Potential Home Builder Bankruptcy

Tousa Inc., a company on our "going concern" list, stopped trading around midday today. This was just about the time its share price dropped below a dollar. I don't know what the cause of the trading halt was (potential de-listing, bankruptcy, etc.) but this company was definitely on many a watch list.

As stated in my first blog on this site (Thoughts on the US Publicly Traded Homebuilders) - which in retrospect appears to be quite prescient considering the downgrades, mortgage malaise, off-balance sheet dilemmas and other issues recently cropping up - the first public homebuilder to go bankrupt should cause banks to seriously consider the capital that they have at stake in the industry. Thus far, banks and lenders have been amazingly lenient in amending loan covenants and the like. No bank wants to be the first to pull a loan from a builder, for if you drive it out of business it definitely can't pay you back. Believe me though, no bank wants to be the last to pull their loans either. The first to go after their monies in first position will most likely get the most of their lunch back, and those last to the table may not get to eat. Keep in mind that every devaluing event in the industry, such as:

• the mortgage crunch,
• the credit crisis,
• the bankruptcy of fellow homebuilders,
• the fire sales by the builders such as HOV's Deal of the Century or Pulte's 56% off deal,
• the foreclosure rate increases,
• the REOs dumped on the market by the banks,
• the newfound competition between banks and builders,
• the rapidly deteriorating macro environment of the builders,
• and the desperate existing homeowners trying to sell;

all cause the aggregate reduction of the banks collateral on a daily basis. This will continue unabated (actually at an increased rate for the next few quarters) for at least a couple of years. Looking at where even the biggest builders stand now, I wouldn't want my money in there for a mere 9% return. Once the first major builder goes bankrupt and those assets are liquidated at true fire sale prices, it will SIGNIFICANTLY devalue all of the other builder's inventory in that geographic region. Banks should listen up. You don't want to be second in line here. I have had Tousa on my list, and I think it may be one of the first to go.

It is my opinion that many in the banking industry and the equity markets are significantly overestimating how much the land and collateral held buy homebuilders is worth in the current markets and the markets of the near to medium term (see Straight Talk From the Homebuilder CFO: The Coming Land Recession, Pt I and Straight Talk From the Homebuilder CFO: The Coming Land Recession, Pt II). If history is any indicator and the macro signs of the severity of this land recession show true, then it will be a matter of several years (not fiscal quarters) before any upturn is to be found. The longer lenders wait to attempt to reclaim capital, the less capital there will be to reclaim; especially if they are relying on the underlying collateral as capital.

The builders are writing down these assets for a legitimate reason, they are worth less day by day (see Centex to Take $1 Billion in Charges as Slump Worsens). If we, at this blog, are right (and I am sure we are) then we have already entered into a real asset recession were the asset values are plummeting and will not recover fully for some time. Lenders can wait until the builders cash flow turns positive (risk 1) or real asset values stabilize and trend upwards (risk 2), or start reaching for their money now. I am not advocating any action, but if I were in the position of the lender I would be past the point of nervous now.

If Tousa indeed is about to file bankruptcy (I hate to spread rumors, but the rumor is that's the rumor, which goes to show you how much rumors are worth:-), it will set off the daisy chain effect which just may spark lenders to start considering pulling their own capital out before it is too late. Although many builders do not have debt coming due soon (HOV does), they all are coming close to, or have tripped over the covenants in their loans thus far, banks have been accommodating, but...

Credit Insights has performed recovery analysis for 4 junk builders (there are now 7 since CTX, PHM, and LEN have been added to the list) as of the numbers at the end of the 2nd quarter. Keep in mind that the 3rd quarter is much, much worse for all builders.

According to them, BZH senior unsecured bonds receive 11% of par, worst case scenario. Under liquidations they would receive 45% par, assuming inventories reduced by 60%.

HOV bond holders receive 7% if EBTIDA fell by another 50%, valued at 4x enterprise multiple. If liquidated, bondholders would receive 55 cents on a dollar assuming inventories fell another 60%.

