Recession aka Foreclosures Rising

More than two years into the housing downturn, unpleasant surprises and market rumors are continuing to wreak havoc in an industry that may be leading the economy into a recession.

The market received its first jolt yesterday from KB Home, a leading home builder that investors have viewed as well-positioned to ride out the downturn. KB posted a net loss of $772.7 million, or $9.99 a share, for its fourth quarter ended Nov. 30, more than nine times wider than the loss that analysts expected.

Much of the loss stemmed from a $514 million noncash charge due to changed accounting for tax purposes. Nonetheless, investors took flight, driving KB's shares down 9.2%.

Getting Worse

• The News: KB Home, which was seen as well-positioned for the housing downturn, reported a wider-than-expected loss.

• What it Means: The report signals housing remains in free fall with no bottom in sight.

• In Other News: Countrywide shares fell 28% amid investor anxiety.

The other home-related stock taking a battering yesterday was Countrywide Financial Corp., a leading provider of mortgages. Its shares dropped 28% amid growing anxiety among investors about falling house prices and the surge in foreclosures.

The housing news and worries about weaker consumer spending helped drive down the broader market. The Dow Jones Industrial Average fell 238.42, or 1.9%, to 12589.07. Banking stocks were broadly lower, with Citigroup Inc. off nearly 4%. The Dow has fallen 11% from its early-October high, a decline that fits the traditional definition of a correction.

"The state of American business this year will depend, I believe, on how we get through the toughest housing correction in our lifetimes," Daniel Mudd, chief executive officer of Fannie Mae, the government-sponsored mortgage investor, said in a speech to the U.S. Chamber of Commerce in Washington yesterday.

Rumors that Countrywide might be preparing a bankruptcy-court filing fueled its decline. The company vehemently denied such plans. "There is no substance to the rumor that Countrywide is planning to file for bankruptcy," a Countrywide spokesman said.

The weak earnings report by Los Angeles-based KB Home was a signal that housing remains in free fall with no bottom yet in sight. "As we enter 2008, we see no indication that markets are stabilizing," KB's chief executive, Jeff Mezger, told investors during a conference call yesterday.

Builders and mortgage companies have been grappling for months with falling home prices and the meltdown in the market for subprime mortgages to people with weak credit. In recent weeks, the outlook has darkened further for housing as unemployment rises and the broader economy treads closer to recession. Last week, the Labor Department reported the U.S. unemployment rate rose sharply in December to its highest level in more than two years.

"Job losses are the final piece," says Paul Puryear, a real-estate analyst at Raymond James & Associates. "If we are in a recession -- and we may well be there right now -- it's going to be hard to sell a house."

Driving KB's quarterly loss was a $514 million charge related to its deferred tax assets. The ability to save on future or past taxes can be entered on a company's balance sheet as an asset. But some auditors say it isn't clear when the home builders will be able to realize these tax savings because of their losses in recent years. So they are requiring some companies to effectively write down much of their deferred tax assets.

Analysts say other builders may face similar write-downs because of the industry's uncertain outlook, and that builders may not be profitable until 2009 or 2010. The deferred tax assets, although written down for now, will eventually produce a gain.

KB has been cutting prices to move homes. Its average selling price dropped 12% to $247,800 in the fourth quarter from a year earlier. But the supply of homes remains stubbornly high. Also, more of KB's buyers are canceling contracts for homes than some analysts had expected.

The write-downs are spooking investors and forcing some builders, including KB, to renegotiate the terms of their revolving credit lines with lenders. That's because the tax-asset charges, coupled with continued write down of land and home values, could cause many builders to fall below a minimum tangible net worth level required by their lenders.

KB said it expects to strike a new agreement with its banks by the end of its first quarter. Red Bank, N.J., builder Hovnanian Enterprises Inc., which reported a $216 million tax-asset-related charge last month, said it has received the necessary waivers from its lenders.

"It's a total headache for the builders,'' says Ivy Zelman, chief executive of Zelman & Associates, a housing research firm. "I don't think it's going to push any of them into bankruptcy. But it's another poker chip that the banks have in their favor."

Many analysts took comfort in KB's ability to generate cash and reduce its debt. The company increased its cash balance by $625 million from a year earlier, while its ratio of debt to total capital improved to 31% from 43% a year earlier.

As for Countrywide, investors are worried not only about its subprime exposure but also about its holdings of other types of risky loans including option adjustable-rate mortgages. Option ARMs allow borrowers to choose smaller monthly payments that increase their loan balance. If borrowers aren't careful, they can end up over their heads in debt.

Kenneth Posner, an analyst at Morgan Stanley, said he believes a bankruptcy filing by Countrywide is unlikely, at least in the short run. Mr. Posner said the company appears to have enough cash to meet its debt obligations in 2008, though there is a "thin margin for error."

The company plans to release fourth-quarter results Jan. 29. After reporting a loss of $1.2 billion for the third quarter, Countrywide forecast that it would return to profitability in the fourth quarter. Now, though, "very few people I talk to believe that's realistic," said Frederick Cannon, an analyst at Keefe, Bruyette & Woods in San Francisco.