Randomly Noted

In our sporadic, somewhat random, review of commentary about the level of structural unemployment in the U.S., we’ll add some recent comments from Jeremy Grantham of the fund management firm GMO.

They were part of Grantham’s well-reasoned and clearly presented jeremiad at perceived policy overreach by the Federal Reserve, which he maintains doesn’t result in long-term benefits to the economy and creates eventually harmful asset price bubbles.

A reminder about why the debtae on the nature of the high unemployment rate in the U.S. is important. The bigger the portion of the 9.6% unemployment due to structural issues – skills mismatch, geographic mismatch, etc – the less that monetary policy can do to solve the jobless issue, even if all the Fed’s quantitative easing plans work fully as intended. That in itself is a big if…

According to Grantham, by 2007 overbuilding in the housing industry drew about one million additional workers to the sector. The view that housing artificially decreased the unemployment rate has been heard before, but Grantham adds some twists.

He reasons that many of the “lightly skilled” workers drawn to housing would otherwise have fallen victim to another structural unemployment problem caused by increased globalization between 2002 and 2007. Less-skilled work went to lower-wage nations.

“With the housing bust, construction fell below normal and revealed this large increment in structural unemployment,” Grantham recently wrote. “Since these particular jobs may not come back, even in 10 years, this problem may call for retraining or special incentives.”

The SEC alleges Goldman's work on a CDO enabled something else

It’s hard to say that the structured financing transaction at the heart of latest Wall Street scandal was what ultimately led to the credit crisis. But this transaction did involve a number of banks with financial ties to the deal that ultimately had to be bailed out.

This latest Wall Street drama has also dragged into it two of the biggest players on both sides of the financial markets – Goldman Sachs and hedge fund Paulson & Co.

The Securities and Exchange Commission today charged Goldman with fraud because it said the firm and an employee knowingly created a deception that allowed Paulson to make a billion dollars. The story involves some other favorite bad guys – subprime mortgages and complicated structured financial instruments. Paulson wasn’t charged.

The question is what this case might ultimately mean for both Goldman and Paulson.

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Make no mistake about it. Breaking a 13 quarter streak of net losses is a good thing and K. Hovnanian, the homebuilder, has something to crow about. Investors pushed the stock up 4% in after hours trading Tuesday and will likely push it higher when trading opens Wednesday.

But the savvy investor will look beyond the headlines to see that the corner has not been turned for homebuilders in general and Hovnanian in particular. Start with this – the company reported after-tax net income of $236 million. But when you back out a tax benefit of $291 million, the company lost around $54 million. Sure, that’s better than the triple-digit millions of dollars of losses we’ve been seeing, but it doesn’t show strength – instead it shows a slowing of the bleeding that took place in the housing market. The company noted that its contract cancellation rate was the lowest in nearly five years. But it was 21%. And sales were off 14%.

Yes, good to break that bad losing streak. But there is still some way to go before one can feel good about homebuilders.

Here’s a staggering statistic mentioned in Fannie Mae’s just released financial results – nearly 1 out of every four residential properties in the U.S. (24%) today has negative equity because the value of the homes are less than the mortgages against them. What that likely means is any rebound in housing prices will be slow at best. If homeowners with negative equity wal away from their obligations, forced home sales will tilt the supply-demand balance of homes in favor of supply, as in too much of it. Thus the continued pressure on housing prices.

And of course this isn’t good news for a company that holds a lot of these mortgages. Fannie Mae reported a 4Q loss of $16.3 billion, an improvement over the loss of $19.8 billion a year ago. Things are so bad at Fannie that it asked for an additional $15 billion from the Treasury just a few weeks ago. All of this comes on the same day that another government-owned company, AIG, posted staggering losses as well.

How bad is the outlook for Fannie? It says in its filing that it can’t be certain about its long-term sustainability (in other words, it may not be around.) And it says that the dividend payments it will have to start paying the Treasury for giving it money (via preferred stock investments) will be so large that the company will have to borrow from the Treasury to pay the Treasury those dividends. The question isn’t what the long-term sustainability of Fannie Mae is but how long can the Treasury sustain a situation like this.

