February 28, 2010 - Warren Buffett's annual letter to Berkshire's shareholders was released this morning. Here is a reprint of the section where he talks about manufactured housing:
Finance and Financial Products Our largest operation in this sector is Clayton Homes, the country´s leading producer of modular and manufactured homes. Clayton was not always number one: A decade ago the three leading manufacturers were Fleetwood, Champion and Oakwood, which together accounted for 44% of the output of the industry. All hae since gone bankrupt. Total industry output, meanwhile, has fallen from 382,000 units in 1999 to 60,000 units in 2009.
The industry is in shambles for two reasons, the first of which must be lived with if the U.S. economy is to recover. This reason concerns U.S. housing starts (including apartment units). In 2009, starts were 554,000, by far the lowest number in the 50 years for which we have data. Paradoxically, this is good news. People thought it was good news a few years back when housing starts the supply side of the picture were running about two million annually. But household formations the demand side only amounted to about 1.2 million. After a few years of such imbalances, the country unsurprisingly ended up with far too many houses.
There were three ways to cure this overhang: (1) blow up a lot of houses, a tactic similar to the destruction of autos that occurred with the “cash-for-clunkers” program; (2) speed up household formations by, say, encouraging teenagers to cohabitate, a program not likely to suffer from a lack of volunteers or; (3) reduce new housing starts to a number far below the rate of household formations.
Our country has wisely selected the third option, which means that within a year or so residential housing problems should largely be behind us, the exceptions being only high-value houses and those in certain localities where overbuilding was particularly egregious. Prices will remain far below “bubble” levels, of course, but for every seller (or lender) hurt by this there will be a buyer who benefits. Indeed, many families that couldn´t afford to buy an appropriate home a few years ago now find it well within their means because the bubble burst.
The second reason that manufactured housing is troubled is specific to the industry: the punitive differential in mortgage rates between factory-built homes and site-built homes. Before you read further, let me underscore the obvious: Berkshire has a dog in this fight, and you should therefore assess the commentary that follows with special care. That warning made, however, let me explain why the rate differential causes problems for both large numbers of lower-income Americans and Clayton.
The residential mortgage market is shaped by government rules that are expressed by FHA, Freddie Mac and Fannie Mae. Their lending standards are all-powerful because the mortgages they insure can typically be securitized and turned into what, in effect, is an obligation of the U.S. government. Currently buyers of conventional site-built homes who qualify for these guarantees can obtain a 30-year loan at about 51/4%. In addition, these are mortgages that have recently been purchased in massive amounts by the Federal Reserve, an action that also helped to keep rates at bargain-basement levels.
In contrast, very few factory-built homes qualify for agency-insured mortgages. Therefore, a meritorious buyer of a factory-built home must pay about 9% on his loan. For the all-cash buyer, Clayton´s homes offer terrific value. If the buyer needs mortgage financing, however and, of course, most buyers do the difference in financing costs too often negates the attractive price of a factory-built home.
Last year I told you why our buyers generally people with low incomes performed so well as credit risks. Their attitude was all-important: They signed up to live in the home, not resell or refinance it. Consequently, our buyers usually took out loans with payments geared to their verified incomes (we weren´t making “liar´s loans”) and looked forward to the day they could burn their mortgage. If they lost their jobs, had health problems or got divorced, we could of course expect defaults. But they seldom walked away simply because house values had fallen. Even today, though job-loss troubles have grown, Clayton´s delinquencies and defaults remain reasonable and will not cause us significant problems.
We have tried to qualify more of our customers´ loans for treatment similar to those available on the site-built product. So far we have had only token success. Many families with modest incomes but responsible habits have therefore had to forego home ownership simply because the financing differential attached to the factory-built product makes monthly payments too expensive. If qualifications aren´t broadened, so as to open low-cost financing to all who meet down-payment and income standards, the manufactured-home industry seems destined to struggle and dwindle.
Even under these conditions, I believe Clayton will operate profitably in coming years, though well below its potential. We couldn´t have a better manager than CEO Kevin Clayton, who treats Berkshire´s interests as if they were his own. Our product is first-class, inexpensive and constantly being improved. Moreover, we will continue to use Berkshire´s credit to support Clayton´s mortgage program, convinced as we are of its soundness.
Even so, Berkshire can´t borrow at a rate approaching that available to government agencies. This handicap will limit sales, hurting both Clayton and a multitude of worthy families who long for a low-cost home.
In the following table, Clayton´s earnings are net of the company´s payment to Berkshire for the use of its credit. Offsetting this cost to Clayton is an identical amount of income credited to Berkshire´s finance operation and included in “Other Income.” The cost and income amount was $116 million in 2009 and $92 million in 2008.
The table also illustrates how severely our furniture (CORT) and trailer (XTRA) leasing operations have been hit by the recession. Though their competitive positions remain as strong as ever, we have yet to see any bounce in these businesses.
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Buffett's Shareholder Letter Evaluates Manufactured Housing
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