Milken Institute - Mortgage Crisis Overview

Demystifying the Mortgage Meltdown: What It Means for Main Street, Wall Street and the U.S. Financial System James R. Barth Senior Fellow

Glenn Yago Director of Capital Studies Milken Institute October 2, 2008

1

“I have great, great confidence in our capital markets and in our financial institutions. Our financial institutions, banks and investment banks are strong.” Treasury Secretary Henry Paulson March 16, 2008 CNN

2

… but just six months later…

“The financial security of all Americans … depends on our ability to restore our financial institutions to a sound footing.” Treasury Secretary Henry Paulson September 19, 2008 Press release

3

“Any real estate investment is a good investment … ”

4

“Any real estate investment is a good investment … ”

… Really?! 5

Subprime mortgage meltdown timeline December 2006–September 2008 Dow Jones U.S. Financial Index 650

Feburary–March 2007: More than 25 subprime lenders declare bankruptcy.

Aug. 16, 2007: Countrywide gets emergency loan of $11 billion from a group of banks.

Sept. 30, 2007: NetBank goes bankrupt.

Oct. 24, 2007: Merrill announces $7.9 billion in subprime writedowns, surpassing Citi’s $6.5 billion.

550

450

350

250

Dec. 2006: Ownit Mortgage, a subprime lender, files for bankruptcy.

Feb. 2007: HSBC sets aside $10.6 billion for bad loans, including subprime.

Apr. 2007: New Century, a mortgage broker, files for bankruptcy. July 31, 2007: Two Bear Stearns hedge funds file for bankruptcy.

Aug. 6, 2007: American Home Mortgage files for bankruptcy.

Jan. 11, 2008: Bank of America agrees to buy Countrywide. Jan. 30, 2008: Fed cuts discount rate to 3.5%.

Mar. 16, 2008: JP Morgan Chase offers to buy Bear Stearns; Fed introduces Primary Dealer Credit Facility.

Mar. 18, 2008: Fed cuts discount rate to 2.4%; Fed funds rate to 2.25%.

July 30, 2008: President Bush signs a housing rescue law.

Dec. 12, 2007: Fed introduces Term Auction Facility.

Aug. 17, 2007: Fed cuts discount rate to 5.75%; Fed introduces Term Discount Window Program.

Sources: BusinessWeek, S&P, Global Insight, Milken Institute.

Mar. 11, 2008: Fed offers troubled banks as much as $200 billion in loans; Fed introduces Term Securities Lending Facility.

Feb. 13, 2008: President Bush introduces tax rebate stimulus program of $168 billion.

June 9, 2008: Lehman announces a $2.8 billion loss. July 11, 2008: IndyMac is seized by FDIC.

Aug. 1, 2008: First Priority Bank closes. Sept. 14, 2008: Lehman files for bankruptcy. Sept. 16, 2008: Fed loans AIG $85 billion. Sept. 23, 2008: Washington Mutual is seized by FDIC.

Sept. 7, 2008: U.S. seizes Fannie Mae and Freddie Mac.

Sept. 29, 2008: Citigroup agrees to buy Wachovia bank.

6

Overview

7

Home mortgages: Who borrows, how much has been borrowed, and who funds them? Total value of housing stock = $19.3 trillion Subprime 8.4% Mortgage debt $10.6 trillion Prime 91.6%

Securitized 58%

Non-securitized 42%

Governmentcontrolled 46%

Private sectorcontrolled 54%

Equity in housing stock $8.7 trillion

Note: total residential and commercial mortgages = $14.7 trillion; 5 percent = $700 billion Sources: Federal Reserve, Milken Institute.

8

The mortgage problem in perspective 80 million houses 27 million are paid off 53 million have mortgages 48 million are paying on time

5 million are behind (9.2% of 53 million with 2.8% in foreclosure) Sources: U.S. Treasury, Milken Institute.

This compares to 50% seriously delinquent in the 1930s.

9

I. Low interest rates and a lending boom

10

Did the Fed lower interest rates too much and for too long? Federal funds rate vs. rates on FRMs and ARMs Percent 8 30-year FRM rate

7 6 5 4

Target federal funds rate

3 1-year ARM rate

2

Record low from June 25, 2003, to June 30, 2004: 1%

1 0 2001

2002

2003

2004

2005

Sources: Federal Reserve, Mortgage Bankers Association, Moody’s Economy.com, Milken Institute.

