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Fund Spy

Perhaps Not a Prophet, but Definitely Prophetic

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

It took me a while to regain my bearings after hanging up the phone. It was last week and a small group of us had just finished a long chat with Bob Rodriguez, manager of  FPA New Income (FPNIX) and  FPA Capital . (He's also the firm's CEO and an equity partner.) Like a rank amateur, all I could say at the end of the call was that I needed to go back and process what I had just heard.

We had just finished listening to Rodriguez, a two-time Morningstar Fund Manager of the Year, review his current thinking on the financial crisis. The word "sobering" doesn't do the conversation justice.

"We're in a new financial system. Look at our letter, 'Crossing the Rubicon' from March. We've gone over. We do not know the boundaries or the depth.

"The worst of this crisis will be more severe than anticipated and will impact several areas. It will create additional difficulty for government bodies.

"Experts will call the bottom more than once. We will let individual security valuations guide us. There are no textbooks for this. There are no maps."
--Bob Rodriguez, Oct. 27, 2008

A Leaky TARP?
Rodriguez's frustrations run far and wide. Chief among them is that the first major recognition of the problem's scope, Treasury Secretary Hank Paulson's first draft of the Troubled Asset Recovery Plan, was focused on purchasing distressed mortgage assets from the banking system, which one might say Rodriguez viewed a little like putting out a bonfire with a drum full of lighter fluid because it is a liquid.

In the same vein as sentiments offered to us by Bill Gross three days later (and several days before the theme was widely discussed in the press), Rodriguez's partner Steve Romick, who manages  FPA Crescent (FPACX), penned a piece for the firm's Web site on Sept. 23.

"The U.S. Treasury's proposed plan only provides liquidity, not the necessary hundreds of billions of new capital that will have to be replaced."
--Steven Romick and the partners at First Pacific Advisors, Sept. 23, 2008

The title of the piece, "The Elephant(s) in the Room" refers in part to the fact that, without other pre-emptive action, and/or massive capital injections into the banking system, execution of the TARP by purchasing troubled assets off of bank balance sheets without significantly overpaying for them would likely result in new write-downs, pushing banks below their regulatory capital requirements, into the hands of FDIC, and effectively out of business.

He's Been Mad...for a Long Time
Really, though, the problems started long before that from Rodriguez's perspective, and he recognized that the dangers to banks and other large financial firms were potentially fatal. In September 2005 he noted, "The absolute level of debt is at an all-time high, with banks having the highest percentage of real estate loans as a percentage of total loans on record." By September 2006, the inability of  Fannie Mae (FNM) or  Freddie Mac (FRE) to publish financials because earlier problems were detected began to scare Rodriguez as well, and he started to focus on agencies with explicit government connections. Meanwhile, counterparty risks convinced him to stay away from credit default swaps.

It's jarring to go back and read the New Income fund's September 2007 letter, written on Nov. 5, 2007, after the first few big public signals of trouble mushroomed--but more than four months before the watershed collapse of Bear Stearns. After taking an $11 billion charge a day earlier, Citigroup had $134.8 billion in assets on its balance sheet being marked with notoriously problematic pricing models, rather than by market prices or market-based price evaluations. At the time, Rodriguez noted that Citi had less than that sum in stockholders' equity on its balance sheet.

A Problem of Calculated Dissonance?
Rodriguez saw broader signs of trouble in the market even before banking risk reared its head. His shareholder letters going back to 2004 catalog a series of concerns that probably made him feel like Don Quixote at the time, tilting at windmills, but which now make him look more like a sage.

In the March 2004 letter, for example, he and comanager Tom Atteberry raised their (somewhat controversial) belief that calculation of the consumer price index has been distorted by the substitution of changing home prices with so-called "owner-equivalent rents."

A seemingly arcane distinction, the problem became clearer when Atteberry noted that while home prices rose 7.2% in 2003, rents were stagnant, and the demand for apartments had been falling as U.S. home ownership has increased notably in prior years. So instead of reflecting the significant home-price inflation that many people across the U.S. were experiencing, a portion of CPI was (and still is) getting calculated with a hypothetical rental rate being driven down by the very phenomenon causing housing prices to rise.

Combined with what the pair viewed as understated growth in medical costs, it's easy to see how these phenomena may have, over the past several years, distracted some observers from the significant bubble developing in housing prices. That may seem disconnected from the rest of the crisis, but there's an overarching theme, which is that policymakers and market-watchers were failing to see critical signs that Rodriguez began to recognize years ago.

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Eric Jacobson does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.