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2006-11-17 Policy Monitor Final: Not your Father's Housing Cycle - Josh Rosner

2006-11-17 Policy Monitor Final: Not your Father's Housing Cycle - Josh Rosner

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Published by joshrosner
Cohesive view on the coming financial crisis of 2008, written in November of 2006. I had already called the top in housing... here are excerpts from other prior reports

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 wou
Cohesive view on the coming financial crisis of 2008, written in November of 2006. I had already called the top in housing... here are excerpts from other prior reports

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 wou

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PHONE: 212.219.9096 NOVEMBER 17, 2006 | PAGE 1





®


NOVEMBER 17, 2006
Gimme Shelter
Today’s horrible housing starts number will no doubt add to the case being
made for an economy heading into a downturn and the inevitability of rate
cuts by the Federal Reserve.

But behind weak aggregate US housing and construction data lie significant
variations between categories. While new home sales do not look so good
and existing home sales are soft, commercial real estate remains downright
robust. The coasts are hurting, but the great swathe of the “flyover” country is
not in meltdown.

TWO MELTDOWNS FOR THE PRICE OF ONE?





















SOURCE: ARIZONA REPUBLIC

More to the point, the Fed is sticking to its central tendency scenario that yes
residential housing is certainly soft, but the steepness of the downward slope
is leveling off into a more gradual and bearable decline. And most importantly
of all, the mighty US consumer is still spending.

Not everyone agrees with the Fed, and one of those is Josh Rosner, an
independent financial services analyst, who wrote this week’s Back Page
Essay “This Is Not Your Father’s Housing Cycle.” His contrarian view makes
for an interesting read once you are settled into a comfy chair safe at “home.”

Enjoy the read.



Sassan Ghahramani
CEO, Medley Global Advisors
THIS WEEK!

DIVERGENCE INDICATOR p. 2
THE MAJORS 3
FED: Minutes minders
ECB: Remember December
BOJ: GDP calm
RBA: Futurists
SNB: On watch

OIL AND ENERGY 7
OPEC: Hawks fly


GLOBAL POLITICS
5

US-China: Ill winds
US Politics: Pelosi’s gambit

EMERGING MARKETS 8
Turkey: On hold
Poland: Rate calm
Hungary: Inflation concerns
China: Crickets chirping
BoK: Property rights

US REGULATORY 10
Telecom: Dems get a voice
US Utilities: Ill freeze warning
Coal: New PRB train on track



BACK PAGE ESSAY 11
Not Your Father’s Housing
Cycle – by Josh Rosner

Disclaimer: This was prepared by Medley Global Advisors, LLC (“MGA”). The contents are not intended to provide investment advice and under no circumstances does this represent a recommendation to
buy or sell a security. The information contained herein reflects the opinions of MGA based on information received by MGA from independent sources. While MGA believes that the information provided to
it by its sources is accurate, MGA has not independently verified such information. Neither the author nor MGA has undertaken any responsibility to update any portion of this in response to events which
may transpire subsequent to its original publication date. As such, there can be no guarantee that the information contained herein continues to be accurate or timely or that MGA continues to hold the
views contained herein. Tel: (212) 219-9096 | Web: www.medleyadvisors.com
®



BACK PAGE ESSAY

Not Your Father’s Housing Cycle

Like the four horsemen of the proverbial apocalypse, four
big legislative issues in financial services (credit rating
agencies, hedge funds, depository institutions, and
mortgage finance players) are each garnering attention
as businesses in need of new controls. There are few
observers pointing out that they could ride together
compounding and accumulating their risks.

The ISSUE is whether over the reliance of each upon the
other fostered a mispricing of risk and WHETHER
structural changes created on the cyclical upswing be
tested in a downturn. Ultimately, the unfolding housing
and mortgage market story is not one of regional
economic activity, as housing cycles have historically
been, but rather a financial market confidence game.

Unlike prior housing cycles in which prices were primarily
driven by regional commercial activity and
demographics, the current cycle has been driven by a
massive democratization in mortgage credit and the
growth of innovations in securitized markets. Due to
short term economic incentives to do so, these changes
have been under-appreciated by the mortgage industry,
the Nationally Recognized Statistical Rating
Organizations, and investors. If the market demand for
mortgage backed securities and collateralized debt
obligations decline and assumptions by rating agencies
are incorrect, the risks may be transmitted from the
market to the real economy.