2006

2007

2008

11

Home price bubble and credit boom

Low interest rates and credit boom US$ trillions

Percent 6.0

4.5 4.0

5.5

3.5

5.0

2.5 2.0 1.5

0.5

4.0

250

3.5 200

3.0

3.0

1.0

Index, January 2000 = 100

US$ trillions

1-Year ARM rate (right axis)

Home mortgage originations (left axis)

4.5

2.0

4.0

1.5 1.0

3.5

0.5

0.0

3.0 2001

2003

2.5

2005

2007

S&P/Case-Shiller National Home Price Index (right axis)

Home mortgage originations (left axis)

150 100 50 0

0.0 2001

2003

2005

Sources: Inside Mortgage Finance, Mortgage Bankers Association, Moody’s Economy.com, S&P/Case-Shiller, Milken Institute.

2007 12

II. Homeownership, prices, starts and sales take off

13

Credit boom pushes homeownership rate to historic high Percent 70 69

Q2 2008: 68.1%

Q2 2004: 69.2%

Home price bubble peaks in 2006 Index, January 1987 = 100 380 S&P/ 330

68

280

67

230

66

180

65

130 Ave rage , 1965–Q2 2008: 65.2%

64 1998 2000 2002 2004 2006 2008

Cas e -Shille r National Hom e Price Inde x

California and national home prices reach record highs US$ thousands 700 600 500 400 300

California m e dian hom e price California ave rage 1987-2008 $229,748

U.S. m e dian hom e price

200 OFHEO Hom e Price Inde x

80 1998 2000 2002 2004 2006 2008

Sources: U.S. Census Bureau, OFHEO, Moody’s Economy.com, S&P/Case-Shiller, California Association of Realtors, Milken Institute.

100

U.S. ave rage , 1987-2008: $121,280

0 1998 2000 2002 2004 2006 2008

14

Housing starts hit a record in 2005 Housing units, millions 2.0

Millions 4

Existing homes for sale (left axis)

January 2006: 1.8 m illion

3

1.5

1.0

Homes for sale Millions 0.8

July 2008: 641,000

0.0 1998 2000 2002 2004 2006 2008

5.6

1.2

4.2

0.9

2.8

1

Millions 1.5

0.4

Ave rage s tarts , 1959–July 2008: 1.1 m illion

0.5

Millions 7.0

Exis ting hom e s ale s (le ft axis )

0.6

2

Homes sales reach a new high

New homes for sale (right axis)

0.2

0 0.0 1998 2000 2002 2004 2006 2008

Sources: U.S. Census Bureau, OFHEO, Moody’s Economy.com, Milken Institute.

1.4

Ne w hom e s ale s (right axis )

0.6 0.3

0.0 0.0 1998 2000 2002 2004 2006 2008

15

III. Subprime borrowers and subprime mortgages

16

Who is a subprime borrower? National FICO scores display wide distribution

What goes into a FICO score?

Percentage of population 40

Types of credit in use

Prime = 79%

10% 30

20

New credit

27 Subprime = 21%

35%

18 15

13

12 8

10

Payment history

10%

Length of credit history 15%

5 2

0 up to 500499 549

550599

600649

650699

700749

750799

800+

Amounts owed 30%

Sources: myFICO.com, Milken Institute.

17

Prime and subprime mortgage originations by FICO score reveal substantial overlaps Percent of total originations FICO below 620 Prime: 6.6% Subprime: 45.2%

20 16

FICO above 620 Prime: 93.4% Subprime: 54.8% Prime

12

Subprime

8 4

00 -9

80

0

-7

99

79 0

-7

78

76

0

-7

59

39 74

0

-7

19 0

-7

72

70

0

-6

99

79 0 68

66

0

-6

-6

59

39 0

-6

64

62

0

-6

19

99 60

0

-5

79 0

-5

58

56

0

-5

59

39 0

-5

54

52

0

-5

19

99 50

0

-4

79 0

-4

48

0 46

0

-4

59

0

FICO score Sources: LoanPerformance, Milken Institute.

18

ARMs look attractive to many borrowers Percent 8.0 7.0

30-year FRM rate

6.0 5.0 4.0 1-year ARM rate 3.0 2.0 2001

2002

2003

2004

2005

2006

2007

2008

Sources: Mortgage Bankers Association, Moody’s Economy.com, Milken Institute. 19

ARM share grows, following low interest rates Percent of all outstanding home mortgages 25 20 15 10 5 0 2001

2002

2003

2004

2005

2006

2007

2008

Sources: Mortgage Bankers Association, Moody’s Economy.com, Milken Institute. 20

Largest share of ARMs go to subprime borrowers Percent of mortgage type 60 FHA ARM Prime ARM

Subprime ARM

50 40 30 20 10 0 2001

2002

2003

2004

2005

2006

2007

2008

Sources: Mortgage Bankers Association, Moody’s Economy.com, Milken Institute. 21

Subprimes take an increasing share of all home mortgage originations US$ trillions

8.4%

4.0

Subprime 3.0

Subprime's share: 7.8%

7.4%

18.2%

21.3%

Prime

20.1% 7.9%

2.0

1.0 0.9% 0.0 2001

2002

Sources: Inside Mortgage Finance, Milken Institute.

