Homebuilders in a Hole

Homebuilders in a Hole

Battered by the bust, they're filing for Chapter 11 and begging hedge funds for help
by Dean Foust and Dawn Kopecki

When Kara Homes began building Horizons at Birch Hill, a community for active seniors, the plans were ambitious: 228 spacious residences that weren't typical cookie-cutter McMansions. But four years later, the project in Old Bridge, N.J., has been abandoned by Kara, which is now in Chapter 11. A dozen or so homes stand unfinished, the front doors swinging in the wind, and the half-built clubhouse bears a large "Unsafe for Human Occupancy" sign.

"It's not a great situation, but we're all hanging together," says Frank Ramson, one of the development's 70-odd homeowners. "What's killing us is the uncertainty of how long it might take another builder to step in."

Ramson isn't alone in his angst. The downturn in the housing market has caught the nation's homebuilders by surprise, leaving many overextended with costly land they can't develop and unfinished homes they can't sell. The financial strain is starting to show. From Arizona to Arkansas, dozens of small- and midsize builders have filed for bankruptcy over the past six months.

And in late April, credit analysts at Moody's Investors Service (MCO) warned that a number of large homebuilders could fall out of compliance with their debt agreements later this year, leaving them at risk of default unless lenders come to their rescue by agreeing to rework their loans. Some builders are so desperate, in fact, that they're even running into the arms of hedge funds to bail them out with fresh loans at high rates and onerous terms.

More Bankruptcies?
Wall Street certainly has its concerns about the industry. This year the price of credit default swaps—in effect, a tool for bondholders to hedge their risks—has risen sharply for several large builders, including Pulte Homes (PHM), Toll Brothers (TOL), and D.R. Horton (DHI). Toll Brothers Chief Financial Officer Joel Rassman says: "The people buying the swaps may think it's riskier, but the people actually buying our paper don't [because our spreads with Treasuries are shrinking]."

But for the industry as a whole, there may be even more problems waiting just below the surface since many builders entered into big land deals with partners, amassing billions in debt that doesn't show up on their balance sheets. "I think we're going to see a lot more [bankruptcy] filings in the next 6 to 12 months," says Tucson attorney Eric Slocum Sparks, who is representing one local builder, AmericaBuilt Construction, in Chapter 11. "I've got a couple of clients who want to see me next week, and I know these aren't social visits."

The extent of the industry's woes will depend on where housing heads from here. So far analysts and executives alike are unsure whether, or by how much, the slump will deepen. But the trends aren't pretty. The National Association of Realtors now predicts that new-home sales are likely to drop 18% this year, a bleaker scenario than the 9% decrease in the February forecast.

Daring Bets
Nonetheless, the current generation of builders entered this downturn with far better balance sheets than their brethren in the last housing bust during the late 1980s. And barring a total collapse in the market, lenders are also likely to offer a safety net, making concessions to keep the builders afloat in the near term. "I expect the lenders will be willing to work with them," says Fitch Ratings analyst Robert Rulla. "They'll want to maintain that relationship for when the turnaround comes."

Still, those lifelines can come at a big cost, namely higher interest rates, special loan modifications, and tough new stipulations that restrict everything from the builder's right to repurchase shares to its ability to take on new debt for future expansion.

For some, the white knights may be hedge funds. Consider the plight of Dominion Homes (DHOM), an Ohio-based builder that sold $257 million worth of homes last year. When Dominion fell close to default last August on $216 million in bank debt, hedge fund Silver Point Finance bought the loans and negotiated tough terms. Some $90 million of the refinancing came with an interest rate of 15%, vs. the 9.25% Dominion had been paying.

Silver Point also stipulated that it could receive a 15% stake in Dominion in the event of default. "The [fund was] willing to go where no other regulated institution would go," says Ronald F. Greenspan, an attorney and restructuring adviser for FTI Consulting (FCN). Dominion CFO William Cornely admits the new rates are high, but says it "affords us the opportunity to continue operations during the downturn and position us for the rebound."

