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--- Begin Message ----Caveat Lector- Gary North's REALITY CHECKIssue 387 October 15, 2004 THE HOUSING BOOM FALTERS The boom that began in 1996 may be coming to an end. In some cities, it has more than come to an end. Consider an article that appeared in the Las Vegas "Review- Journal" (October 5). The headline: REVERSING TREND: Builder cuts prices on new homes Decline in demand prompts move by Pulte Homes, angering investor This caught one reader's eye. When he sent the article to me, it caught mine, too. The article began with a photo of a modest-looking, 1,900-square foot home. The photo had a horror story description. The Gonzales family of Phoenix walks into their new rental home in Henderson's Anthem master-planned community. Denver-area real estate investor Ross King bought the home for $498,000 in September, less than two weeks before Pulte Homes lowered the price tag on similar models to $382,990. Mr. King is not a happy camper. The price of the products offered by his competition -- Pulte, from which he purchased his speculation home -- has just dropped $116,000. If he wants to sell it, buyers know that a secondary seller is going to accept a discount from his asking price. Knock off 10%. From $383,000 subtract $38,000. That's $345,000. Then take off the 6% commission. He is down to $324,000. Take off a couple of thousand in closing costs. Mr. King has just shed almost $200,000. This took less than a month. My guess is that he did not pay $200,000 down. He is therefore in a large debt hole. Mr. Gonzales got the better deal. He can move out if rents drop. He does not own his own home, but he also does not owe anything beyond his lease contract. He is mobile in a way that Mr. King isn't. Denver-area resident Ross King is furious about the Pulte Homes price cuts, which came less than two weeks after he closed on a 1,900-square-foot home in Henderson's Anthem master-planned community. King paid $498,000 for the house, which he bought as an investment. The same model now lists for $382,990 after costing as much as $516,990 in June. Poor Mr. King. He probably thought he was getting a steal when he bought that $516,000 home for a mere $498,000. But he is now hopping mad. King, a telecommunications consultant who earns in the mid-six figures annually, said he understands markets rise and fall. But he thinks he was the target of a hard sell by a Pulte Del Webb sales staff he believes was hoping to profit from the higher price tag. "I was told that if I didn't close (on Sept. 24) I could be jeopardizing my $18,000 down payment and that per Pulte's agreement they would fine me several hundred dollars a day thereafter," said King, who has spoken with a lawyer about the episode. The article goes on to say that Pulte has reduced home prices by 5% to 25%, depending on the region. WHEN EXPERTS LOSE THEIR SHIRTS Pulte is one of the most successful home builders in America. It has been in business since 1950, the era of the mass-produced home. The company knows its business. Like every builder, it has to keep building. And like every builder, it gets hammered when a turndown comes. Pulte executives announced the cuts to counter a dramatic decline in foot traffic, which was off by as much as 35 percent at some of its 18 Las Vegas Valley subdivisions. Company executives believe the decline is the result of inflated housing prices that have in part been driven by real estate investors seeking a healthy return on their money. For anyone who got caught in the mania that began this year in Las Vegas, paying top prices, this equity loss will hurt. The drop has wiped out first-time buyers' equity. New home prices in the valley appreciated by 35 percent during the first eight months of this year, according to Home Builders Research. Over the past decade, the median price of a valley home has more than doubled while median household income has increased just 22 percent. The median price of a new valley home was $259,700 in August; the price for an existing home was $250,000, according to Home Builders Research. Obviously, the housing market in Las Vegas has hit a brick wall. But frantic buyers who outbid each other during the first eight months did not see this coming. Frantic home buyers never do. They think it's now or never. They think it's the last train out. It was not the last train out in Las Vegas. Executives of Pulte Homes believe the company will build 3,500 houses in the valley this year, trailing only market leader KB Homes. But a major increase in the number of resale homes on the market -- currently about 16,000, up from February's 1,400 -- has prevented Pulte from selling houses at the higher prices, Palmer said. She believes about half of those homes were built this year, suggesting many are being sold by investors. Take a look at the chart for the price of Pulte's stock. It's not reassuring. On October 1, it went off the cliff. At one point later in the week, there were no buyers. The price gapped down. Volume soared. The lemmings sold out. You don't see charts like this very often. (http://snipurl.com/9po2) WINDING DOWN It usually takes time for every mania to wind down. The stock market usually winds down first. This was surely the case with the new housing industry. The industry's P/E ratio fell into the range of 7 during the summer. This is in comparison with 17 for the S&P 500 (which Standard & Poor's no longer publishes in an HTML page on its site). Some analysts learn slowly. Such was the case of one hapless soul, who I will not name here. On Yahoo's Smart Money site on August 10, we read an article previously published on its premium site. The article is used to get you to subscribe to the premium site. It did not motivate me to shell out the money. Here's why. The author asked, "Are Home Builders Cheap?" He answered in the negative. He referred to "the battered shares of home builders." Battered surely describes Dominion Homes, whose shares peaked at $40 in March, and which now sell in the low 20's. (http://snipurl.com/9pov) Our