2003

2004

2005

2006

2007

Q2 2008

22

Subprime mortgages increase rapidly before big decline Originations

US$ billions

1,400

700

625

600

600

1,200

Average annual growth rates 1,240 1995–2006: 14% 1,200 2006–Q1 2008: -23%

540

973

1,000

500

800

400 310

600

300 200

Outstandings

US$ billions

160

200

191

940

895

699 574 479

400 200

100 14 0 2001 2002 2003 2004 2005 2006 2007

Sources: Inside Mortgage Finance, Milken Institute.

Q2 H2 2008 2008

0 2001 2002 2003 2004 2005 2006 2007

Q1 2008 23

IV. Mortgage product innovation

24

Subprime and Alt-A shares quadruple between 2001 and 2006, then fall in 2007 2006, $3.0 trillion

2001, $2.2 trillion 2%

5%

14%

7.9%

7%

2.7%

14%

4.9%

57.1%

9%

9.6%

8%

11%

20%

4% 2%

33.2%

13%

Q1 2008, $480 billion

2007, $2.4 trillion

8%

20%

16%

14%

47.3%

FHA & VA Conventional, conforming prime Jumbo prime Sources: Inside Mortgage Finance, Milken Institute.

67.2%

p Subprime Alt-A Home equity loans 25

ARM hybrids dominate subprime originations (2006) Prime conventional Other ARM 7% ARM hybrids

Alt-A

Subprime Fixed 9%

Othe r ARM 23%

30-year ARM balloon with 40- to 50-year amortization 26%

23%

Fixed Fixe d 31% 70%

Sources: Freddie Mac, Milken Institute.

Other ARM 4%

ARM hybrids 46%

2- and 3-year hybrids 61%

26

V. Securitization

27

The mortgage model switches from originate-to-hold to originate-to-distribute Residential mortgage loans 1980: Total = $958 billion

Residential mortgage loans Q2 2008: Total = $11.3 trillion

Securitized 15.6% Held in portfolio 41%

Held in portfolio 84.4% Sources: Federal Reserve, Milken Institute.

Securitized 59%

28

Securitization becomes the dominant funding source for subprime mortgages Percent of all subprime mortgages securitized since 1994 80 70 57

60 50 40 30

40 31

29

45

43

42

45

47

62

65

68

68

68

50

33

20 10 0 1994 1995 1996 1997 1998 1999 2000

Sources: Inside Mortgage Finance, Milken Institute.

2001 2002 2003 2004 2005 2006 2007

Q1 Q2 2008 2008

29

The rise and fall of private-label securitizers New securities issuance 2% 42%

21%

20%

1985 Total = $110B

35%

Ginnie Mae

4%

13% 56% 2001 Total = $1.3T

6% 18%

2006 Total = $2.0T

29%

First half 2008 Total = $734B

Sources: Inside Mortgage Finance, Milken Institute.

33%

22% 46%

38%

Freddie Mac

15%

Fannie Mae

Private-label

30

The rise and fall of private-label securitizers Outstanding securities 6% 13%

14%

18%

7%

35%

25%

55% 1985 Total = $390B

2001 Total = $3.3T

7%

30%

2006 Total = $5.9T

26% First half 2008 Total = $6.8T

26% 39%

29% 33%

Ginnie Mae

Freddie Mac

Sources: Inside Mortgage Finance, Milken Institute.

Fannie Mae

37%

Private-label

31

VI. Affordability

32

Debt-to-income ratio of households has increased rapidly

Ratio of home price to household income surges

Home mortgage debt/disposable personal income Q4 2007: 139.5% 150

Median home price/ median household income 5.0

Home mortgage share of household debts reaches a new high in 2007 Percent 75

Q2 2007: 73.7%

2005: 4.69

4.5

70

125

Q2 2008: 73.4%

4.0 2007: 4.29

3.5

100

Average, 1957–2007: 79.7%

3.0

Average, 1952–2008: 64.2%

Average, 1967–2007: 3.38 2.5 1998

2001

2004

65

2007

75 1998

2001

2004

2007

Sources: U.S. Census Bureau, OFHEO, Federal Reserve, Moody’s Economy.com, Milken Institute.

