Thursday, July 24, 2008

Builders Dislike Taste of Own Medicine

Turnabout, apparently, isn’t fair play.

After years of graft, deceptive lending and millions in profits on shoddily built houses, homebuilders are getting their just desserts.

The Wall Street Journal reports that banks, under pressure from regulators and shareholders to reduce their exposure to the housing market, are backing out of construction loans en masse. Builders, for their part, are crying foul.

Construction loans are like credit cards for big development projects: As the building goes up, developers draw on the loan to buy materials, pay employees and settle up with contractors. Banks like KeyCorp (KEY), Bank of America (BAC) and now-defunct IndyMac were active in the space, particularly in boom areas like southern California.

Recently, however, plummeting home prices have called the value of such projects into question. Banks are now refusing to honor their end of the bargain. If ground hasn’t been broken or the project is only partially complete, developers are left in the lurch: They're forced to repay the loan, post cash or sell the property. If they refuse, banks can push the project into foreclosure - and developers into bankruptcy.

Construction loans often carry personal guarantees, obligating builders to pony up their own assets if a deal goes sideways. In turn, builders are taking lenders to court, arguing that they have no cause to renege on their commitments. Banks, on the other hand, argue that property values have fallen to such an extent as to make many projects uneconomical.

As long as it can find an appraiser willing to value the property at a level that supports this claim, the bank has the upper hand. Finding an appraiser to do their bidding isn’t hard, since appraisers value properties based on what their clients (i.e. banks) want.

The fact that builders are being forced into financial shackles by questionable appraisals does have a touch of morbid irony. During the boom, big developers like Centex (CTX), KB Home (KBH) and Lennar (LEN) built homes, then lent borrowers money to buy them. Since they controlled the loan origination process, they ordered appraisals from cronies who inflated the prices. Builders reaped the benefits, while homeowners got stuck with a home they paid far too much for.

Now that they’re on the other side of the fence, developers don’t find the game quite as fun. "If banks want to get out of residential lending, that's fine; let's sit down and figure it out," said one builder. "But that isn't being done. The rug is literally being pulled from under us and games are being played."

While banks may be acting in bad faith, minimizing their exposure to risky loans by any means necessary, it's doubtful that courts will find against them. Judges are already buried under foreclosure filings stemming from the irresponsible actions of builders gone wild.

So builders shouldn't expect much by way of sympathy.