Using Up Cash
If business doesn't stabilize, more builders could find themselves in the same hole in the ground as Dominion. Already, some analysts are concerned about the pace at which many builders have been burning through cash. Moody's credit analyst, Joseph A. Snider, notes that 11 of the 21 large builders whose debt his firm rates had negative cash flow in 2006 as many were stuck with higher-than-expected inventories of homes they couldn't sell.

Dallas-based Centex (CTX) took a $150 million charge after walking away from options for more than 37,000 lots nationwide and wrote down other land by roughly $300 million, triggering a 79% plunge in fiscal 2007 profits. "We still see uncertainty in many of our markets," Centex CEO Timothy Eller told analysts on Apr. 30, warning that the industry could be in the middle of a three-year correction.

More bloodletting may be ahead. Many large builders also took minority stakes in joint ventures, allowing them to stockpile land for future needs while keeping billions in debt off their balance sheets. Alisa Guyer Galperin, an analyst at the Center for Financial Research & Analysis, estimates that Lennar (LEN) is on the hook for up to $910 million of $5.6 billion in debt through partnerships not on its books.

Battles Ahead?
One fear is that if a partner runs into financial trouble, Lennar and other homebuilders could find themselves battling with lenders that demand they make good on the partnership's total outstanding debt. Florida builder Technical Olympic USA (TOA) is now embroiled in a lawsuit with one of its lenders, Deutsche Bank (DB), which claims the builder is in "multiple potential defaults" on $675 million in debt owed by joint venture partners that failed.

For its part, Lennar CFO Bruce Gross says the company has mitigated its risk by partnering with strong institutional investors like the pension fund CalPERS and has structured the deal to make sure it isn't liable for its partners. "Our joint ventures are very strategic and are designed to share the upside opportunity and downside risk with other investors," says Gross. For now, Wall Street is thinking only about the downside.

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real estate, mortgages, home builders, hedge fund returns, lending, real estate market downturn

Are Hedge Funds Worth It?

Hedge fund managers sitting pretty

Annual lists of high-paid hedge fund managers show astronomical gains ($1.7 billion at the top of the list -- for just one man), but is it worth it to use a hedge fund manager? Typical hedge funds come with a 2% management fee no matter how they perform, and they include a big cut on profits that exceed certain amounts. Even low-performance hedge funds can mean big profits for managers.

Worth a Lot, but Are Hedge Funds Worth It?
By DAVID LEONHARDT

When Institutional Investor’s Alpha magazine released its annual list of the highest paid hedge fund managers last month, it allowed the rest of us to play an entertaining little parlor game: what could you buy if you made as much money as those guys?

James Simons, a 69-year-old mathematician who was at the top of the list, earned $1.7 billion, which equaled the amount of money that the federal government spent last year running its vast network of national parks. Down at No. 3 on the list, Edward S. Lampert of Greenwich, Conn., the investor who owns a large chunk of Sears, made $1.3 billion, which, if you forget about taxes, would have allowed him to buy the entire economic output of Sierra Leone. We’re talking about real money here.

Today, Alpha magazine will release another big list, and this one offers a chance to answer another, arguably more important, question: Are these billionaire hedge fund managers really worth it? The reason hedge funds are a license to print money is their fee structure. A typical fund charges a 2 percent management fee, which means that it keeps 2 cents of every dollar that it manages, regardless of performance. Mutual funds, on average, charge about 1 percent. On top of the management fee, hedge funds also take a big cut — usually at least 20 percent — of any profits that exceed a predetermined benchmark.

So in a good year, a fund’s managers bring in stunning amounts of money, and in a bad year, they still do very well. Some quick math shows why: 2 percent of a $5 billion portfolio, which was roughly the cutoff for making Alpha’s list of the 100 largest funds, equals $100 million. A fund’s managers get to take that fee every single year.