60 1998

2001

2004

2007

33

VII. Collapse

34

The recent run-up of home prices was extraordinary Index, 2000 = 100 250 Annualized growth rate of nominal home index: 3.4%

Current boom

Great Depression

200 World War I

150

World War II

1970’s boom

1980’s boom

100

50

0 1890

Long-term trend line

1900

1910

Sources: Robert Shiller, Milken Institute.

1920

1930

1940

1950

1960

1970

1980

1990

2000

2010

35

Home prices don’t go up forever Change in home prices in 100 plus years Percentage change in nominal home price, year ago 30 Great World World Depression War II War I 25

1970’s Boom

20

1980’s Boom

Current Boom

Average, 1890–2007: 3.7%

15 10 5 0 -5 -10

+/- one standard deviation

-15 -20 1890

1900

1910

Sources: Robert Shiller, Milken Institute.

1920

1930

1940

1950

1960

1970

1980

1990

2000

2010 36

2005: The collapse begins Home price indices, percent change on a year earlier S&P/Case-Shiller 20 10 city 15 S&P/Case-Shiller national

10

OFHEO

5 0 -5 -10 -15 1988

1990

1992

1994

1996

1998

Sources: S&P/Case-Shiller, OFHEO, Moody’s Economy.com, Milken Institute.

2000

2002

2004

2006

2008 37

Forty-six states had falling prices in the fourth quarter 2007 United States: - 9.3% (fourth-quarter annualized growth)

Source: Freddie Mac.

38

If you bought your house… One year ago…

Five years ago… -1.0

-3.2 -4.7 -5.2 -5.8 -7.1 -7.3 -7.3 -8.1 -9.5 -13.9 -15.7 -15.9 -16.3 -17.0 -20.1 -23.7 -24.2 -25.3 -27.9 -28.3 -28.6

% change in price, June 07-08 Sources: S&P/Case-Shiller, Milken Institute.

Charlotte Dallas Denver Boston Portland Seattle New York Cleveland Atlanta Chicago Minneapolis W ashington Composite 20 Detroit Composite 10 Tampa San Francisco San Diego Los Angeles Phoenix Miami Las Vegas

48.4 Seattle 48.0 Portland 28.2 27.9 26.8 26.3 26.3 26.0 24.4 22.9 20.5 18.6 14.3 9.1 6.6 6.5 6.1 5.9 4.8

-21.3

-0.7 -3.8

Washington New York Phoenix Los Angeles Tampa Miami Las Vegas Charlotte Composite 10 Composite 20 Chicago San Francisco Atlanta Dallas San Diego Boston Denver Minneapolis Cleveland Detroit

% change in price, June 03-08 39

Housing starts sharply decline Percent change, year ago 30 15

Homes sit longer on the market … Number of months that homes sit on the market 12 Existing homes 10

… as home appreciation slows Percent 20

Months

Pe rce ntage change from ye ar ago in m e dian hom e s ale s price (le ft axis )

0 2

10

0

4

8 -15 -30 -45

0

6 June 2008: -41.9% July 2008: -39.2%

-60 1998 2000 2002 2004 2006 2008

8

4 2

6

-10

New homes

0 1998 2000 2002 2004 2006 2008

-20 1999

Num be r of m onths hom e s s tay on m ark e t (right axis )

2001

2003

2006

10 12 2008

Note: Shaded area represents fluctuation within one standard deviation from mean (1.28%) Sources: Mortgage Bankers Association, OFHEO, Moody’s Economy.com, Milken Institute.

40

VIII. Delinquencies and foreclosures

41

Foreclosures are nothing new, but … Thousands of foreclosures per year 2,150 1,900 1,650 1,400 1,150

Av erage 661,362 annual foreclosures from Q2 1999 to Q2 2006

900 650

08

Q

2

20

20

07

07 4 Q

Q

2

20

20

06

06 Q

4

20 2

Q

Q

4

20

20

05

05

04 2 Q

Q

4

20

20

04

03 2 Q

Q

4

20

20 2

Q

4 Q

Sources: Mortgage Bankers Association, Milken Institute.

03

02 20

02 20

2 Q

Q

4

20

01

01 20

2 Q

Q

4

20

00

00 20

Q

2

19 4

Q

Q

2

19

99

99

400

42

… their numbers have doubled Thousands of foreclosures per year 2,150 1,900

Average 1,316,220 annual forclosures from Q3 2006 to Q2 2008

1,650 1,400 1,150

Average 661,362 annual foreclosures from Q2 1999 to Q2 2006

900 650

08 20

07 2 Q

Q

4

20

20

07

06 2 Q

4 Q

2

20

20

06

05 20 Q

4 Q

Q

2

20

05

04 20

04 4 Q

Q

2

20

20

03

03 4 Q

Q

2

20 4

Q

Sources: Mortgage Bankers Association, Milken Institute.

