A Global House of Cards: Interview with Josh Rosner
April 7, 2008
We start this issue of The Institutional Risk Analyst with some final thoughts on the Bear, Stearns & Co (NYSE:BSC) failure and the bailout of the other primary dealers following the Senate Banking Committee hearings last week.
First, we notice that former Fed Chairman Alan Greenspan is defending himself on www.ft.com against a growing army of detractors. But we repeat that, in our view, the mortal sin of Greenspan and other US regulators over the past two decades was not irresponsible monetary policy, but rather dropping the ball on bank supervision and market structure. We described the ill effects of allowing the liberal academic economists at the Fed's Board of Governors in Washington to set bank supervision policy in a comment in Friday's American Banker.
In particular, in the two decades of Greenspan's tenure, the Fed's Washington staff, other regulators and the Congress allowed and enabled Wall Street to migrate more and more of the investment world off exchange and into the opaque world of over-the-counter derivative instruments and structured assets. This change is described by people like Greenspan and Treasury Secretary Hank Paulson as "innovation," but our old friend Martin Mayer rightly calls it "retrograde."
In a market comprised primarily of exchange traded instruments, there is little or no counterparty risk. OTC trades which reference exchange traded benchmarks are likewise far more stable. By replacing exchange traded securities with ersatz OTC instruments, Greenspan and the quant economists who dominate the Fed's Washington staff have created vast systemic risk that need not exist at all and that now threatens our entire financial system.
BSC failed not because it had too little capital or too little liquidity, but because the thousands upon thousands of OTC trades which flow through the firm's books are bilateral rather than exchange traded. It was the understandable fear of counterparty risk, not a lack of capital or liquidity, which killed BSC. The irony is that the "financial innovation" of OTC derivatives and structured assets takes us backward in time to the chaotic situation that existed in the US prior to the crash of 1929.
Would that the Congress and the Fed had the courage to confront Paulson and the other banksters who have turned America's financial markets into an increasingly unstable, derivative house of cards. If all federally insured commercial banks, mutual and pension funds were required by law to invest only in SEC registered, exchange-traded instruments, the threat of further systemic risk could be eliminated tomorrow. What a shame that neither Chairman Bernanke nor FRBNY President Timothy Geithner said that last week when they appeared before the Senate Banking Committee.
In order to gain some further perspective of the state of the financial markets, this week The IRA talks to Josh Rosner, Managing Director of Graham, Fischer & Co, a New York based independent research consultancy that advises regulators and institutional investors on housing and mortgage finance related issues. Previously he was the Managing Director of financial services research for Medley Global Advisors.
The IRA: So Josh, thank you for making time to speak with us. What did you think of the Senate Banking Committee hearing on Bear, Stearns?
Rosner: When Chairman Christopher Dodd asked the witnesses about whether the government set the price for the JPMorgan Chase (NYSE:JPM) acquisition of BSC, everyone's answer seemed to be "ask Tim Geithner." You saw when Dodd asked Chairman Benanke about who set the price for the BSC purchase, the response was "ask President Geithner."
The IRA: It also was interesting to see Treasury Undersecretary Robert Steel throwing Geithner under the bus. Our friends in the big media, including Larry Kudlow, were impressed by Geithner, but we found his performance to be one of the scarier episodes we can recall on Capitol Hill in some time. Somebody on the Board of Governors staff needs to quietly explain to Geithner that reserve bank presidents don't have personal views on policy issues, especially when they are in front of a congressional committee on national television. And after the hearing, JPM's Jamie Dimon almost seemed to be laughing when he spoke to Bubblevision Queen Bee Maria Bartiromo and thanked Geithner and Chairman Bernanke for their "dedication."
The IRA: So what is the Rosner view of the world? The party line in Washington and on Wall Street is that everything's fine and we'll return to normal growth in the second half of 2008.
Rosner: I see troubles radiating outward. What I mean specifically is that there is no functional change in the problems in the mortgage markets. What is really making us feel OK, at the moment, is the fact that banks are destroying shareholder capital and that they are raising new money. That's all well and good, but we still have not changed the underlying reality, namely that most of the losses taken so far are due to mark to market issues. We have not yet really seen the bulk of the underlying credit losses.
