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Perhaps Not a Prophet, but Definitely Prophetic--Page 2

Bob Rodriguez sounded the subprime alarm before most knew what subprime was.

Mortgage Recipes for Disaster
In fact, it was clear to the FPA team that consumers were getting drunk on credit, lenders were overserving them, and regulators were looking the other way.

One indicator was the nature of the loans being originated and early signs of their poor performance. Rodriguez and colleague Tom Atteberry expressed concern several times over the explosive growth of mortgages that could easily become difficult for borrowers to afford. Referring to adjustable-rate mortgages (ARMs) in a September 2005 letter, Atteberry presciently noted that, "What has transpired is that the borrower who is least able to absorb the increased loan payment now has a very large percentage of loans subject to rising rates."

Rodriguez also sounded an alarm that loans to some borrowers were already showing signs of trouble. So-called Alt-A mortgages made to borrowers with high credit scores, but quirks of one sort or another such as self-employment, had begun defaulting only six months after origination, while loans made to subprime borrowers were noticeably suffering from credit deterioration. In March 2006, he lamented, "...the U.S. consumer seems to know no bounds as to how far to push the credit envelope. There are many financial institutions that are also willing to help."

In March 2007 Rodriguez summarized the severity of risks that had long concerned him, detailing a report from First American Real Estate Solutions that claimed ARMs had rocketed to 70% of mortgage originations from 1.7% in 2003, with low-documentation loans at nearly 80%. By 2006, interest-only and negative-amortization loans (for which low teaser rates are offset by rising principal balances) had exploded to 35% and 42%, respectively.

Naked Emporers
Rodriguez was incredulous at the lack of response from rating agencies and regulators. You can practically hear the steam whistling out of his ears when you read his description of a March 2007 call with Fitch Ratings, during which Atteberry was told that the firm's rating models assume a continuation of home price appreciation in the low- to mid-single digits, in line with 50 years of history.

"[Atteberry] asked, 'What would happen to your [ratings] model if HPA [home price appreciation] were flat?' They responded that the model would start to break down. If HPA were a negative 1% or 2%, the model would completely break down."

I had to go back and reread that portion of the letter several times. I was convinced that it wasn't a series of typos only after I saw the sentence repeated in an unrelated set of documents. By now we've seen the result, but it still strains the mind to think that the ratings agencies were stupid enough to believe their analytical logic was sound, or that they knew it wasn't but didn't believe they would ever be exposed.

In mid-2007 Rodriguez gave a speech to the CFA Society of Chicago that could someday go down in history as the bond-geek's version of Franklin Roosevelt's first inaugural "The Only Thing We Have to Fear Is Fear Itself" speech. In it he skewered the Office of the Comptroller of the Currency, the U.S. National Association of Insurance Commissioners, and the major credit rating agencies, and capped those off by questioning Fed Chairman Bernanke's assessment of the subprime crisis spillover potential.

The Day After
At this point, the events that followed have become seared into most of our brains. Bear Stearns, Fannie Mae, Freddie Mac,  Merrill Lynch , Lehman Brothers, Washington Mutual, and Wachovia are all effectively swept away, whether by hurried acquisition, conservatorship, or in the case of Lehman Brothers, bankruptcy.

Rodriguez's rapt attention to these issues has been rewarded. Whether he deserves credit for the fact that FPA Capital places in the elite 10% of its mid-cap value peers for the year to date, even though it has tumbled 31%, is a conversation for another day. The 3.3% return and top-percentile rank achieved by FPA New Income for the same period are undeniably distinguished achievements.

Today, it's evident that Rodriguez has lost whatever faith he may have still had in the Fed or the U.S. Treasury.

All of the Fed's 2007 actions were predicated on the belief that the biggest systemic challenge of the subprime crisis was one of liquidity, as evidenced by successive rate cuts early in the year. Rodriguez began to believe long ago, however, that this was a crisis of capital destruction, not simply one of diminished liquidity.

As far as he is concerned, the TARP, the Commercial Paper Funding Facility, and the Money Market Investor Funding Facility all should have been undertaken six to nine months earlier. Even then he expresses tremendous skepticism that the TARP will be successful from a policy perspective, much less produce a profit for the government.

Rodriguez sneers that the assets  J.P. Morgan (JPM) took over from Bear Stearns--with the promise of a backstop for all but $1 billion of them--have already been marked down by 20% since the deal took place. And he's livid that we still know almost nothing about the acquired assets. If the FDIC, SEC, OTS, OFHEO, the Fed, and Congress all had an opportunity to exercise better supervision over Fannie, Freddie, and the mortgage markets overall and chose not to, Rodriguez reasons, why should he have any faith they're going to get things right now?

Will the Sun Come Out Again?
What really stopped me cold is that Rodriguez is not convinced this thing is anywhere near over. That's not to suggest panic. My colleague Russel Kinnel, director of mutual fund research and editor of Morningstar FundInvestor, managed to maintain his composure during the conversation and reminded me thereafter that while Rodriguez essentially remains on bond-market lockdown--limiting himself to just about the most plain-vanilla, low-risk bonds he can find and still generate some meaningful return--he has canceled his stock-buying strike. Of the cash pile he had built in FPA Capital--it totaled 33% at third-quarter end--he had deployed 25% of that stake into new purchases by the end of October. Since last year when the quantitative and qualitative screens Rodriguez uses to sift companies--based on his strict preferences for strong balance sheets, free cash flow, and more--produced a record-low 33 companies, it today provides a list of 400, the most since he began running it in the 1980s.

Still, Kinnel used the word "chilling" to describe Rodriguez's view on where the economy is headed. He anticipates surging unemployment (which we already began to see Friday), plummeting consumer goods sales, and the attendant effects they'll have on housing--and in a vicious circle, unemployment. Against that backdrop, Rodriguez is being exceedingly cautious and making purchases in FPA Capital at a deliberate and risk-averse pace. He's selecting only companies that he feels very strongly can withstand the harsh environment he worries is coming. And he's still worried about what he calls imponderables. Rodriguez therefore favors taking a "measured" approach to buying stock over time and letting prices come to him. All that said, he stipulates that it's purely a matter of judgment. There are no formulas.

Rodriguez is being even more cautious with his bond charge, FPA New Income. He believes that risk expectations are clearly different among clients in his bond fund. "Half of success is survival. We're still hunkered down." In fact, he's not even sure what to think about the junk-bond market. "With high-yield spreads over 1,600 basis points, the high-yield market can't survive. The question is, will rates fall fast enough for the companies to refinance at rates they can afford?"

It's worth being loud and clear that there are well-regarded, very intelligent managers in the investment industry who, while they may agree with Rodriguez on most things, are more sanguine about the Fed and Treasury Department's chances for success, the future health of the economy, and even the junk-bond market.

Whether he's right or not about the future, it's important to note that the linchpin to his past success has not been some ethereal ability to "predict the market." Investors frequently ask us to steer them to such oracles, but most of us at Morningstar don't believe they exist. What Rodriguez has proved, however, is that he has tremendous skill in analyzing the fundamental landscape of our economy and markets, and that he's able to understand them. That alone gives plenty of reason to pay close attention when he says, "The worst of this crisis lies ahead. We are proceeding through a crisis to which there is no end."

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