The Robbo Report is proud to present to you an exclusive interview with Aaron Krowne the founder of www.ml-implode.com. Aaron created and launched the 'Implode-O-Meter' on Dec 31st, 2006 to track mortgage lenders that were going out of busines and the housing finance breakdown in general. Since then the site has been featured on CNBC, Bloomberg, and The Wall Street Journal as well as The Economist, US News & World Report, and a myriad of newsletters and publications, and boasts well over 7 Million visitors.

As you can imagine he has been very busy lately striving to provide his visitors with up-to-date information as the mortgage industry has been going through a very volatile period. But Aaron was kind enough to make sometime for us to answer some key questions many people have concerning the current state of the mortgage markets and his take on where the market is headed.

The Robbo Report (RR): As of 08/2/2007, 135 mortgage lenders have 'imploded'. How many more lenders will fall?

Aaron Krowne (AK): I honestly don't know how many at-risk outfits are left….dozens, perhaps. We're trying to gather together ALIVE and stable lenders for our industry readers to bring their business to. But as far as continued fallout, I'm more worried about banks at this point. Banks are between 50 and 60% exposed to real estate by their net assets. Banks have held up thus far because they have much deeper pockets than the non-bank lending specialists, though a few have taken sizeable write-downs on mortgage portfolios. But it is well known the write-downs have been largely put off by delaying the mark-to-market process; even the bulk of the ratings downgrades have still not happened, so the real balance sheet hit is yet to come. And banks will see their real estate holdings of all sorts deflate in value. Those that weren't sufficiently diversified or aren't considered "important" enough for a bail-out could see failure. After an interlude since the last recession, we've already had a few small credit union and bank failures. I expect this to turn into a tidal wave, short of a massive intervention by the government (i.e. a blanket bailout which the public will shoulder-this would not be a "good" thing).

RR : Why are these mortgage companies closing?

AK : Two main factors. One was a genuine foolishness regarding the expectations of continued appreciation, a continued low interest rate regime, and a lack of historical perspective regarding default rates (many of these companies had relatively humble beginnings but proliferated and expanded aggressively in just the past couple years). Of course the symptoms of this foolishness were low capitalization, poor underwriting standards, and outright fraud. But these are symptoms, not causes.

The second cause is less talked-about, however: it is the fact that for years the real income of median America has been declining…arguably, since the mid-70s. The trend has accelerated under Bush II. Wall Street and the government have ignored this or worse, aggressively pursuing a campaign of spin and denial. But now anyone who originated or invested in mortgages is getting burned by it. In sum, the ability of Americans to service their mortgage debt was lower than thought, and continues to decline. Until that trend reverses, the level of home ownership will have to fall. Home prices will have to fall. The wealth to support the wished-for "ownership society" and high asset valuations is simply not there.

RR : What is the difference between those that are surviving and those who are not in the market?

AK : Better underwriting standards have certainly helped, thus far, but many more major originators will likely be burned badly (or even fail) because of factor #2 above (an increasingly poor country). Increased defaults are being seen across the board - not just subprime, not just Alt-A. What has helped even more is high capitalization: the ability to hold a larger portfolio, the ability to cover loan buyback demands, the ability to cajole more credit out of Wall Street. Originators that are themselves banks of course have it best. But they won't be unscathed before the situation starts to improve.

RR : Which lenders do you see positioned well enough to make it through this crisis?

AK : I wouldn't want to pick favorites. Appearances have often proven deceiving; we've had some sudden implosions of often surprising players (the latest in trouble being the "too big to fail" Countrywide). I don't get a lot of time to think about the lenders that remain. Major banks are of the safest bet you can get, and that may not be saying much.

RR : After trying to reassure investors that they had sufficient access to liquid fund, $46.2 Billion and has expanding with the purchase of Homebanc…What is your take recent market moving statement by them saying they faced "unprecedented disruptions" in the debt market and secondary market for mortgages. It said these "could have an adverse impact on the company's earnings and financial condition, particularly in the short-term."?

AK : I'm not sure why they didn't know this on August 2nd, but they did on August 9th. But eventually everyone in denial has to own up to reality (UPDATE: they are now the subject of at least two class-action lawsuits for making related false and misleading statements, for time periods ending Aug 9 2007). The insiders at CFC have been selling shares like gangbusters, and purely selling, for the last couple years. This suggests to me that their "denial" was a P.R. campaign, not "true self-delusion." The information was always out there to know what was going on in the market. But its hard to continue such a campaign in the face of deteriorating earnings.

