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PHONE: 212.219.9096 NOVEMBER 17, 2006 | PAGE 1

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NOVEMBER 17, 2006

Gimme Shelter Today’s horrible housing starts number will no doubt add to the case being made for an economy heading into a downturn and the inevitability of rate cuts by the Federal Reserve.

But behind weak aggregate US housing and construction data lie significant variations between categories. While new home sales do not look so good and existing home sales are soft, commercial real estate remains downright robust. The coasts are hurting, but the great swathe of the “flyover” country is not in meltdown.

TWO MELTDOWNS FOR THE PRICE OF ONE?

SOURCE: ARIZONA REPUBLIC

More to the point, the Fed is sticking to its central tendency scenario that yes residential housing is certainly soft, but the steepness of the downward slope is leveling off into a more gradual and bearable decline. And most importantly of all, the mighty US consumer is still spending.

Not everyone agrees with the Fed, and one of those is Josh Rosner, an independent financial services analyst, who wrote this week’s Back Page Essay “This Is Not Your Father’s Housing Cycle.” His contrarian view makes for an interesting read once you are settled into a comfy chair safe at “home.”

Enjoy the read.

Sassan Ghahramani CEO, Medley Global Advisors

THIS WEEK…

DIVERGENCE INDICATOR p. 2

THE MAJORS 3

FED: Minutes minders ECB: Remember December BOJ: GDP calm RBA: Futurists SNB: On watch

OIL AND ENERGY 7 OPEC: Hawks fly

GLOBAL POLITICS 5 US-China: Ill winds US Politics: Pelosi’s gambit

EMERGING MARKETS 8 Turkey: On hold Poland: Rate calm Hungary: Inflation concerns China: Crickets chirping BoK: Property rights

US REGULATORY 10

Telecom: Dems get a voice US Utilities: Ill freeze warning Coal: New PRB train on track

BACK PAGE ESSAY 11

Not Your Father’s Housing Cycle – by Josh Rosner

Disclaimer: This was prepared by Medley Global Advisors, LLC (“MGA”). The contents are not intended to provide investment advice and under no circumstances does this represent a recommendation to buy or sell a security. The information contained herein reflects the opinions of MGA based on information received by MGA from independent sources. While MGA believes that the information provided to it by its sources is accurate, MGA has not independently verified such information. Neither the author nor MGA has undertaken any responsibility to update any portion of this in response to events which may transpire subsequent to its original publication date. As such, there can be no guarantee that the information contained herein continues to be accurate or timely or that MGA continues to hold the views contained herein. Tel: (212) 219-9096 | Web: www.medleyadvisors.com

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BACK PAGE ESSAY

Not Your Father’s Housing Cycle

Like the four horsemen of the proverbial apocalypse, four big legislative issues in financial services (credit rating agencies, hedge funds, depository institutions, and mortgage finance players) are each garnering attention as businesses in need of new controls. There are few observers pointing out that they could ride together compounding and accumulating their risks.

The ISSUE is whether over the reliance of each upon the other fostered a mispricing of risk and WHETHER structural changes created on the cyclical upswing be tested in a downturn. Ultimately, the unfolding housing and mortgage market story is not one of regional economic activity, as housing cycles have historically been, but rather a financial market confidence game.

Unlike prior housing cycles in which prices were primarily driven by regional commercial activity and demographics, the current cycle has been driven by a massive democratization in mortgage credit and the growth of innovations in securitized markets. Due to short term economic incentives to do so, these changes have been under-appreciated by the mortgage industry, the Nationally Recognized Statistical Rating Organizations, and investors. If the market demand for mortgage backed securities and collateralized debt obligations decline and assumptions by rating agencies are incorrect, the risks may be transmitted from the market to the real economy.

The old models no longer apply

These changes, more than changes in interest rates, have been a primary driver of US homeownership rates increasing from about 63% a decade ago to almost 70% today. Most of that increase came from availability of credit to previously untapped markets. To lay the housing miracle at the feet of interest rates ignores that much of that rate relief has been eaten up as median new home prices rose from $130,000 in 1994 to about $218,000 today.

