Reggie Middleton's Boom, Bust & Bling Blog - HAS MOVED TO REGGIEMIDDLETON.BOOMBUSTBLOG.COM!!!

Quick note on increase in construction spending: not necessarily good economic news

Listening to CNBC this morning, I heard that residential construction spending has just increased, bucking the consensus and being lauded as good news. The home builders, who are the largest contributors to this index, are buried in debt and need to build in order to monetize the land they cannot sell for positive cash flow. This is their business, and they must build in order to try to make money.  I know it sounds counterintuitive to build houses when you currently have more houses than you can possibly sell, but from their perspective land is worth more with a finished house on it then it is in a raw condition. This is in their individual selfish interests. The problem is that adding more houses is negative for the homebuilding industry in general, negative for the economy since it adds supply to an oversupplied market that has slackening demand, and it steals wealth from homeowners by dropping the values of homes as supply increases further.

I am a contrarian along these lines, as in my viewpoints on share buybacks.

COUNTRYWIDE POSTED its first quarterly loss in 25 years on $2.27 billion in mortgage losses and write-downs and soaring credit-loss reserves. But...

the lender expects to be profitable in the fourth quarter. I don't know about this. Countrywide is taking in more overvalued, underwater residential property in a the midst of a massive residential slowdown, than any other entity that I know of in America. In addition, they have significantly shrunk their business so it will be hard for them to earn their way out of this. Mortgages sales volume and size will decrease since home sales are decreasing amid shrinking housing values, and thier business model is going conforming.

What is CFC going to do with all of those significantly devalued mortgages on their books? What are they going to do with all of the increasing foreclosures coming down the pike? They already wrote many billions of dollars of bad loans, and now they are taking loads of zero equity property in as well. What are they going to do with those? If you think the homebuilders have written down the value of their assets significantly, imagine the competition they will get from Countrywide. Hey, I am being pessimistic, let me take a close look at their numbers before I jump to conclusions.

There is no recession, the economy is in fine shape, and business is strong!!!

I am so convinced of the title, that I have compiled a list to illustrate. Of course, I didn't include the home builders in this list since they have obviously been hit, and I didn't include the banks earnings (since they have obviously not been doing well), and I didn't include the mortgage insurers results (since they have been hit hard), and I didn't include the foreclosure rates (since those are dismal), and I didn't include REOs (with CountryWide becoming the largest holder of single family housing in the country), and I didn't include... Well, you get the message. So let's see what I did include in my compilation to show how far away from recession we are...

My team's latest forecast of real estate price trends  4 years forward (the entire table may not fit in this post, width-wise):

	3Q2007	4Q2007	1Q2008	2Q2008	3Q2008	4Q2008	1Q2009	2Q2009	3Q2009	4Q2009	2010	2011	2012
West	-5.30%	-4.90%	-3.90%	-4.10%	-3.80%	-3.10%	-2.70%	-2.30%	-2.30%	-2.00%	-2.50%	-3.10%	-2.20%
North	-4.10%	-3.80%	-2.80%	-2.10%	-1.80%	-0.90%	-0.80%	-0.70%	-0.30%	0.20%	0.40%	3.70%	4.10%
Texas	-0.80%	-0.20%	0.20%	0.30%	0.70%	1.30%	2.70%	5.40%	10.80%	21.50%	30.30%	24.20%	19.40%
Southeast	-6.00%	-6.20%	-3.90%	-2.60%	-1.40%	-1.20%	-0.40%	-0.50%	-0.60%	2.00%	-2.70%	-8.50%	-9.30%
Average	-4.10%	-3.80%	-2.60%	-2.10%	-1.60%	-1.00%	-0.30%	0.50%	1.90%	5.40%	6.40%	4.10%	3.00%

Straight Talk From the ex-Homebuilder CFO: My interview with a RE lender. Are the banks ready to foreclose builders?

Tracking Stepehn Kim's (Citigroup analyst) brilliant bottom call

Prior to reading the #5 story, yes I know homebuilder stocks are up today... I believe it is called an idiots rally or dead cat bounce....  so, please note that all the stories below are based on last weeks news ending Friday and not any news stories today... with that said....On Oct 2nd, many a fool was relieved to find out that the housing crisis was behind us thanks to a major upgrade of the sector by Stephen Kim.  Mr. Kim wrote in a client report he does not foresee the stocks falling much more.  So I decided, just for giggles, why don't I track the performance of this bottom call.  I based the start price on the closing price of the 21 builder stocks on 10/2.  This of course assumes that you are not a total idiot and bought on the gap up on 10/3, since the builder stocks ran wild on 10/2 with the upgrade.  Results as of the end of Friday 10/19?  9 of the 21 builder stocks were down double digits since Stephen's bottom call.  And I am not talking just the crappy builder stocks.... NVR down 11.34%, DHI down 11.34%, CTX down 12.59% and of course TOA down 62.92%.  13 trading days and almost 50% of the stocks are down double digits.  Nice call Stephen.  The top performer is LEV at 12.13%.  Overall only 5 of the 21 stocks are in the black while the other 16 stocks bleed red.  If today's rally stays... most of the builders are still in the red vs when the bottom call was made 

Straight Talk From the ex-Homebuilder CFO: TOA is TOAst - how I confirm bankruptcies before the Street

The goal of builder weekly is not to rehash what you can get off the news wires.  The goal of builder weekly is to do the deep diving you don't have the time to do and pull out the hidden gems (thought I'd steal that one).  Additionally, it provides you updates of my day to day dealings and what i am hearing from my builder contacts.  Since my blogs will be longer I suggest printing and reading while on the can at work. 