(And of course, now Coutnrywide is tanking, after analysts finally capitulate)

RR : Also, WAMU, the largest U.S. savings and loan, said liquidity in the market for less-than-prime home loans and securities backed by the loans has "diminished significantly." It said that while this persists, its ability to raise liquidity by selling home loans will be "adversely affected."…Thoughts?

AK : Maybe they will have to fund risky loans only with their own money. This wouldn't be a bad thing. Why should a loan be funded which you aren't willing to fund with your own money?

RR : Are two of the country's biggest lender very much in trouble or are they simply trying to prepare their investors for lower mortgage earnings numbers while retained enough access to liquidity to survive the current mortgage crisis?

AK : I think they're certainly being impacted significantly. The nature of their business is shifting dramatically. But I have no illusions that they would be talking this way if they weren't primarily preparing investors for dramatically lower earnings. To behave otherwise is to encourage shareholder lawsuits down the road. As soon as plausible deniability fades, the straight talk comes.

RR : The current mortgage crisis has been blamed on almost every related party at one time or another from the ratings agencies, the hedge funds, the lenders, the brokers, and borrowers...your business is tracking the lenders and your will be launching a Hedge Fund implosion site…what is your take on what is happening?

AK : They all just participated in the credit mania. It's that simple. And the Fed controls the master dial; they control the money supply and the entire banking system.

RR : Is this mortgage industry crisis a case of greedy borrower now playing dumb or greedy mortgage brokers/bankers who took the money and ran?

AK : Neither; as above. Both are two effects of a deeper cause: the credit bubble, and the Fed.

I was reading recently that the bank reserves required to hold AAA-rated loans is $.52 on the $100. The reserves required to hold BB-rated loans are something like $56 on the $100. The Fed sets those limits. The Fed also influences the standards for what a valid rating is. It selects the allowable ratings agencies. This is all a "tiny" piece of the picture and you can already see massive influence potential and ability to police the market.

At the other end of the spectrum, you have Greenspan jawboning the public into exotic mortgages at historically-low interest rates, and in the process giving the implicit green-light to aggressive originators. The Fed's finger prints are all over this bubble. This might explain some of the Fed's reluctance to simply drop the funds rate as Greenspan would have: we now know that that just made the problem worse, and they know we know it! And probably more importantly, they know foreigners (who are getting some of the worst-burned from the toxic MBS) know it.

RR : Who do you believe will be hurt even more with a forecasted increase (Fitch Ratings +50%) in adjustable rate mortgage defaults?

AK : The big "surprise" will be that this is the middle class. But the middle class got maximally over-extended, so this shouldn't be surprising. To afford rising prices, more and more exotic loans were taken, with more fraud by both the borrower and lender. This then made prices rise even higher, which of course generated a vicious feedback cycle. Watch the "pay option" loans. Borrowers loved these, especially in California. They are very insidious because these loans don't immediately turn delinquent when the borrower gets into trouble - the borrower just pays less of the monthly mortgage bill. But this just compounds their problem, unless more money is truly around the corner (taking a pay option is like paying that much of your mortgage from a credit card with a significantly higher APR than the mortgage - financial suicide). So if the income condition of more pay option borrowers is worsening rather than improving, then it follows that the pay option craze will soon turn into a wall of default, when finally the negative amortization on these loans is maxed out (typically about 115%).

UPDATE: here's an item sent to me yesterday on what's going on with the middle class that adds yet another piece of evidence supporting what I have said above:

"The percentage of middle-income neighborhoods in the 100 largest metropolitan areas across the country dropped from 58% in 1970 to 41% in 2000, according to the Brookings Institution. The study, which defined moderate-income families as those with incomes between 80% and 120% of the local median, found that these neighborhoods are disappearing faster than the proportion of metropolitan families earning middle incomes, which in three decades has fallen from 28% to 22%. The trend suggests that people are moving out of economically diverse neighborhoods, and the resulting disparities between high- and low-income neighborhoods make it harder for lower-income homeowners to move up the residential ladder." (http://www.time.com/time/topten/2006/underreported/10.html)

This country is no longer what the financial models assume it is! Note that the above item is a double-whammy for real estate impact.

