Builders Have Further to Fall

Over the last 12 months, Hovnanian had negative free cash flow of $284 million. If the company loses money this year, it won't produce free cash flow. Thus there is a reason the stock trades at a 38% discount to stated book value.

Most other builders are facing similar issues with impairments and leverage. Lennar is an example of a better capitalized builder, with a debt-to-equity ratio of 0.46 -- one of the lowest in the sector. But what happens if you fully impair the company's inventories, raw land, and many joint ventures? The short answer is that it's very difficult to quantify how much risk is left in the balance sheet, and debt-to-capital ratios would balloon further with more impairments.

In fairness, most industry sources do not expect any builder to face bankruptcy, with the exception of possible liquidity crises at two small-cap firms: Tarragon Corp(TARR Quote - Cramer on TARR - Stock Picks) and Comstock Homebuilding(CHCI Quote - Cramer on CHCI - Stock Picks). Tarragon is facing questions as it prepares to split into two companies, and Comstock has had delayed closing on a major condo conversion project that has raised concerns about problems with lenders.

And some builders aren't facing major negative headwinds.

Two stocks with the balance sheets best positioned to ride out the downturn in housing are NVR(NVR Quote - Cramer on NVR - Stock Picks) and MDC Holdings(MDC Quote - Cramer on MDC - Stock Picks), Barron says. NVR already has more cash than debt on its balance sheet. MDC should be in that position by the end of the year, he says.

While Barron likes both companies' business models, he doesn't recommend buying either because he sees another leg down for the entire homebuilder sector, and the stocks tend to trade in line with each other.

"The whole group will see new lows," says Barron, adding that a 10% to 15% drop might be too conservative, since the stocks tend to overshoot on the downside or upside.

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