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March 29, 2007

Spring Doesn't Bloom for Homebuilders
by Chad Hudson

Evidence continued to pile up that the housing sector remains in turmoil. There was a brief reprieve last week as the National Association of Realtors reported that existing home sales unexpectedly jumped 3.9% to 6.69 million annualized units, surpassing estimates by 39,000 units. It was also the highest number of existing homes sold since last April. The median price dropped 1.3% compared to last year, which was the seventh consecutive month of year-over-year price declines. Existing home inventory jumped 6% to 3.748 million homes, almost back to the record levels reached last summer.

New home sales in February were a completely different story. Sales of new homes dropped 3.9% to an annualized 848,000 units. Additionally, sales during the previous three months were revised down by a cumulative 172,000 units. The West was the only geographic area where sales increased. The number for sale increased by 1.4% to 546,000, which pushed the months supply up almost a full month to 8.1 - a level not seen since January 1991.

This week, Lennar reported first quarter earnings of $0.43 per share, which included a charge of thirty-six cents per share and a gain of $0.70 per share. Excluding all that, the company earned a dime per share, substantially lower than the $1.58 earned last year. Wall Street was disappointed in with the 29% drop in orders (Credit Suisse was expecting a 2% drop and they are one of the larger bears on the group). This has pushed backlog down 51% in units and 54% in dollar value. Incentives increased to 13% of the home price from 4% last year, but down marginally from last quarters 13.5%. In late January, when Lennar reported fourth quarter results it said, "if the current environment of strong employment, low interest rates and a healthy economy continues, and the market for new home sales demonstrates traditional, seasonal improvement, we will meet or exceed our 2006 earnings of $3.69 per share." Its tone has changed over the past two months. During its conference call this week the company offered the following commentary (sorry for the length, but it offers a good assessment of the market through the eyes of one of the largest builders):

Let me begin by saying that these are difficult times for the homebuilding industry. We have recently completed our quarterly operation reviews with our division management team and based on these extensive business plan and execution reviews, I can say first-hand and with certainty that market conditions are very difficult across the country. As I listen to many of the leaders in the industry speak - that is our competitors - and as I listen to economists and analysts and investors, the message is becoming very unified and that is although we see some sporadic indications of firming in some markets and we all look forward to seeing a firm foundation from which we can build forward, the reality is that market conditions are still challenging at best and in some markets continuing to deteriorate.

Simply stated, the supply of homes available for purchase has continued to climb while demand has been sharply reduced. On the supply side, the market, once driven by speculative build-up in demand and purchases that over the past years spurred more recent build-up in inventories, supply from speculators then put -- increased supply as they put the homes back on the market and created a supply overhang and an overall climate of customer caution. On the demand side, the investor/purchaser part of demand has all but evaporated. Primary purchasers are either on the sidelines or demanding better pricing before purchasing, and because of the rapid deterioration of the subprime lending market, an additional component of demand has now been sidelined because of the inability of a customer to qualify for a mortgage or because the purchaser of a customer's home needed for closing cannot qualify.

What is clear is that supply and demand have shifted and are continuing to shift in many markets more rapidly than expected, and the inventory overhang will have to be absorbed before conditions normalize. This is not new information. There remains a sizable amount of work to be done before our markets find an equilibrium. This also is not new information. What is new information is that we have not yet seen evidence that the much anticipated winter-spring selling season has yet kicked in.

Home pricing is continuing the process of being recalibrated in many markets through the use of incentives, brokers' commissions, and price reductions, and the industry is continuing to be challenged to adjust home prices and land values as well. This recalibration process has not yet stabilized. Furthermore, it's unclear today whether there is another shoe to drop. Questions remain as to whether the economy will weaken in a housing-led recession or perhaps the supply and inventory overhang will be exacerbated by the resetting of mortgage rates on the many adjustable rate mortgages that have fueled the market over the past years. Rate adjustments are creating payment stress concurrent with home prices falling and equity evaporating. On the other hand, the liquidity that exists in today's financial market is a real wildcard and could be a critical mitigating factor, alleviating negative market forces and restoring balance.

While there has been some realization that home sales might come under additional pressure due to the problems in the subprime market, there has not been any discussion on whether it could lead to a structural change. Prior to the recent surge in residential housings, home ownership rates in the United States hovered around 64% since at least 1965. It peaked in 1979 at 65.8% and slid to 63.8% in 1988 before recovering. As the stock market boomed, the number of homeowners grew as well. From 1995 the home ownership rate increased from 65.1% to 67.5% in 2000. However, as the stock market fell, more people bought homes with the ownership rate peaking in 2004 at 69.2% and has since declined marginally to 68.9% at the end of last year. Last week, we discussed the rapid growth in subprime and Alt-A mortgage originations. It is certainly more than coincidence and as the subprime market becomes rationalized, there will likely be downward pressure on the home ownership rate. With over 109 million occupied homes, every 100 basis points drop in ownership puts over one million homes on the market. There is a combined 4.3 million new and existing homes on the market. Going back to historical ownership rates would essentially add a similar number of homes that would need to be absorbed.

As the housing market has stumbled over the past several months, the rest of the economy has remained stable. This has started to change over the past month or so and data released over the past week confirmed that the economic backdrop has started to weaken. Consumer confidence fell four points to 107.2 in March. The drop was entirely due to consumers expectations, which fell 6.9 points to 86.9. This was the lowest level for the expectations component since August 2006. While the present situation marginally improved, the labor differential (the percent that views jobs plentiful minus those that believe jobs are hard to get) rose to 11.4, the largest differential since August 2001. It is difficult to say that consumer confidence is weak; after all it's just four points lower than the five-year high set last month. But there are growing indications that economic growth is on dangerous footing. One of our biggest concerns has been that due to the amount of leverage on the household balance sheet, any slowdown in consumer spending will accelerate quickly. While the subprime mess will likely have larger fallout than most economists are forecasting, it's the Alt-A market that bears attention. If that market comes under pressure, that will likely be the straw that breaks the camel's back.

Chad Hudson
Mid-Week Analysis
PrudentBear.com

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