Vertical Integration is Conflict of Interest

HOT: Letters sent in 2007 by CtW Investment Group to the boards of directors of 11 homebuilders support our belief that many of the nation’s biggest builders acted improperly by using their vertically integrated entities like Ponzi schemes, putting them at the center of the global financial collapse. Our own informal survey of 17 of the largest Texas homebuilders found that 16 of them were vertically integrated and owned their own mortgage companies, title companies, and/or insurance companies.

The national trend of relaxing regulatory oversight over a period of decades allowed homebuilders to become vertically integrated, thus creating a natural “conflict of interest.” It also encouraged the bad business practice of pushing risky loans onto home buyers and then offloading the risk in the secondary market as mortgage-backed securities.

Builder-owned mortgage companies weren't as tightly regulated as banks. They could more easily make risky loans and then sell the loans to investors as mortgage-backed securities. These investors didn’t know anything about the borrowers' ability to repay the loans, so Wall Street invented Credit Default Swaps to insure them against defaults. The scheme worked fine until the home supply bubble burst and prices fell.

We believe Texas was at the center of the collapse because it has arguably the most relaxed homebuilder regulations, and its lack of accountability encouraged many questionable acts, such as cutting corners with substandard materials and shoddy construction, pressuring inspectors to overlook building code violations and defects, and pressuring appraisers to inflate home values. It seems that substandard homes and subprime loans both contributed to the collapse, which was sparked by an oversupply bubble. Recovering will require legislative changes at the state and national level to restore strict regulatory oversight of two vertically integrated industries gone wild - homebuilding and finance.

CtW Investment Group Calls on Homebuilders to Address Compliance Failures

Dedicated Board Committees Needed to Oversee Legal and Regulatory Compliance

For Immediate Release

Washington, September 5, 2007 – The CtW Investment Group, pointing to large homebuilders’ role in creating the current crisis in the housing and credit markets, today called on the boards of directors of the nation’s largest homebuilders to establish dedicated compliance committees to protect the companies and their shareholders in the face of mounting legal and regulatory scrutiny. 

“Homebuilders are not passive victims here,” said Bill Patterson, Executive Director of the CtW Investment Group.  “Through improper business practices, particularly within their mortgage affiliates, the nation’s largest homebuilders in fact helped cause the industry-wide collapse. This turmoil has already destroyed billions in shareholder value, while exposing shareholders to considerable legal, regulatory and reputation risk.” 

Homebuilders with affiliated mortgage units are especially vulnerable since these units create an incentive for builders to sell families homes they cannot afford by granting them excessively risky mortgages and then offloading that risk by selling the mortgages to unwitting investors in the secondary market. This conflict of interest, the Group argues, requires effective compliance procedures and attentive board oversight.  Failure to effectively manage this conflict is at the heart of the illegal business practices that allegedly took place at Beazer Homes, among others.

In letters to 11 of the largest homebuilders, the Group specifically asks each board to establish a Legal and Regulatory Compliance Committee of independent directors to conduct a comprehensive review of the company’s compliance status and implement a compliance program to detect and prevent material compliance failures. Such committees are common at firms that face significant regulatory and litigation risk, including health care, insurance and pharmaceutical companies.

The CtW Investment Group works with pension funds sponsored by unions affiliated with Change to Win, a coalition of unions representing nearly 6 million members, to enhance long-term shareholder value through active ownership.  These funds, together with public pension funds in which CtW union members participate, have about $1.4 trillion in assets and are substantial long-term shareholders of the 11 homebuilders.

The 11 homebuilders in the S&P 500 large cap and S&P 400 mid cap indices received letters  These include Beazer, Centex, D.R. Horton, Hovnanian Enterprises, KB Home, Lennar, MDC Holdings, NVR, Pulte Homes, Ryland Group and Toll Brothers  In total, the 11 firms—eight of which have been sued by shareholders or homeowners this year—have lost $23 billion in value through the first eight months of 2007. 

For additional information, contact Michael Garland at 212-290-0308.

Please click the following link for specific Board letters:

[We fear that CtW Investment Group was itself a victim of the collapse they foresaw. Their website has not been updated since October 2008, and their NYC phone# is no longer working. We were able to leave a recorded message at their Washington office but have not heard back yet, and we have no email address. In case their site suddenly disappears, we copied the following 11 letters to our own site and link there instead.]

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Early Warning Signs

[cut/paste from the CtW Investment Group website]

The Wall Street Journal recently reported that the U.S. mortgage crisis is “comparable to some of the biggest financial disasters of the past half-century.”  At the epicenter of this crisis are a set of financial institutions whose massive failure to manage mortgage-related risk not only destroyed billions in shareholder value, but also destabilized the global capital markets and precipitated a credit crunch that now threatens to throw the U.S. economy into recession.

The boards of directors at these firms bear ultimate responsibility.  Specifically, while it is the CEO’s job to manage risk, the NYSE listing requirements mandate that it is the responsibility of the board’s audit committee or other designated committee to review the firm’s major financial risks and assess the steps management has taken to control such exposure. The banks’ board failures are especially egregious since it was apparent by mid-2005 that mortgage lenders were loosening lending standards and an overheated U.S housing market was at risk of collapse. 

By mid-2005, it was apparent that a housing bubble had developed and that the risks of a severe mortgage downturn had increased dramatically.  Fueled by historically low interest rates, the creation of mortgage products targeting less credit-worthy borrowers and abundant liquidity from a booming secondary market for securitized mortgages, home prices had virtually doubled over the previous five years.

Housing starts, which had increased every year since 2000, peaked in second quarter 2005.  Mortgage interest rates began rising, with the average rate on a conventional 30-year fixed rate loan jumping from 5.6% to 6.7% between June 2005 and June 2006. And mortgage lenders were loosening their lending standards and increasingly using novel loan products, including interest-only mortgages, option adjustable-rate mortgages and no documentation loans. 

But one need not have been the CFO or director of a bank to know that a national housing bubble had developed and could burst. One need only have read the news, where a growing number of economists, investment analysts and public policy experts were sounding the alarm:

• On May 27, 2005, economist Paul Krugman of the New York Times said he saw “signs that America’s housing market, like the stock market at the end of the last decade, is approaching the final, feverish stages of a speculative bubble.” 
• On June 9, 2005, Federal Reserve Chairman Alan Greenspan, while downplaying risk of a national housing bubble, acknowledged in testimony to the Joint Economic Committee that he saw “signs of froth in some local markets where home prices seem to have risen to unsustainable levels.” 
• On July 26 2005, The Wall Street Journal reported that “Mortgage lenders are continuing to loosen their standards, despite growing fears that relaxed lending practices could increase risks for borrowers and lenders in overheated housing markets.” The article cited increases in novel loan products, including interest-only mortgages, option adjustable-rate mortgages and no documentation loans.  
• By December 2005, even some CDO traders warned the bubble could burst. Jason Schechter, then head of CDO trading at Lehman Brothers, echoed other participants at the Opal Financial Group CDO Summit when he said: “What concerns me though is: is this liquidity here to stay, or are we at risk for a sizable downturn?” (Asset Securitization Report, December 12, 2005) 

A number of firms did take action to reduce their mortgage-related risk exposure. Goldman Sachs, for example, began aggressively reducing its mortgage-backed securities exposure in late 2006, both by reducing inventory and hedging. Morningstar recently named PIMCO’s Bill Gross the best fixed-income fund manager in 2007, lauding him for avoiding exposure to subprime securities and for anticipating the effect that the decline in home prices would have on the broader economy and corporate bonds.