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Even as homebuyers were being offered a free washer, dryer, refrigerator and window blinds, plus 5 percent off the price or in cash to pay closing costs, business was dragging at Reeves Williams’ communities.

So at the end of July, Reeves Williams, a home builder in the South, began offering $20,000 in incentives or cash assistance. In the first week, 22 buyers had signed contracts for new homes. Then the mortgage market fell into a tailspin.

“We lost 17 of them. It was a huge hit,” says Martha Fondren, vice president of sales. “It was a credit issue. They did not have horrible credit. But they didn’t have the credit scores to get (a loan), and six months ago they would have.”

Since early August, the real estate market has sunk deeper into recession. Forecasts of a recovery have been pushed back to the middle of 2008 — at the earliest. For home builders, the market conditions are already worse than the last housing recession, in 1991-92. And depending on how the subprime mortgage debacle plays out in coming months, this recession could be more painful for the industry than the wicked one in 1980-82.

“Based on activity since early August, our experience is worse” than the past two corrections, Robert Toll, CEO of Toll Brothers, told investors at a recent Credit Suisse conference.

Sales of new homes fell in August to their slowest pace in 12 years, and the median price fell by 7.5 percent, the sharpest annual drop in 37 years. The confidence level of builders has fallen to its lowest point since the last housing recession.

“Who can’t be concerned with what we’re looking at right now?” Toll asks.

Many builders, of course, are partly to blame because they overbuilt in some of the most torrid markets and slapped together homes on the speculation the party would go on. Those are the companies now bearing the brunt of the contraction.

But few builders — even the conservative ones — have escaped unscathed. Most of them face wrenching decisions about whether and by how much to reduce headcounts, lower prices, delay or abandon developments and write off and sell assets. And the builders are affecting the health of the broader economy, according to the Federal Reserve.

Short of cash, several builders have renegotiated with their banks to avoid defaulting on the terms and conditions of their credit lines and loans. Builders are squeezing subcontractors and suppliers for discounts. They’re also redesigning homes to be smaller or with cheaper features.

“We are reanalyzing every location we’re in,” said Ara Hovnanian, CEO of Hovnanian Enterprises.

Last month, the company sold 2,100 homes in a three-day nationwide “deal of the century” sale with big price reductions. The company has fired 30 percent of its employees, reduced its inventory of home lots by nearly half, renegotiated with subcontractors and re-evaluated option-contracts to buy land.

“No. 1, we’re not assuming a quick recovery,” Hovnanian says. “We’re operating as if this is going to continue for a long time.”

Since the middle of last year, builders have written off $10 billion in real estate, according to Stephen Kim, an analyst at Citigroup. He expects the companies to write off nearly $4 billion in the third quarter. Several public builders will report their earnings later this month. But Wall Street got a nasty preview recently when KB Home and Lennar released grim results.

A significant deterioration

KB Home said its cancellation rate spiked to 58 percent for its third fiscal quarter, which ended in August. The company said it abandoned plans to build homes in Indiana and Fort Myers, Fla.

“There was a significant deterioration in the housing market, and this accelerated dramatically toward the end of the quarter,” said Jeffrey Mezger, CEO of KB Home. The number of buyers touring model homes and signing contracts hit “the lowest levels of the current housing downturn.”

KB Home hasn’t borrowed against its credit line but has renegotiated the terms to protect its liquidity. Beazer Homes, Standard Pacific, TOUSA and others have also gone back to their lenders for new terms on their loans or credit lines.

But the struggles of builders, lenders and sellers aren’t the only gauge of the housing industry. There are still some positive signs. Interest rates are still historically low. And buyers with good credit enjoy plenty of loan options. There are also pockets across the country where home sales are still healthy and prices are rising.

In the greater metro area of Tulsa, sales rose more than 7 percent in August to near-record levels. Prices also climbed. The real-estate markets are solid, too, in most parts of South Dakota and Texas, for example.

On Monday, Robson Communities raised prices 1 percent on its active-adult development in Denton, Texas, because development costs are rising and sales are healthy. Still, the Phoenix-based developer projects it will sell only 800 homes this year, half the number it sold last year. And the company has handed pink slips to 25 percent of its employees.

