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Bubble, Banks and Builders

Written by Reggie Middleton

Monday, 24 December 2007

Reprinted from 10/6/2007

Well, equity prices are rising to record levels, shorts are getting squeezed as companies that seem to be headed towards bankruptcy are gaining 10% per day, and the macro/micro environment for the housing and banking industry looks bleaker by the day. Well, you can't hide absolute failure for long in the real estate markets, for unlike mark to model bonds, these are bricks and dirts that everyone can touch and feel (and research). I have some VERY interesting analysis here, but first let's recap the weeks behind us.

Financial cos. earnings and announcements for the 2 weeks ending Friday, October 05, 2007

Sovereign Bancorp Sees Hefty Q3 Charges [SOV]: The Philadelphia, Pennsylvania-based company said it would boost its pretax provision for credit losses in the third quarter to $155 million to $165 million from $51 million in the prior quarter.
Merrill Lynch & Co. Inc. (MER), the world's largest brokerage, said it would write down nearly $5.5 billion in credit losses and post a net loss for the third quarter.
Washington Mutual Inc. (WM) said it expects third quarter earnings to drop by about 75% because of factors related to weakening conditions in the nation's housing market. This is WaMu's mortgage arm's 5^th straight quarterly loss. This time it is big enough to bring the whole company to the red.
Citigroup Inc. (C) said earlier this week that it currently expects a year-over-year decline of about 60% in its third-quarter net income, lamed by dislocations in the mortgage-backed securities and credit markets and weakness in the consumer credit environment. The company expects to return to normal earnings in the fourth quarter.
Deutsche Bank, Germany's biggest lender, and UBS, Switzerland's largest bank, also came out with similar warnings earlier this week, saying they saw billions of dollars of charges as a result of the fallout from the recent credit crisis.
Lehman Brothers Holdings Inc. (LEH) last month reported a 3% slide in its third quarter earnings, reflecting weakness in capital markets, specifically in fixed income.
Morgan Stanley (MS) reported an 18% decline in its third quarter earnings, hurt by $940 million mark-to-market losses on loans, reflecting the illiquidity created by the current credit crunch.
Bear Stearns Companies Inc. (BSC) reported its biggest profit decline since at least 1998 due to rising defaults in the sub-prime category and reduced fixed income trading. The company's third quarter profit dropped 61% from a year ago.

In addition, Lennar, the largest US homebuilder by revenue announced the biggest loss ever in their 52 year history of half billion dollars. KB Homes, despite one time gains of nearly 3/4 billion dollars, still managed to deliver a loss for the quarter. The banks say that upcoming quarters look much better, and Citibank analysts state that the builders may be hitting a short term bottom. Okayyy.

Let's see how good the upcoming quarters look for the banks since they wrote down the value of their asset backed bonds instead of getting rid of them. Then we will examine the newfound competition between the banks and the builders.

Below is a list of bank REOs. A REO (Real Estate Owned) is property that a banking (or banking related) institution is forced to hold when a loan that they either issued, purchased, or became legally responsible for was foreclosed on and the property held for collateral was taken back . Generally speaking, an increasing REO inventory indicates increasing foreclosure activity. Foreclosures are very bad for bank balance sheets and performance. REOs are worst. If the bank cannot reclaim its full principle, back interest, and expenses from the sale of the REO, the amount not reclaimed is a complete loss. In order to move REOs quickly, banks are willing to take a loss by:

reducing the price of the REO below that of the P&I outstanding,
offer preferental (below market or flexible term) pricing on loans to the buyer of the REO, usually profesional investors or first time homebuyers,
and other such concessions.

If a significant amount of REOs hits the market, they will compete directly with other sources of housing supply, namely homebuilders and existing homeowners looking to sell. REO can very deeply discounted, which makes them difficult to compete with on a pricing basis, and since they come with the blessing of a bank, tend to have a "deal you can't refuse" financing arrangement as well. Banks are willing to get these blights off of their balance sheets by any means necessary!

The list of institutions here is far from complete and is meant to represent only the REO and foreclosure inventory trend for a metropolitan area, not the absolute REO or foreclosure inventory in a market. Graphs are used to infer trends*.

Mo nthly Averages of REOs for Riverside, CA

What we have above is a 2 and 1/2 times increase in REOs in just five months. Still not convinced of a problem? To give you an even clearer picture, here are the numbers for the last 10 weeks.