RR : Several CDO or bond packages were downgraded only after the default rates within the package after they were purchased based on the initial ratings. How did the credit rating agencies blow these AAA CDO bond ratings?

AK : Sanguine market assumptions, questionable models, conflict of interest, and plausible deniability. The plausible deniability, in case you are wondering, is the blanket disclaimers the ratings agencies give that say the ratings aren't actually the "actionable" risk assessments you might think they are.

They also failed to sufficiently scrutinize new, complex instruments. Complexity adds risk. They didn't account for this "X" factor. This is a huge systematic error of the current finance regime: the near-religious belief that complex quantitatives by themselves reduce risk, when in fact their widespread use and abuse (which greed pushes them towards) increases risk.

RR : Do you believe there should be a structural change in how the ratings agencies are hired, or rather paid by those that hire them to rate the bonds they are selling. As opposed for instance: having the ratings agencies be paid by those who actually use the rating to purchase the bonds like hedge funds and pension funds?

AK : I would like to see a variety of competing systems emerge after this. Switching the payor of the ratings would potentially help a lot - but structures would need to be put up that help brand securities as rated by quality rators, whose track records are exposed. This actually isn't much different from the challenges faced by "made in America" car components campaigns, "certified organic", or "sustainable forests" campaigns. There's normally no exposure to this sort of deep "supply chain" quality control at the retail level for complex products, but it can be done, by the right system in place. Flipping the payor has also been done for open access academic publication. This actually works in concert with traditional, subscriber-paid publication. There is room for both, and you can shop for either kind of "quality control".

The government could assert a very powerful influence here without passing a single regulation by holding ratings agencies to certain performance criteria themselves before purchasing any AAA securities rated by them.

A more heavy-handed approach might be to outlaw sell-side ratings. Buyers could then sponsor any rator they wanted, or more likely, form buyers' consortia to rate potential attractive purchases.

RR : Assuming the rating systems remains the same, are these ratings weighted or considered less because of the hire/pay structure we discussed and the fact that these bond packages are not downgraded until after losses are seen in the pipeline, thus the investor has already lost money?

AK : I think there is already a mass loss of credibility here. It's going to get worse as the losses reverberate down to Main Street.

I would like to see this kind of reaction lag integrated into some sort of ratings agency "grade", which could be used for future securities purchase decisions.

But the take-home point on ratings is that the AAA rating was basically polluted. It was devalued, or even destroyed (that's why we're having a general credit crunch at this time -- perhaps earlier than if the market had had to wait for corporate defaults and the like). Heaven and earth will have to be moved to restore confidence in the "investment grade" fixed-income market now.

RR : What are the possibilities of Chinese or Middle Eastern monies coming in to save the mortgage industry?

AK : They don't seem very eager to do so. HUD's Jackson already did the tin cup tour and got a chilly reception.

They might try to participate just enough to keep their dollar holdings from collapsing too rapidly. It is important to note that they already were propping up the market. In fact I'd say the Chinese influx of money was even more instrumental in lowering mortgage interest rates over 2001-2006 than the low Fed funds rate was. When China first adjusted their currency peg in 2005, the impact on mortgages was three times the adjustment in the peg (or maybe it was six times; I can't remember exactly). Yet the Fed raised rates from 1% to 5.25% from 2004 to 2006, and mortgage rates (as with long interest rates in general) stayed stubbornly low. Mortgages changed only a fraction of the change in funds rate. This is all actually unsurprising: the Fed only sets the short-term rate, not long-term (the government's real long-term rate influence is through lying about inflation).

My point is that the dollar-recycling phenomenon, which is due to the US's trade deficit, was already fuelling the market. If we only continue the same level of deficit financing, the market will still continue down, because it simply reached an intrinsic point of inability to service the debt that had built up.

The new risk, however, is that Chinese and oil exporters will actually diminish their financing of the US. Even a little bit would be catastrophic. I think the question is how soon this will happen, not if.

RR : What are your thoughts on Freddie and Fannie lobbying to change their lending guidelines/caps?

AK : This is a very important development. This is possibly the most important proof that Fannie and Freddie do not see themselves as private, profit-driven companies, but rather as government bureaus that function to provide welfare to the entire housing market. A sane CEO of a private company would not agitate to take on loads of bad debt. A bureaucrat, however, would, because it would expand his appropriations -- the size of his fiefdom.