“Because we tend to focus on the senior buyer, the problem is not making the decision on the new house; it’s selling their old house,” says Steven Soriano, executive vice president for Robson.

That’s partly because there’s a bloated 10-month supply of existing homes on the market and more than eight months’ worth of new homes for sale. Even when sellers do receive offers, the deals often collapse because buyers run into trouble qualifying for a mortgage.

Gordon Milne, CFO of Ryland Group, says that 10 percent of its buyers last year purchased homes with “Alt-A” loans; those are for borrowers with reasonably good credit but no down payment and little or no proof of income or assets. Now that such loans have virtually disappeared, Milne says, “We’re scrambling a bit to find mortgages for buyers who were in that 10 percent, and we can’t find them for all of them.”

Half of Ryland’s buyers backed out of their contracts in the most recent quarter, Milne says, and the company had to lay off 30 percent of its staff. With its business shrinking, Ryland Homes has combined its Fort Myers and Tampa offices. In California, it’s consolidated four of its offices into two.

“There is definitely a lot of discounting going on in some cities,” Milne says, adding that many builders are offering 5 percent to 20 percent in incentives and price cuts, depending on the community.

This month, Ryland is promoting a “40th Sales Finale.” Its home prices in Fort Myers, for example, have been slashed by up to 30 percent on completed homes that are sitting vacant. Buyers there also get $10,000 toward closing costs.

“It’s hand-to-hand combat out in the field,” Milne says. “We look at the competition down the street, what they’re doing, and we’ve got to match it.”

Stuart Miller, CEO of Miami-based Lennar, says he thinks some builders’ price cuts have been “unrealistic, maybe even ridiculous.” Lennar reported the worst quarterly financial results in the company’s history and a surge in cancellation rates.

Miller says he walked away from 15,000 home sites the company had planned to develop and has laid off 35 percent of his staff. “August seemed to be a melting pot of all things negative,” Miller says.

Some laid-off employees have managed to find jobs in commercial real estate, which so far hasn’t been affected as much by the turmoil in the credit markets. But the magnitude of the downsizing among builders is exerting a drag on the economy that could, in turn, further dampen demand for new homes.

“We have hundreds of thousands of jobs to lose over the next six to 18 months,” says Mark Zandi, chief economist for Moody’s Economy.com. “Housing employment accounts for 10 percent of all jobs nationwide and 15 percent of the economy.”

In Naples, Florida, Zandi says, 20 percent to 25 percent of the area’s jobs are housing related. “I’d be surprised if in Florida the economy isn’t already in recession,” he says.

Rising foreclosures

Adding to the home builders’ troubles are the rising number of foreclosures. The foreclosure rate is expected to rise through next year as 2 million homeowners must begin making higher payments on their adjustable-rate loans. Though only a portion of them will ultimately lose their homes, lenders tend to price foreclosed homes very aggressively to get them off their books.

“The clampdown on borrowing is happening when borrowers are facing their first reset and looking for a way out,” Zandi said. “And there’s no way out.”

Congress and the Bush administration have made proposals to help some homeowners through tax relief and the Federal Housing Administration. But it’s still unclear how many people will be helped. The relief to the building industry will likely be minimal.

In northern Mississippi and Shelby County, Tennessee, Reeves Williams ended its $20,000 incentive program on Monday. Even though David Smith, who bought one of the builder’s homes in June, didn’t get as many freebies as the company was just offering, he said they swayed his decision to buy.

Smith, 63, an avid bridge player and an editor at Bridge Bulletin magazine, received $4,500 off the price, $4,000 in closing costs, and said, “The fact that I could get a house and not have to buy a fridge, washer or dryer, it was significant to me.”

Fondren, the vice president of sales, says even its more-generous program didn’t draw in enough buyers. Now, she’ll negotiate with buyers on a case-by-case basis. The company also will lower prices by building less-expensive homes — without the granite or tile, for example, that used to be standard.

“If the option was all hardwood floors in the house, we might put them in the dining room but put carpet in the great room and bedrooms to shave a little off the price,” Fondren says. “People aren’t qualifying for as much.”

Special thanks to the Florida Association of Realtors.