(/)

A Brief History of
Credit Disasters
June 9, 2009 9:15am by
 I introduced Josh Rosner at TBP conference
(http://www.ritholtz.com/2009/06/tbp-
conference-recap/) 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 dont 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 sectors growth in the 1990s 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 homeHowever,
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 Macs 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
Maes 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 Maes 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 Maes American dream of
homeownership into the American nightmare
of homeownership where people are trapped
in their homes, Mr. Rosner said. If incomes
dont rise or home values dont 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 Maes accounting practices long
before regulators issued their recent reports,
Newsweek reports in the current issue. And
that report may rekindle questions about Wall
Streets ability to issue unbiased research.
After Wall Streets biggest firms settled with
regulators in April 2003 over charges of
fraudulent stock research, the industry
promised a new era of independenceThere 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 Maes

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 companys regulatory woes were the
immediate problem, other forces out of
Fannies 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 companys 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
reallocatedmaybe 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 itselfPerhaps
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
economyInvestors in unrated tranches
would get badly hurt and; Investors in some
investment grade trancheswould see loss rates
that werent 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 fathers 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 CDOs 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 YorkRosner 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 dont know how much trash is on their

balance sheet, says Josh Rosner of researcher
Graham Fisher & Co. It seems theyve 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 FNMS 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
futureIt 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 GSEs
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 BofAs 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:

 Theyll 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
(http://papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID1401854_code968997.pdf?
abstractid=1162456&mirid=1) (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?
(http://www.hudson.org/files/publications/Mason_RosnerFeb15Event.pdf)
(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
(http://www.hudson.org/index.cfm?
fuseaction=hudson_upcoming_events&id=393) (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)
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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