The Feds Ride to the Rescue--on a Tortoise

The Senate Banking Committee took testimony today from Federal Reserve chairman Ben Bernanke, Treasury Secretary Hank Paulson and SEC head Christopher Cox.

The headline here is that Bernanke testified that the economy will see a “period of sluggish growth, followed by a somewhat stronger pace of growth starting later this year as the effects of monetary and fiscal stimulus begin to be felt.” He added that “overall consumer price inflation should moderate from its recent rates” and that “inflation expectations should remain reasonably well-anchored.”

However, lots of after-the-fact refereeing, lots of gaseous rhetoric from senators with their own hobbyhorses that wiped out some icebergs in the Arctic, notably the questions from left field about naked short selling from Sen. Robert Bennett of Utah, home to companies that have come under fire from short sellers, such as online retailer Overstock and just about any penny stock you can think of.

Not much tough talk about the structural changes that need to be made, but you can't blame Bernanke--he's being as creative as he can applying the paddles to the Goldilocks economy, with hefty rate cuts and by pumping liquidity in, which includes opening wider the discount window as well as term auction facilities.

Paulson, well, he is parachuting in to a minefield that he didn't create. Neither did Cox, though the SEC is still the water pistol, not the shotgun behind the door, as Supreme Court Justice William Douglas had hoped it would be.

Not enough tough talk about correcting a housing finance system that is built on sand. Not enough talk about how once again investors are suffering because greed has won out over common sense on Wall Street.

Not enough talk of the moral hazard that arose when banks no longer cared about keeping a tight leash on delinquent borrowers because they shoved those loans off their books in securitizations to reap hefty fees, bye bye borrower.

Or how credit ratings agencies reported record profits by getting rich fees from Wall Street to rubberstamp their toxic subprime securities with triple A ratings, but now the raters run from accountability by hiding behind the ruse that their ratings are really “opinions” protected by First Amendment free speech rights, and that they now argue they don't have to actually examine any of the loans backing these securities because they are not auditors.

And nothing much about bond insurers who mindlessley sold guarantees backed by their microscopic capital reserves to Wall Street for its dodgy subprime securities, guarantees that are really paper promises.

The market’s problems are structural. An asset bubble without the guardrails is agonizingly painful once it bursts. Without those guardrails, it will happen again. So who in government will grow a spine to make necessary changes, instead of blowing taxpayer money in bailouts or loan work-outs that many don't deserve?

Sad to say looks like no one. The free markets will remain a free-for-all. Why do the good guys, the taxpayers who pay on time and watch their wallets, have to pay for this mess?

So let’s do a recap of where we are. The US economy saw a massive run-up in house prices of 130% from 2000 to 2006. The bubble then burst in 2007.

Treasury Secretary Paulson says 1.5 million homes are now either in default or in foreclosure, and the government is moving fast as it can to do workouts on these loans. Some predict 2.2 million could default or be foreclosed on. Detroit has the most foreclosures in the country, with Irvine and Stockton, Calif. also hurting.

Builders have already drastically cut housing starts by 30% in the past year to an annual rate of 1mn, levels not seen since May 1991. Projections are for another dropoff of 30% in 2009.

With existing homes, the National Association of Realtors says pending sales are down 24.2% from a year earlier--California, Nevada and Arizona are really feeling the pain. Existing home sales this year will fall to a 20-year low of 4.3mn units, says the National Association of Home Builders.

But housing will stabilize in 2009, says David Berson, chief economist for the PMI Group.

So, we need to get to the ground zero of the housing crisis, and that’s the home builder sector.

Home builder stock charts up until recently have looked like toboggan-sled runs. Strange, then, to see a recent stock market rally in some home builder stocks that has some wondering whether the stock market has turned back on the lights in the House of Pain.

The thinking goes, lower home prices, still historically lower mortgage rates and Fed rate cuts will provide a floor under their distressed shares. Builder stocks at one point recently were up 45% since mid January.

But here’s why you should not get taken in by this suckers’ rally.

Inventories are still quite high and lenders are more scared than a skunk at a picnic.

The glut of hard to sell unsold homes and condos, as gauged against the monthly rate of sales, continues to climb to really uncomfortable levels. Builders are still mindlessly building too much, and their reality check bounced a long time ago. Prices dropped, with the national median price of a new home falling 5.8% in the last three months of 2007 to $206,200, the steepest quarterly drop recorded by the National Association of Realtors since 1979.

The NAR adds that inventories are at a supply of 10 months, the highest level in 18 years. To wipe out the supply glut in housing, builders will have to pump out just 800,000 houses annually for two years, Merrill Lynch says. That’s about half of the going rate up until recently.

Moreover, there are hidden time bombs on the companies’ balance sheets—off balance sheet debt—that could keep the home building sector dark for a while longer.

Specifically, many home builders entered into land deals with partners, but then shoved billions of dollars in debt from those deals into off balance sheet vehicles, debt that could come back to bite their stocks. Put that debt back onto their balance sheets, already underwater with an ocean liner of debt, and the companies’ already dirt-cheap book values fall deeper in the hole.

Specifically, many large builders took minority stakes in joint ventures, which let them stockpile land for future needs while keeping billions in debt off their balance sheets. If they don’t’ make sales, if they can’t move that land, they’re still very likely on the hook for their share of that off-balance sheet debt.

Alisa Guyer Galperin, an analyst at the Center for Financial Research & Analysis, figures that 13 of the country’s biggest homebuilders on average have debt to capital ratios that look way uglier with this off balance sheet debt factored in, as much as 977 basis points higher than typically reported.

This is why investors should care about higher debt to capital ratios. A company with high debt-to-capital ratios faces costs, like interest, on these debts that can suck free cash flow out of a company, cash that could go toward expanding an operation (yes taking on debt can also help pay to grow a company, but at a big cost—especially if management is poor). High debt can weigh on a company and increase its default risk.

Lennar, one of the country’s biggest home builders out of Miami, Fla, and NVR, a homebuilder in Reston, Va., have the most off-balance sheet debt (the Center also adds that NVR in each of the last three years bought developed lots from a company controlled by a board member—did it get a fair price for shareholders?)

Homebuilders may be held responsible for their share of joint venture debt guarantees, based on their pro rata share of the joint venture or the JV’s specific recourse agreements. The accounting rules are really loose here—the homebuilders themselves get to decide whether or not they are the prime beneficiaries of an off balance sheet deal, and so whether they need to book the debt on their balance sheets.

The Center’s Guyer Galperin has estimated that Lennar is on the hook for up to $910 million of $5.6 billion in debt through partnerships not on its books. Lennar and other home builders are already fighting with lenders that are stamping their feet to force it pay off its share of their partnerships’ total outstanding debt.

And Deutsche Bank has already sued Technical Olympic USA, alleging the Florida builder is in "multiple potential defaults" on $675 million in debt owed by several failed joint venture partnerships. Lennar says it’s protected from any problems because it’s hooked up with solid institutional investors like the pension fund CalPERS and has set up deals to ensure it isn't liable for partners.

Watch out.