20

02

02 20

2 Q

Q

4

20

01

01 20

00 Q

2

20 4

Q

2

20

00

99 19 Q

4 Q

Q

2

19

99

400

43

Subprime mortgages accounted for half or more of foreclosures since 2006 Number of home mortgage foreclosures started (annualized, in thousands) 2,000 Subprime: 12% of mortgages serviced (M arch 2008)

Subprime 1,600

FHA and VA

50%

Prime (includes Alt-A) 54%

1,200

55%

800 37% 400

0

36%

37%

44%

47%

29%

29%

29%

34%

35%

34%

34%

33%

Dec. 2003

June 2004

Dec. 2004

June 2005

Dec. 2005

Sources: Inside Mortgage Finance, Milken Institute.

22%

20%

52% 17% 31% June 2006

13% 32% Dec. 2006

56% 9% 11%

37%

8% 42%

33% June 2007

Dec. 2007

M arch 2008

44

Subprime ARMs have the worst default record Home mortgages delinquent or in foreclosure (percent of number) 35

Q2 2008, Subprime ARM: 33.4%

30

Subprime FRM: 11.8%

25

FHA and VA: 5.8%

20

Prime FRM: 3.0%

15 10 5 0 Q2 1998

Q1 1999

Q4 1999

Q3 2000

Q2 2001

Sources: Mortgage Bankers Association, Milken Institute.

Q1 2002

Q4 2002

Q3 2003

Q2 2004

Q1 2005

Q4 2005

Q3 2006

Q2 2007

Q1 2008

45

Percentage of homes purchased in Q2 2008 that now have negative equity

United States = 44.8% < 20% >= 20% and < 35% >= 35% and < 50% >= 50%

Sources: Zillow.com, Milken Institute.

46

Percentage of homes sold for a loss (Q2 2008)

United States = 32.7% < 15% >= 15% and < 30% >= 30% and < 45% >= 45%

Sources: Zillow.com, Milken Institute.

47

Percentage of homes sold that were in foreclosure (Q2 2008)

United States = 18.6% < 1% >= 1% and < 25% >= 25% and < 40% >= 40%

Sources: Zillow.com, Milken Institute.

48

IX. Damages scorecard

49

Losses/write-downs, capital raised, and jobs cut by financial institutions worldwide US$ billions 200

Number of jobs cut 60,000

Jobs cut (right axis)

48,000

160 120 80

Capital raised (left axis)

36,000 24,000

Losses/write-downs (left axis)

12,000

40

0

0 Prior quarters

Q3 2007

Q4 2007

Q1 2008

Q2 2008

Q3 2008

Note: Q3 data are through September 25, 2008. Sources: Bloomberg, Milken Institute.

50

What is the cumulative damage? Cumulative losses/write-downs, capital raised, and jobs cut by financial institutions worldwide US$ billions 600

Number of jobs cut 140,000 120,000

500 Jobs cut (right axis)

400 300 200

100,000

Capital raised (left axis)

80,000

Losses/write-downs (left axis)

60,000 40,000

100

20,000

0

0 Prior quarters

Q3 2007

Q4 2007

Q1 2008

Q2 2008

Q3 2008

Note: Q3 data are through September 25, 2008. Sources: Bloomberg, Milken Institute.

51

Recent losses/write-downs and capital raised by selected financial institutions US$ billions, through September 25, 2008

Losses /write-downs

Capital raised

Citigroup, United States

55.1

49.1

Merrill Lynch, United States

52.2

29.9

UBS, Switzerland

44.2

28.2

HSBC, United Kingdom

27.4

5.1

Wachovia, United States

22.7

11.0

Bank of America, United States

21.2

20.7

Morgan Stanley, United States

15.7

5.6

IKB Deutsche, Germany

15.0

12.3

Washington Mutual, United States

14.8

12.1

Royal Bank of Scotland, United Kingdom

14.4

23.5

World total

521.9

379.2

Sources: Bloomberg, Milken Institute.

52

Financial stock prices take big hits Percentage change in stock price, December 2006–September 2008 -99.8 -99.7 -97.5 -97.4 -95.4 -94.3 -93.9 -90.0 -72.8 -66.0 -65.6 -35.8 -34.4 -3.3 5.5 Note: * Bear Stearns stock price is to May 2008. ** Countrywide stock price is to June 2008. Sources: Bloomberg, Milken Institute.