author describes himself as a skeptic of the skeptics. The standard thinking on home builders is this: As the Fed hikes interest rates in the coming months, mortgage rates will rise sharply, finally choking off demand in a sector that has enjoyed booming growth for years. Today's stunning earnings gains won't be repeated tomorrow, the skeptics argue. But the contrarian in us says that the combination of investor pessimism and rock-bottom PEGs makes residential construction companies worth a closer look right now, regardless of what happens on the interest-rate front. And, anyway, there's reason to believe that investors are misreading the writing on the drywall with regard to mortgage rates: The yield on the 10-year bond, which drives mortgage rates, touched 4.8% in June. Now, it's at 4.26%, despite two interest-rate hikes. Anyone who accepted this analysis may have bought Pulte shares. The author focused on Pulte. Pulte's growth over the past 10 years has been impressive. Its closings and annual sales have increased 14% and 20%, respectively, per year. Profits have compounded at 27%. Those who've held Pulte shares for 10 years are up 467%. Second-quarter results for the company, reported July 26, showed sales increasing 29% year-over-year to $2.5 billion and profits from continuing operations jumping 54% to $187.7 million. Per-share profits of $1.45 topped analysts' expectations by two pennies. New orders for the quarter were up 17% and backlog increased by 31%. A.G. Edwards analyst Gregory Geiber thinks Wall Street has to start to think differently about home builders, especially Pulte. "It is, perhaps, a disservice to investors to be overly focused on the debate about the interest-rate/near-term cyclical aspects of the housing market as it is a distraction from the more subtle, but ultimately much more important, evolution in the large public builders -- like Pulte," wrote Geiber in a July 28 research note. (http://snipurl.com/9pog) Subtle? What happened to Pulte earlier this month was about as subtle as a cattle prod. This is not to say that Pulte is doomed. It isn't. Any builder that can stay in business for 54 years is likely to survive. But the stock market is facing rising short-term interest rates, a typical first year after a Presidential election (down), a $400 billion Federal Deficit, a $600 billion trade deficit, and a national savings rate that is under 4%. The housing market has been turned into a bubble since 2000, replacing the stock market as the way to easy riches for the average Joe. The problem is, Mrs. Joe wants a bigger, nicer home. Mrs. Joe sees their home as a consumer good. Joe justifies the expense, and the 30-year mortgage, as an investment. A bubble keeps getting larger, and its skin getting thinner, and the supply of air seems inexhaustible. The air is fiat money. The supply of fiat money comes from the government, by way of the central banks, both foreign and domestic, and by way of the couple known as Fannie Mae and Freddy Mac. --- Advertisement --- Bad news: This year -- and for many, many more to come -- your ballot may as well be a piece of toilet paper! It doesn't matter who eventually buys this election... the country is destined to go bust no matter who sits in the Oval Office. America stands on the verge of a deep political chasm and the coming train wreck could obliterate stock portfolios, crush home values, and decimate savings funds... but there's a solution: And it can allow you to protect yourself, your family, your house, and your wealth from the impending economic disaster while giving you 7 ways to profit... Get all the details now... http://www.agora-inc.com/reports/DRI/electA04 ----------------------- "I CAN GET IT FOR YOU WHOLESALE!" The housing market is now facing scandals in Fannie Mae and Freddy Mac, the two gigantic mortgage lending institutions. More than this: these two organizations are inherently beyond understanding -- surely beyond the understanding of Congress, which is thought to regulate both outfits. In a critical essay on fool.com, of Motley fame, Bill Mann writes: I remain somewhat baffled at the lack of real, visceral anger about what's taking place at Fannie Mae (NYSE: FNM), but perhaps I should not be. The numbers are too big ($1 trillion plus in assets), the pain thus far has been limited to a 16% decline for shareholders from before the scandal, and perhaps most important, what the company has done wrong is deeply complicated and esoteric. A 16% hit is not to be taken lightly. Fannie Mae's chairman was on TV recently, justifying everything, saying that everything is under control. In short, things are probably very bad. Confusion and complexity reign at Fannie Mae, though. In fact, I'm willing to say something that analysts will likely find scandalous: I believe that Fannie Mae is unanalyzable. Fannie Mae, like its sister company, Freddie Mac (NYSE: FRE), uses extraordinarily complex financial statements, layers of derivatives, and has enjoyed years of poor regulatory oversight. Even before Fannie received a stunning and long overdue rebuke from its governmental overseers, it took a Herculean effort to be able to determine how much actual cash flow the company made in a given year. . . . What staggers me, though, is the fact that of 21 Wall Street analysts who cover Fannie Mae, 11 still recommend it as a "buy" to their clients. That's unbelievable to me. This is a company that in the best of times has financial statements a Turing machine [a high-powered computer that supposedly thinks like a human -- GN] couldn't decipher, is at the very beginning of uncovering a scandal that goes who knows how deep, is facing what could be a multiyear reformation, and has a management team that looks unlikely to survive the probing. It's not so much that I think that most investors have no idea how to analyze Fannie Mae, it's that I don't believe that the analysts have much of a clue, either. The author then describes what the Federal National Mortgage Association does. It was founded in the 1930s and privatized