4/2/2008

Industry Update: Homebuilders
By David Urani

In the past few months, homebuilding stocks have made some very optimistic moves upward, and a look at the Dow Jones Index of U.S. Home Builders (ticker: $DJUSHB) shows that ever since the beginning of 2008, this industry has been on an uptrend. The most recent data to reach the public eye actually has some mixed signals but in the end we can clearly see a capacity for improvement.

First there was the National Association of Realtors’ (NAR) existing home sales report, which was perhaps the most optimistic of all of the data we have seen. The report actually showed a sequential increase in existing home sales from January to February; something we haven’t seen since July 2007. Annualized sales increased to 5.03 million from 4.89 million. Though the sales of existing homes (basically used homes) does not directly affect homebuilders’ financial situation, it has a very significant impact on the housing market as a whole. Excess supply in the market is one of the main factors causing home prices to fall, and it is good to know that some progress was made in working through that excess inventory. The inability of customers to sell their old homes has also been a major deterrent to new home sales, so if homeowners are able to get their old properties out the door, this bodes well for the homebuilders.  The potential downside to this report is sales are still lingering at a very low level, but one cannot expect sales to all of a sudden jump back to a “normal” rate.

Secondly there was the Census Bureau’s new home sales report. The data certainly took some sting out of the existing sales report’s ensuing rally. Sales fell to an annual rate of 590,000 in February from 601,000 in January, marking a continuation of the fast deterioration we have been witnessing for over a year.

Earnings reports from Lennar and KB Home were the final pieces of data, and they did not impress. Both performances were typified by very slow sales, as demand was very stubborn. While they lagged in sales, however, they did a good job of shoring up their balance sheets, as both companies continued to streamline operations in an effort to shield themselves from continued losses. As a result, they have both lost some capacity to make sales, while giving themselves more maneuverability in the future. Lennar made aggressive efforts to sell off excess inventory holdings and proactively write down inventory value in prior months, and this showed through in its most recently completed quarter, as losses were mitigated and the outlook appears optimistic. All in all, the homebuilders intentionally took considerable damage at the end of 2007 in an effort to soften the effect of any future losses.

The good news for us is that the market has not yet seen the full benefit from recent actions taken by the Federal Reserve and Federal Government which should help to improve trends throughout 2008 and into 2009. Here is a list of significant developments:

1. Peak cycle Federal funds rate of 5.25% in September 2007 has been cut to 3.00%. Theoretically, this should make borrowing between banks easier, and as such it translates into lower mortgage rates.  Unfortunately, this has failed to materialize to a large degree thus far given the frozen state of the credit market.  Many would-be buyers continue to be on the sideline waiting for more attractive rates, while those looking to transition into fixed rates from adjustable rates mortgage (ARMs) remain frustrated by the lack of movement in rates.

2. White House “Teaser Freezer” plan which was put into action on January 1, 2008, temporarily freezes adjustable mortgage rates for a select group of borrowers who have been deemed at risk of foreclosure, but can be helped with aid. The plan also gives the Federal Housing Administration (FHA) more mobility in allowing consumers to refinance into fixed rate federal loans. These actions should help to stall the upcoming expected wave of foreclosures in 2008. January foreclosures increased to 233,001 from 215,749 in December, which emphasizes the need for help in the mortgage market.

3. Economic stimulus package signed on February 13 raised the maximum loan cap on government sponsored lenders Fannie Mae and Freddie Mac. The companies can now finance loans of up to $729,750, above the previous limit of $417,000. This will provide lower rate mortgages to more homebuyers and provide liquidity to the mortgage market in general as higher priced homes are sold through.

4. Office of Federal Housing Enterprise Oversight (OFHEO) announced that it will lift the caps on Fannie Mae and Freddie Mac’s mortgage investment portfolios. The companies had been limited to $735.0 billion portfolios in the aggregate, but starting March 1, it will be unlimited. This action will further expand Fannie Mae and Freddie Mac’s abilities to provide more affordable loans and give the mortgage market more liquidity. The OFHEO also reduced its 30% capital requirement on the companies to 20%, which will allow them more freedom to expand portfolios.

5. The Federal Reserve said on March 13 that it will make $200 billion worth of treasury bonds available for financial institutions to swap with FHA mortgage backed securities. This will help to add liquidity into the lending market and make mortgages cheaper and more available to homeowners and home buyers.

All in all, as mortgage rates decrease, assisted by interest rate cuts and intervention from Fannie Mae (ticker: FNM) and Freddie Mac (ticker: FRE), purchasing a home should become a more attractive and feasible proposition for consumers. Furthermore, as home prices continue to fall, consumers will certainly be alerted, and the psychological barrier of fear surrounding poor economic conditions should eventually be offset by perceived lucrative buying opportunities. What is important to realize about the current housing market situation is that no one particular factor, such as specific government action or sales price discounts, will act as a catalyst to turn around the market. The ultimate goal is for consumers to become comfortable enough to spark a wave of buying due to a convergence of external stimuli. This occurrence is slowly being facilitated by rapidly falling home prices and government aid.

In the last three months massive profits have been made in housing stocks and there is more to come. Don’t miss out on the next rally; consult your Wall Street Strategies representative today!

Written by David Urani a Research Analyst for Wall Street Strategies (www.wstreet.com) specializing in the homebuilding, staffing, medical devices, and logistical services industries.