W ashington Mutual Lehman Brothers Freddie Mac Fannie Mae AIG Bear Stearns* W achov ia Countrywide** Merrill Lynch Morgan Stanley UBS Equity Goldman Sachs Bank of America JP Morgan & Chase W ells Fargo

53

Financial market capitalization takes big hit Total loss in market value: $728 billion, December 2006–September 2008 -142 -101 -80 -74 -60 -50 -44 -43 -42 -41 -28 -24 -21 4 US$ billions Note: * Bear Stearns stock price is to May 2008. ** Countrywide stock price is to June 2008. Sources: Bloomberg, Milken Institute.

17

AIG W achov ia Bank of America UBS Equity Morgan Stanley Fannie Mae Merrill Lynch W ashington Mutual Freddie Mac Lehman Brothers Goldman Sachs Countrywide** Bear Stearns* W ells Fargo JP Morgan & Chase 54

X. Credit crunch and liquidity freeze

55

Tightened standards for real estate loans Net percentage of domestic respondents tightening standards for commercial real estate loans 100 80

The end of S&L crisis Dotcom

LTCM

60

Subprime

40 20 0 -20 -40 1990

1992

1994

Sources: Federal Reserve, Milken Institute.

1996

1998

2000

2002

2004

2006

2008 56

Widening spreads between mortgage-backed and high-yield bonds Basis points, spread over 10-year Treasury bond 1,800 Maximum spread: 08/29/2008: 955.8 bps 1,600 1,400

Merrill Lynch Mortgage-Backed Securities Index

1,200 1,000

Merrill Lynch High-Yield Bond Index

800 600 400 200 0 01/2004 07/2004 01/2005 07/2005 01/2006 07/2006 01/2007 07/2007 01/2008 07/2008 Sources: Merrill Lynch, Bloomberg, Milken Institute.

57

Liquidity freeze Spread between 3-month LIBOR and T-bill rate

Basis points 350

Se pte m be r 18, 2008: 313 bps

300

100 80

200

100

Basis points 140 120

Augus t 20, 2007: 240 bps

250

150

Spread between 3-month LIBOR and overnight index swap rate

Ave rage s ince Augus t 2007: 130 bps

Ave rage s ince Augus t 2007: 69.8 bps

60 40 Ave rage s ince

Ave rage s ince 1985: 76 bps

De ce m be r 2001: 21.1 bps

20

50

0

0 2006

Se pte m be r 19, 2008: 127.5 bps

2007

Sources: Bloomberg, Milken Institute.

2008

2006

2007

2008 58

Counterparty risk increases Average CDS spread, basis points Basis points 500 AIG rescued 400

Lehman Brother files for bankruptcy and Merrill Lynch acquired

300

Government announces support for Fannie Mae and Freddie Mac

200 Bear Stearns acquired 100 0 07/2007

09/2007

11/2007

01/2008

03/2008

05/2008

Note: Counterparty Risk index averages the market spreads of the credit default swaps (CDS) of fifteen major credit derivatives dealers, including ABN Amro, Bank of America, BNP Paribas, Barclays Bank, Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs Group, HSBC, Lehman Brothers, JPMorgan Chase, Merrill Lynch, Morgan Stanley, UBS, and Wachovia. Sources: Datastream, Milken Institute.

07/2008

09/2008

59

Commercial paper issuance dries up Quarterly change in outstanding amount, US$ billions 150 100 50 0 -50 -100 Issuers of asset-backed securities -150

Other issuers

-200 Q1 2006 Q2 2006 Q3 2006 Q4 2006 Q1 2007 Q2 2007 Q3 2007 Q4 2007 Q1 2008 Q2 2008 Sources: Federal Reserve, Milken Institute.

60

Federal Reserve responds by cutting Fed funds rate, but mortgage rates remain relatively flat

Percent 10 9 8

Percent 5.0 4.5

Freddie Mac 30-year fixed rate mortgage rate (left axis) 30-year FRM (left axis)

4.0

7

3.5

6

3.0

5

2.5

4

2.0

Federal funds rate (left axis)

3

1.5

2

1.0

Spread (right axis)

1

0.5

0 01/2007

0.0 03/2007

06/2007

09/2007

12/2007

Sources: Freddie Mac, Federal Reserve, Moody’s Economy.com, Milken Institute.