Many will agitate for Fannie and Freddie to become bail-out vehicles, thinly-veiled or not veiled at all. I think these calls should be resisted, so we can go through the full correction we need. It will hurt a broad swathe of society, but a huge bailout of the banking sector is misplaced, and will hurt all of us even more in the long run. Let the weak hands fail. Bring back Schumpeter!

If there is going to be any bail-out, it should be at the homeowner, to renegotiate foreclosures, not at the financial level.

RR : Will this move help alleviate the problems subprime and 'alt-a' mortgage lenders?

AK : It would help banks and other holders of these securities. It may keep some originators alive. But it won't solve the problem of deteriorating ability to service debt.

RR : Do you expect to see default rates to continue to creep even more from subprime lenders/markets into conventional mortgage lending/markets?

AK : Yes. This is already happening, day by day. It will get worse. I expect job loss to increase as in all recessions, and probably get quite bad. This will turn a lot of "prime" borrowers into people who can no longer pay. Wages and lagging inflation will have the same macro effect as job loss (this is a great area of subterfuge & confusion in public discourse and policy of late). In addition I believe lots of prime ARM portfolios are really pay option waste dumps under the hood, which are time bombs. Many others are simply ARMs that were expected to refi before adjusting, taken out on shaky terms. This is also quite bad. Another thing corrupting loan portfolios is that LTV-based metrics were used in a deceptive way -- often the same mortgage holder has on its books both the first and second lien of the same origination in the same pool of loans. And it is likely that other marginal sorts of loans were wishfully branded "as prime" and are lurking out there in the market.

I'm not sure who is left that is purely "conventional". But even if they just do 30-year fixed loans, this will be bad for them. They will lose not through defaults, but through owning an income stream which fails to keep pace with inflation!

RR : In your opinion, there should be a federal bailout for lenders and markets? Will there be?

AK : No. But there probably will be, to some extent. It won't "solve" the problem - it will be enough to maintain appearances, save some of the favored political patrons, and of course, be extremely expensive for taxpayers. Take the S&L bailout, which would be about $300 billion in today's dollars, multiply that a few times, and you have your starting point.

RR : In your opinion, should there be a federal bailout for borrowers that are increasingly facing foreclosure?

AK : They should have to give up ownership of their houses (maybe not vacate), unless they can prove they are clean and fraud was perpetrated purely by the lender. (and certainly this did happen a lot). Otherwise, they should short-sale or renegotiate the loan privately. We cannot give away free houses; the market will never correct this way and the populace will be damaged by being left fiscally irresponsible, like spoiled children.

RR : How do you respond to critics such Hillary Clinton, who said something to the effect of "Buyer beware…easy to say if you are not the one losing your house", and Jim Cramer who has said of no government borrower/consumer bailout will result in a country of Tom Joads and a rerun of the Grapes Of Wrath?

AK : Well, if no one else does it, the banks will effectively "bail out" many borrowers. It will simply be cheaper to renegotiate loans than foreclose. Of course, millions of foreclosures will still happen. It is going to be pretty unpleasant all around. But people should keep their cool. Don't "walk away" from your home; find some professionals to work with your mortgage holder ( I'm building IamFacingForeclosure.com into a resource center and place to start with this process). Don't expect to be bailed out by the government - its unfair to ask for Big Brother to bail you out because you're really asking your fellow citizen to cover for your mess or misfortune. But they can't really afford it either! Worst case is Chapter 13 and loans will have to be renegotiated to something you can afford.

RR : How much is the housing/mortgage sector responsible for the recent economy woes?

AK : Significantly, but only indirectly. The housing bubble came along to provide a gigantic credit card to a broke American Economy. It was direct used to fund a large fraction of consumer spending over the past few years. But that credit card was maxed out in less than five years. Most of the spending growth over that period, and much of the job growth, actually came from this "credit card." Since the credit card is now maxed out (the bubble is deflating, a-la Minsky), spending growth will reverse and so will job growth. That means recession.

The 2001 recession should have probably been longer and deeper. We're paying the piper now, for using the housing bubble to "avoid" the unpleasant reality of recession and correction from the previous investment bubble.