Well the builders had a down week and a few (KBH, CTX) made a valiant, but failed effort (of course) in trying to stay over the 50 day moving average... whereas others.. (TOA, SPF) LMAO... didn't even know there was a rally in builder stocks... only TOL has successfully stayed above the 50 day for 2 weeks now and I have explained in the past why i like TOL.  There is no reason to follow builder AP wires anymore because every week (for my real job) I review every SEC filing and news wire for the following builders - BZH, BHS, CTX, CHCI, DHI, DHOM, HOV, KBH, LEN, MDC, MHO, MTH, NVR, OHB, PHM, RYL, SPF, TOA, TOL, and WCI.  So lets get on with our countdown for the week

#4 - Short clips

On a daily basis our homebuilders provide us with so much blog fodder its almost more annoying than amusing.  So short clips represent a few speeding tickets to slow down and stare at before we move on to the really good car wrecks

DHOM (8K) sold 153 homes at a price 8% below their backlog average price and have 4 months of backlog... I wouldn't put them on bankruptcy alert......... yet

BHS (8K) sold 130 homes in 33 selling communities.. that is a net sales absorption pace of 1.3 a month... the only builder making money on a pace like that is some redneck working out of a trailer.  If you think BHS isn't bleeding with absorptions like that then your an idiot.  They are taking a $40-50m write-off.  I need more info on the pricing of backlog and sales to determine if they are in crap... Their balance sheet today would not put them on bankruptcy watch

More than lower interest rates fueled the recent real estate boom

The credit innovation thing is what is perpetuated in the media - but for one it is not the innovation that caused the bubble. Innovation leads to liquidity which in, and of itself is good. What we had in the last bubble, was carelesseness, the ultimate moral hazard - otherwise known as OPM on the street (other people's money). You see, if it ain't your monies at risk, you are much less likely to care if the loans are good or bad. That is why the most popular buzzword in the media is a misnomer - "subprime". There was no subprime contagion, for subprime was never the problem of the bubble or the bust. If anything, it was subprime underwriting - not subprime loans. It was the careless underwriting standards borne by banks that did not have to face the consequences of just giving out money to anyone (at least past their one year risk retention stipulations, hence the popularity of 2 year ARMs). Thus, it is prime, subprime, alt a, alt b, and everything in between where the actual problems will manifest. Those who follow the media buzzwords or actually believe the BS of the ratings agencies who were compensated by the entities they were rating on a basis that was contingent on a favorable rating, are bound to be surprised by an apparent "contagion", again and again, and again, and again, and......

Before that lax lending standards really took off gentrification pushed up housing prices in the urban areas of the US where upper middle class commuters chose to live closer to the center of the metro areas (the inverse of what happened in the last major housing cycle that developed and propped up the price of the suburbs and exburbs). This is fundamentally sound, for price did not outstrip income. Of course there are several socioeconomic factors that come into play which are too complex to get into here (but I will get into them in other posts with fun models to download and play with :-) Gentrification led to sprawl (due, in part, to the displaced urbanites), and both were exacerbated by lower interest rates and flexible funding/easy credit, like jet fuel on smoking tinder. Once writing loans off of someone else's balance sheet became popular and combined with the great global macro experiment, then fundamentals ran amuck and cap rates dropped to the level of, or even below that of the risk free rates. Such a level is unsustainable (eventhough you have some investors who are still trying to push cap rates towards zero, I have seen large deals done at 2% with money markets yielding over 4%), hence where we are now.

It pays to have intricate knowledge of the markets from a local perspective, which is why I'm taking my time to take positions in the foreign (non-US) markets. I have intimate knowledge of some US markets, but that does not necessarily help me in the foreign markets. From what I have observed thus far, they are behind the US, but we will export our own brand of "burst" soon enough.