The IRA: Ditto. We have been talking about this for six months, but there seems to be a refusal on the part of many observers to accept that the losses reported to date have been primary trading book write downs vs. actual charge offs of loan losses. Citigroup (NYSE:C), for example, did just 120bp in aggregate charge offs in 2007.
Rosner: There is a lack of appreciation or maybe a lack of understanding between these two issues, mark to market losses and actual credit losses, and we need to distinguish between these two issues. I continue to believe that we are going to see further downward pressure on home prices -- regardless of what the Congress believes or intends or manipulates. Unless we actually nationalize the housing industry, there is not much we can do to avoid the downward correction in home values.
The IRA: But haven't we already largely nationalized the home market already? Our interview with Bob Feinberg (GSE Nation: Interview with Bob Feinberg) illustrated that point. During the Joint Economic Committee hearing last week, when Chairman Bernanke appeared prior to the BSC session, Senator John Sununu (R-NH) talked about the various federal government programs already in place for housing. It took him almost five minutes of soliloquy to go through them all.
Rosner: That's right. We have a universe of government programs to encourage home ownership, but we need to reconsider the benefits of getting people into homes and how to craft government policies to make these markets more rather than less stable. Historically home ownership was seen as a way to make better neighbors and stronger communities. We need to go back and look at what aspects of home ownership were responsible for conferring these benefits.
The IRA: For example?
Since the late 1930, home owners generally took out 30-year fixed rate mortgages which were illiquid instruments tied to illiquid assets, namely the home, which required the borrower to make monthly payments of principal and interest into what was effectively a forced savings plan.
The IRA: You're talking about our grandparents. And they basically could not modify the mortgage or even move easily.
Rosner: Correct. Other than moving, they could not extract equity. And when they purchased the house, they could not do so without having a substantial amount of equity going into the transaction. I would argue that it was those features that benefit society and support, from a Washington policy perspective, the social importance of home ownership.
The IRA: And not the ability to turn a house into a speculative vehicle? The folks at the National Association of Realtors will be disappointed to hear you say that. The NAR is running TV ads that claim homes double in value on average every ten years.
Rosner: Right. And there is an aspect of this that nobody in Washington is talking about. Let's go back to the prior model of home ownership. Typically a family bought a home around the time of family formation. So you got married and then you and your wife bought a house. You had your kids in that house. And you had a 30-year fixed rate mortgage and every month you made a payment of principal and interest. That process usually began in the late-twenties to early thirties of a person's life. That meant that at about the age of 60, the home owner was able to have a mortgage burning party. So as they retired, their expenses fell and the value of their unencumbered assets had risen. They had a real asset to supplement their pension, pay for grandchildren's college, etc. Because we have allowed this model to change, the US faces a huge burden in the future that we have not yet even begun to talk about in Washington.
The IRA: You mean financing the last chapters of the American Dream for the boomers a la Dennis Hopper?
Rosner: Yeah. This unfunded burden of caring for retirees has significant implications for the dollar and for the federal budget deficit going out years into the future. Many of today's speculative real estate borrowers will end their working lives with little or no savings and are going to become wards of the state in their retirement years. We have not even discussed that anywhere yet. With an increasingly aging, migratory population, maybe the US needs to look at incentives for rental housing instead of putting all of the policy emphasis behind home ownership.
The IRA: If you look at the idiotic rhetoric coming from political candidates from both parties about "restoring the American Dream," meaning making home prices go up again, it is not hard to imagine a future Congress voting to essentially socialize the US economy in the name of caring for indigent old folks. But let's get back to the current mess. How do you assess the state of the real estate market and the implications of this for financials?
Rosner: We are starting to see an acceleration of the delinquencies and loss rates moving from subprime through alt-a through the prime market. GSEs like Fannie Mae (NYSE:FNM) and Freddie Mac (NYSE:FRE) are in no position frankly to do much to save themselves let along save the market.
The IRA: Agreed. Cap or no, we can't see how either FNM or FRE can lever up to take more risk. Are we missing something?
Rosner: Yup. The GSEs have come up with yet another bright idea to add to their financial woes. Haven't you heard? What FNM is doing, which goes back to the accounting shenanigans, is actually using most of the capital relief granted by OFHEO for their "Home Saver Advance." Most people outside the real estate industry are not following this at all. FNM has now crept out of their secondary market role and into the primary market. We have heard nothing from HUD, OFHEO or the FM Watch folks about this.