RR : Will this 'credit/liquidity crunch' move into other commercial and corporate lending?

AK : The answer already appears to be "yes". Spreads have shot up on corporate debt and long rates have increased. These are classic pre/early recession conditions. The M&A "bubble" has already burst. Just ask KKR (and their investment bankers). There are signs of a peaking in the commercial real estate sector as well.

RR : Do you believe that this mortgage crisis will lead the U.S. into a recession?

AK : We're already in a recession. GDP doesn't just dip down to effectively zero and then come back strong. It might fluctuate but it will spend some time underwater before coming back. Plus, there's the fact that GDP is a gamed metric, stemming from how inflation is measured, primarily. Finally, the BLS employment metrics are a joke, admittedly (by the BLS) missing economic turns, and the inflation reporting also makes compensation look better than it is. We're already having "shadow job loss" in declining median income, increased un-willing part-time employment, more "discouraged" workers, more corrections systems denizens (7.5 million now), and illegal immigrants losing employment (just ask WalMart how its sales are doing these days).

Finally, crime is a leading indicator of recession, and we are seeing a sharp nationwide uptick in violent and property crime -- nearly 10% in some categories such as robbery.

The housing market will just kick all this into "visible" territory.

RR : One factor in this mortgage crisis that has been overshadowed and not really talked about much is that conforming mortgage rates have actually been lower over the past few weeks… Why has this been virtually ignored? Will this help stabilize the housing market?

AK : It is to be expected by a shifting of funds to the conforming market. There is a flight to quality. I'm glad to see more prudent mortgages being funded. But in the long term, I expect this move to be over-shadowed by the global flight of funds to quality, which means out of the U.S. The U.S. economy is the "sick man" of the world. Everyone knows it. Next comes acting on it. This will bode poorly for mortgage rates. Also, domestic investors will begin demanding higher returns as inflation accelerates, and becomes harder to hide. Interest rates will be pushed up on multiple fronts.

RR : Will enough mortgage lenders crash where we will have a consolidation of lenders and limited program options?

AK : It is pretty limited on these fronts already! I don't know how much diversity will flourish again, after the market comes back. I would be glad to never see widespread subprime and Alt-A. They just make no sense. As niche products, yes, but in volume, no way.

RR : Or what in your opinion will the mortgage industry look like once we emerge from this crisis?

AK : A good bet seems to be banks and bank-based shops, a few major independent lenders that are also banks, and origination specialists that have very good standards and a strong retail presence. I suspect the pure origination shops will need to really add unique value; perhaps focusing on long-term customer relationships and guidance even more. Also the origination shops will likely emphasize products like the reverse mortgage. That is already happening. It is the next wave. The reason it is exempt from much of the rest of the collapse is because its actually a way to profit from the declining income and wealth trend. It is a way to profit from people "selling the house back to the bank"; then effectively renting till death (it is a brilliant financial marketing trick to be essentially renting while receiving a check from the landlord every month). It is a sad testament and the ultimate irony for an "ownership society", but there it is. There won't be many other workable options for many people.

RR : What needs to change in the industry to diminish the likelihood of this happening again?

AK : I actually don't think the industry is the real source of the problem. Prudent origination and funding standards could always avert this sort of catastrophe, but the last real estate mania was just 15 years ago (with major fallout, which the public of course paid for). I even remember it. And there was a subprime collapse in the last credit crunch, in 1998. It almost killed NovaStar. I've also heard from numerous mortgage bankers who have been through 2 or 3 market cycles about how familiar all this looks to them. So do we really think the industry doesn't have the "institutional memory" to allow it to avoid imprudence crazes? Not likely. The history and information are there; they are just being ignored. Plausible deniability plus throwing a few culprits to the wolves always provides sufficient remedy.

So I don't think, in essence, that "try to remember to be responsible" is terribly useful advice. In a mania, good information is discarded in favor of emotional, irrational choices. You can never stop a mania by telling people to just try to observe when they are in the mania, and to please not do foolish things. That's an oxymoron.