Do you see how steep this incline is, and how much it is increasing week by week? REOs have nearly doubled in the past 10 weeks. This is not an anecdotal blurb, look at the longer trend captured above. Things are getting very bad, very fast. Yet, banks like Citi, Washington Mutual, et. al. say that the worst is behind them. Someone should email them a copy of this blog.

Now its Bank vs. Builder vs. Homeowners - Who will win the race to the bottom of the profit ladder?

Companies like KB Homes are fighting for thier existence to get rid of land and inventory by any means necessary, even at a loss. Thus, they are discounting heavily, by up to and over 50% in many cases. KB Homes offers houses in Riverside County, CA at the following highly discounted fire sale prices:

2 stories, 5,187 sq ft, 4-5 bedrooms + family, 5.5 bathrooms, 4 car garage $736,990 - $142 per foot
2 stories, 4,914 sq ft, 4-5 bedrooms + family, 4.5 bathrooms, 3 car garage $747,990 - $152 pr foot

Companies like IndyMac bank are approaching the same situation. They have all of this real estate on thier books, despite the fact they are a mortgage company. It is ironic, since the builders have all of these mortgages on thier books, despite the fact they are home builders (in '06, Lennar originated 41,800 mortgages worth $10.5 billion). The mortgages are going bad on the builders books, and the real estate is going bad on the bankers books.

This is what IndyMac is offering:

Property Address

Price

Bed

Bath

SqFt

3559 Cortez St

$244,900

832

11356 Rancho Loma Dri

$334,900

1427

3124 Rainforest Dr

$433,900

2125

7872 Northrop Dr

$439,900

2676

8491 Lodgepole Ln

$489,500

2900

Currently, the homebuilders are actually offering their new inventory at a cheaper basis per sq. foot than the bank REOs. That won't last for long however, as it become obvious to the banks that they need to slash prices even more aggresively to move the property. When that happens (in a period of months), then IMB is to be accompanied by many banks in a mad dash to slash, and they will be fiercely competing with homebuilders fighting for their existance. All of whom will be competing with the existing homeowner trying to sell. There can only be one absoute price winner, with the other two simply cycling back through the banks one way or the other - either through foreclosure, corporate loan default, REO on balance sheet as unsold dead weight, or a new loan to finance a vulture investor buying for pennies on the dollar. While it appears that the homebuilders are selling larger homes for less than the banks, the banks are very, very willing to discount further off the offering price and make deals. Further, the homebuilder McMansion model is failing, with buyers now looking for smaller, cheaper homes - exactly like the ones being thrown back onto the market by the banks with cheap financing.

Who else is involved in this mess?

The organizations below are either government agencies or institutions sponsored by the government. HUD and VA are government agencies that promote home ownership and fair housing and back loans issued under their respective charters. Freddie Mac and Fannie Mae are GSEs that were created by the government to increase home ownership through the purchase of loans meeting their standards. This is thier REO involvement in Riverside. That's right, the tax payer is going to have to directly foot the bill or a decent portion of this stuff. According to these numbers, Fannie and Freddie are going into the real estate management and sales business - and to think, they are actually lobbying to have thier inventory caps lifted. Imagine, if that were to happen (actually, it already did) what this will look like this time next year!

Bank Owned

The REO listed below are owned by banks, loosely define as diversified, non-governmental financial institutions providing services other than mortgage lending/origination. Bank REO is currently being tracked for Bank of America, Chase, Citi, HBSC, and IndyMac. Needless to say, IndyMac is going to have a rough next couple of quarters!

Here we have the major OPM (other people's money) houses, loosely defined to be organizations that generally find purchasers for loans that they originate or issue. Through various legal arrangements with the institutions that finance them, brokers/originators can (sometimes) end up owning the property they originated a loan for if that loan goes bad. The originator of the year is Countrywide. These guys are amazing. Just click here for more info on Countrywide and Washington Mutual, the banks that say the worst is behing them, ha!

Countrywide, as an ongoing concern, is a joke. Speaking of ongoing concern, I seriously have my doubts. They are about to be one of the largest owners of single family housing in the country.

Next, we will review the REO status in all of the homebuilders most profitable MSAs to see what banks they are competing against and what banks are in trouble.

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