Running With the Devil | John Burns Real Estate Consulting

Running With the Devil

Inside the Bailout: What We Get vs. What We Need

The Emergency Economic Stabilization Act of 2008 (EESA), signed into law on Friday, was adorned with billions of dollars in earmarks. Still, it seems there was little room for home builder interests*, except the one that’s so broad-sweeping that even bi-partisan “frenemies” can all stand behind it: The Restoration of Confidence.

Today, the only constant is change. As Congress moves from crisis to crisis – scrambling to quench whichever fire burns brightest at the moment – we’re left to consider: Just what does all this mean for home building?

We’ve organized our analysis of where the industry stands today and what issues will be critical for smart decision-making going forward as follows:


Any semblance of Housing Stimulus 2.0 was left out in the cold. The following items were missing from the legislation:

  1. A Net Operating Loss (NOL) Extension
    Last week, a group of tax directors from several of the large (mainly public) home builders met to discuss their ongoing wish for the extension of the NOL carry-back. The tax director for the Senate Finance Committee spoke to the group and acknowledged that the banks would also see benefit from the relief. Ultimately, House Republicans included the 5-year carry-back in their alternative to the bailout, but it was met with opposition from House Democratic leadership.Despite the ongoing resistance, it seems clear that there will continue to be opportunities to talk about NOL, particularly as the banks – and other industries that could benefit – now feel the stress on their balance sheets that the home building industry has been suffering for a while.
  2. A Stay of Execution for the Death of Down Payment Assistance (DPA)
    Despite some initial traction from a last-ditch, grass-roots effort to preserve seller-funded down payment assistance, the financial crisis engulfed the momentum. In other words: R.I.P. DPA. You’ll be missed by many. This table of comments from the publicly traded builders’ more recent quarterly earnings calls shows the prevalence of DPA programs in their sales.

    Public Builder Down Payment Assistance Program Usage
    Beazer (BZH) 20% of customers in 6 months ending June 30, 2008
    Centex (CTX) 25% of closings in quarter ending June 30, 2008
    DR Horton (DRH) 29% of closings in quarter ending June 30, 2008
    K Hovnanian (KHOV) 16% of loans for 9 months ending July 31, 2008
    Lennar (LEN) 45% of loans Lennar originated in quarter ending August 31, 2008
    M/I Homes (MHO) 18% of closings in quarter ending June 30, 2008
    Meritage (MTH) 14-15% of closings in quarter ending June 30, 2008
    Pulte (PHM) 10% of closings in quarter ending June 30, 2008
    Ryland (RYL) 18-20% of backlog in 6 months ending June 30, 2008
    Standard Pacific (SPF) 12% of deliveries in 6 months ending June 30, 2008

    Eliminating DPA is expected to have a very negative effect on the demand for housing, as almost all buyers will now need to make at least a 3.5% down payment. While some builders may have seen a recent uptick in sales attributable to promoting the fact that these programs will disappear, the long-term demand will certainly fall. Michael Rehaut at JP Morgan estimates that this could impact roughly 17% of new home sales.

    Though there is no replacement for DPA, it’s expected that buyer assistance programs will come back in different forms. Already, there are reports of local bond issues being examined to fill the gap, though the downside of such a program is the incessant red tape as well as geographic constraints.

  3. A True and Substantial ($15k-$20k) Home Buyer Tax Credit
    Anecdotally, builders are universally confirming that the $7,500 tax credit for home buyers (technically a loan), which was seen as the cornerstone of this summer’s housing stimulus package, has failed miserably. Even in the ultra-public forum of quarterly earnings calls, executives are venting their frustrations at the effort – the CEO of Lennar called it “anti-stimulus.
    In mid-September, one CEO of a large public builder participated in a conference call with Representative Richard Neal (D-MA), Chairman of the Select Revenue Measures Subcommittee of Ways and Means, and suggested that what the housing market needed was a $15,000 tax credit with no recapture that was available to all home buyers, not first-time home buyers only.In the days immediately following the call, the Chairman suggested that, “as discussion of a second stimulus package takes place, home builders should work with other interested parties to advance that proposal.”The costs of such a proposal are being modeled: As of mid-September, the NAHB’s rough estimate – as the Joint Committee on Taxation (JCT) would score it – was $75 billion over ten years. (Thirty billion over ten years if the first-time home buyer restriction were retained). However, the organization told builder executives it would continue to work with advocates on Capitol Hill to secure an official estimate from the JCT.More recently, the tides have turned. Talk now centers around the belief that discussion of this tax credit is self-defeating since an initiative was passed once with little effect. In addition, sources report sentiment in Washington is that the credit will have little effect since few buyers can even secure a loan. The question being asked is, “Why spend $75 billion on something when you can’t be sure it will work?”
  4. Construction Loan Eligibility Among the “Bad Loans” Wiped Out in This Bailout
    It could be argued this might be the most important single issue (in the context of this bailout) that was relevant to home builders.
    Several banks went to Capitol Hill and pushed hard to get bad construction loans rolled into the bailout as an eligible Treasury purchase because so many builders have gone belly-up based on their inability to pay off these notes. Reportedly, these banks’ proposals didn’t gain traction because the idea was introduced too late in the game to build any momentum from other banks and/or home builders.The only silver lining is that the language defining “troubled assets” is broad enough in definition that it leaves a window cracked open for the Treasury to purchase additional loans, though it must confer with the Fed for approval to do so.Over the last 18 months, delinquencies have continued to rise on construction loans, and that problem has truly amplified for for-sale residential construction loans. As shown in the chart below, delinquency rates are highest on construction loans for condos, followed closely by single-family construction loans.That being said, single-family loans are the much bigger problem despite the lower delinquency rate, because they account for 86% of all for-sale residential construction loans outstanding.In terms of percentages, single-family construction loans remain small – just 2% of the loans outstanding among the top 100 banks.
    However, the total dollar value is significant – $244.6 billion across all banks. That’s particularly telling when you consider that most of the writedowns banks have recognized so far (roughly $500 billion worldwide) have been related to subprime mortgages alone.We have yet to see the ultimate effect construction loan writedowns will have on banks, not to mention:

