Tuesday, February 13, 2007

My Thoughts On The Housing and Sub-Prime Mortgage Debate

Here are some of my thoughts on the very intense and emotional debate continuing on the subject of the housing market and sub-prime loans:

Housing is going to crash. Our society will soon be living in cardboard boxes. No wait, housing has bottomed and is getting better. Never mind, sub-prime foreclosures will be creating plenty of inventory for the Toll Brothers (TOL) homeowner-wanna-bes. I better check the housing blogs and chat rooms to be sure of what the real story is.

Hasn't this housing debate become more heated than a judicial appointment on Capitol Hill? It sounds like my children arguing over who gets to pick the movie we watch from On Demand. I prefer to take the higher ground. Here is what I think:

· Housing overheated about two years ago (as does any asset class that tends to attract too much speculation). The margin morons got into the real estate game and that signaled a top.

· Homebuilders recognized that:

· They needed to shrink inventory in speculative hands and slowed down construction to absorb the oversupply.

· They held too much land or land options in areas in which land was plentiful and needed to adjust and write-down accordingly.

· Housing is regional, not national. You can't compare housing in Florida or Las Vegas or Phoenix with that in suburban Chicago or New Jersey or Metro DC.

· The secondary market for housing is still strong where the jobs are. Take a look at the towns located along the Metro North or NJ Transit Midtown Direct commuter lines to New York City. New homes are being built out further on those lines and I don't expect that to diminish until all that land is built on. If the Midtown Direct could expand to Phoenix, that would be another story.

· A surge in sub-prime housing was created as:

· Hurricane relief brought a huge surge in demand for lower income sub-prime housing such as trailer homes and lower income private homes.

· Improved financial, infrastructural and crime conditions in urban centers combined with government tax and other incentives have created a environment conducive to inner city lower income single family home construction and purchasing.

· Increased employment pushed more people from rental to home buying on the margin.

· Homebuilders are in the "kitchen sink" part of the cycle in which they will write-down, sell off and reserve as much as they can. Throwing everything into the kitchen sink comes at the bottom, not the top, of a cycle.

· Our population is growing by 3 million to 4 million people per year. That amount is likely to increase, not decrease, as we age and immigration continues. Where are they all going to be housed?

Think about all the above when we consider KB Home (KBH), which is reporting. To be fair, I have a buy-write on Hovnanian (HOV). When I put it all together, I see a mixed bag -- some good, some bad -- and we may be close or at equilibrium. The top of the housing market is behind us. The bottom is here or near but those betting that the worst is yet to come will be proven wrong. What we are not at the bottom of, but are near the top of is the emotion attached to the housing and mortgage market.

Epilogue: KBH reported its 4th quarter results. My thoughts of the earnings report and conference call is summarized below:


You cannot characterize KBH’s quarter as pretty. Cancellations are still running high even though management tried to put rose colored glasses on the fact that they seemed to decline sequentially. Gross margins were putrid. As always, we need to look forward not back. The two most informative parts of the conference call came from the peek in 1q07 and the Q&A with Ivy Zelman. So far, if the traffic and sales for 1q07 is only of about 10% then one can argue that the deterioration in the housing market is slowing down and that the worst may already have occurred. The interaction with Zelman on sub-prime was interesting. It confirms my belief that sub-prime housing is a category onto its own and is also part of the localized nature of real estate. I would expect homebuilders to begin to abandon certain states that are in secular economic decline, such as Michigan and Ohio, while waiting out the storms in Phoenix and Las Vegas.


Favoring the housing bulls is the fact that this quarter was definitely a "kitchen sink" quarter for KBH. They tossed so much out the window as part of the company's impairment and write-down that you know that the company is cleaning up the balance sheet and getting ready for the next upturn in the market. When you back out the impairments and write-downs, KBH earned about $2.26 down 34% year over year, which was less than the drop in cancellations. Furthermore, revenues rose 13% and ASPs increased as well, another point for the bulls.

My opinion is that the cyclical decline in housing is near or at an end. Furthermore, the big meaty shorts trades have already been booked. We will continue to have a high level of volatility in the sector and more trading opportunities will present themselves as the sub-prime, housing and interest rate dramas continue to unfold. The next step for this sector is going to be takeovers especially if the bears continue to push shares lower.

Finally, KBH has its own specific issue of the departure of a respected CEO and the ascension of a new individual to that role. That is always a risk for any stock. I am maintaining my positions in HOV for now.

At the time of this Blog entry and the Street.com articles, Scott Rothbort, his family and or clients of LakeView Asset Management, LLC was long shares of HOV and short calls of HOV -- although positions can change at any time.

6 comments:

Jeff said...

Interesting and helpful. It is nice to see some objectivity brought to this discussion.

Thanks!

SCOTT ROTHBORT said...

Thanks Jeff. Please see Dr. Jeffrey Miller's thoughts on this subject on A Dash of Insight (link to the right)

Anonymous said...

interesting/helpful? huh - I dont understand - where were all these homebuilder bulls in 1980 1990 even 2000. amazing - if u look at a long term chart home builders havent done anything until 2001 when Greenspan dropped rates to 1% = these stocks are going a lot lower - sorry scott

Anonymous said...

In the early months of the year 2000, shares of Sun Microsystems, Dell Computer and Microsoft all reached levels significantly higher than they have today.

In 2000, one might have argued "hey, we're in the information age! we're gonna need a lot more computers and software to run on them as we move into the future. Share prices in these companies have to bounce back soon."

But share prices in all those securities dropped significantly and have not bounced back to their year 2000 peaks (even in nominal terms -- and that despite significant profit growth in MSFT's case). Share prices simply got way ahead of themselves.

The fact that the US population is growing doesn't necessarily mean that the housing prices will remain close to current levels. It's at least possible that housing prices simply got way ahead of themselves.

SCOTT ROTHBORT said...

Comparing shares of Sun Microsystems, Dell Computer and Microsoft to the housing market is an apples to oranges comparison.

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