They liked KB Homes better, but I think what many are missing with KB Homes is that they have been running an operating loss for 2 quarters straight, masked by one time gains which they have no more of. After selling the only division which contributed positive cash flow (the French operations), they are now going to generate an even larger negative cash flow, at what I can guesstimate would be considerably in excess of a quarter billion dollars per quarter (which is what they generated with the help of the French operations) facing a much more difficult market than they did when they took the first quarter billion dollar operating loss. This will significant eat through the cash generated by the one time gains and bust their debt covenant. For the next year or so, there is just no economic need for the homebuilders.

Unfortunately, it appears that many of these companies are worth more dead than alive. A vulture grab for the raw assets with a sharp haircut would have a better risk return ratio than the actual bonds or equity of the companies. This is why I am perplexed by many of the institutional value plays in these companies' equity. I short right into the hands of some pretty accomplished guys. One of us is wrong! Vulture plays in the bonds or the underlying assets, maybe, but the equity??? There are better opportunities out there.

Even if many of the companies do survive, homebuilding is a staid cyclical industry - not a growth industry as many seem to perceive from the recent market bubble. We will not see numbers like that bubble again in this lifetime.

See Straight Talk From a Homebuilder CFO: did Wall Street mis-categorize (mis-value) builders and are you?, Straight Talk From the Homebuilder CFO: The Coming Land Recession, Pt I and Straight Talk From the Homebuilder CFO: The Coming Land Recession, Pt II for more on this perspective.

Comments are quite welcome below.

Comments

[Jim]

Many of the big builders (like SPF) finance their operations mostly with senior bond debt-not bank debt.

In the event of a bankrutpcy the senior secured creditors will control the bankrutpcy process and will not fire sale assets as you predict. I don't see a tremendous downward price spiral but at 10-15% decline is possible in some markets.

Things are bad-but not as bad as you make them seem.

Jim

[Reggie]

Goog to have you on the blog, Jim. The is a variety of debt in the mix: mortgage operations are funded either through special purpose entities (except when credit ratings don't allow) or warehouse credit lines. These are both done through banks. Most of the builders also have credit lines through banks as well. And yes as you have mentioned, most of the big builders also have significant senior unsecured and secured bond debt as well, but as I described above it doesn't entail all of thier debt mix.

This is all academic, though, for if there was a bankruptcy I don't see how a fire sale could be avoided. The builders have already been more aggressive than a 10-15% decline in thier pricing and they still can't move inventory in any significat amount (referencing HOV's Deal of the Century with more than 20% off many prices, DHI's auctions, Pulte's make a deal, etc.). As a matter of fact, Pulte has tried cutting prices by over 50% on some properties and I doubt if they made significant progress.

So if the builders can't get away with 20-50% haircut on retail finished housing, I don't see what makes anyone think that senior bondholders with less experience in a bankruptcy liquidtion proceeding can make a 10-15% haircut on the much less liquid wholesale raw and unfinished land market fly - not to mention the finished houses and communities. Exactly who is going to buy this stuff at a 10-15% discount wholesale that nobody currently wants at a 20-50% discount retail?

Credit Insights factors a 60% haircut in liquidation, but if that were to happen in the near future, there is no guarantee that prices will not trend down that much or more in the next year or two.

[Reggie]

BTW, much of the logic in the land devaluation was explained in the "Coming land recession" piece. See http://reggiemiddleton.typepad.com/reggie_middletons_perpetu/2007/10/straight-talk-5.html and http://reggiemiddleton.typepad.com/reggie_middletons_perpetu/2007/10/straight-talk-6.html

[Linda]

Great post! I plan on reading the rest of your blog that relates to this topic.

I'm looking to get back into the market after being chased out by the dot-com bubble. I think shorting housing stocks is the safest bet on the planet right now.

I don't have a lot of money to wager with, though, so I have to pick one "Biggest Loser." Do you have a favorite that you think will drop like a rock in short order? Which would you pick if you were me?

[Reggie]

I'm glad you like my work. Unfortunately, I can't (and won't) give out investment advice to the public. I feel my blog should present a lot of opinionated commentary though. I have some interesting research coming up.

[Linda]

OK ... I've got you bookmarked.

[Linda]

OK ... I've got you bookmarked.