Thursday, September 20, 2007

Home Builders, CDs and Corp. Paper

Home Builders, CDs and Corp. PaperSocialTwist Tell-a-Friend
Fil Zucchi

The following piece was written on August 27:

“We all know the treatment housing stocks have received and at this point few seem to offer decent risk/reward on the downside. The thing to watch carefully now is the debt of these companies and the news-flow around them.

I’ve gone over a bunch of fixed income research concerning this group and while the analysts continue to reassure readers that most companies are still cash flow positive and they will come out stronger when the market turns, one can’t help but get that funny feeling that the real message of those notes lies not in the “all is well” boilerplate, but int eh passing mention that technical violations of debt covenants are not a big deal because the lenders will undoubtedly wave those covenants.

Perhaps they are correct. However, we are often told that bond investors are the “smart” money because they are closer to the financials of the companies than equity investors. After all, bond holders are not in the business of taking principal risk.

Yet Standard Pacific (SPF) and Lennar (LEN) have had to renegotiate loan terms, Beazer Homes (BZH) won’t say where its debt stands until its internal investigation on accounting issues is concluded, Comstock Homes (CHCI) has already gone through one restructuring and its faith hangs on the future sales at a project in Alexandria, VA, and . . . .well, you get the picture. Furthermore, considering how frothy things used to be for homebuilders, one would think that the covenants were probably loose enough already.

Are these covenant workouts a sign that bondholders want to avoid defaults at least as much as the debtors? Isn’t this the same movie we saw in the late 1980’s with respect to commercial loans, before everything hit the fan? Will the daily new lows in the stocks of these companies create their own set of technical defaults?

Most eyes are fixated on mortgage debt, derivatives, and the likes, but few for now dare speak of actual defaults in plain vanilla corporate obligations, especially the kind still rated BB or better (how is that possible?). If that were to happen, that is what you can call the “other shoe”.

Since then, and despite yesterday’s Fed cuts, very little has changed:

The 7-year paper of most issuers has rallied 5-10% but still yields 12-15%.
The CDS’ on these debts have also come in some, but still trade at spreads 3-5x what they were in May, and some spreads suggest a pretty high risk of default. Just a few minutes ago S&P warned that approximately $35b of B rated corporate paper (not just homebuilders) is at risk in 2008, and for our purposes we will ignore that there may be 5x-10x that amount of CDS written against it, for which someone is going to have to pony up some cold hard cash.

No amount of shuffling of debts between GSE’s or other pan-handling bailouts address the key problem: there is way too much debt out there that folks and companies are beginning to struggle to pay. The homebuilders are at the forefront and they should be watched very closely.


Editor Note: Fil Zucchi spent this summer on the long trip back to the Old Country -- Italy. We are glad to find him safe and sound at his HQ on the East Coast.

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