    • Alt-A
    • Credit card debt
    • Student loans
    • Municipal and corporate bonds
    • Credit default swaps
    • Commercial R.E.

Click here for more data from Foresight Analytics on construction lending.



Today’s debate is over an ultra-short-term bailout – the Wall Street piece – liquidity. The theory is that, if the banking system can make loans, people will start buying homes. The fact is that there’s a lot of wishful thinking in that.

According to a Washington insider who works directly with one of the largest banks near failure, banks are acknowledging that eliminating toxic debt is JOB 1. But make no mistake: the problem goes much deeper than getting bad debt off the hands of the banks. There are structural issues upon structural issues that need to be addressed before these entities can begin to make loans in a meaningful way.

EESA has passed, and taxpayers will apparently be buying up bad loans, but it’s hardly a panacea because there are other issues critical to the industry’s recovery and eventual vitality that remain unresolved.

  1. What About Frennie?
    The Treasury Dept.’s takeover of Fannie and Freddie (Frennie) nearly four weeks ago marked the beginning of the subsequent bailout-apalooza. And so much distraction has occurred in the weeks since, that the failure, the scandal and – more importantly – clarity on what happens now has been shoved to the back-burner.
    Much was written in the immediate wake, and the consensus was that the nutshell impact would be on keeping mortgage interest rates low. After a significant dropoff in rates in the weeks following the takeover, rates have begun to inch up again, as shown in the graph at right. But now that the bigger sins have revealed, first and foremost, it’s not even about rates – it’s all about liquidity.Just How Will The GSEs (or should we say GOEs?) Underwrite?
    The whole economic model that kept Fannie Mae going was its ability to take mortgages and securitize them. Then institutions would buy them, keeping liquidity in the system. In the short-term, at least, that’s a model that clearly doesn’t work for two reasons:There is no money in the system to purchase the securitized packages.
    Investors who bought in were likely so burned, they won’t get near that flame again. The Treasury implored a swath of banks to buy the Fannie Mae preferred stock. Then, upon takeover, the stock tanked. (Both moves underscore the fact that the GSE stocks were ripe.)
    An effort has been made to soothe the pain to those investors. Within EESA, there is an unprecedented provision that states if an entity has losses arising from Frennie stock, instead of being treated as capital losses (no gains to recognize to offset!), banks will be allowed to convert those capital losses to ordinary losses – then they can be offset against ordinary income.What form these GSEs ultimately assume remains to be seen. Despite the fact that a group is currently being formed in Washington with the intent to lobby for reform, there is not a lot of talk about reform itself.Discussion is mainly focused on whether the entities should be privatized. However, due to the instability it would bring to interest rates, complete privatization seems unlikely. The GSEs artificially insured against risk in mortgages, and if that security goes away, someone will be expected to pay.If the GSEs remain as they stand with government guarantees, a capital injection from the Treasury allows them to expand the sphere of lending. There is also talk about the need to drop the minimum FICO hurdle rate for buyers to the lower 600s (with even lower standards in regions like Texas).In the meantime, all eyes are curiously watching to see what the structure of the conservatorship will look like. (According to former HUD secretary Henry Cisneros, the deadline for that unveiling is January 1). There is a lot to delve into regarding this issue alone, and it’s one we’ll continue to explore.

