Homebuilders in a Hole

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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.

Foust is chief of BusinessWeek's Atlanta bureau. Kopecki is a correspondent in BusinessWeek's Washington bureau.