Downgrading the Housing Woes - TheStreet

Downgrading the Housing Woes

McGraw-Hill's CEO shrugs off the bad news -- even as unit S&P sees 'no signs of a turnaround.'
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McGraw-Hill

(MHP)

CEO Terry McGraw dropped a bullish bomb in the company's first-quarter earnings call Tuesday.

"I think the housing market slump has bottomed ... in terms of sales and new starts," he said, according to a transcript of the conference call. "We will see throughout the year certain defaults on some of the subprime loans, but it won't have a material impact in our opinion on our results."

McGraw stuck his neck out on a day when the National Association of Realtors on Tuesday reported an 8.4% drop in existing-home sales in March -- the largest plunge since 1989.

Additionally, McGraw's own subsidiary, ratings agency Standard & Poor's, reported the housing market is showing "no signs of a turnaround," according to a press release. The S&P/Case-Shiller Home Price Index comprising 20 cities fell 1% in February from the same period in 2006 -- a rate of decline not seen in almost 15 years, says S&P.

Some homebuilder stocks fell on the housing news, which also caused major averages to surrender early gains:

Centex

(CTX)

,

Pulte Homes

(PHM) - Get Report

and

Hovnanian

(HOV) - Get Report

each ended the day down over 0.7%.

As with the homebuilders, major averages closed above their intraday lows, thanks in part to strength in chips stocks and another round of strong corporate profits.

The

Dow Jones Industrial Average

closed up 0.3% to 12,953.94, short of a record but just 46 points from the 13,000 psychological milestone after trading as low as 12901.68 and as high as 12989.86 intraday. The

S&P 500

slipped a fraction to close at 1480.55, and the

Nasdaq Composite

finished the day up a hair to 2524.54.

McGraw's comments seem particularly impetuous considering that ratings agency S&P and competitor

Moody's

(MCO) - Get Report

are increasingly under the microscope for possibly misstating the risk in mortgage-backed securities and related derivatives, given the rising defaults and foreclosures among subprime borrowers.

On Friday, Moody's itself noted that its prior estimates of subprime losses were too low. The company ratcheted up its expectations of losses for pools of subprime loans originated in 2006 to 6% to 8% from prior estimates of 5.5% to 6%, according to a company statement.

The revenue streams for S&P derived from the explosion of these derivative products and mortgage-backed securities are substantial. According to Credit Suisse analysts, 40% of S&P's revenue growth in 2006 came from rating collateralized debt obligations (CDOs). Analysts believe demand for such securities -- and thus ratings thereof -- will slow with lower rates of mortgage origination and securitization in the housing slump.

"We believe the potential for continued weakness as we move through April, May and June remains quite real," write Credit Suisse analysts in a report published in late March.

Credit Suisse believes CDOs contributed 30% to Moody's total profits in 2006. Credit Suisse expects Moody's, which reports its first-quarter earnings Wednesday, will revise down its guidance, particularly with respect to CDOs and mortgage-backed securities ratings revenues. Moody's is more dependent on the ratings for its overall health, while McGraw Hill has substantial revenue streams from businesses other than Standard & Poor's.

About 56% of McGraw Hill's total revenue growth in the first quarter came from its S&P unit. McGraw Hill's net income for the first quarter was 40 cents per share, up from 20 cents per share a year ago and 9 cents ahead of consensus estimates. McGraw Hill's revenue jumped 14% in the quarter to $1.3 billion, beating analyst estimates for $1.24 billion in revenue.

McGraw Hill's stock gained 4.5% Tuesday while Moody's was up 2% ahead of its earnings. The stocks have moved largely in correlation with sentiment in the market surrounding the subprime mortgage headlines.

On the conference call, McGraw said the subprime "thing" has garnered "an awful lot of spotlight in the general press -- and I don't think it is as warranted or deserved."

Perhaps among that unwarranted press, McGraw is speaking of Tuesday's "Ahead of the Tape" column in

The Wall Street Journal

or Gretchen Morgenson's piece in

The New York Times

on Sunday -- both of which raise the specter of a potential reputation problem for the ratings agency.

The New York Times

notes that an S&P representative told Congress earlier in April that the firm had downgraded just 0.3% of subprime issues.

"S&P has been on top of this situation," says Steven Weiss, a spokesman for the rating agency. "S&P saw problems developing in the subprime loan market one year ago -- and did something about it."

Weiss is referring to S&P one year ago raising credit criteria and surveillance standards for subprime loans. McGraw made a similar point on the conference calls, saying S&P changed some criteria to reflect "the fact that some of those lenders were too aggressive."

The bigger issue here is that actual ratings downgrades, like those done in 2005 to slice U.S. automakers

Ford

(F) - Get Report

and

General Motors

(GM) - Get Report

to speculative grade or "junk" status, can create selling sprees in the rated securities.

The selling of debt securities can, in turn, easily spill over into stocks and dislocate other financial markets as investors embark on risk-aversion frenzies. Such a frenzy would fulfill Credit Suisse's warning of declining demand for CDOs and perhaps even corporate debt. And such a pullback in demand for risky assets would surely hurt S&P a bit more than the current contagion-free subprime meltdown.

But McGraw says the market for CDOs is still strong -- "a continuation of the attractiveness of those investments

that give portfolio mangers more flexibility."

Surely McGraw is right that a decline in the subprime market will not mean Wall Street stops innovating and developing derivatives that S&P can rate. But McGraw's optimism about housing smacks of defensiveness and a desire to insist that S&P isn't complicit in the excessive lending and securitizing that led to the rising defaults and foreclosures haunting the housing market.

Tech Bulls Take the Reins

Most stock investors, like McGraw, shrugged off the bad housing news Tuesday as the bulls took control by midday. Much of the strength came out of the troubled tech sector, which has lagged in the recent rally.

The semiconductor sector finally got a boost on the heels of a strong earnings report from

Texas Instruments

(TXN) - Get Report

, which gained 8%, and Altera

(ALTR) - Get Report

, which jumped 7.7%. The Philadelphia Semiconductor Sector Index gained 3%.

Elsewhere, Dow component

IBM

(IBM) - Get Report

gained 3.8% on news the company announced a new $15 billion share-repurchase authorization and boosted its quarterly dividend.

Also aiding the Dow were

Honeywell

(HON) - Get Report

, which also boosted its dividend, and

DuPont

(DD) - Get Report

, which climbed 1.4% after posting better-than-expected quarterly results.

In keeping with TSC's editorial policy, Rappaport doesn't own or short individual stocks. She also doesn't invest in hedge funds or other private investment partnerships. She appreciates your feedback. Click

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