Homebuilder CDS vs. Stock Prices: Which Is Correct?

On Tuesday the S&P Case/Schiller home price index data was released and it was not good. The S&P stock index decided it was a good reason and traded 2.63% or 23.33 points higher. Yesterday, the National Association of Realtors released existing home sales data which turned out to be at least as good if not a bit better than expectations and the market decided to sell off 17.27 S&P points or 1.89%.

Are you beginning to see a pattern here? Today, the Census Bureau releases new-home sales. So can we expect a good number to be bad and a bad number to be good, again? That’s the fun part, we never know until its history.

One of the problems with existing home sales is that “up” is not necessarily a good thing as foreclosures are counted as sales too so, like dessert, what looks good can actually be bad for you.

To stem the foreclosure tide there has been a lot of pressure [political] put on all the players up and down the mortgage food chain to “modify” mortgages. Modifications can include adding delinquent amounts to the loan principal, lowering interest rates, extending maturities and changing ARMs to fixed rate loans.

The problem, according to a recent report by Fitch Ratings is that this does not seem to be working e.g. keeping people in their homes as well as intended. Imagine that, a politically motivated action with unintended consequences; will wonders never cease!

Fitch looked at mortgages bundled into securities between 2005 and 2007; the period considered the height of mortgage lunacy by many. The findings of Fitch’s work were that somewhere between 65% and 75% of modified sub-prime loans will fall 60-days or more delinquent within 12 months.

Two main reasons were given for the “re-defaults”. 1) Modifying loans for borrowers that were likely to default whether or not the loan terms were changed and 2) falling home prices causing deep underwater borrowers to become more so and simply walk away from their modified loans.

“Based on redefaults to date, an optimal modification formula has not yet been found,” said Diane Pendley, the author of the Fitch Report.

Bank of America Corp. (BAC), purchaser of mortgage lender to the stars [and Chris Dodd], Countrywide Financial Corp. has modified 50,000 mortgages as part of a settlement brought by state attorneys general against Angelo Mozilo’s old firm. BAC claims the modifications are saving borrowers an average of $195 a month.

Using the Fitch percentages that means about ~35,000 of those mortgages will redefault within a year. Needless to say with a majority of modified loans going into default anyway this problem is not going away anytime soon.

Toll Brothers (TOL) has a slightly different outlook on things as they reported higher orders than analysts expected in their fiscal 2^nd quarter results. This was countered by news of a 51% decline in revenue and a fall of 9% in the number of homes scheduled to be built. To throw a few more numbers at you, total orders were down 37% from a year earlier but had doubled from the previous quarter.

The CEC Strategy is currently short, BDK, HD, KBH, MDC, MLM, OC and SWK in the construction sensitive sector. CDS spreads, in general have been rising and stock price falling even with Tuesday’s blip.

TOL, like most of the other homebuilders, saw rising stock prices and falling CDS spreads from early March through early May. Things have changed around since then and the reverse is now true. TOL in particular has seen its CDS spreads turn lower again recently even as the stock continues to fall. It will be interesting to see which asset class turns out to have been moving in the correct direction.

Comments

[HardwoodFlo...:]

We have certain element hitting right now which will keep the housing market down. We were just working through the bust now we are getting hit by "classic" recessionary housing issues (read unemployment). This will continue to hurt the housing market in terms of inventory. Then you have to couple in the Atl-A factor with rising rates. Then compound that with the fact that the high end cannot move without JUMBOs and you have set up for a continuing trouble in the market- despite the gains it's made (e.g. working down inventories) because the sales volume is so anemic.

What one must realize now however is the M2 money supply(and Personal Savings Rates). It is through the roof. This means that people have money. This also means that people who don't have to sell aren't. What they are doing instead is remodeling- this time with real income and improving the place where they live now by adding-on or just fixing up. This is great and plays right into your central point about the housing of the future.

The housing of the future is back to the future. It's builders building to design, it's people fixing up where they live for the long term and it is a much more stable environment. The only frustrating caveat to all of this is the employment picture- people have to have a job to stay in their house. The future of housing is like you reference not about the big wall street builders. It's back to the future and smaller "mom and pop" shops building to design to suit the needs of real people not those looking for the Toll Brothers "McMansion". The big builders sold investors on the idea that they had a better handle on "market research" with their "in house economists" and that they could avoid the pit falls of traditional housing cycles because of this. Well we all know how that turned out. Inevitably they started managing for each quarter and that meant building more and more houses with more and more square footage (price per square foot never changed). When you coupled this with the cheesy products being offered on mortgages (reverse amortization and the rest) coming from their wall street friends it spelled a disaster.

I cannot feature how people could be recomending home builders right now. Bizarre. Now Home Depot I could understand. As people decide not to sell into this weak market they might choose to remodel or improve their surroundings etc. So I could see that as a remodel play. But of those that can stay in their house whose going to move in a weak market. Moreover, they cannot "move-up" becasue of the JUMBO issue so this leaves you back where we started with starter-homes and distressed sales which will only further exasperate the market.

In sum, add-in the Alt-A shocker and we are just working through the bust and now we have classic recessionary issues hitting the mortgage/housing market (i.e. unemployment) and couple that with interest rates increasing on John Q. Public who is still in an option arm, things will get worse not better on the housing front (in terms of sales/build etc/ move-up market).

May 29 12:55 PM

[craigclower:]

Mr. President why are the banking,and loan company not making loans as you promised they would do for the american people we are all hurting and not getting any help. Time for them to answer to you for not helping us the little people that keep them in business, maybe we should boycott their business. Check obamamortgage2009.blog...

Jun 16 05:50 AM

[charles Wil...:]

I own a condo and have an outstanding balance of $140k, consisting of $104k primary and $36k secondary. I took the home equity to consolidate debts. At the time the property was valued at $163k but now it is valued at $134k. I'm looking to sell because i am engaged and will be moving into my fiancee's home. Check obamamortgage2009.blog... If I have a buyer who offers me within say $5-7k of the outstanding, can i agree to assume a loan on the residual and pay the bank the difference over time with interest? The same bank holds both mortgages.

Jun 16 06:15 AM