A Brief History of Credit Disasters

I introduced Josh Rosner at TBP conference as the best analyst you never heard of. Despite his having written extensively on these subjects in a prescient fashion, many investors and fund managers still don’t know who Rosner is.

I want to change that. I asked Josh sometime ago to assemble a timeline of his most important writings and calls, and he has — finally — complied.

-Barry Ritholtz

~~~

From Josh:

In July 2001 I wrote:

“Specifically, it appears that a large portion of the housing sector’s growth in the 1990’s came from the easing of the credit underwriting process. Such easing includes:
The drastic reduction of minimum down payment levels from 20% to 0% · A focused effort to target the “low income” borrower · The reduction in private mortgage insurance requirements on high loan to value mortgages · The increasing use of software to streamline the origination process and modify/recast delinquent loans in order to keep them classified as ‘current’ · Changes in the appraisal process which has led to widespread over-appraisal/ over-valuation problems If these trends remain in place, it is likely that the home purchase boom of the past decade will continue unabated. If there is an economic disruption that causes a marked rise in unemployment, the negative impact on the housing market could be quite large. These impacts come in several forms. They include a reduction in the demand for homeownership, a decline in real estate prices and increased foreclosure expenses… These impacts would be exacerbated by the increasing debt burden of the U.S. consumer and the reduction of home equity available in the home…However, a protracted housing slowdown could eventually cause modifications to become uneconomic and, thus, credit quality statistics would likely become relevant once again. The virtuous circle of increasing homeownership due to greater leverage has the potential to become a vicious cycle of lower home prices due to an accelerating rate of foreclosures.

In 2003 & 2004 I was among the first to identify fraud at FNM/FRE while 25 traditional analysts said “buy”. I can offer you report after report on this if it would be helpful.

January 12 2004 the WSJ recognized the views expressed in my reports and wrote:

“If “2003 was the year of questions about Freddie Mac’s accounting, 2004 will likely be a year in which investors increasingly question the lack of volatility at Fannie Mae and regulators take a closer look at their a 1000 accounting practices,” says Josh Rosner, an analyst at Medley Global Advisors, a financial research firm in New York. While Mr. Rosner favors Freddie Mac on a fundamental basis for 2004, he says that the many potential political and regulatory developments that could affect these companies this year could alter that outlook.”

In October 2004 I told the NYT:

“Still, the most damaging legacy of Fannie Mae’s years of unchecked growth may not be evident until the next significant economic slump. Only then, argued Josh Rosner, an analyst at Medley Global Advisors in New York, will the effects of Fannie Mae’s relaxed mortgage underwriting standards be felt. A result could be a more pronounced downturn in the real estate market and more stress on the consumer. ”The move to push homeownership on people that historically would not have had the finances or credit to qualify could conceivably and ultimately turn Fannie Mae’s American dream of homeownership into the American nightmare of homeownership where people are trapped in their homes,” Mr. Rosner said. ”If incomes don’t rise or home values don’t keep rising, or if interest rates rose considerably, you could quickly end up with significantly more people underwater with their mortgages and unable to pay.””

In the October 18, 2004 Newsweek profiled my work:

“A Wall Street analyst raised some red flags about Fannie Mae’s accounting practices long before regulators issued their recent reports, Newsweek reports in the current issue. And that report may rekindle questions about Wall Street’s ability to issue unbiased research. After Wall Street’s biggest firms settled with regulators in April 2003 over charges of fraudulent stock research, the industry promised a new era of independence…There is one analyst who raised some red flags: Josh Rosner of Medley Global Advisors, which sells research analysis to big investors.”

In December 2004 Gretchen Morgensen of the NYT pointed out

“A few analysts are not under Fannie Mae’s spell, however, and they take a different view. One such skeptic, Josh Rosner, an analyst at Medley Global Advisors in New York, said that while the company’s regulatory woes were the immediate problem, other forces out of Fannie’s control would put significant pressure on its business of buying and selling billions of dollars in mortgages. And on the subject of Fannie Mae, Mr. Rosner is worth heeding. For a year, he has been warning clients about coming Fannie Mae woes; his has been a lonely voice of reason on the company’s prospects.”

Even on Nov 5, 2005 I wrote a tempered

“You should remember that the ability to manage the home as a liquid asset without having to sell it is a feature unique to this housing cycle. To assume that a slowdown in the housing market will quickly translate in unmanageable losses, panicky regulators, or a disallowance of new product offerings is unrealistic. As long as investors expect a level of credit quality deterioration worse than what we actually see, which is more in the hands of the credit rating agencies than the regulators, even liquidity in the MBS/ABS market should remain adequate although tighter.”

