Toll Brothers downgraded ahead of earnings

NEW YORK (CNNMoney.com) -- Toll Brothers had its shares downgraded to a sell recommendation Tuesday, as worries rise that rising problems in the market for large mortgages would hit the luxury home builder.

The recommendation came from Bank of America equity research, which had previously had a neutral recommendation on Toll Brothers (Charts, Fortune 500) shares. Shares of Toll Brothers fell about 5 percent in late-morning trading in New York on the downgrade.

Toll Brothers shares fell as an analyst gave it a sell recommendation, even though the luxury home builder has yet to report a loss in the current downturn.

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Toll Brothers is the nation's No. 7 public home builder by revenue. The six larger builders all reported losses in their most recent quarters, but Toll has so far managed to remain profitable in the current housing slump. The market for higher-end luxury homes had initially held up better than the broader new home market in the housing downturn.

But that segment of the market now is under pressure due to recent problems in the market for securities backed by jumbo mortgages, or those greater than $417,000.

Jumbo mortgages traditionally were seen as safe investments, particularly prime jumbo mortgages, as they are made to people with large incomes and good credit ratings.

But rising defaults and delinquencies in subprime mortgages, made to people with less than top credit, as well as in so-called Alt-A loans, made to borrowers who couldn't provide full income documentation, has spilled over into the other parts of the mortgage market, such as jumbo loans.

The current crisis in mortgages securities has hit the demand for anything other than securities which can be backed by two government-sponsored mortgage finance companies - Freddie Mae (Charts, Fortune 500) and Fannie Mae (Charts), and thus driven up the cost of jumbo loans to borrowers. And that increase in cost has trimmed those lenders' borrowing power.

On Aug. 8, Toll Brothers reported preliminary results for its fiscal third quarter, which ended in July, in which it said revenue, backlog of orders and new contracts signed all declined by more than 20 percent in the quarter. It said given the current problems in the market, it did not feel comfortable giving any earnings guidance for the period.

It is due to give final results before the market open Wednesday, with analysts surveyed by earnings tracker First Call still forecasting earnings per share of 6 cents a share, down from $1.07 a share a year earlier.

The note from Bank of America analyst Daniel Oppenheim forecast that Toll Brothers will now report a 7-cent a share loss in the third quarter and an 18-cent a share loss in the current period.

He also cut its 12-month price target for Toll shares to $19 from $29, putting the price a bit below Tuesday's levels. He cited the spreading problems in the jumbo loan market, particularly for Alt-A jumbo loans that he estimates accounts for 43 percent of Toll sales. And he said that Toll Brothers' land holdings, which are larger compared to its sales volume than the industry average, will be a negative for shares going forward.

"We think that the deteriorating affordability [from higher mortgage rates] and worsening high-end traffic levels will lead investors to view Toll's land position as more of a liability than an asset," he wrote.

The drop in both sales volume and prices of new homes has caused many builders to take large charges to write down the value of their holdings or get out of options they held on undeveloped land. Toll Brothers was working to finalize its own charges, which it said earlier this month would be between $125 million and $175 million in the third quarter.

But many builders have seen much bigger than expected charges, and with it much bigger than expected losses.

Lennar (Charts, Fortune 500), the nation's No. 1 builder by revenue, reported a loss rather than the forecast narrow profit in its most recent quarter, and No. 2 home builder D.R. Horton (Charts, Fortune 500) and No. 3 Centex (Charts, Fortune 500) both reported losses far greater than expected.

Overall, a survey by the National Association of Home Builders found its members confidence in the market at a 16-year low in August. And while builders have scaled back dramatically on housing starts and permits for additional homes to the lowest point in more than a decade, soft sales and years of overbuilding in some markets have resulted in a serious glut of new homes for sale on the market, according to government figures.