Signs indicate homebuilder bonds have further to fall before reaching rock bottom

By Jennifer Lanning Drey

Portland, Ore., Oct. 12 - When Beazer Homes USA Inc.'s bonds showed initial upward movement following the company's announcement of results from its internal audit investigation, it seemed possible, at least for a moment, that the last of the bad news for the homebuilding sector was finally out.

Under closer scrutiny, however, it appears the builders' bonds still have further to fall before hitting rock bottom, sources said.

An end to the decline is probably at least one to two years away, one trader told Prospect News on Friday.

"More defaults and a rise in interest rates as we have inflation - that will cause the bonds to go lower," another trader said.

Even more dismal, most sources also agreed that homebuilders will not see the bottom until at least one industry player ends up in bankruptcy court.

"It could get worse, if any of these companies have to file," said one trader who was otherwise relatively optimistic about the environment for homebuilders, saying bonds have probably bottomed out, at least in the short term.

Same old Beazer

While Beazer's announcement that it would restate its financials due to accounting errors was initially taken to be a positive sign, as one portfolio manager pointed out, from an operating perspective, it didn't change anything for Beazer.

Beazer's preliminary results for the quarter ended Sept. 30 show home closings declinine 39% from the comparable period in the prior fiscal year, according to the same company news release that also announced the early results of the investigation.

"Getting beyond their legal issues is certainly positive news, but from an operating perspective, nothing has improved," said Kenneth Monaghan, a portfolio manager for ING Investment Management.

Standard & Poor's and Fitch Ratings each downgraded Beazer following the disclosures of the audit committee.

Frank Lee, an analyst with independent bond research firm CreditSights, said it is premature to say that Beazer's bonds have bottomed out given that the full magnitude of the company's legal problems has not yet been quantified.

Beazer still faces an ongoing investigation by the Securities and Exchange Commission, which could lead to high penalties, he pointed out.

"It's not the end. I think there's going to be more problems ahead," Lee said, adding that costs associated with further litigation could force the company into bankruptcy.

Downturn means downgrades

Monaghan believes that the likelihood of further downgrades by the ratings agencies is evidence that homebuilder bonds, as a whole, will still fall lower.

"The cycle's not over. The homebuilding sell-off is well underway, but it's not hit the bottom," he said.

On Thursday, Moody's Investors Service said it downgraded Centex Corp., Lennar Corp. and Pulte Homes, Inc. senior unsecured notes to Ba1 from Baa2 and assigned the companies corporate family ratings of Ba1.

The agency also lowered Centex's $1.25 billion commercial paper program and Lennar's $2 billion commercial paper program to Not Prime from Prime-2.

The downgrades reflected the common woes of the industry, including gluts in inventory and cash pressures, Moody's said.

Monaghan believes the other ratings agencies will follow, and as investment-grade issuers' outstanding bonds move into high yield territory, even more investors will decide they want nothing to do with them.

To a certain degree, homebuilder management teams can maintain credit ratings, despite the challenging environment, if their primary goals are a solid balance sheet, lowering debt, improving cash flow and good liquidity, Fitch said in its quarterly U.S. Homebuilding/Construction: The Chalk Line report, released earlier this week.

However, the agency warned, the possibility of the housing downturn continuing longer and becoming even deeper than presently anticipated, due to a recession, "could have broad implications on 2008."

Monaghan believes most of the homebuilders are not paying enough attention to balance sheet improvements.

Poor mortgage conditions

On top of possible downgrades, homebuilders are also up against a mortgage market that is likely to get worse - another signal that homebuilder bonds are not ready to make any permanent upward movement, Monaghan said.

Home sales will likely fall sharply in September and October because of the tighter lending environment, particularly in the subprime mortgage market, a team of Wachovia Securities Economics Group analysts said in a special commentary report released last week.

Moreover, the Wachovia report said delinquency rates on adjustable-rate subprime loans have risen sharply in recent months and should head higher over the next year as more loans reset.

In September, foreclosures were up 99%, as compared to the same month in the previous year, according to the RealtyTrac Monthly U.S. Foreclosure Market Report.

Further declines in housing metrics could occur, particularly because delinquencies and mortgage defaults could spike upward, which would likely lead to mortgage terms being further tightened and loan originators, in turn, over-tightening mortgage standards, Fitch said.

As Monaghan put it: "The game's not over yet."

Q3 results may shock

CreditSights' Lee expects to see more shocking news - on the level of Centex's Friday announcement that it expects to take $1 billion in fiscal second-quarter write downs - coming from the homebuilding industry when the major players announce third quarter earnings.

In the preliminary quarterly announcement, Centex also decreased its projected consolidated cash flow to $500 million for fiscal 2008, down from previous estimates of $750 million.

For many homebuilders, generating cash flow will be even more important than increasing earnings, Lee said, because of their upcoming debt maturities in 2008 and 2009.

Homebuilders with maturities in 2008 or 2009 include Centex, D.R. Horton, KB Home, Lennar Corp., Ryland Group, Inc. and Standard Pacific Corp., according to Fitch's Chalk Line report.

"You have a whole bunch of problems here that still could get a lot worse," Lee said.

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