Okay, I have just recharged the batteries in my crystal ball: Back tested Home Price Trends - Historical and Forecasted

My analysts have performed a lot sell side research, and I am an industry outsider that thinks out of the box. I have never worked for the sell side, thus I think very differently. Hence we tend to come at things from differing angles. This is good. Diversity is good, even when it results in others disagreeing with my theses. When creating the pricing and forecasting engine for the Ryland model used in my last post, I noticed that the numbers appeared to be too optimistic, at least according to my grassroots investor's gut instincts. I know "gut instincts" is not very scientific, but regardless, I told the team to go back and check the numbers. It received a slight tweak, but my gut still told me something was off, despite the fact three smart and knowledgeable people scrubbed the numbers for 2 weeks straight. They used many sources for each city that Ryland built in OFHEO, CME, Case/Shiller, MLS, REOs, Foreclosures, etc. I then got the following email which created a spark:

You’ll love this:

“While fishing one day I was introduced to the recently retired president ( age 42) of Ryland Homes and his view was that the housing debacle in Florida is going to get much worse than the current state. He had conveyed the disturbing number of houses that would not be completed to a finished project currently being constructed and their internal projections of available buyers at higher interest rates and more importantly qualification standards. In his opinion the bottom is still years away there and most like the same in other areas of previously high appreciation above the norm. They are renting unsold condo's on the beach for 1% per year of asking price in an attempt to at least generate some type of CF until a sale might take place in an unbelievably overbuilt and overpriced market. He also thought that a 30% decrease in value from today's number ( already discounted from the top) is probable and the most important idea is that most in his industry are still in the denial mode vs the desperation mode necessary to make a true bottom.”

http://www1.investorvillage.com/smbd.asp?mb=2234&mn=77658&pt=msg&mid=3229300

Now, I just reviewed this guy's company so the numbers were fresh in my mind. In addition, I was pondering what could have been wrong with the analysts numbers. Empirically, the methodology was sound. So, I took their numbers and removed ALL government data, scrubbed them with market data only taking into consideration the foreclosure and REO rates (using proprietary algorithms), then back tested the results. Voila! Numbers that matched my gut feel, and more importantly numbers (or at least a methodology) that can be partially verified through back testing. Having just went through this exercise when the email above arrived prompted me to run the new numbers through the Ryland model. The result, whewww!!! No wonder all of those insiders are selling all of those shares. Things looked pretty bad with the ivory tower, conservative numbers. The more realistic grassroots numbers pushed through the Ryland model screams Bad News!!!  For the record, we have Miami dropping (32.07%) from this month to 2011. You see, Ryland management and I really do think alike. We're both selling Ryland stock and we're both forecasting similar numbers for real estate pricing. Hey, to agree with me, those Ryland guys must be pretty damn smart:-)

I will have my analysts thoroughly back test the results and refine the model even more, but in the mean time I think we are on to something. Let's take a look at what we have.

For the record, this data has yet to be adequately and fully adjusted for condos. This, and the filtering of new construction and investment properties, is the weakest component of the Case Shiller index (see my opinion on that topic here). YTD, condos have underperformed single family housing in 14 out of 24 Metropolitan Statistical Areas. Needless to say, the new construction is being heavily discounted. Also, keep in mind that most of the markets that did not participate in the bubble are still participating in the recession due to the fact that many homeowners used exotic financing for their homes, which ended up with a non-traditional, often unpleasant result of distress, foreclosure an REOs. A perfect example of this would be Detroit. In the graph below I have outlined the last 20 years of housing appreciation in the US for 10 metro areas. Click the picture to enlarge.

Notice the difference in intensity between the last residential real estate bull market and this most recent bubble. It is a BIG difference. Each market entered the  Boom, the Burst & eventually, the Recovery at a separate  and individual date, thus have been calculated and graphed accordingly. Residential real estate is very local. What is very different this time around is the severity of the bubble, and how correlated the markets are - not just across the US but throughout  the Americas, parts of Asia, N. Africa, & Europe as well. For more on how this occured, you can read “The Great Global Macro Experiment”

What does Reggie Middleton and Ryland's upper management have in common? They are both selling shares faster than no doc loans get approved!

Okay. I admit, the title is pretty corny - but this blog post is really not that funny either, at least if you're long Ryland. The upper management of Ryland have sold more $33 million dollars of stock in the past year with at least $25 million of that dumped very recently in the last 3 months - right before the quarter reports. Here's another coincidence, despite the fact that the stock has been rapidly decreasing over the last year, none of the management have taken advantage of the opportunity to buy the stock a this cheap price - they have just sold. Hmmm! I wonder if there is something in this upcoming quarterly report that would make you want to dump your shares faster than the cannibal dumped his ex-girlfriend too??? For those of you who didn't laugh - there is this tasteless joke, "What did the cannibal do after he dumped his girlfriend? He wiped his @#$!" You should be laughing now. The reason I am telling corny jokes is to prepare you guys and gals who are long RYL for something that may not put a smile on your face.

Well, first let's take a look at who sold all of this Ryland stock (besides me, of course), then let's make our best guesstimate at why everybody decided to fund their kid's piano lessons right before quarter end (click the graph to enlarge).

Ryland's Bankruptcy Score - Coming out of 2006, it looks like Ryland's Z score fell off of a cliff!

Beware the short squeeze Monday in Builders???

The SEC exception that allowed naked short selling ends Monday. This may or may not cause short covering that can drive up the stock of heavily shorted companies such as the home builders. This would be what is called a sucker's rally, for once the short covering is over and any company that deserved to be shorted reaches an even higher basis, the shorts will be even more aggressive on the way down for the stock will be trading higher than its perceived fundamental value.

For more on the SEC rules, click here: http://sec.gov/rules/final/2007/34-56212.pdf

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.