02/2008

05/2008

08/2008

61

Congress and White House responses z

HOPE NOW

z

The Economic Stimulus Act of 2008

z

Housing and Economic Recovery Act of 2008

z

Conservatorship of Fannie Mae and Freddie Mac

z

Temporary guaranty program for money market funds

z

Temporary ban on short selling in selected companies

z

Bailout package? 62

XI. When will we hit bottom?

63

Looking for a bottom? Economists say the economy isn’t at its low point yet, and house prices likely won’t get there until 2009 Does this feel like the bottom to a downturn? Yes 27%

When will home prices hit bottom? 1st half 2010

6%

2nd half 2009

29%

1st half 2009 No 73%

Source: Wall Street Journal.

38%

2nd half 2008 1st half 2008

17% 4% 64

How far do home prices have to fall? Annual rents as percent of home prices 6.5 Q2 1971: 6.08% 6.0 5.5 5.0 Q1 2008: 3.93%

4.5 4.0

Average, 1960–Q1 2008: 5.04% Average, 2000–Q1 2008: 4.06%

3.5 3.0 1960

Q4 2006: 3.48% 1965

1970

1975

Sources: Davisa, Lehnertb, Martin (2007), Milken Institute.

1980

1985

1990

1995

2000

2005

2010

65

Combinations of rental price growth rates and rent-to-price ratios to get home prices back to their Q4 2006 value

Rent-to-price ratio

Annual homehome price price decline required Annual decline

-2.0%

-5.0%

-10.0%

-15.0%

-20.0%

3.80%

2010 Q3

2008 Q4

2008 Q2

2008 Q2

2008 Q2

4.00%

2013 Q1

2009 Q4

2008 Q3

2008 Q2

2008 Q2

5.00%

2024 Q1

2014 Q1

2010 Q4

2009 Q3

2009 Q1

5.04% average

2024 Q3

2014 Q2

2010 Q4

2009 Q3

2009 Q1

6.00%

2026 Q4

2017 Q3

2012 Q3

2010 Q4

2009 Q4

Sources: Davisa, Lehnertb, Martin (2007), Milken Institute.

66

Alternative measures of the affordability of mortgage debt for California US$/month 4,000

Payment with 100% LT V Payment with 90% LT V Payment with 80% LT V

3,500 3,000 2,500 2,000

M ortgage payment assumptions: Every month, a home is purchased at median price, buyer takes out a 30-year conforming, fixed-rate loan with 80% LT V. Payment also includes 1% property tax per year, 0.1% property insurance.

1,500 1,000 500

Maximum affortablility limit is 38% of median household

0 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 Sources: Moody’s Economy.com, Milken Institute.

67

XII. What went wrong

68

The importance of Fannie Mae and Freddie Mac US$ billions 3,000 2,443

2,500

2,067

2,000 1,410

1,500 1,000

886

879

944

500 0 Fannie Mae: total assets

Fannie Mae: total MBS outstanding

Sources: Freddie Mac, Fannie Mae, FDIC, Milken Institute.

Freddie Mac: total assets

Freddie Mac: Commercial Savings total MBS banks: total institutions: outstanding residential real total estate assets residential real estate assets

69

Fannie Mae and Freddie Mac: Too big with too little capital? US$ billions 3,000 Total assets 2,500 Total MBS outstanding 2,000 1,500

1,778 1,410

1,301

1,123

1,022

1,000 500

2,443

803 752 133

844

805

886

879

316

288 41

0 Fannie Mae Freddie Mac Fannie Mae Freddie Mac Fannie Mae Freddie Mac Fannie Mae Freddie Mac 1990 1990 2003 2003 2006 2006 2Q 2008 2Q 2008

Sources: Freddie Mac, Fannie Mae, Milken Institute.

70

Fannie Mae and Freddie Mac are highly leveraged Mortgage book of business over capital measures 300 250

Fannie Mae

Freddie Mac

244x

200

167x

150 100

60x 60x 64x 65x

56x 58x

81x

50

48x 52x 56x

59x

55x 57x -393x

0 Core capital

Fair value

2005 Sources: Freddie Mac, Fannie Mae, FDIC, Milken Institute.

2006

Core capital 2007

Fair value 2008Q2 71

Freddie Mac’s and Fannie Mae's retained private-label portfolios Subprime

Alt-A

All others $122.2 billio

Freddie Mac, 2006 61.2%

25.0%

13.8%

$76.1 billion

Freddie Mac, 2007 57.4%

13.1%

29.5%

Fannie Mae, 2005

$86.9 billion 32.1%

37.4%

30.5%

Fannie Mae, 2006

$97.3 billion 46.4%

36.1%

17.5% $94.8 billion

Fannie Mae, 2007 33.8% Sources: Freddie Mac, Fannie Mae, FDIC, Milken Institute.