2. What’s The Impact of Suspending Mark-to-Market Accounting?
The EESA ducked the issue directly but did do two things:

  • Underscored the SEC’s ability to suspend mark-to-market accounting; in essence, the practice that pins the current market price on assets held, regardless of what was paid for them.
  • Asked that the issue be studied

Today, with values plummeting in the financial world, it’s this anticipation of marking to market that is causing some hysteria among banks. The banks, along with some lawmakers, are complaining that being forced to write down billions of dollars worth of securities is squeezing the credit markets.

With the ruling suspended, banks have an opportunity to apply some value to assets now perceived to be worth $0, in the hope that values will recover someday. This strategy worked during the Latin American debt crisis in the early 1980s. The other side of the coin is that it underscores the artificiality in the accounting.

When times were good, this was a discussion you never heard. If you held an asset with a book value of $10 million, yet you could sell it for $12 million, there was an imbedded gain – yet the idea of marking it up to market was ridiculous.

Just the threat of marking assets to market is, in fact, causing the short-term dislocation, primarily because there IS no market. Even if only as a short-term market aberration, it exists.

Facts on Marking to Market:

  • It’s an accounting issue, not a legislative statue. In other words, it’s a “ruling” that can be suspended, much like the ban on short-selling stock.
  • It’s also a philosophical discussion. Do you cleanse the system, hold the institutions’ feet to fire, and let the free market go to work? Or do you save the institutions and assume they will eventually recover value?

What Remains Unclear:

  • The proposed length of the suspension.
  • The impact that suspending the ruling might have on land values.
  • How the assets previously marked to market would be treated relative to those preserved under the suspension.

The Treasury, the Fed, and many accounting firms support the belief that divorcing the value of assets from their true market price can reflect an artificial view of financial well-being. They point to the S&L crisis as an example of the effect of inflated values.

Turning Japanese?

From the 1960s to the 1980s, Japan achieved an astounding annual growth rate of 8%, which ultimately led to rampant speculation in commodities and real estate. In that same period, land prices rose 236% in the country’s 6 largest cities. Property speculation continued on for another 10 years and by 1990, land rose another 103% (another 272% in those same six cities!)The dangers of not marking to market are a prolonged economic turnaround, as evidenced by Japan’s decision not to do so, which ultimately led to the decade-long slump in the 1990s.

The government put on the brakes to control inflation in 1989 crashing the stock market and wreaking havoc in the financial systems. By 1991, the real estate bubble burst.
The country did not employ a mark-to-market mentality during the freefall, and that decision is what many now point to as a contributor to a decade of economic stagnation.In 1990, Japanese banks held 22% of the country’s mortgages. Plus, many of the loans to small businesses were backed by property, and our research shows that nearly three-quarters of the local banks’ lending were to these small businesses.

3. What About Foreclosures?
If there is a singular focus we can look to as an industry that begins to move everything forward, it’s the need to stop the bleeding associated with foreclosures. Be it in broad strokes, or house-by house, keeping people in their homes immediately makes the assets of banks and builders worth more.

Values keep plummeting as foreclosures continue to escalate. The latest Case-Schiller Index is down 18% from its peak in mid-2006, consensus is that we’ll have another 10% fall that has to be absorbed before there is stability.

According to the Mortgage Bankers Association, 1.25 million loans (2.8% of all loans) were in the process of foreclosure at the end of 2Q08, nearly double the 636K (1.4% of all loans) in 2Q07. And there is more to come. Nearly one in six people currently owe more on their mortgage than their home is currently worth. There are another 2 million ARMs alone on the verge of adjusting. The only silver lining in all this is that distressed sales, have accounted for positive resale sales growth in recent months.Currently, the system’s structure contains no great reasons not to default, which is causing a spiral effect on the market, the banks, investors, Wall Street and the entire economy.

The language of the EESA contains an implicit trade – government will help get the paper off banks’ books, in return, banks are expected to show some forbearance with loans. Though the sentiment is imbedded, it’s unclear as to how and when it will be implemented.

Earlier this week as a result of a settlement with several state attorneys general offices, Countrywide (now owned by B of A) announced that it was creating an $8.4 billion fund dedicated to renegotiating interest rate and principal reductions on 400,000 mortgages (125,000 in California alone) in an effort to stave off foreclosures.

Despite the obvious difficulties of tracking individual resold mortgages back through the system to find the “end owner”; and despite the unknown mindset that owner might have relative to a workout or payout of the mortgage, Countrywide says it is dedicated to helping renegotiations. The fund also contains provisions to offer rent subsidies to some home owners undergoing foreclosure.

Following the Countrywide/B of A announcement, attorneys general and banking regulators from 11 states are calling on leading subprime mortgage servicers to follow suit and adopt broad-based loan modification programs.

As one home builder executive aptly remarked, “Until the some meaningful steps have been made to stave off foreclosures, anything else that we are doing is just putting a band-aid on cancer.”