in the 1960s. It is a federally chartered corporation, owned by shareholders, that serves as a quasi-governmental agency. The company's charter gives it the objective of making sure there is money available for Americans who want to buy a home to get mortgages, but you cannot simply call up Fannie Mae and ask its loan officers about the going rate on a seven-year ARM; it doesn't loan money to retail home buyers. Instead, it provides liquidity for lenders by providing liquidity in the secondary mortgage market. In other words, it's a wholesale lender. It is buying consolidated packages of mortgages from lending institutions. It makes money available to the retail lenders who make money available to home buyers. Fannie Mae doesn't just hold onto all of these mortgages, though. It will take your loan and package it up with hundreds of others and market them as mortgage-backed securities (MBS) that it then sells to investors (for example, insurance companies, pension funds, or even mortgage REITS like Annaly Mortgage (NYSE: NLY)). Fannie Mae provides a guarantee to these investors that they will receive timely principal and interest payments, no matter what happens with the underlying mortgages. Well, isn't that nice of Fannie? There is nothing like a guarantee issued by a quasi-governmental agency to get investors to part with their hard-earned money. There is one slight problem, however. If there are large numbers of defaults, Fannie Mae will have to make the investors whole. If there is a massive crash and defaults overwhelm Fannie Mae, it has an ace in the whole: your tax dollars. Even though the company's debt offerings clearly state otherwise, the financial markets believe that Fannie Mae's status as a government-sponsored enterprise implies that the government will provide full faith and credit for Fannie's debt. It is for this reason that Fannie Mae maintains a AAA credit rating, even though at a 78:1 debt-to-equity ratio it is levered many times what is allowed international banks. (Debt is defined as mortgages on its books plus the value of its guarantees.) Fannie is exempt from regulation by the Securities and Exchange Commission (though Fannie Mae has in the last few years begun filing 10-Ks and 10-Qs), it is also exempt from state and local taxes. The U.S. president gets to appoint several board members, and the U.S. Treasury Department approves Fannie Mae's debt issuance. And it has approved and approved and approved. Fannie Mae and Freddie Mac have virtually unlimited access to capital, at funding costs that are below the rates otherwise available on the market. There are trillions of dollars at stake here. These trillions have been poured into the residential real estate market. Home ownership has risen to 70% of America families, a record. That's the good news. Here is the bad news. As Fannie and Freddie have approached saturation in their core businesses, they've branched out, basically by taking on more risk. Fannie and Freddie have been arguing against the need for statutorily required mortgage insurance for loans above 80% of the value of the home, the bailiwick of private mortgage insurance providers like MGIC (NYSE: MTG), Radian Group (NYSE: RDN), and PMI Group (NYSE: PMI). Why would they do this? Because Fannie and Freddie want to cut out the expense of paying the PMI providers, even though it increases the risk of their overall portfolio. That's the trouble with any market that attracts 70% of any population. There are millions of not-ready-for-prime-rate borrowers scrambling for a piece of the action. It has a AAA credit rating, despite the fact that its debt levels in no way warrant such a rating, and it has a nearly limitless channel to capital, at interest rates that are below market. Add to these elements the fact that Fannie Mae is not a governmental operation, but a for-profit corporation, and you have the recipe for -- well, for what's going on right now. Why worry about risks when you have the implied backing of the federal government? Why worry about capital structure when no matter what your cost of debt is fixed at a below market rate? Mr. Mann then lays it on the line. Want to know why Fannie Mae is in trouble? It's simple enough: This company, more than any other in America, is run by, in the interests of, and with the protection from politicians, not businesspeople. Yes, I know that it seems crazy, given the shambles of ethics extant in Corporate America, to crave their leadership, but there you go. There is no company that has more powerful lobbying in Washington than Fannie Mae. Really, the only thing more absurd than Corporate America wagging its finger about shareholder interests is a bunch of politicians wagging their fingers about crooked accounting. Fannie Mae's long been a cat in desperate need of having a bell tied to it. http://snipurl.com/9ppn CONCLUSION The stock market has rendered its judgment on new home builders. It has also rendered judgment on the primary wholesale lenders. The market's judgment has been negative. What is the market telling us? That the housing boom is coming to an end. My assessment is much the same. Unless you live in a region that is experiencing net in-migration, it is time to hunker down in your poor, miserable hovel. You don't need to buy up. If you live in a home that you could rent for your mortgage payment, taxes, and insurance, you are living where you belong. I think the housing boom is over. Maybe not in your town and probably not in mine: Wal-Mart country. But if you live where it costs $500,000 for a home that Mr. Gonzales can rent for $1,600 a month, you're better off to sell the $500,000 home and imitate Mr. Gonzales. ------------- -- Been to the Daily Reckoning Marketplace Yet? -- If not, you ought to see what you've been missing. Want to read more from our regular contributors? This is the place to find it. We've collected some of the best financial advice and commentary available anywhere and presented it to you all in one place. 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