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“Do You Have A Pulse?”
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April 21, 2007

Quote of the Week – “As I’ve said to all our salespeople, if a buyer is warm and has a pulse, we want to put them on paper.” Don Tomnitz

I haven’t heard a quote like that in more than a year. It was a common phrase used when people would ask if they could get a mortgage during the bubble top. The response was, “if you can fog up a mirror, you can get a mortgage.”

Market Conditions – I’m hearing the worst news from California. It seems like there is no bottom to pricing. Tomnitz even declared Horton is back to “Rock Bottom” pricing, meaning they will do whatever it takes to sell a home. More on this below. Following California for continuing bad news is Florida and Arizona, but you can include the Northeast as well. Texas? Not far behind. This was the last market to crack, but now we are hearing the same thing from Texas, that we are hearing from other markets as they cracked.
Pulte’s net new orders fell to 8,499 for the quarter - a 21% drop from the same period last year. Closings dropped 37% to 5,420 homes during the period. Do the math. Dugas has joined the gloom with his soft quote of, "The operating environment for homebuilding continues to be challenging, with orders and closings remaining under pressure."

DR Horton Conference Call – It was agonizing to say the least. It was a 2 hour and 15 minute call that could have been done in 45 minutes. If I heard Tomnitz boast that Horton has the highest operating margins one more time, I was ready to scream. Big deal. If you have the highest operating margins, but your sales are falling off the cliff, who cares.
Here’s what I heard them say – “difficult environment” – “lack of pricing power” – “266,000 lots of which 2/3 are owned (5.3 year supply)” – “SGA up 10%” – “27% cut in employees” – “46% of homes under construction are spec” Whoa! Isn’t this one of the companies that said they didn’t build spec homes?
Add to the spec homes the contracts that are going to cancel. Just think about his comment, where they noted they are putting anyone under contract that has a pulse. And they are doing this to take the buyer out of the market. None of this makes sense. If you’re spending the time and money to sell a home, you want to make sure the buyer has the ability to close. The flip side of this strategy is a higher cancellation rate down the road. But as we have all seen, no one is looking down the road. The builders are still building far more inventory than we need.

They admitted to a whopping 27% cut in employees. Sooner or later these numbers must show up at the Fed level, no matter how hard they try to hide it. Multiply the 27% by the subcontractors that are losing their jobs, the mortgage brokers, furniture sales people etc. How many industries do you know of that cut 27% of their work force when times are good . . . or stabilizing. Although, I must give them credit for noting that the housing market is NOT stabilizing.

Other tidbits include starting half the amount of homes they started last year. Once again, how many industries do you know of that cut production in half when things are stabilizing or turning up. On the flip side, a 50% cut in starts is eventually a good thing, as it will reduce inventory. Unfortunately, with the amount of inventory on the market now, and the inventory coming into the market from foreclosures and auctions, we have a long way to go.

There were so many things on this call that were disturbing . . . or should have been. When Dave from UBS asked about cancellation rates, Tomnitz said they were controlling this by lowering prices, reducing land costs and cutting employees. Lowering prices means lower margins, but everyone is lowering prices, and inventory is still far too high. As for reducing land costs, that’s kind of tough to do on land you are building on, so let’s dismiss that attempt to double-talk. And of course cutting employees reduces costs, but if you don’t need as many employees, that means you have a problem with sales. Tomnitz believes cancellation rates will remain steady . . . unless prices continue to fall. News Flash: Prices are still falling!

When another caller asked about California, Tomnitz was careful to say he wanted to be politically correct this time. He said California is “tough” (read-SUCKS). 80% of their impairments were in California. But they only took impairments on 16 communities. That should be disturbing to everyone.

Here’s an interesting note on why Horton’s impairments may be on the low side compared to their competitors. Horton may be looking at impairments differently, but I will leave it up to you to verify this with Horton. It appears that most builders look at impairments based on Gross Margin less SGA, but Horton looks at Gross Margin less Direct Costs of 5%. So here is an example:

Gross Margin $300 less SGA of $300 = $0 and time to impair

Gross Margin $300 less 5% Direct Costs = $285 and no impairment.

If Horton has the same $300 SGA, then they should take an impairment. But they are not, because they are only looking at Direct Costs. It doesn’t make a lot of sense to me, and I cannot verify it, since they don’t talk to guys like me. However, when you consider how small their impairments are, you better be scratching your head. Some of these guys are simply hoping things will turn before they get into regulatory problems, but land is crashing even faster than home prices. And the carrying costs of these subdivisions are going to start crushing these guys. They can only lay off so much of the staff, even if that is 95%. But they still have all of the carrying costs of the land and projects, not to mention SGA which is sky high now.

When asked about the age of their land, they cheerfully volunteered that 2/3 of their land was bought in 2004 or earlier. Two problems. One, that means 1/3 of their land was bought at the top. Second problem. When they were asked how much land was bought in 2003 or earlier, their was no answer. The caller tried again, and asked if 50% of their land was purchased in 2004, but they would not answer. That’s not a good sign for a company that seemed to have all the answers . . . or at least all the answers they wanted to answer. By the way, they own 2/3 of their lots, so there is no chance to go back and renegotiate.

You gotta love the “pulse” comment for qualifying a buyer. Put this together with the fact that 30% of buyers could afford a home in California last year, compared to 11-12% this year. Unfortunately, that number is getting darker, as mortgage issues plague the industry.

