on the way down, and who can get more creative with incentives. The Catch-22 here is simple. Margins after all of this nonsense are approaching zero for most builders, and the madness has not stopped. But if builders don’t dump standing inventory now, they will have heavier losses if they continue to carry these homes and watch prices further deteriorate as the competition drives prices down further. Catch-22

“2) Monetize Land

“As if standing inventory were not enough of a problem, builders have two additional problems. First, they have land, some of which is entitled and improved. Second, they have thousands of projects that are already started, with roads, sewers, and utilities already in place and paid for with lots of debt. They might be able to walk from land options and land that is not entitled, but it is not very easy to walk away from land that is already in the development process with billions of dollars of debt tied up.

“If the builders move forward with the developments, they are further increasing inventory. If they don’t, they face problems with carrying costs of entitled land or shutting down a development that has already started. But carrying costs are not the only problems builders face. If they have already started the development, they most likely have a time frame with the local government to complete the build out. Some local governments require builders to post a bond insuring the completion of developments. And how many homes do you think a builder can sell in a ghost town of a few spec homes? People want to live in a community, not a construction site.

“Thus we have the second Catch-22.

“3) Scale Back

“One would think this is the smartest option. When demand drops off, it is usually a good time to cut back on supply. But if the builders scale back, that means lower numbers for Wall Street. We’d see lower starts and lower sales and lower revenues and lower profit. Oh, almost forgot the ‘bonus factor.’ We’d also see lower bonuses to the top dogs who greedily reaped in tens of millions of dollars each during a market fueled by irrationally greedy speculators that essentially had nothing to do with their business acumen or experience.

“One top builder has already announced it plans to continue building so it comes out of this as a volume leader and capture branding. It’s losing money on each sale, but it’ll make it up in volume? That’s pretty expensive branding. Once again, we have a Catch-22. If the builders scale back, Wall Street will not see the numbers it wants to see. If the builders don’t scale back, Wall Street will see some numbers, but the increase in inventory will complicate the problem with lower prices and bottom-line losses will be the only numbers Wall Street will see.

“Book Value

“In addition to the three Catch-22 issues, Wall Street seems enamored with the low book values of the builders. I’ve got news for you. The book value numbers for this group are as misleading as a deaf and blind Seeing Eye dog. We’ve seen a few builders take write-downs on some land, but if you crunch the numbers, it’s crystal clear that these write-downs are not enough.

“Homework

“Look at D.R. Horton’s (DHI) recent write-down in comparison with its land position. Look at Lennar (LEN) and the other builders referenced in the informative piece appearing in the Oct. 2 issue of Barron’s. Think about WCI Communities (WCI) and Brookfield Homes (BHS). Is their land old land with value, or is it relatively new land that they paid top dollar for? Finally, take a look at what happened to Kara Homes in New Jersey. A large regional builder that choked on its land and inventory. Choked right into bankruptcy.

“This is where it gets tricky. It’s not easy finding out at what prices, where, and when the builders purchased land and/or options on land. For land purchased prior to 2000, the book value will most likely hold. For land purchased in 2005 or later, these guys are in trouble, and much of that land is probably worth 25-50% less than what they paid. For land purchased between 2000-2004, there is a gray area as to what the land is worth. The bottom line when it comes to land is that builders bought land just like the flippers bought their preconstruction homes. Price was a secondary issue. The primary concern was getting entitled land.

“The crash of the housing industry is only now getting started, as it will spread virally to all of the boats it floated during the rising tide. Housing has touched every single segment of our economy, and it will darken all of those segments as the industry collapses to the worst levels we’ve seen since the Depression. The NAR and other groups producing numbers have been great cheerleaders, but when you’re pumping out misleading numbers, I don’t care how beautiful or loud the cheerleaders are, the situation is a no-win Catch-22 for the homebuilders no matter how one looks at it.”

Thanks, Mike.

I find it interesting to see yet another Catch-22.

Please compare and contrast “NAR Thinking Big for ’07” with “2006 Subprime Loans Doing Badly.”

“Thinking Big” outlines additional (and unwarranted) handouts the NAR wants from the Democrats, including:

• Subsidized flood and hurricane insurance
• Eliminate the FHA’s 3% down-payment requirement
• Raising the cap on loan terms to 40 years
• Getting the “FHA and Fannie Mae and Freddie Mac back on track and working in every state.”

Following is an additional snip from the article:

“Lereah called the big Democratic congressional win a ‘positive turn.’

“‘From a regulatory perspective, I think it’s great,’ the economist said. ‘The Bush White House, a White House that has been pro-banking, not pro-real estate, has been declawed.’

“As he sees it, the GSEs have “had their hands tied behind their backs” while the administration and Congress battle over which agency will regulate the agencies and how to control the growth of their retained portfolios. But not for much longer.

“‘Now I see something different,’ Lereah said. ‘They will get a tough regulator, but they will be able to participate in a robust way once again. That’s very good for all of us.’

“The NAR senior vice president also called on the group to take a leadership roll with regard to housing policy.

“‘We are the biggest association in America and I think the most powerful,’ he said. ‘We should develop our own housing agenda and lead rather than follow.’

Lereah Is a Loser

The policies Lereah espouses are the very same policies that made housing unaffordable in the first place: an ownership society promoting housing, subsidized insurance, decreased lending standards, and unmitigated growth in GSEs. I see four policies attempting to make “housing more affordable” all doing the exact opposite. Now Lereah’s solution to the problem is the same solution that led to the bubble in the first place.

While pondering that idea, please consider “2006 Subprime Loans Doing Badly”:

“Subprime loans — or loans made to borrowers with less than perfect credit — from 2006 aren’t just performing badly. The loans, in particular those used to back mortgage bonds, could prove to be one of the worst performing groups yet, according to UBS.

“In a conference call titled ‘How Bad Is Subprime Collateral?’ Tom Zimmerman, head of ABS research for UBS, and David Liu, head of mortgage credit, discussed how much higher loan delinquencies and foreclosures are for 2006 subprime loans compared with similar subprime loans from earlier years — the result of deteriorating underwriting quality from lenders combined with a slower housing market.

“Still, despite the adverse conditions, ‘I guess we are a bit surprised at how fast this has unraveled,’ said Zimmerman. While it’s ‘not a secret that subprime collateral has performed pretty disastrously so far,’ he said, ‘I must say we were a bit surprised by the magnitude with which’ the loans ‘deteriorated this year.’

“The rate of subprime loan delinquencies of 60 days or more — meaning borrowers are that far behind in their payments — has climbed to about 8%, up from about 4.5% a year ago.

“These 60-day-plus delinquencies jumped up fairly sharply in the past few months, to 3.63% for the 2006 loans in October, up from 2.95% in September and 1.62% in July, according to UBS research.”

The Ultimate Catch-22

Lereah is, quite simply, a huge part of the problem, and zero part of the solution. Anyone who wants a house already has one or cannot afford one. Looser lending standards will have a negative impact on both writeoffs and affordability.

In the long term, what is sorely needed is an enormous housing bust to deal with affordability issues as well as to put a final end to the credit bubble we are in. But that will eliminate some of Lereah’s perceived power and, arguably, all of his credibility, so he cannot go along with it. Instead, he promotes the policies that got us into trouble in the first place.

Regards,
Mike Shedlock ~ “Mish”
November 28, 2006