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October 08, 2007

Homebuilders in Desperation
by David Shvartsman

If you've been keeping an eye on the news in the U.S. at all these past few months, you know that the situation in housing has continued to deteriorate, despite the much too early bottom calling from industry spokespeople, vapid "economists", and the media's talking heads.

We've reached the "bust" portion of this particular boom-bust cycle, and with each passing week there are new stories to fill in the picture of the real estate market's decline.

Which is where this next story comes in. From Bloomberg, "Homebuilders Liquidate Assets in Desperation Sales".

D.R. Horton, with annual revenue of about $11 billion, and Hovnanian Enterprises Inc. now face the worst choice in the worst residential real estate slump since the 1930s. They're selling homes at any price they can get.

"It's desperation time and some companies may not make it," said Alex Barron, an industry analyst at Agency Trading Group Inc. in Wayzata, Minnesota. "At this point in the housing cycle, if you have too much debt, it's hard to get out from under it."

Homebuilder profits depend on the cost of land, said John Burns, president of John Burns Real Estate Consulting in Irvine, California. Companies can still make money building on land purchased before the 2005 peak of the five-year U.S. housing boom, though price declines of as little as 10 percent might wipe out those profits, he said.

"They are all losing money," Burns said. "They'll talk in terms of gross margin and it sounds like they made money, but they actually lost money because they didn't make their costs."

As the article points out, many of the largest homebuilders are saddled with significant debt and are generating cash from one-time deals, like selling mortgages, discounting, and cutting back on land purchases. According to data from the credit-default swap market, the companies' bonds currently trade "as if they were junk".

Why are conditions so bad? Here's a bit of an economic backdrop to this market drama, courtesy of an earlier Bloomberg piece on sluggish home sales:

Real-estate sales and prices are likely to keep falling after borrowing costs rose and mortgages became more difficult to get last month as defaults on subprime loans increased. Lower home values and slower job growth have the potential to undermine consumer sentiment and spending, economists said.

"Bloated inventories, declining prices and sluggish demand continue to overshadow the housing market," said Christopher Low, chief economist at FTN Financial in New York. The current situation "can be very unsettling to consumers."

That's why many of the leading homebuilders have jumped in and started slashing prices on their already built "product". This merchandise has got to go, preferably before the suckers start seeing new, lowered home prices printed out in black and white.

I'm reminded of a video I watched a couple of weeks ago, in which Hovnanian CEO, Ara Hovnanian was spinning away at a Bloomberg interviewer's suggestions that the company's fire-sale of newly built homes was an act of desperation. "Oh, not at all", he said. It's simply a matter of cutting down the price of a little excess merchandise.

He also added that the housing market was "very near" a bottom. What a salesman.

But what was really going on was that Ara Hovnanian's company wanted to be the first to the door when it came to cutting prices, because they knew the industry as a whole would have to follow. It's just common sense, as pointed out by Jim Rogers when the same Bloomberg interviewer put the question of Hovnanian's discount strategy to him.

Keep your head on straight during all of this. If you're letting the media turn your head and influence your thinking on this topic, then you're probably not thinking at all. Here's a quick story to illustrate my point.

I have a friend who recently sold his condo and is now looking to buy a house (he is living in a rental house for the time being). The only problem is that asking prices are still quite high for many of the homes he is looking at (he is a young professional, and is not looking at anything extravagant for his area at all).

He told me this week (as we drove around looking at some of these homes) that he had recently attended a gathering, where he had a conversation with someone about the housing market.

When the guy he was speaking with found out that my friend was patiently trying to wait out the almost-inevitable further decline in house prices, he reacted with a kind of shocked indignation. "How much better do you think these prices are gonna get for you?", he asked my friend, as though he was personally aggrieved by this stance.

Shock, anger, and denial is what we are seeing with regard to falling home prices and the average person's slowly eroding standard of living. Thank inflation and a sort of negative "wealth effect" arising from lower home prices.

David Shvartsman
Finance Trends Matter

Copyright © 2005-2008 David Shvartsman

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