Absence of Fear

As as a portfolio manager I read a lot of market commentary and market research written by other money managers and the elite of Wall Street.

I would say that 99% of "macro" commentary/research that I read falls into one of two categories:

1) this is really good stuff because it reaffirms my opinion, 0r
2) this makes sense but I don't agree with it and the author did not present enough evidence to change my opinion

Once in a while I am lucky enough to come across a piece that looks at a commonly discussed topic and actually provides some original thinking.

A friend forwarded me this text of speech given by Robert Rodriguez to the CFA Society of Chicago. Mr. Rodriguez is the President and CIO of First Pacific Advisors and runs large equity and fixed income mutual funds as well as institutional money. This guy has been managing money longer than I and most of the people currently running money have been alive and has seen many a cycle in his career.

In this speech Mr. Rodriguez covers everything from subprime to private equity to energy prices and as you would expect for a guy holding 40% cash and 20% energy stocks in an equity mutual fund he is pretty bearish.

The great insight for me came in the section titled "Securitization Contamination." All the usual suspects of greed by banks and complacency by rating agencies are there. What I did not realize is that all the MBS models used by rating services assume a ZERO chance of home price DEPRECIATION for anything more than a year or two. To a certain extent this makes sense and based on the recent 50 years of history home prices falling or staying flat in nominal terms for more than a year or two would really be a black swan event.

But is it impossible? Mr. Rodriguez makes the argument that it is in fact possible to envision home prices falling or staying flat in nominal terms for an extended period of time. And if this happens or the market start believing that this can happen than we will really see blood on the streets.

How did this insight change my thinking? For one, I have started educating myself about mortgage REITs and homebuilders by reading annual reports and trying to get my hands around the accounting. Up until this point, I have thought about valuation and margin of safety with the mindset that there will be some pain for a few years but things will revert back to normal by around 2010 give or take 6 months and the strongest players will emerge stronger and with more market share.

Now, I have no choice but to model in the possibility of a serious contraction in mortgage lending and with it a necessary decline in housing starts for a longer period of time than a couple of years. I will have to adjust my margin of safety to assume that what happened in manufactured homes market where lenders backed away after gorging themselves and have not returned after nearly 5 years can happen in the broader housing market.

There is way to much other good stuff in this speech to summarize, so I will strongly encourage that you spend 10 minutes and read the entire thing. But here are a few tastes to get your appetite wet .....


"[we asked] what if HPA [home price appreciation] were to decline 1% to 2% for an extended period of time? They [Fitch's MBS rating group] responded that their models would break down completely."

Here is another great line .....

"when others are having headaches and need Tylenol, on other words, liquidity, we will provide it to them but at a very, very high price"

Keep in mind that many of the people in the audience were the "others" he was reffering to.....Ballsy!

And the coup de grace for anyone thinking that this guys is just a talking head or a pundit trying to capitalize on a correct market call .....

"We are willing to bet our firm and our reputation to be right. This may lead to investor defections, but that is the price one has to be willing to pay to be right."

This guy is the cream of the crop of investment business, both for his investment acumen and willingness to take career risk to do right by his clients. I feel lucky to be able to watch and learn.