Tomnitz defined their previous strategy of Rock Solid pricing. Read – We’re not going to lower prices and play that game. Well, that strategy flopped. So now it is back to Rock Bottom pricing, meaning they will do anything to compete. I predict Rock Bottom pricing will soon be Under the Rock pricing in order to move inventory. Maybe with all of the rock analogies, I should have titled this piece “Cliff Diving at Low Tide.” And if it was not clear enough, Tomnitz said, “Don’t be confused about one thing, we’re back to Rock Bottom pricing in California.” He didn’t make it clear that they will be following the same strategy in Arizona, Florida, the Northeast and beyond. But I can assure you they are and they will.

More double-bubble talk. With all of the bravado about margins and how Horton is the best of the best, Tomnitz told us that he believes the mortgage crisis is going to get worse for the next two quarters. So one must ask. If we are already experiencing severe affordability issues, and we are selling homes to anyone with a pulse, how does one think the cancellation rate is not going to increase substantially? Mortgage qualifications are tougher now than a year ago. And here we have the largest builder telling us it is going to get worse for at least the next two quarters. When asked about EPD (early payment default) numbers, they said they were not going to get into details. Add that to the woes of selling homes to people with a pulse.

Ivy asked about the good will write off for Trimark, and the answer was brief but explosive. Tomnitz based the decision on the increase in construction defect litigation. As I have noted in earlier updates, this is an area that will plague builders for years to come.

Conclusion – Tomnitz noted that pricing will be more competitive for the next quarter to reduce spec homes (the ones they don’t build), and he told us the mortgage crisis will continue for the next two quarters. Lower prices = lower margins. Mortgage problems = fewer buyers. I think the combination of lower margins and fewer sales spells trouble. At least in my book.

Orlando Housing Data – I’ve attached a few reports for you. Feel free to call to discuss. Here are the facts for the Orlando MSA:

Inventory up 6.76% from February.

Sales down 41.96% for March from 2006.

Mortgage Fraud – Another company feels the initial sting of what promises to be a wave of litigation backed by Washington and the sharks that are already on the scent. Here is a link to an article involving Hovnanian http://www.news-press.com/apps/pbcs.dll/article?AID=/20070415/RE/70414026/1075

When FBI Comes Calling

Fight Mortgage Fraud Crimes Charges

100% Federal Criminal Defense Firm.

www.federalcrimes.com

I think you’ll see more of this, and we will keep you posted on who’s next to feel the bite.

Foreclosures – Up 47% from a year ago and one in every 775 homes in the foreclosure process. This is the BIG story, for this will touch many parts of the economy. I’ve attached a file with foreclosure stats for the US. It’s a lot to digest, but here are some fun facts:

441.67% increase in Maine foreclosures YOY – Maine?

219.44% increase in New Hampshire foreclosures MOM and . . .

1 of every 183 homes in Nevada is in some state of foreclosure!

But these are just numbers. We’re going to suffer the hard consequences in many areas:

1 - We are going to see a flood of inventory on the market. The builders will feel that, but so will the subcontractors and vendors that will be out of work. And so will all of the owners trying to sell homes in the normal course of life.

2 – The rental market will see a surge, but with this comes a hit to the home improvement industry. Renters don’t make significant improvements. By the way, the big box stores take a double hit, because many of the subcontractors used Home Depot and Lowes for their supplies.

3 – Back to the flood of inventory. This will translate into lower home prices, which means lower tax revenue for cities and states. It also means fewer homes being built . . . and lower revenue to cities and states that rely on impact fees and permits.

4 – Banks will take a huge hit, since the homes coming back on the market will sell at prices nowhere near the loan amounts.

WCI - Still no word from Jack McCabe’s mystery buyer, and really nothing new to report. From calls I’ve made, sales are at a stand still for WCI.

Inventory and Sales – Inventory UP – Sales DOWN – The Washington Post just started a Sunday series titled “A Glut of New Houses -- and What That Means for You”

Alt-A – If you think the subprime issue is contained, think again. That happy smile on the delinquency rates chart is not a happy thing, unless you are on the short side.

Corus Bankshares – I saved the most obvious for last. Corus announced a 39% drop in Q1 earnings. Glickman said the decline was a result of the housing market troubles. DUH Adding to this bombshell of old news . . . the company’s loan holdings consist almost entirely of loans related to the condominium market. As if that was news to anyone. Neither is this really news, when he noted an increase in loans with problems. Double DUH. But as painful as it might have been for him, Glickman then said, “It would not surprise us to see an even greater impact on earnings over the next several quarters, or even years.” He has no idea how bad it is going to get.
But he summed it all up in a nice tidy package for us when he said, “. . . problem loans could get worse before they get better.” I think he meant to say “will” instead of “could.” As you know, I spend quite a bit of time monitoring the progress of Corus backed projects. Probably more time than anyone on the Corus staff. Sales have stopped. Many of their projects are Class C or worse. And they are entrenched in the worst markets in the United States.

Despite the doom and gloom surrounding Corus, the stock price actually closed up 3.79% for the week. Oh, and did I mention Corus has been buying shares of Fremont. In fact, they are a major holder with 1,574,000 shares (2%). For those of you not familiar with what Fremont does . . . their business is non-prime, sub-prime and condo development loans alongside Corus.

What’s Next – Business Week reported that consumers are turning to their credit cards instead of the ATMs they had in home equity. Homeowners that became addicted to home equity – easy money, are now in quite a bind. Their home equity has disappeared, and for many so have their jobs. How long before the nation’s banks face a credit card crunch? No spillover?

Disclosure – I have a put position on Corus, but no other positions in the stocks referenced.

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Mike Morgan, J.D., CRS, GRI
Morgan Florida Real Estate
Morgan@MorganFlorida.org 
772-260-5448

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