Wednesday, June 27, 2012

Golden Lies In The Media

The big banks have becoming hedge funds but are backed by the Fed and taxpayer funds. You think that provides them with a competitive advantage? The Fed encourages and abets big banks to trade like hedge funds so the banks can generate, even craft, earnings to keep them afloat.  Bill King, The King Report
If you woke up this morning and read some of the headlines that pertain to the housing market, you might be convinced that the bottom is in and the next bull market in housing is starting.  Of course, it's funny how homebuilder, realtor and Government numbers diverge from one of the best "grass root" statistics:  mortgage purchase applications.  Mortgage purchase applications declined again last week: "The unadjusted Purchase Index decreased more than 2 percent compared with the previous week and was almost 3 percent lower than the same week one year ago."  Here's the report from the Mortgage Bankers Association:  LINK

How can the housing possibly be going through a recovery when purchase applications have been mostly lower week to week during the peak home selling season?  Makes no sense.  Either the mortgage bankers are lying or the homebuilders, realtors and Government are all lying.  I know which constituent I would bet is lying.  I will say, that there has been a lot of strength in the low price end of the market.  But this is coming from investors who are taking advantage of Government financing programs to buy low-end homes and turn them into rentals.  As I have shown in previous posts, Fannie and Freddie announced this program several months ago.  Ironically, they needed an outlet for all the homes they repossessed to make room for more foreclosures...wash, rinse, repeat.  A friend of mine had put in an offer on a lower end priced townhome last week in an area of Denver that had bubbled up during the housing bubble and she was topped by an investor who paid the full asking price.  This won't last and real buyers would be well advised to not chase it.

The other source of housing market euphoria was this morning's earnings report from Lennar.  The headline proclaimed a huge increase in earnings for the quarter and the CEO announced that the housing market was in recovery.  Of course, what was not in the headlines was the fact that LEN used a complicated accounting maneuver to generate most of its earnings.  Of the $453 million in reported GAAP earnings, $403 million of it was generated by a non-cash "reversal of the deferred tax asset valuation allowance."  Essentially, a deferred tax asset occurs when a company pays the tax man more in actual cash taxes than it reports in GAAP income for reporting to shareholder purposes.  There's two sets of books, the GAAP book and the "cash" book, or the book of numbers used to calculate actual tax payments to the Government.   There are "timing" differences for recognizing income between the two sets of books, and depending on the circumstances, in any given year a company may pay a lot more or a lot less the Government in taxes than it reports to investors in financial statements.  It's a great earnings management tool for management.

Depending on the situation that creates a deferred tax asset or liablity, it has the effect of either reducing or increasing GAAP income vs. tax income.  When this happens, a balance sheet account is set up called a "deferred tax asset" (or liability) and over time, this asset is amortized into net income to "recapture" income that occurred but not recognized for GAAP reporting purposes.  In LEN's specific situation, the deferred tax asset resulted from declining revenues (it's too complicated to go into here).  So LEN decided that the housing market is going to get  better for the foreseeable future and it was allowed to recognize most of its deferred tax asset this quarter by "revaluing a lot lower (by $403 million to be precise) its deferred tax asset.  It has no real cash or economic impact on the company other than to juice the stock in the short term.  It's complete accounting chicanery and it's an accounting standard that needs to be reformed.  It also enables LEN CEO Stuart Miller earn a big bonus assuming part of his compensation is based on earnings.

Having said that, you can understand by Miller is so bullish on the housing market.  He has to be because it's the only way he can justify using the accounting gimmick he used to generate 88% of LEN's reported income.  I remember Stuart Miller and Lennar from my junk bond days.  We did a complicated junk bond financing for LEN's financing arm.  LEN is a by-product of the Drexel Burnham accounting fraud days and Stuart Miller has never seen an accounting gimmick that he didn't lovingly embrace.  In fact, Miller has been a very steady seller of LEN stock over the past decade.  If he's so bullish on housing, shouldn't he be loading up investment account with LEN stock?

The point here is you have to really "look under the hood" these days in order to differentiate from headline, reporting fraud/hype and the truth.  More important, you really have to know where to look.  I had to brush on the accounting for deferred tax assets from my U of Chicago days in order to make sense of LEN's earnings report, understand why it's fraudulent and understand my Miller was so ebullient on the prospects for the housing market.

After untangling that GAAP accounting mess, in conjunction with the mortgage purchase index indicator, in conjunction with what I know and have written about the escalating foreclosure dynamic, I have concluded that homebuilder stocks like LEN are still a good short-sell play and the real, organic housing market is still going a lot lower.

11 comments:

  1. solid, concise, ez to understand analysis, Tks

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  2. Dave, Great post... really one of your best. I have enjoyed your past expose's into bank earnings statements... and this post draws on this same wheelhouse of yours.. but to take a MM propaganda headline and disassemble it in such a thorough and thoughtful way, add some good anecdotals, then tear into the LEN story the way you did... WOW.. you are the best friend a truth seeker could have. I appreciate you efforts very much! 1Kg lunar Dragon.

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    1. Thanks 1KgLD. I appreciate the comments!

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  3. Perhaps a lot of all cash buyers/investors are causing fewer mortgage apps.

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    1. There's some component to that but mortgage purchase apps should not be going down almost every during peak season for home sales. Also, the % of all cash buyers is likely pretty constant over time and purchase apps have been declining all season and pretty much all year.

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  4. The day of reckoning will eventuality come for anyone or any entity that continually hides the inconvenient truth. And if it is successfully hidden for too long, when it finally reappears, it is always a motherfucker. Nice breakdown Dave.

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  5. I have no insight into the US real estate market, but for what it's worth, Martin Armstrong according to his economic confidence model indicates that the US real estate market will rally from mid-2012 to mid/late-2015 and then roll over in 2016 and continue another down leg to even lower low's.

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    1. Most people who followed Armstrong through his jail saga and his work after he got have come to the conclusion that he's either insane or some kind of crazy psychopath. His analysis and commentary is self-serving and unfounded.

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  6. That may be your subjective opinion about Armstrong and you appear to base it more on other's opinions about the man than on your own. I have followed his reports for quite a few years now and his theory/model based on "pi" and/or other ratios related to cycles that naturally occur in physics, life, finance, and economics is very credible. But what cannot be questioned is his uncanny accuracy in getting the macro picture right along with the timing of it.

    Anyways, just out of curiousity (because I do not follow USA real estate), I looked up a chart of $HGX (housing index). An interim bottom formed early June around 112 and on July 3 it is breaking out to new 52-week high above 138, and it has been rallying hard since late 2011 from around 75. Unanimous decision, case closed!

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