The IRA: We are shocked. Go ahead.
Rosner: FNM has announced that they will give a $15,000 loan to borrowers with negative equity so that they can pay down some of their principal balance and therefore refinance into a new mortgage. First of all, this loan is not secured by the property but rather by the personal guarantee of the borrower.
The IRA: So FNM is getting into the consumer lending business? Looks like more mission creep.
Rosner: Basically, yes. It is unsecured debt. So FNM is no longer just operating in the secondary mortgage market but in the primary consumer lending market. Second, what they are really doing is paying that $15,000 because it is cheaper than having to buy defaulted loans out of mortgage pools guaranteed by FNM and cover arrears.
The IRA: Kind of, sort of looks like modification? Or not?
Rosner: No, the GSEs have been doing modification. This is something worse than that. With a bank that modifies loan, someone has to take the loss when the loan re-defaults. Here, FNM and FRE are modifying but without the increased security of the underlying asset. They're actually taking an unsecured exposure.
The IRA: Yup, which they will end up eating. The loss given default on these "homeowner saver loans" will be 100%.
Rosner: Yup. And given that re-default rates on modified loans were north of 20% in good times, it will be interesting to see how bad it gets this time around. The GSEs are trying to outrun problems that are faster than they are.
The IRA: You've been speaking to a lot of bankers and government officials outside the US. What is your perspective on the housing credit situation outside the US?
Rosner: Let me circle around to that. The credit problems are spreading into the prime market. They are already visible in the home equity line of credit market. The HELOCs are typically committed lines and frankly people often forget that in some respects, at least in this cycle, the consumer lenders, revolving lenders, credit card lenders, are in a better place that the HELOC lenders. The revolving and credit card lenders can change your available lines overnight and change your rate terms with the same speed. The HELOC lenders cannot.
The IRA: The latest line out of the banks is that they see a growth opportunity in small business credit card lending. The mail solicitations from lenders like C and Advanta that we've reviewed feature terms that encumber the small business as well as the individual, and then kick the rate up to 31% APR the first time you are late. What does a 31% penalty rate say about the probability of default on that portfolio?
Rosner: Yes, except for the fact that it is a terminal probability. What I mean by that is that the last asset which a borrowed defaults on is the primary mortgage…
The IRA: At least it used to be. The FT reported a while back that the 2006 production was the reverse, with borrowers defaulting on mortgages before credit cards or auto loans.
Rosner: No, the mortgage still is the last thing to go into default. The borrowers we've see default already are those with no other resources. Where I think we see the next leg and what I am watching carefully now is that we are seeing the drawdown of committed but undrawn lines of credit by distressed borrowers who are taking cash out of the line to pay first their primary mortgage and then revolving lines of credit. At some point we reach a terminal period where they default on their credit card and then their primary mortgage. I'm not sure it does not go in the other order, but we'll see. That is the reason, I believe, that we've seen a little bit of a slowdown, a respite from a massive spike in defaults, because the borrower who is Alt-A and prime largely, even with the decline in home values, still has access to credit. Consumers do not give up spending of their own volition. They do so only after they have exhausted all other options.
The IRA: Suggesting that we could be headed to a huge uptick in default experience in unsecured and mortgage loans in the not too distant future?
Rosner: Yes, we will see the drawdown of HELOCs until they are exhausted, resulting in an eventual upsurge in defaults on mortgage-related and revolving credit.
The IRA: It is funny you raise this issue because we have been watching the slow decline in Exposure at Default which we calculate for all US banks using The IRA Bank Monitor. There are only two reasons for such a broad, secular trend; either people are using available lines or banks are reducing exposure by cutting unused lines.
Rosner: Right, it is pretty hard for a lot of the banks to reduce consumer lines, both from a contractual perspective and from an operations management perspective. I would be very wary of institutions that have HELOC exposure. For the time being, I would be less concerned with the credit card companies. And then there is the situation in commercial real estate, where the wheels are starting to shake and even fall off the wagon.
The IRA: So let's go overseas for a second. We know you have to get packed and head back to the airport.
