Housing starts in the US sank 6.3% in September to a seasonally adjusted rate of 817,000, the lowest level in 17 years. That's worse than economists had expected, with a consensus forecast of a 1.7% drop in home construction.

Moreover, economists expect further declines in the fourth quarter. Building permits, an indicator of future activity, fell 8.3% to a 786,000 annual rate.

The decline in housing starts--the third precipitous drop in a row--should help weed back existing housing inventories, however, all of this means the home builders remain under severe pressure. That includes Hovnanian (HOV), Centex Corp. (CTX), D.R. Horton (DHI), Lennar Corp. (LEN), Toll Brothers (TOL) and Pulte Homes (PHM).

More so as U.S.-regulated banks are rapidly getting out of home building. "This is, by far, the toughest time for home builders since World War II," said James Hamilton, an economics professor with UC San Diego. "It's really a phenomenal collapse in the market these past two years."

On top of all this, Standard & Poors lowered its credit ratings on seven homebuilders in the last three months, and had cut 11 in the preceding quarter. Large homebuilders--like D.R. Horton, Lennar Corp. and Pulte Homes-are working furiously to cut back production to levels last seen in 2000 and 2001, while others have retreated as far as 1994.

Supply Glut Socks the Home Builders

The National Association of Realtors says that inventories are at a supply of 10.4 months, the highest level in 18 years. The US Census Bureau releases new home sale and supply data, with data dating back to 1963. As of August 2008, there was 10.9 months of supply, down slightly from the peak of 11.2 months seen in March of this year. August marked the sixth consecutive month of double digit months of inventory, a trend that has never happened dating back to 1963.

Previous highs of 11.6 months of supply were made in April 1980, with a few other months of double-digit supply in 1981. In short, the current levels of inventory are unprecedented, warns Meredith Whitney of Oppenheimer Equity Research.

To wipe out the supply glut in housing, builders will have to pump out just 800,000 houses annually for two years, Merrill Lynch says. That's about half of the going rate up until recently.

House Price Declines Hurt

Housing futures imply a housing price peak-to-trough drop of 22% by November 2008, a drop of 29% by November 2009, and a drop of 33% by 2010. Under this scenario home prices would return to levels last seen about eight years ago, essentially wiping out nearly a decades' worth of home price appreciation.

Home Builders' Ugly Debt Picture

The average leverage of investment grade home builders, as measured by debt to earnings before interest, taxes, depreciation and amortization, could grow to four times in late 2007, from a current average of 1.8 times.

Moody's Investors Service has already reported that a worse-than-expected housing slump has left home builders with less cash flow to cover debt interest, and some ratings could be cut if that trend continues.  

Cash flow is the key to reducing debt and interest expense, but companies have had a harder time boosting cash flow than in previous downturns, Moody's said.

Home Builders' Hidden Time Bombs

There are hidden time bombs on the home builders' balance sheets--off balance sheet debt, which could keep the home building sector dark for a while longer.

Specifically, many home builders entered into land deals with partners, but then shoved billions of dollars in debt from those deals into off-balance sheet vehicles, debt that could come back to bite their stocks.

Put that debt back onto their balance sheets, already underwater with an ocean liner of debt, and the companies' dirt-cheap book values fall deeper in the hole.

Here's how it works. Many large builders took minority stakes in joint ventures, which let them stockpile land for future needs while keeping billions in debt off their balance sheets. If they don't make sales, if they can't move that land, they're still very likely on the hook for their share of that off-balance sheet debt.

Alisa Guyer Galperin, an analyst at the Center for Financial Research & Analysis, figures that 13 of the country's biggest homebuilders on average have debt to capital ratios that look way uglier with this off balance sheet debt factored in, as much as 977 basis points higher than typically reported.

Why Debt Ratios Matter

This is why investors should care about higher debt to capital ratios. A company with high debt-to-capital ratios faces higher costs, like interest, on these debts that can suck free cash flow out of a company, cash that could go toward expanding an operation (yes taking on debt can also help pay to grow a company, but at a big cost-especially if management is poor).

High debt can weigh on a company and increase its default risk.

The Center for Financial Research & Analysis figures that Lennar, one of the country's biggest home builders out of Miami, Fla, and NVR, a homebuilder in Reston, Va., have the most off-balance sheet debt. The Center also adds that NVR in each of the last three years bought developed lots from a company controlled by a board member-did it get a fair price for shareholders?

Homebuilders may be held responsible for their share of joint venture debt guarantees, based on their pro rata share of the joint venture or the JV's specific recourse agreements. The accounting rules are really loose here-the homebuilders themselves get to decide whether or not they are the prime beneficiaries of an off balance sheet deal, and so whether they need to book the debt on their balance sheets.

The Center's Guyer Galperin has estimated that Lennar is on the hook for up to $910 mn of $5.6 bn in debt through partnerships not on its books. Lennar and other home builders are already fighting with lenders that are stamping their feet to force it pay off its share of their partnerships' total outstanding debt.

And Deutsche Bank has already sued Technical Olympic USA, alleging the Florida builder is in "multiple potential defaults" on $675 million in debt owed by several failed joint venture partnerships. Lennar says it's protected from any problems because it's hooked up with solid institutional investors like the pension fund CalPERS and has set up deals to ensure it isn't liable for partners.