On November 16, 2005 I was nearly alone in my view that the decline in consumer credit quality was more than just Katrina related. I wrote “As we have previously stated (MGA “Home Is Where Your Wallet Is” 11/1/05), we continue to expect consumer mortgage credit quality to show deterioration in the third quarter (largely from energy prices and Hurricane Katrina) and expect that it will continue to rise from there. Even if foreclosure rates increase by 200% or 300% over the next 12 or 18 months that would be a return to a more normalized level of losses.”

In Feb 2006 I wrote

“The re-emergence of this risk at a cyclical turning point in the housing market should lead investors to recognize that industry data may be increasingly less reliable as a determinate of industry health. While transparency and clarity always best serve public markets, the process of change to industry practices, such as title insurance, often causes dislocations, but may be happening at a cyclically challenging time. Importantly, while we continue to believe that unprecedented structural changes to the fundamentals of the housing market will provide support to housing in the short term, these same changes will increase the risk to investors once a slowdown begins in earnest. We also remain focused on potential misreads of regional housing signals by out-of-region national lenders and asset-backed investors that could create volatility and potentially negative consequences for some issuers access to the securitization markets.”

In March 2006 I wrote

“We continue to expect that refinancing activity will remain stronger than consensus expectations. This will occur as a result of both those borrowers who are prudently doing so and those forced to continue to surf the curve. Even so, we continue to expect, barring a round of rate cuts, home purchases will decline and “phantom” inventory will continue to grow rapidly. As this occurs appreciation rates in many markets will suffer and it will become more difficult to effectively engage in the profitable application of loss mitigation activities so that foreclosures will mount. Also, Basel II will likely create a new definition of defaults based on reasonableness of repayment as opposed to just clear and present economic loss. This too may insure the level of stated defaults will rise dramatically over the next few years. On a more macro-basis, while the Fed is clearly willing to slow consumer spending by reducing reliance on home finance activity there are potential add-on effects that bear watching. According to BLS data, nearly 40% of all jobs created in the past four years were in housing-related fields. As home construction and purchases begin to slow many of these people will have to find work elsewhere unless they can get reallocated…maybe to servicing bad loans. “

In November 2006 I wrote

“Unfortunately, it is unlikely Congress will act until after a crisis of some uncertain magnitude has presented itself…Perhaps investors will not get spooked or become markedly credit risk averse and we will get that hoped for soft-landing as regional economic activity suggests. However, if history can be used as a guide it would force consideration that excess liquidity in financial markets tends to dry up abruptly. Given the size of these markets a reversal in liquidity, due to endogenous or exogenous factors, could result in significant impact on the real economy…Investors in unrated tranches would get badly hurt and; Investors in some investment grade trancheswould see loss rates that weren’t in NRSRO models. All of this could spill into the real economy and remove the new bidder at the same time that inventories are piling up. It is not certain of course that a hard landing scenario will occur since the market trigger would, by definition be a surprise, but it appears irresponsible for risk managers to merely “buy the rating” without greater scrutiny of the assets they are purchasing or of the rating agencies work. This is not your father’s housing cycle; it is a liquidity cycle driven by a rapid expansion and democratization of credit. Viewed through this lens, one is reminded that housing cycles usually unwind slowly but massive credit growth cycles usually implode. “

On Feb 15 of 2007 I published my now well known paper at the Hudson Institute calling for an imminent crisis in CDO’s which would collapse appetite for MBS and kill mortgage funding in the real economy.

“We therefore maintain that the shrinkage in RMBS sector is likely to arise from decreased funding by the CDO markets as defaults accumulate. Of course, mortgage markets are socially and economically more important than manufactured housing, aircraft leases, franchise business loans, and 12-b1 mutual fund fees. Decreased funding for RMBS could set off a downward spiral in credit availability that can deprive individuals of home ownership and substantially hurt the U.S. economy.”

I was nearly alone in saying it was not contained to subprime.

In July 2007 I wrote

“As we have made clear since the beginning of the year, the mortgage finance problems are not isolated to subprime, subprime just had a shorter leash. It is now becoming clearer to others that it is spreading to Alt-A and will ultimately move directly into the prime market. We expect recent vintage CMBS to show marked deterioration in the performance of the much of the underlying collateral shortly. Both the CMBS and CLO markets will almost certainly see rising liquidity problems. There is little doubt that beyond large future impairments there are many institutions with significant levels of embedded losses that have not yet been recognized as a result of questionable valuation. These will come to light as more downgrades occur, fund redemptions rise, margin calls increase and regulators more closely scrutinize portfolio valuation assumptions for illiquid instruments. These realities create a demand for investors, especially given the fiduciary nature of many of their obligations, to demand greater disclosures of the collateral, valuation and the structural features of the portfolios of companies they invest in. Those managements who refuse to see the significance of this tide-change, with power shifting from issuers to buyers, will find reduced access to the capital markets and a higher cost of capital.”