Rosner: In the UK, we have already seen a 10% decline in commercial real estate values. And my contacts in that market expect to see a further 10% decline from there. In that context, when you hear reports of further new build in the US commercial market, that only confirms my belief that we will see our market fall as well. For the large international Basel II institutions, none of this is good news. The same global banks with exposure to the US residential and commercial markets also have exposure to the burgeoning problems in the Spanish real estate market, Irish housing problems, UK housing problems, and Italian housing problems.
The IRA: So do we detect the first signs of interest rate ease in the EU?
Rosner: Definitely. I think we are at the front end of the day when you want to be long the dollar and short the Euro. The Spanish mortgage market funds in the repo market, not via deposits. I think that at some point there is going to be significant tension in Europe because the Germans and the French are not going to want to finance Spanish mortgage collateral. This could be the catalyst for a crisis in Europe. Do I think that it will spell the end of the Euro? No. Do I think that it will create a period of uncertainty? Yes.
The IRA: You mean that German and French banks will no longer want to finance Spanish real estate speculation for the benefit of UK retirees?
Rosner: Yes, especially if you remember that the Germans are already going to be licking a lot of wounds. The good news is that the German Landesbanks have no more than 25% of their float to the public. The bad news is that the German federal government is going to have to bail out the state governments.
The IRA: Some of our sources say that the Landesbanks are something like 5x the problems at UBS (NYSE:UBS).
Rosner: Correct. My understanding is that there is one institution with about $50-60 billion in exposure and another has $80 billion. So there is no way that the German government will have sufficient bandwidth to help support the Spanish banks.
The IRA: Maybe Spain becomes the next Iceland?
Rosner: We should differentiate between Northern Europe and the rest of Europe. Where the rest of Europe moves west to get their exposures, Northern Europe mostly moved east. While they have significant exposures to problematic mortgage markets, they don't have the type of exposures to structured assets and so their exposures are not leveraged.
The IRA: To change gears a bit, what is your reaction to the Paulson proposal?
Rosner: As usual, I think the proposal is largely misunderstood. To me this is more about Paulson creating a legacy rather than expecting the regulatory reform agenda to move forward in an election year. The most glaring part that was missing was rating agency oversight. The rating agencies were at the center of the problem with structured assets and continue to be at the center of the problem. Either the SEC must be given new powers to regulate the rating agencies or we need a new regulator, but the silence on this count in the Paulson proposal was striking.
The IRA: Forgive us if we are not surprised. Any final thoughts before you head back to Paris?
Rosner: The housing market woes in the US will not be over before 2010, regardless of what legislative initiatives come out of Washington. The fundamental reason why we are having these problems in the US is that real wages and incomes have not kept pace with home prices since the 1960s and that's what drove demand for these affordability products. Unless the Congress wakes up and let's home prices correct so that we restore some balance between wages and affordability, this problem will remain for years to come.
The IRA: That implies a 40-50% cut in home prices from peak levels and an insolvent US banking system.
Rosner: Yes, long term trends in home prices suggest that we will revert to the peak levels of the previous cycle. That implies that we are going back to the pre-1991 peak home price levels.
The IRA: Yikes. Then you agree with our view that the US government may be forced to take over some of the largest banks?
Rosner: Yes, well, we won't call it nationalization, but in economic terms that is the substance of the situation. One of the striking comments I hear in Europe is that at least with Northern Rock, the Financial Services Authority in the UK screwed up the first time, but then admitted the mistake and publicly nationalized the bank. With Bear, Stearns, the US has nationalized the bank and appointed JPMorgan as conservator, but then US regulators tell the public and the Congress that it was not nationalization.
The IRA: The Fed seems to be incapable of admitting that they screwed up, whether on structured assets or Bear Stearns. I've never heard anyone at the Fed admit, for example, that their active push to allow banks to migrate more and more business over the counter and off exchange has vastly increased systemic risk.
Rosner: The difference between Fed's prior to the Greenspan and the Bernanke Fed is that the former did not see themselves as part of the President's Cabinet
The IRA: Exactly, Bernanke seems completely co-opted by Paulson and the Goldman Sachs mafia that runs the Treasury. Both Bernanke and Geithner seem so weak and lacking in market experience that is almost sad to watch them testify next to banksters like Steel and Paulson.
Rosner: Correct and that is a very dangerous path for the United States.
The IRA: We'll leave it there. Travel safe Josh.
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