While it remains to be seen whether the U.S. Attorney for the Western District of North Carolina turns up evidence that Beazer Homes USA violated any laws in its mortgage operations, it is not alone in facing scrutiny from the federal government-and the press. Newspapers and public officials have turned a microscope on the building industry.

On Wall Street, when news broke on March 28 of a federal investigation into Beazer's lending practices, the company's stock plunged to a 52-week low of $27.71. By week's end, the stock had recovered to $29 by midday March 30, but that was less than half its value at this time last year. Still, analysts seemed willing to give the company the benefit of the doubt.

Michael Rehaut, the home building analyst at JP Morgan Securities, put out a research note stating, "While impossible to determine the outcome of such an investigation, we do note that one scenario is that the investigation ultimately focuses on only a few subdivisions and results in only several millions of dollars in fines, and therefore not be material." But Rehaut did express concern with the comments of an FBI agent in an interview with BusinessWeek magazine, which broke the story of the investigation. "The language of the FBI spokesman is particularly troubling, as the investigation also includes 'corporate and investments,'" Rehaut wrote. "Also we note that at minimum from a perceptual standpoint, the departure of CFO Jim O'Leary last week to be CEO of Kaydon and the firing of General Counsel Kenneth Gary on 2/14 for a 'personal pattern which includes violations of company policies' creates red flags, which may fuel the investigative process."

Rehaut had an underweight rating on Beazer stock to begin with, even though he has been maintaining a positive sector stance on the home building industry. He expressed concern, however, that "several politicians' calls for hearings on predatory lending may create some overhang on the group. However, we do note that in the past, BZH's legal issues have stood out among the builders."

Similarly, Daniel Oppenheim, a building analyst with Bank of America Securities, put out a note that reflected his belief that the problem at Beazer had to do with buyers overreaching in a stretched market and that it "may be difficult" for the feds "to prove fraud."

Alex Barron of JMP Securities in San Francisco put out a note on March 29 stating, "We have looked into the Beazer story that broke earlier this week in a bit more detail in order to get some facts and to avoid making premature judgments. Thus far, we have found the following: A law firm filed a class action lawsuit against BZH on March 26, 2007 alleging one customer who bought a Beazer home in 2001 in North Carolina was harmed due to a higher than average foreclosure rate in that community, which has caused home prices to depreciate. The lawsuit alleges the company helped prospective low-income buyers qualify for loans for which they would not have otherwise qualified. Beazer told us that as of yesterday, the company has been contacted only by the Attorney General's office of North Carolina with a request for information regarding certain loan documents, but that, to its knowledge, it is not the subject of an investigation by the DOJ, FBI, or IRS, as reported by BusinessWeek. While we have no particular viewpoint on such individual law suits related to builders or lenders, we believe there is likely to be plenty of similar 'noise' near term surrounding the fallout of the sub-prime mortgage market correction in process."

There are currently three legal issues facing Atlanta-based Beazer. The first is the subpoena seeking documents related to its mortgage business issued by the U.S. attorney in North Carolina, which was issued at the request of the Inspector General of the U.S. Department of Housing and Urban Development. The second is a class action lawsuit filed March 29 in U.S. District Court for the Northern District of Georgia. That lawsuit, filed on behalf of people who bought Beazer stock by Lerach Coughlin Stoia Geller Rudman & Robbins LLP of San Deigo, alleges that Beazer misled shareholders in several ways, including "(a) the Company lacked requisite internal controls over its lending practices, which, as a result of its improper lending practices prior to and during the Class Period, would lead to numerous foreclosures and other problems; (b) the Company's business was growing in large part due to its improper lending practices to low-income borrowers; (c) many of the Company's buyers would not be able to pay their loans after the first two years, which would lead to decreased sales and earnings and numerous foreclosures; and (d) given the increased volatility in the lending market, the Company had no reasonable basis to make projections about its 2007 results and as a result, the Company's 2007 projections issued during the Class Period were at a minimum reckless." The law firm is actively seeking to recruit new parties to the class action. The third is the lawsuit mentioned in Alex Barron's research report.

The lawsuit and the federal investigation were initiated by a series of stories in the Charlotte Observer that probed Beazer's involvement in mostly low-income developments in the north and west suburbs of Charlotte in which there are now foreclosure rates of 20% to 25% among people who bought homes there. The series reported that 388 homes representing 13% of the 2,900 built by Beazer between 1997 and 2006 in Mecklenburg County had been foreclosed upon. The national foreclosure rate is 3%. The foreclosures were concentrated in 10 developments, where Beazer built 1,150 homes ranging in average price from $100,000 to $150,000, and 70% of the mortgages originated by Beazer were backed by the FHA. Of those homes, 280 have been foreclosed upon, a rate of 26%.

The series focused on a development called Southern Chase in Concord, N.C., which opened in 1997 with prices starting at $80,000. People camped out to be first in line when the development opened. Of the 406 Beazer homes in the development, 77 have been foreclosed upon, 45 of them with FHA-backed mortgages. The newspaper alleged specifically that Beazer failed to properly document that two borrowers could afford monthly payments, as required by law, and that it charged "at least 5" borrowers fees that were "several times" the maximum allowed by the laws governing FHA loans. In one specific case, the newspaper reported that Beazer submitted an FHA mortgage application that understated monthly income by $187 and omitted a car lease payment of approximately $350 without the approval of the borrower. The paper also reported that home appraisers used to determine the value of homes in the community were hired by Beazer. It quoted residents and area real estate experts saying that homes had been appraised at inflated values.

A review conducted by HUD resulted in the April 2006 surrender of a license to make FHA loans by Beazer's Charlotte division, but the paper said the company continued making FHA loans through its other divisions. At the time of the license surrender, HUD said it would take no further action. But now it has, through the U.S. attorney's office.

It appears that the investigation centers on FHA-backed loans. There is no state or federal governing authority charged with regulating the subprime mortgage market per se, although there are laws prohibiting fraud in mortgage lending. The question for builders that own lending arms would appear to be whether they have dealt with FHA loans and how those loans were documented. No-down-payment loans were ended by FHA in 2004 after having been offered since the middle 1990s.

The factors that could affect a builder's exposure to the subprime mortgage market include price point and geography. Geography enters into consideration largely through the condition of the local housing market. Where prices are falling, and incomes are low to moderate, exposure increases.

In a recent report on the deterioration of the subprime and Alt-A mortgage markets, Ivy Zelman, home building analyst for Credit Suisse, listed Standard Pacific, KB Home, Lennar, MDC, D.H. Horton, Centex and Beazer as higher risk in terms of exposure to the subprime mortgage market. K. Hovnanain, Ryland, MHD, WCI, Pulte, Toll Brothers are NVR were less exposed.

Learn more about markets featured in this article: Charlotte, NC.