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Tuesday, September 18, 2007

Homebuilders jump on rate cut - move is overdone

Today Reuters reported the following:

"Home builder sentiment fell for a seventh straight month in September as tougher mortgage requirements hindered sales from bloated inventories, the National Association of Home Builders said on Tuesday.

The NAHB/Wells Fargo Housing Market index declined 2 points to 20, matching the record low of January 1991 when the economy was in the throes of a recession, the NAHB said in a statement. But an interest rate cut by the Federal Reserve on Tuesday offered the industry hope, the NAHB's chief executive said."

After the Fed cut both the Fed Funds rate and the discount rate by 50 basis points today, the SPDR HOMEBUILDERS ETF (XHB) took off and registered a 5% gain on the day. The 24/7 Wall Street blog reports that the Jim Cramer "Mortgage Madness" portfolio was the best performing group today. Beazer Homes (BZH) was up 18% on the day!

Was that performance warranted or was it "irrational exuberance?" The home builders are down in the dumps but investors are walking on clouds.

Problems in residential construction are well known and are related to the following:

1. Excess inventories of unsold new homes are forcing builders to cut prices and offer incentives to boost sales. This is reducing margins for builders. Unsold inventories are causing builders to carry land and buildings on their books, tying up capital that could be applied elsewhere, to pay down their debt, for example.

2. The reluctance of investors to buy mortgage-backed securities has reduced the flow of funding used to finance many home loans.

3. Stiffening of lending standards and requirements has reduced the pool of eligible home buyers. It has also reduced the size of homes for which buyers can be approved. The McMansion is increasingly out of reach.

4. Over coming months, inventories of unsold homes could potentially increase even further as the number of foreclosures increases for the least credit-worthy borrowers.

Will the rate cut really help?

The rate cuts could increase market confidence which might help investors return to mortgage-backed securities which, in turn, increases the flow of funds to lenders who could make more loans at better rates. The change in Fed Funds rate also directly allows mortgage rates to come down.

So we have two positives that will help the mortgage rate picture. This will help reduce the inventory of unsold homes as loans become more attractive to buyers.

Lower rates will help some but not all of the borrowers whose loans will reset over the coming months. The Fed's cut will only have a marginal effect on those borrowers who are in way over their heads. Thus, in this case, the Fed cut is a neutral factor at best.

Separately, Congress passed legislation today that would allow the FHA to back refinanced loans for borrowers who are delinquent on payments because their mortgages are resetting to sharply higher rates from low initial "teaser" levels. On the surface, this is also a positive but in looking closer, it will only help those borrowers with good enough credit to refinance. And FHA backing only protects the lenders. With a limited budget, the bill will not come close to bailing out all of the estimated 2 million to 2.5 million borrowers with adjustable-rate mortgages who are in danger of default. So this factor also appears to be neutral or insignificant.

In conclusion, the cuts today are a net positive for the housing market but it will still take many months to work off an inventory bulge of this size. We are at the end of the selling season so for many builders, they may have to wait until next spring before they see a real bounce in sales. Builders will continue to carry this inventory going forward, so they will be cautious about building more homes while the current inventory glut remains. Holders of mortgage-backed securities will still need to be wary of the low quality loans that will end up in foreclosure which could again erode market confidence. These foreclosures are a wild card: they will cause the inventory of unsold existing homes to swell which could, in turn, slow the reduction in the inventory of unsold new homes. As mentioned above, there are a good 2 million homes in danger of foreclosure due to resets and some percentage of them will end up standing empty. From my point of view, today's behavior was certainly exuberant and somewhat irrational as investors have gotten a bit ahead of themselves.

Disclosure: author owns no stocks mentioned in this article

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