This credit expansion has allowed issuers to justify their expected default and prepayment assumptions based on

historic models, models almost certainly been invalidated by those fundamental changes that have driven such historically unprecedented originations.

Changes include the growth of private label securitization markets, reduced down-payment requirements, use of cyclically untested automated underwriting and valuation models, proliferation of new mortgage products, reduced private mortgage insurance requirements, and compromised appraiser independence. The result has been the piling on of new risks with limited historical experience by which to gauge those risks.

Since, historically speaking, non-conforming mortgage risks were borne by the lending institution it would have previously been unthinkable to have a year when 45% of sub-prime loans had "limited documentation," 20% were "Interest Only" or 30% were piggybacks. In fact nearly 65% of IO and Pay Option Arm mortgages are low or no documentation loans, and almost 15% of those were for investment properties. Since the mid-1990's conventional and subprime securitization rates have roughly doubled, leaving banks with the questionable impression they have passed those risks to market participants.

Just as originators have been increasingly willing to originate loans without much traditional due diligence, investors have become used to purchasing mortgage

Josh Rosner is an independent financial services analyst PHONE: 212.219.9096 NOVEMBER 17, 2006 | PAGE 10

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BACK PAGE ESSAY

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Subprime Baa3 Spread to LIBOR

If non-conforming MBS demand wanes significantly or if MBS performance models prove inadequate, we could witness a market driven downward cycle of model assumption problems leading to downgrades, reduced mortgage liquidity and further downward pressure on home prices. This would be especially likely in markets that have seen dramatic speculative and second home purchases. As home prices fell the new breed of speculative homebuyers would begin to list investment properties putting further downward pressure on prices. As this spiral continues we could see prepayment and default models falter again, thus reasserting this "death spiral."

Unfortunately, it is unlikely Congress will act until after a crisis of some uncertain magnitude has presented itself.

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Oct - 06 The risk of spillover into the economy

Perhaps investors will not get spooked or become

assets with little due diligence other than checking the ratings by the ratings agencies. These agencies have been allowed to operate without constraints and enormous conflicts. While NRSROs are often thought of as financial services companies (with exceedingly high margins), they are financial publishers and often assert their First Amendment rights when their analysis proves wrong.

Currently NRSROs receive significant consulting fees for advising asset-backed issuers on structuring deals to garner higher ratings. They rarely adjust ratings until after performance has deteriorated materially. When credit rating agencies begin to see methodological shortcomings to address they typically put potential changes out for comment to customers/issuers before making those changes. When they do make analytical changes they usually do so only for new issuances and rarely for prior issuances.

Unlike other assets the agencies rate, the grab for yield supported massive and new investor interest in MBS. In turn, this demand spawned the growth of synthetic CDOs where historic assumptions are even less relevant and cyclically untested algorithms are more relied upon. These algorithms have not been widely analyzed yet support an asset class that is hardly transparent. Moreover, unlike other financial instruments, these are used more for ratings arbitrage than for economic business purpose.

markedly credit risk averse and we will get that hoped for soft-landing as regional economic activity suggests. However, if history can be used as a guide it would force consideration that excess liquidity in financial markets tends to dry up abruptly. Given the size of these markets a reversal in liquidity, due to endogenous or exogenous factors, could result in significant impact on the real economy.

Several investment banks bottom lines would be hurt as securitization volumes decline; Private mortgage insurers capital would be stressed; Many banks would have to increase reserves and take writedowns; Originators would have to consider implicit recourse risks; Investors in unrated tranches would get badly hurt and; Investors in some investment grade tranches would see loss rates that weren't in NRSRO models. All of this could spill into the real economy and remove the new bidder at the same time that inventories are piling up.

It is not certain of course that a hard landing scenario will occur since the market trigger would, by definition be a surprise, but it appears irresponsible for risk managers to merely "buy the rating" without greater scrutiny of the assets they are purchasing or of the rating agencies work. This is not your father's housing cycle; it is a liquidity cycle driven by a rapid expansion and democratization of credit. Viewed through this lens, one is reminded that housing cycles usually unwind slowly but massive credit growth cycles usually implode.

PHONE: 212.219.9096 NOVEMBER 17, 2006 | PAGE 11