C.M.O. 3.30.2009

Credit Market Overview
March 30, 2009

When success depends on repeating a specific function with precision, minor variations in execution can wreak havoc with performance. Brain surgery, sports, and trading all come to mind. While trading is the least physical of the three, keeping one’s mind in the game is just as important when making split second decisions as it is when trying to hit the high inside fastball. When things are not going right, the place we are most often told to go is “back to the basics”, that is of course, when it’s not “to the locker room”.

Going back to the basics with regard to our current two outs in the bottom of the ninth, bases loaded, down by 3 runs, full count situation means looking for improvement in the two things that got us here. While I’m open for suggestion my candidates would be housing and the banks. Since the question of which came first is similar to the age old dilemma between the chicken and the egg I’m going with housing today.

There was recent news from Mountain House, CA of improvement in the home prices of that 2,600 unit master planned community which was followed by the announcement of a +5.1% MoM change in Existing Home Sales by the National Association of Realtors vs. an expected decrease of -0.9%.

Also of late, the Federal Housing Finance Agency reported that house prices rose 1.7% from December to January while the NAR’s Affordability Index (173.5 preliminary for February) is now 67% off its lows for this cycle and 52% above its 1991 year-end level after the 1990-1991 recession.

This was followed Friday by KB Homes’ (KBH) announcement of a “sharply” narrowed first quarter loss aided by fewer right downs and a 26% rise in net orders; the latter a result of reductions in cancellations. (Now before my perma-bear friends accuse me of going soft, I’m just talking about the news being less bad, not good, just less bad.)

The key to KBH’s recent success it seems is that they have been offering smaller, more affordable homes as a way to stay in the game while foreclosure sales push prices to bargain basement levels. “Homes must change with the times,” President and CEO Jeffrey Meager said in a recent earnings call adding that the “revamped” models will account for 50% of deliveries by year end.

Individual business strategy is a good way to differentiate yourself from your peers but it never hurts to fly with a tailwind and that extra push is being supplied by none other than Ben & Co. at the Federal Reserve. “The Federal Reserve’s announcement that it intends to purchase Treasury securities over the next six months caused bond yields to drop and mortgage rates followed.” Frank Nothaft, FRE CEO said recently.

“Rates for 30-year fixed mortgages peaked last year at 6.63% on July 24.” He continued, “With the most recent average 30-year fixed-rate mortgage, the interest rate difference is almost two percentage points; which amounts to a savings of about $225 in monthly mortgage payments for a $200,000 loan.” N.B. The average 30-year fixed-rate mortgage for the week ended 3/26/2009 was 4.85%, the lowest since FRE’s weekly survey began in 1971.

Take heart perma-bears, all is not, as the song goes; Sunshine, Lollipops and Rainbows. First there is the question of what happens if the recent improvements in housing turn out to be temporary. Peter Eavis reported in the WSJ that “policy makers fear that another downturn in housing prices could trigger a correlative increase in defaults, increasing foreclosures and forcing prices down even further”.

There is also the question of whether people are willing to take on new mortgages when the current raison d’être is to de-lever. During the ‘90-‘91 recession, personal disposable income covered 114% of household liabilities; that number was just 75% at the end of last year.

The other fly in the ointment is the jobs outlook. With non-farm payrolls decreasing by 650,000+ in February and a total of 12.5 million people out of work, not counting the “under-employed” we hear so much about, the propensity for even those with jobs to incur major expenses continues to ebb.

Data on delinquencies is not going in the right direction either. It appears defaults are now rising on loans made prior to 2006 when lending standards deteriorated quicker than good intentions at last call. First American CoreLogic reports that in January of this year Alt-A loans made in 2005 defaulted at a 4.2% rate up from 0.64% in January ’08. FACL also said that prime mortgages that didn’t qualify for FNM or FRE purchase were defaulting at a 0.56% rate vs. 0.07% in the same period a year ago.

The road ahead could also prove bumpy for KBH and other builders as the well of previously paid taxes begins to run dry. Loss-making companies can collect refunds on tax payments made over the previous two years. KBH is estimating a $220MM refund on that basis this year. Next year however, the refund bucket comes up with nary a drop.

Another builder, DHI, is expecting $677MM this fiscal year based on previously paid taxes and was lucky(?) enough to have paid taxes in 2007 so it will be in line for a similar albeit smaller refund next year. Beyond that only an improving economy can provide the foundation for profits.

Bringing this all back to the correlation between credit and equity; KBH’s stock price bounced off of the $8.00 level first set in November of 2008, in early March of this year and has since risen to $15.05, its closing price last Friday. The CDS market had not given a clear confirmation of that buy signal as CDS levels on KBH actually rose from 3/3/2009-3/9/2009 as the stock moved off the $8.00 support. The CDS price fell from 3/9/2009-3/18/2009 but leveled off before rising again on 3/23/2009.

The CEC Strategy requires consistent, negatively correlated movement between the CDS and equity to trigger buy and sell signals. The noise between these two markets in KBH at the moments brings to mind Robert Rodriquez’s of First Pacific Advisors response when asked if there was a key to his investment ethos. His mantra he said was “winning by not losing”.

Enjoy the week.

Jim Delaney