In July 2007 Reuters interviewed me and wrote:

“The Japanese banking crisis, triggered in the early 1990s by a slumping property market and brokerage collapses, led to a decade-long credit crunch. The government subsequently had to step in to stabilize the banking system by injecting public money into top banks. “The Japanese experience of holding large losses as opposed to taking a hit and moving on was a direct cause of the Japanese malaise,” said Josh Rosner, author of the report and a managing director at Graham Fisher, an investment research firm in New York…Rosner also compared the current subprime crisis to the U.S. savings and loans crisis in the 1980s, when waves of S&L failures led to a federal bailout. In the Japanese case, the bursting of the asset bubble in the real estate and stock markets led to a deteriorating economy. Japanese banks were saddled with massive non-performing loans, raising concerns about a systemic meltdown.”

In August 2007 I was possibly the only analyst to argue that Fannie and Freddie were not only unable to save the market but were at great risk. Newsweek quoted me saying:

“”We don’t know how much trash is on their balance sheet,” says Josh Rosner of researcher Graham Fisher & Co. “It seems they’ve shot themselves in the foot.” Fannie declined to comment. Says a Freddie spokeswoman: “We are well positioned to withstand even a severe and enduring period of heightened credit risk.” This quote came after my report which, among other things, highlighted: “The GSEs are bound by the non-traditional mortgage guidance so there is only so much they could re-underwrite even if they wanted to “save everyone”. The GSEs were among the early pioneers of low documentation loans, Automated Underwriting, moves to lower allowable FICO scores. As early as 2004, 16% OF FNM’S portfolio had FICO scores below 660 (S&P 12/06). Similarly, even before the recent speculative frenzy by buyers, FNMs 2004 exposures to second homes and vacation properties was about 8% (S&P 12/06)…There is very little known about their loss mitigation practices and whether these practices are effectively keeping borrowers in their homes or if they are merely pushing losses off into the future…It appears, prior to the recent requirement that they conform to the Joint Guidance on non-traditional mortgages, one or both GSE were offering negative-amortization products that seem not to have begun to fully amortize until after the reset period. (“Higher-risk products such as interest-only, sub-prime, Alt-A and negative amortization loans are growing, but are currently about 20 percent of the book of business”…). If the market continues to deteriorate there may also be risks to the abilities of other counterparties to continue to act as economic counterparties… We are in a period of increasing stress in the mortgage markets and will likely continue to see rising mortgage industry levels of Alt-A and subprime REO. Regardless of the direct impact to the GSEs book of business this would conceivably reduce the recoveries on the GSE’s REO portfolios;”

I can keep going through MLEC, TARP, Q1 on EPS quality, CMBS… but I think you know all that…. Remember in early January 2009 I wrote

“Ultimately, I expect larger than expected losses will come from inadequate reserves relative to the risks in BofA’s HELOC, construction, commercial real estate and commercial loan books and also from the poor timing and likely worse modeling of their acquisitions of Countrywide and Merrill Lynch. Given our economic outlook, it seems reasonable to consider BofA may be the next ‘Citi’. I do wonder if the Government will approach things differently or take on their obligations without forcing BofA equity holders to relearn the forgotten price of poor risk-taking in investments.”

Feb 24, 2009 I wrote:

“They’ll almost certainly come back in 6 months or so for a third round run of this. In the meantime consider that last years Treasury net issuance of about $350 billion could increase above expectations of about $1.5 trillion to perhaps $2.2 or $2.3 trillion. It is enough to expect China, Japan and others to continue to purchase our debt. Will they quadruple or quintuple their purchases? What would happen if we had an undersubscribed auction? How long could we have a straw buyer bidding? What would happen to inflation expectations?”

I have attached links to the larger papers.

Download “Home Without Equity is Just a Rental with Debt (June 29, 2001)

http://www.institutmontaigne.org/medias/documents/06-29-01 Home Without Equity is a Rental .pdf

“How Resilient Are Mortgage Backed Securities to Collateralized Debt Obligation Market Disruptions?” (February 15, 2007)
http://www.hudson.org/files/publications/Mason_RosnerFeb15Event.pdf

“How Misapplied Bond Ratings Cause Mortgage Backed Securities and Collateralized Debt Obligation Market Disruptions (May 3, 2007)
http://www.hudson.org/index.cfm?fuseaction=hudson_upcoming_events&id=393

My recently authored “Toward an Understanding: NRSRO Failings in Structured Ratings and Discreet Recommendations to Address Agency Conflicts
http://www.iinews.com/site/pdfs/JSF_Winter_2009_Rosner.pdf

Joshua Rosner
Managing Director
Graham Fisher & Co., Inc.
O – (646) 652-6207
C – (917) 379-0641

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