On the long drive back from Quebec on Tuesday (after a little cross-country skiing trip northwest of Montreal), we were listening to the radio (in French) to get a sense what’s on the minds of the Quebecois. Two main topics of discussion, over and over again. The first was on the Olympics and a general complaint that the games were being broadcast in Quebec in English and not in French. The radio folk weren’t implying the games should be broadcast just in French. But that there should be some French spoken. It’s an interesting point, and a unique one – there aren’t too many countries where two languages are the official languages of different regions. That’s borne out by visiting some small Quebec towns and villages where no English is spoken. Period. I tend to agree with the Quebecois – French should have been spoken since the French population is a significant one in Canada.

The second topic was on business and more specifically, asking if there was a housing bubble in Montreal and Toronto.

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Beazer Homes USA’s accounting mess is coming back to haunt it. We’re reporting that Beazer’s CEO, Ian J. McCarthy, has received a Wells notice from the Securities and Exchange Commission. This means SEC may bring an enforcement action against McCarthy “to collect certain incentive compensation and other amounts allegedly due.” It’s not clear how much McCarthy may have to forfeit, or whether other Beazer execs will have to fork up money as well. There’s precedent for this type of action: One other company, CSK Auto Corp., was previously targeted by the SEC under the Sarbanes-Oxley law’s clawback provision, colleague Dawn Wotapka reports. In that case, CSK’s former CEO had to repay the company $4 million in bonuses and stock-sale profits. In Beazer’s case, the homebuilder understated its income from 2000 to 2005 by setting aside a rainy-day fund for land development and home construction costs.

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By most measures, things are starting to look a little better for homebuilders like Beazer Homes. At Beazer, the cancellation rate for new homes dropped to 34.7% versus a staggering 46.3% a year ago. And new orders are up 2.4% versus last year’s fourth quarter. While sales were down nearly 42%, the company did record income from continuing operations of $35.3 milion versus a huge loss a year ago.

But make no mistake about it, those earnings don’t tell the story of a complete turnaround at Beazer. Like some other companies, Beazer took advantaged of the depressed credit markets and bought back some of its debt at a deep discount. That resulted in a roughly $90 million gain in the quarter for Beazer. So, back that number out, and Beazer once again reported a loss. Directional improvement yes. But still a long way to go before real growth and profitablity.

If this trend continues, the housing market (which seemed to be stabilizing) could get worse before it gets better.

Moody’s Investors Service today downgraded Commodore CDO III and noted that about 29% of the mortgages and other securities that the CDO has invested in are in default. That’s up from about 17% at the end of February.

Fitch took similar action in late September and noted at that time that many of the subprime residential mortgages that are part of this CDO were vintage 2004 and 2005

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Some good news from Toll Brothers today: the big home builder says it’s managing to boost prices in some communities across the U.S. The company’s not specifying where, but any sign of rising home prices adds to the growing sense the economic downturn has plateaued. DJN colleague Dawn Wotapka quotes Toll CEO Robert I. Toll as saying “customers are recognizing that now is the time to get into the market to take advantage of near-record affordability and what is still, for now, a buyer’s market.” So, as buyers surface, Toll’s able to offer fewer incentives and lift some prices. Another builder, Ryland Group, likewise says “incentives are pulling back” and prices are stabilizing in most of its markets across the nation. As a very recent home buyer myself, this is reassuring – suggesting as it does that our new abode isn’t poised to sink in value if indeed the U.S. housing market has stabilized. Fingers crossed.

The housing crisis hasn’t been good to companies that build them or make products that go into them. Like Armstrong World, which produces flooring, ceiling materials and cabinets. In the most recent 2Q, Armstrong said sales were off 20% versus last year and net income was down 50%. And the outlook for the rest of the year remains equally grim.

So why did private equity firm TPG Capital just spend $180 million to buy a big chunk of Armstrong and structure it in such a way that Armstrong doesn’t receive a nickel?

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