What would really help would be to set the right rules to the whole game. The banking system needs to be gutted. The Fed sits at the top of the pyramid and they always allow more credit to be extended, because people love it in the short term. In fact the Fed eschews any analysis tools that would let them separate "good" economic growth from unproductive (even dangerous) credit expansion.. They like counting credit expansion as GDP growth (side note: they even count national borrowing as GDP growth, that's why we use the GDP today and not the "GNP", which was adopted coincidentally right when the US tipped into chronic trade deficit). The Fed is the wellspring of all credit. If excess credit continues to be supplied, people will find a way to abuse it. You cannot fix this problem by regulating at the "surface" of the market -- if you create new regulations in one market, the credit will go to another market and form a bubble there, or it will find alternative ways into the same market by circumventing the rules, or people who aren't the targets of regulation in the same market will find ways to abuse the credit.

But few will listen, and short of Ron Paul getting elected (hey, his support base is gaining momentum), I don't see the necessary Fed reform or outright abolishment taking place. Instead we'll probably see some sort of Sarbanes-Oxley of housing finance, just the kind of "surface regulation" I mentioned above, which will just become an albatross around the industry's neck, and probably do as much harm as good. The one unambiguous "win", of course, is making Capitol Hill look tough, and helping some politician's career.

RR : You are currently facing a 'frivolous' lawsuit from a lender in California…please tell us what you can about it. Including, what is the current status, the next steps, and your fundraising needs.

AK : We are being sued for what I think falls well within free speech rights, journalistic or otherwise. All we did was post a "whistleblower" email, with independent evidence it was substantially true. I do not know today how much of it was or was not. We posted a generic correction when LCC complained, and pulled the post when they refused to supply their own correction. This happened within the span of a day. The company is angry the post went on our main "implosion" list, but they misconstrue the nature of this list to suit themselves. They ignored our disclaimers. If every journalist had to avoid saying anything in a headline that could be misconstrued relative to the context of an article, the effects on the press would be devastating. Every headline would be pages of legalese. But that is the implicit standard we are being held to. We cannot rightfully be held culpable for irresponsible readers.

The core of the damages claim is that we are supposedly culpable for LCC's loss of nearly $4 million in warehouse funding, allegedly as a result of the post. We believe cannot rightfully be held culpable for the independent decisions of banks. That's ridiculous.

Currently we have raised about $21k, and our billable expenses so far are about $22k (this is relatively cheap). The outpouring of community support has been impressive and much appreciated, but the suit is over yet, and the burden has hit our small operation hard (not counted have been the non-billable costs, which include various consequences of the law suit's disruption of running the site and interference in my life generally). Mere mortals cannot afford lawsuits these days. I suspect LCC is banking on this. Thus, we are trying to raise a warchest of $50k or so.

RR : On your website discussion about the lawsuit you say that "certain malicious and dishonest elements in the industry want to shut us down"…please expound on that statement…

AK :The behavior of a number of companies has proven to me (and some other observers I know) that they simply want to keep information about their condition from getting out. In other words, they try to operate in secrecy. Presumably this is so they can deceive their employees, investors, funders, regulators, and/or various business counterparties. They want to extract the maximum benefit from all of these stakeholders for as long as possible, prudence and ethics be damned. Gaining profit is not a bad thing, but when one must operate in secrecy to do so, it is usually a bad sign. It usually means someone is being scammed.

We have been threatened by a number of companies before. They all imploded (through to bankruptcy) before any had a chance to file suit (though we don't know how serious their threats really were). We have always offered to give their side of the story if they supply it; but about half just want the adverse information buried. They want the voices speaking out against them to be silenced.

RR : Your website, www.ml-implode.com has been become a go to site for many people to follow this mortgage crisis and get the inside scoop on how lenders are fairing…tell us the story about the site and where you see it going as this crisis worsens, but then also starts to inevitably recover.

AK : I cannot honestly say where the site will go. I would like to leave it up as a historical record even when it is basically "inactive". I want people to remember this, and learn from this. That was my intent when starting it. It has become more of a current newswire in response to the industry, which I see as a way of supporting the initial objectives. Most seem to agree with this and have been receptive to it (the numbers are pretty convincing).

Maybe the site will morph to an ongoing coverage of routine "implosion" in the industry, with a compliment of the healthy companies. Maybe it will have coverage of the recovery. I think this will all be determined as the situation unfolds, as the evolution of the site has done so far. The readers make it pretty clear what they want and need from the site. If the "distractions" can be kept to a minimum, maybe I can be an agent to help provide more of what they need, and help the industry (and the economy) heal.