Last year was actually a pretty tough year for the industry. Because hedge funds tend to make a lot of countercyclical bets — thus the name — they can often turn a profit even when the stock market falls. When it’s rising broadly, though, many struggle to keep up. Last year, the Standard & Poor’s 500-stock index jumped 14 percent, while the average hedge fund returned less than 13 percent, after investment fees, according to Hedge Fund Research in Chicago.

But the men — and they are all men — who appear on Alpha’s list of top earners don’t manage average hedge funds. They manage the biggest funds in the world, the ones that are winning the Darwinian competition for capital, and many of them aren’t having any trouble beating the market. One of the funds at Mr. Simons’s firm, Renaissance Technologies, delivered a net return of 21 percent last year. The other returned 44 percent after fees. And Mr. Simons, who relies on a fantastically complex set of algorithms, doesn’t charge “2 and 20” — as the typical industry fees are called. He charges “5 and 44” — a 5 percent management fee and 44 percent of profits — yet he has still been doing very well by his investors for almost two decades.

I realize that a lot of people find 9- and 10-figure incomes to be inherently excessive. Or even immoral. From a strictly economic point of view, however, they are also perfectly rational. You cannot find anyone else who is providing the same returns as the best hedge fund managers at a lower price. If you don’t like it, you don’t have to give them your money.

(Even if you do like it, they probably won’t take your money. In exchange for being lightly regulated, hedge funds are open only to wealthy investors and big institutions.)

Thanks to their incredible performance, the biggest funds have grown far bigger in recent years. The 100 largest firms in the world managed $1 trillion at the end of last year, or 69 percent of all the assets in hedge funds, according to Alpha. At the end of 2003, the top 100 had less than $500 billion, or only 54 percent of total hedge fund investments.

“The best performance is coming from the largest funds,” said Christy Wood, who oversees equities investments for the California Public Employees’ Retirement System, which, like a lot of pension funds, is moving more money into hedge funds.

But there is an irony to this influx of money. It all but guarantees that hedge fund pay over the next few years won’t be as closely tied to performance as it has been. The hundreds of millions of dollars that have flowed into hedge funds have made it all the harder for fund managers to find truly undervalued investments. The world is awash in capital.

All that capital, of course, also translates into ever-greater management fees, regardless of a fund’s performance. The flagship hedge fund at Goldman Sachs lost 6 percent last year, but it still brought in a nice stream of fees. Bridgewater Associates, which is based in Greenwich, has earned a net return of less than 4 percent in each of the last two years. Yet its founder, Raymond T. Dalio, made $350 million in 2006.

“When we have a bad year, we’re essentially flat,” Parag Shah, a Bridgewater executive, told me. “And when we have a good year, we have a great year.”

Goldman and Bridgewater may well bounce back, but the combination of extraordinary pay and ordinary performance is going to occur more and more in the coming years. Outside of the highfliers on the Alpha list, it’s already the norm. Since 2000, the average hedge fund hasn’t done any better, after fees, than the market as a whole, according to research by David A. Hsieh, a finance professor at Duke. Still, even mediocre managers, after a lucky year or two, are able to attract gobs of capital and charge “2 and 20.”

So are today’s hedge fund managers really worth it? Sure, but only if they deliver the sort of performance that Mr. Simons has, and very few will in the years ahead. More to the point, it’s extremely difficult to know who the stars will be.

In all sorts of walks of life, people tend to think that the past is a better predictor of the future than it really is. That’s why journeyman baseball players — a Yankees pitcher named Carl Pavano comes to mind — are able to sign huge contracts based on a single good season. It’s also why so many investors chase returns.

The genius of the world’s hedge fund managers isn’t only in how they invest their money. It also lies in having set up an industry that takes advantage of a timeless human trait.

E-mail: Leonhardt@nytimes.com
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hedge funds, portfolio managers, hedge fund returns, alpha, beta