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Tickers in this Article: KBH
When the CEO and some of the management team of the nation's fifth-largest homebuilder, KB Homes (KBH), resigned this week and admitted to the use of options backdating, one might have expected the shares to suffer.

CEO Bruce Karatz admitted to backdating stock option grants since 1998, during a time when he has been paid more than a quarter a billion dollars in salary and options.

So, while the board is now recovering $13 million in excess option awards, Karatz can now dump his remaining $150 million in stock (2.5% of outstanding shares).

The KBH Board fired Gary Ray, head of human resources, and accepted the resignation of Richard Hirst, executive vice-president and chief legal officer. Any way you slice it, that's not good news.

According to The Wall Street Journal, Karatz was one of the highest-paid executives in 2005, making $155.9 million, mostly from exercising options.

The board's press release claimed that, "the company's review didn't reach any conclusion about whether there was intentional wrongdoing on Karatz's part."

Now the board is looking for an independent, non-executive chairman. In the meantime, Kenneth M. Jastrow II, a director of KB Homes since 2001 and Chairman and CEO of Temple-Inland, will serve as the board's lead director. And KB Homes is searching for people to fill the newly created positions of chief compliance officer and risk assessment officer."

To make matters worse, a recent UBS housing study forecast that the homebuilder industry's EPS will decline by 22% in 2006. UBS is now forecasting a further decline of 46% in 2007, along with a 28% decline in top-line revenue.

On top of this, the historical housing stock price support metric, book value per share, is sliding at KB Homes, down from $37.66 per share in Q2 to a target closer to $30, the decline coming from contract write-downs, land purchase option dispositions, and other write-offs. With $2.46B in long term debt and a $1.5B surge in inventory in the last reported quarter (Q2 2006), there looks to be further book value write-downs in store for KBH.

Investors who think they are being contrarian by buying homebuilders shares may be in for a rude awakening. The recession of 2007 will likely bring losses for these firms. The bulk of KBH's operations are in the riskiest, most over-extended housing markets: California, Nevada and Florida.

In September, existing home sales slowed for the sixth straight month, and new home sales were off 14 percent from year-earlier levels, according to government and housing industry reports. And even the National Association of Realtors (NAR) has been steadily cutting its estimates for key metrics:

• Existing Home Sales: 2006 sales slipping from a 6.5% decline in the summer to 8.6%. As well, the 2007 forecast is a very conservative decline of 0.6%

• New Home Sales: 2006 sales falling fast from a 12.8% drop forecast in August to a 16.8% drop, and 2007 sales are already expected to drop 8.7%.

• Housing Starts: 2006 starts are expected to further slow from a 9.1% decline to a 10.6% decline.


The big factor here for KBH is transaction-related revenue. KBH wants clients to use their financing arm, which provides mortgage banking, title, insurance, and escrow coordination services to the company's U.S. homebuyers.

Cash-out refinancing by U.S. homeowners in 2005 took a net $345 billion in equity out of their homes, and another estimated $400 billion this year. Accordingly, the fastest-growing component of the earning assets of U.S. banks was home-equity loans, in which houses are put up as collateral.

These totaled $399 billion in 2005, up $118 billion from a year earlier. In 2005 and 2004, 46% and 42% of mortgage assignations, respectively, had piggyback loans to cover downpayments and transaction costs, twice the proportion of 2003. Even with its other issues aside, what will happen to KB Homes' stock if it faces massive financing write-downs, which shareholders may not discover until next spring?

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