The plunge in mortgage rates in Nov and Dec blew up the hedge for the rate buydowns: surprise cost on top of the regular costs of buydowns.
By Wolf Richter for WOLF STREET.
Homebuilder stocks tanked on Tuesday after D.R. Horton’s earnings call, with D.R. Horton’s stock [DHI] down 9.2%. The sell-off came after the huge rally starting in early November driven by rate-cut mania on Wall Street that had sent folks dreaming of 3% mortgages or whatever (but the mania is fading a little, mortgage rates have risen 30 basis points since late December, to nearly 7%, according to the daily measure by Mortgage News Daily).
Part of the problem was that the gross profit margin on home-sales revenue dropped by 220 basis points from the prior quarter, to 22.9%, executives said during the earnings call with analysts.
About 100 basis points of that 220-basis-point drop in gross profit margin were due to an unexpected cost of mortgage-rate buydowns, on top of the regular costs of the buydowns: a $65 million mark-to-market charge for a hedge gone awry.
The remainder of the 220 basis-point drop in gross profit margin “was primarily due to an increase in incentive levels [the mortgage-rate buydowns] on homes closed during the quarter,” the company said during the earnings call (transcript via Seeking Alpha).
Mortgage-rate buydowns are the most successful incentive homebuilders have. In addition, D.R. Horton — like other builders — is building smaller homes with less expensive amenities, and the average closing price has continued to drop in Q4, it said. With payments lower for a new home than for an existing home, new home sales have held up, while existing home sales have collapsed.
But mortgage-rate buydowns are an expensive incentive in unexpected ways. The massive swing in mortgage rates during the quarter had caused its hedges on those buydowns to lose market value and essentially become useless when mortgage rates dropped. The hedges needed to be restructured, and it triggered the $65 million charge to cost of goods sold.
On top of that, D.R. Horton said it had increased the use of the buydowns during the quarter, that 70% of its deals were made with mortgage-rate buydowns, up from 60% in the prior quarter; and that 80% of the mortgages originated by its mortgage company, DHI Mortgage, were done with buydowns.
And instead of backing away from these buydowns to protect profit margins, they would continue to use them in order to stay “competitive to not only the new home market, but especially to the resale market,” they said. “The ability to have a lower monthly payment for same cost of home is advantageous. So we have no plan in the near-term to stop utilizing it even if we see rates shift down.” And that gave investors the willies all over again.
The hedge gone awry.
The $65 million charge for the hedge was the first time this problem occurred, they said. There had been minor fluctuations “either up or down,” but in Q4, given the significant volatility in rates during the quarter – mortgage rates moved up to 8% in November and then dropped sharply in December – those hedging positions had to be adjusted to reflect that. So it was an unusual situation this quarter.”
To hedge those buydowns, the company buys “forward commitment pools for the next few weeks of deliveries essentially,” they said. “We’re not going out very far, but it is a few weeks, and so that’s when we saw a very sudden sharp change in rates, that can present some exposure there,” CFO Bill Wheat said.
But when rates dropped sharply in November and December, those pools became useless because market rates dropped below where the pool was.
“And it was really a restructuring, so it could be used, not that we weren’t going to fulfill the pool. We just had to restructure it so it was usable,” VP of Investor Relations Jessica Hansen said.
“And then at the end of the quarter, we always have to mark-to-market the value,” Bill Wheat said.
Any more bad hedges hanging out there? “In terms of our position outstanding, we believe that it reflects the current market, and the valuation adjustment in the December quarter takes care of all of it,” Bill Wheat.
“We always have some hedging position outstanding. And so anytime there is a significant sudden change in rates, that can leave some exposure there, obviously,” he said.
“The opposite side of that is the benefits to the business. When rates drop, obviously, that improves affordability and improves our ability to sell at a price point in the core business.”
“And so, what this hedging position allows us to do is offer below market rates on a consistent basis on a broad basis across our business. And like we said, we try to manage that as best as we can, but in a period of significant sudden volatility, there can be some exposure to the position,” he said.
This massive swing in mortgage rates in the middle of the quarter was a “kind of a very unique dynamic that we have not experienced,” and “that’s what led to the mark-to-market adjustment being more severe than it has been in prior quarters,” said COO Michael Murray.
In terms of accounting for the mortgage-rate buydowns: “That $65 million mark-to-market is in cost of goods sold, whereas the cost of just “standard routine” rate buydowns goes “against revenue and flows through our ASP,” [average selling price], explained Jessica Hansen.
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