The old models no longer apply

These changes, more than changes in interest rates,
have been a primary driver of US homeownership rates
increasing from about 63% a decade ago to almost 70%
today. Most of that increase came from availability of
credit to previously untapped markets. To lay the housing
miracle at the feet of interest rates ignores that much of
that rate relief has been eaten up as median new home
prices rose from $130,000 in 1994 to about $218,000
today.

This credit expansion has allowed issuers to justify their
expected default and prepayment assumptions based on
historic models, models almost certainly been invalidated
by those fundamental changes that have driven such
historically unprecedented originations.

Changes include the growth of private label securitization
markets, reduced down-payment requirements, use of
cyclically untested automated underwriting and valuation
models, proliferation of new mortgage products, reduced
private mortgage insurance requirements, and
compromised appraiser independence. The result has
been the piling on of new risks with limited historical
experience by which to gauge those risks.

Since, historically speaking, non-conforming mortgage
risks were borne by the lending institution it would have
previously been unthinkable to have a year when 45% of
sub-prime loans had "limited documentation," 20% were
"Interest Only" or 30% were piggybacks. In fact nearly
65% of IO and Pay Option Arm mortgages are low or no
documentation loans, and almost 15% of those were for
investment properties. Since the mid-1990's conventional
and subprime securitization rates have roughly doubled,
leaving banks with the questionable impression they
have passed those risks to market participants.

Just as originators have been increasingly willing to
originate loans without much traditional due diligence,
investors have become used to purchasing mortgage



Josh Rosner is an independent financial services analyst

PHONE: 212.219.9096 NOVEMBER 17, 2006 | PAGE 10
®



BACK PAGE ESSAY




1000




800




600




400




200




0

Subprime Baa3 Spread to LIBOR
If non-conforming MBS demand wanes significantly or if
MBS performance models prove inadequate, we could
witness a market driven downward cycle of model
assumption problems leading to downgrades, reduced
mortgage liquidity and further downward pressure on
home prices. This would be especially likely in markets
that have seen dramatic speculative and second home
purchases. As home prices fell the new breed of
speculative homebuyers would begin to list investment
properties putting further downward pressure on prices.
As this spiral continues we could see prepayment and
default models falter again, thus reasserting this "death
spiral."

Unfortunately, it is unlikely Congress will act until after a
crisis of some uncertain magnitude has presented itself.
Oct -
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Oct -
02
Apr-
03
Oct -
03
Apr-
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Date
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The risk of spillover into the economy

Perhaps investors will not get spooked or become
assets with little due diligence other than checking the
ratings by the ratings agencies. These agencies have
been allowed to operate without constraints and
enormous conflicts. While NRSROs are often thought of
as financial services companies (with exceedingly high
margins), they are financial publishers and often assert
their First Amendment rights when their analysis proves
wrong.

Currently NRSROs receive significant consulting fees for
advising asset-backed issuers on structuring deals to
garner higher ratings. They rarely adjust ratings until
after performance has deteriorated materially. When
credit rating agencies begin to see methodological
shortcomings to address they typically put potential
changes out for comment to customers/issuers before
making those changes. When they do make analytical
changes they usually do so only for new issuances and
rarely for prior issuances.

Unlike other assets the agencies rate, the grab for yield
supported massive and new investor interest in MBS. In
turn, this demand spawned the growth of synthetic CDOs
where historic assumptions are even less relevant and
cyclically untested algorithms are more relied upon.
These algorithms have not been widely analyzed yet
support an asset class that is hardly transparent.
Moreover, unlike other financial instruments, these are
used more for ratings arbitrage than for economic
business purpose.
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.

Several investment banks bottom lines would be hurt as
securitization volumes decline; Private mortgage insurers
capital would be stressed; Many banks would have to
increase reserves and take writedowns; Originators
would have to consider implicit recourse risks; Investors
in unrated tranches would get badly hurt and; Investors in
some investment grade tranches would 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.


PHONE: 212.219.9096 NOVEMBER 17, 2006 | PAGE 11

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