4. The Political Wildcard
Now that a financial rescue package has passed, the big question is: What then, if anything, does Congress do by way of further stimulus?

Because the loudest opposition to the bailout concept has been in regard to its perceived assistance to fat-cats on Wall Street, it is safe to assume pressure will begin immediately as Main Street looks for the “gimme” they feel they deserve. It’s too soon to speculate just how much pressure will be leveraged around the time of the election, or if Congress will be able to effectively hold another stimulus at bay until it reconvenes in January.

That being said, regardless of who wins the impending election, we will have a new President. With that, comes a new direction on policy-making. Anecdotally, there seems to be a consensus within the industry that the outcome of the election will weigh heavily on the ultimate direction taken with Frennie. If McCain wins, the entities are privatized. With Obama at the helm: the entities are nationalized.


It’s unclear as to how many of these issues will play out – which explains why there are almost as many questions as there are answers.

In a perfect world, perhaps the bailout money is injected as equity into the banks so that they continue to lend. Certainly, until we loosen the credit standards and start lending to less-than-stellar homeowners again, it won’t work.

Maybe the answer is to forget fiscal and monetary policies. The sensible solution may be to write down face value of mortgages and allow borrowers to refinance at fixed rates. Implemented in the Great Depression, it’s a theory considered by some as a panacea to avoid foreclosures, eventual bank failures and eliminate the need for the bailouts in the first place. (There is speculation that a fixed rate of 4.5% for some predetermined window of time would solve all the economy’s ills!)

Regardless, the common thread throughout this piece is that change needs to occur – serious, fundamental change. The disparate and common interests of the companies that form this industry need to be heard, and ultimately championed in a sophisticated manner that reflects home building’s importance to the overall economy.

While home building is being accused of having led us into this depression/recession, it may also be the industry to lead us out – although there is still hard work ahead. Our outlook remains that sales volumes and construction levels are likely to bottom out very soon, and at very low levels. Prices will continue falling because it will take time to clear the excess supply of unoccupied homes as well as the tremendous number of resale homes for sale. Supply-constrained markets will generally rebound first, but won’t fully recover until there is job growth and a 4-5 month supply of resale homes on the market.

In the meantime, here is where your focus should be:


  • Stop Spending Money
    Companies of all kinds are going to run out of cash and not be able to make payroll. Goldman Sachs and GE would not have agreed to pay Buffett 10%+ stock rights if they were not concerned. Monday’s unprecedented announcement to buy commercial paper is designed to protect payroll at large companies. But, what about small companies?
  • Hack Your SG&A
    With revenues dropping so dramatically in this last quarter, it’s been tough to keep cutting at a fast enough rate. As painful as it is, get aligned. Will big builders merge just to cut SG&A as a percentage of revenue?
  • Put Your Congressperson on Speed Dial
    Lobbying efforts are critical to keep the industry in motion. Make your voice heard about the need to stimulate home sales and keep Frennie lending aggressively. In June, we highlighted these policy issues as critical. Today, their relevance is even more clear.
  • Bring Sanity to the Table
    Sell anything you can to generate a tax refund because it looks like the lookback on taxes paid will not be expanded. Rely on people who know the business — even your business — as well as the financials during workouts, and portfolio analysis.
  • Take FHA 101
    Ramp up your FHA knowledge as that is the only source of low down-payment financing. The graph below from Inside Mortgage Finance shows just how much FHA endorsements have grown in the last year.
  • Surround Yourself with Great People
    Top talent makes you smarter, more competitive and more efficient.
  • Know Your Competition, Including Foreclosures
    Community pricing strategies should be based on submarket-specific knowledge.
  • Cross Your Fingers

Clearly, the evolution of our industry is not going to be easy. But, as American inventor Charles Kettering once aptly noted: “The world hates change, yet it is the only thing that has brought progress.”

Throughout it all, we’re committed to delivering valuable intelligence and thought-provoking discussion so that you are expertly informed as you make business decisions. And we want to encourage dialogue about these issues. Please feel to call or e-mail me with questions, insight, and/or opinions.

* Footnote: In an e-mail sent out 10/2/08 by the NAHB, these items included in the current form of EESA were listed as “of particular interest to NAHB”:

  • Extension of the credit for energy-efficiency improvements to new homes for one year through 2009;
  • Extension of the energy-efficient buildings deduction (commercial credit) for five years through 2013;
  • Extension of the credit for energy-efficiency improvements to existing homes for one year through 2009;
  • Extension of the New Markets Tax Credit for one year through 2009;
  • Extension of the standard deduction for property taxes for one year until 2009 (The housing bill passed in July included this provision for 2008); and
  • Extending the expensing of brownfields remediation costs for one year until 2009.


If you have any questions, please contact Lisa Marquis Jackson at (214) 389-9003 or by email.