Home Price Index

The sharp decline in the Case Schiller Home Price Index of 5.4% for
Q4-2007 has caused many to think that improved affordability is signaling the bottom of the new home market, and has fuelled an across-the-board jump in home-builder stocks. However, a close inspection of aggregate housing-industry data shows that virtually all signs are still bearish, and this "here comes the bottom" view is premature. Also, a careful analysis of builders' financials suggests that weaker companies may be headed for bankruptcy or stock-diluting workouts before the housing market does improve.

As the numbers suggest, the bullish effect of increased affordability is being swamped by other forces depressing the new home market, including: buyers' fears of continued price declines and recession; growing inventories that are already at record levels; increasing mortgage payment defaults and foreclosures; limited mortgage availability and unfavorable mortgage pricing.

Prospective buyers' fears of further price declines -- and the problems that price drops bring to mortgaged home-ownership investments -- are justified. The current decline in median home prices of 8.8% in Q4-2007 confirms the continuing downward thrust of the Case Schiller index, and the fact that house price drops are accelerating.

The end of the current house price decline is nowhere in sight.
Goldman Sachs estimates that home prices will fall 20-25% from their
2006 peak, and they have only fallen 10.2% to date. Bank of America's
Chief Economist (Mickey Levy) predicts that home prices will fall for at least another half year. Neither prospective home owners nor mortgage bankers are keen to establish a large mortgage debt on an asset whose value is quickly dropping.

Demand for new homes is also being depressed by high mortgage rates and low mortgage availability. The average interest rate for prime, conforming 30 year fixed mortgages has increased by 19 BPS (basis points) to 5.68% in the past three months, while the average rate for prime, non-conforming loans (mortgages of more than $417,000) has risen 32 BPS to 6.51%. This has occurred even as the Fed has aggressively cut short term rates. One reason that fixed mortgage rates have not followed Fed rates lower is because mortgage rates are tied to long term interest rates and inflation expectations. During the past three months the yield on the 10-year Treasury Note has increased by 3BPS to 3.87%, while inflation expectations (measured by the Cleveland Fed's Adjusted Tips calculation) have increased 38 BPS to 3.15%.

Since last August, mortgage availability has been sharply curtailed by the collapse of the CDO market, lenders' flight to relatively-safe prime, conforming loans, and the inability of large mortgage banks and money-center banks to take new loans onto their balance sheets. These problems will not be reversed in the foreseeable future, which will in turn keep mortgage availability low and will help keep mortgage prices high for some time.

Other forces thwarting homebuyer demand include waning consumer confidence and fear of recession. Yesterday's consumer confidence reading of 75 is down from 87.9 last month. On February 25th, the National Association for Business Economics reported that the number of US business economists who forecast a US recession has doubled in the past three months, to 45%.

Housing market supply indicators are as uniformly bearish as their demand counterparts. Virtually all supply data is weak and continuing to deteriorate. For example, January's 9.9 month supply of new homes will help depress house prices for quite a while. This record supply represents an increase of 38% over January 2007, and is six month's above the 'normal' supply of about four months.

Housing supply will be further enlarged and prices will remain under pressure due to increasing mortgage foreclosures. January 2008's 233,000 foreclosures are up 4.2% from October's numbers, and foreclosures have increased by a stunning 57% in the past year. These bearish trends are paralleled by the increase in mortgage delinquencies through September 2007 (Q4 delinquency data has not yet been published).

The high risk of the weakest builders
While housing industry bulls look beyond the foreseeable future toward the promised land of market recovery, the weakest builders may not get there with them. Irrespective of how their stocks move, homebuilders' viability is dependent on market conditions, and current market trends (as outlined above) strongly suggest that poorly capitalized companies with will not survive – at least not without a dilutive infusion of equity capital.

Beazer Homes (BZH), Hovnanian (HOV) and Standard Pacific (SPF) top our list of most-likely-to-expire homebuilders. A quick look at Standard Pacific's situation, for example, shows why. SPF breached its tangible net worth bank-debt covenant just one quarter after negotiating relaxed covenants with its bankers. It has until March 30th to again renegotiate its indentures. Meanwhile, the company's leverage ratio (debt to equity ratio, reported as 1.69 in SPF's just-released 10K) is deteriorating, and we believe it will rise above its current limit of 1.75 this year. On July 1 SPF's current indentures reduce the limit to 1.65.

In the next two quarters, SPF's leverage ratio will be increased by poor gross margins (currently reported at 2.5% by SPF), negative free cash flow, increased inventory write downs and further deferred tax asset write-offs. As new home prices continue to plunge, SPF's revenues will decline, which will further reduce its gross margins, probably to negative levels. During SPF's latest conference call, management reported its expectation of negative cash flow in Q1-2008, which will further erode its balance sheet.

SPF has written off a portion of its inventory every quarter since the second quarter of 2006 (Q2-2006). These write-offs have been well correlated to decreases in the Case-Schiller home price index and to reductions in median new-home prices. As neither of these indexes show any signs of bottoming, our model predicts further significant inventory write downs for SPF.


Finally, SPF's balance sheet may be damaged this year by further deferred tax asset write downs. Auditors require that this asset be written down in accordance with market conditions and company health as they currently exist, not based on "over the horizon" possibilities. With SPF's foreseeable-future operations looking unprofitable, SPF's auditor (Ernst and Young) can be expected to insist on further write downs, beyond the 53% of this asset that SPF wrote off last year.


SPF has been fighting off its financial troubles by hiring Miller Buckfire – a well known advisor to companies fending off bankruptcy or working through a Chapter 11 restructuring, and by laying the groundwork for an equity/preferred stock infusion. The company has recently doubled its authorized share count from 100MM to 200MM, and registered a mixed shelf filing for up to $600MM of preferred stock or bonds. Given that a bond issuance would further weaken the company's balance sheet, the company can be expected to try issuing preferred stock or common stock. Either option will be difficult unless SPF's stock price holds up strongly, and both options stand to dilute existing shareholders (even in the case of a rights offering for holders who chose not to add to their positions).

West End Advisors is not alone in recommending that investors avoid the weakest homebuilders. Lehman brothers, for example, today assessed Hovnanian's stock as "Underweight," even as it was awarding "overweight" ratings to Toll and DR Horton.

Conclusion
For the foreseeable future, a wealth of data and economic projections show that the benefits of increased housing affordability will be overwhelmed by bearish forces, including buyers' lack of confidence, record-level and still-growing inventories, increasing mortgage defaults and foreclosures, limited mortgage availability and unfavorable mortgage pricing. Before the housing market does recover, some financially weak builders, such as Beazer, Hovnanian and Standard Pacific, are likely to file for bankruptcy or execute other dilutive restructurings.