4.3%

32.0% 72

Leverage ratios of different types of financial firms (June 2008) Lev erage ratio, total assets/common equtity Freddie Mac

67.9 21.5

Fannie Mae

23.7

Federal Home Loan Banks

31.6

Brokers/hedge funds Savings institutions

9.4

Commercial banks

9.8

Credit unions

9.1

Sources: Federal Deposit Insurance Corporation, Office of Federal Housing Enterprise Oversight, National Credit Union Administration, Bloomberg, Google Finance, Milken Institute.

73

Too much dependence on debt? Leverage ratios at biggest investment banks Total assets/total shareholder equity 40 34

35 30

2000

32

28 27

31 28

25 19 19

20

2005

33

June 2008

31

30 26

22

2007

24

24

23 22 22 18

15 10 5 0

n.a. Bear Stearns

Merrill Lynch

Sources: Bloomberg, FDIC, Milken Institute.

Morgan Stanley Lehman Brothers Goldman Sachs 74

Most new securities issued in 2007 were rated AAA by S&P Number of securities rated 1,000 2,000 3,000 4,000

0

AAA AA+

AA AAA+ A

ABBB+ BBB BBBBB+ BB BBB+ B BCCC+ CCC+ CCCCC C D

4,090, or 51%, of new securities rated by S&P w ere rated AAA

Sources: Bloomberg, Inside Mortgage Finance, Milken Institute.

5,000

56 percent of MBS issued from 2005 to 2007 were eventually downgraded S&P

Total

Downgraded

Downgraded / Total

AAA

1,032

156

15.1%

AA(+/-)

3,495

1,330

38.1%

A(+/-)

2,983

1,886

63.2%

BBB(+/-)

2,954

2,248

76.1%

789

683

86.6%

B(+/-)

8

7

87.5%

Total

11,261

6,310

56.0%

BB(+/-)

Note: A bond is considered investment grade if its credit rating is BBB- or higher by S&P 75

When is a AAA not a AAA? Multilayered mortgage products Origination of mortgage loans

High-grade CDO Senior AAA Junior AAA AA A BBB Unrated

Pool of mortgage loans: prime or subprime

88% 5% 3% 2% 1% 1%

Mortgage bonds AAA AA A BBB BB-unrated

80% 11% 4% 3% 2%

Sources: International Monetary Fund, Milken Institute.

Mezzanine CDO CDO-squared Senior AAA Junior AAA AA A BBB Unrated

62% 14% 8% 6% 6% 4%

Senior AAA Junior AAA AA A BBB Unrated

60% 27% 4% 3% 3% 2%

CDO-cubed…

76

Dollar losses in reported cases of mortgage fraud

Mortgage loan fraud surges

US$ millions

Number of cases reported, thousands 60

52.9 50

1,200 1,014 1,000

946 813

37.3

40 30

600

26.0 18.4

20

400

9.5

10 0

800

1. 7 1997

2001

293

225

200

4.7 5.4 2.3 2.9 3.5 1999

429

0 2003

2005

2007

2002

Sources: Financial Crimes Enforcement Network, Federal Bureau of Investigation, Milken Institute.

2003

2004

2005

2006

2007

77

Is adequate information disclosed to consumers? Percent of respondents who could not correctly identify various loan costs using current disclosure forms Prepayment penalty amount Total up-front cost amount Property tax and homeowner’s insurance cost amount Reason why the interest rate and APR sometimes differ Presence of charges for optional credit insurance Presence of prepayment penalty for refinance in two years Loan amount Which loan was less expensive Whether loan amount included finances settlement charges Interest rate amount Balloon payment (presence and amount) Settlement charges amount Monthly payment (including whether it includes taxes and insurance) Cash due at closing amount APR amount

Sources: Federal Trade Commission, Milken Institute.

95 87 84 79 74 68 51 37 33 32 30 23 21 20 20

78

Drivers of foreclosures: Strong appreciation or weak economies? Foreclosures per 1,000 homes 25 Weak economies

Housing bubbles Stockton

20 Detroit 15

Las Vegas

Cleveland Akron

10

Atlanta Warren

5

National average

0 -20

0

Sacramento

Toledo Dayton Denver Memphis Columbus Indianapolis 20

Riverside

Fort Lauderdale

Bakersfield Miami

Phoenix

Oakland San Diego

Tampa

Fresno

Orlando Palm Beach

40

60

80

100

120

140

Five-year price gain, Q3 2002–Q3 2007 (percent) Sources: U.S. Treasury Department, RealtyTrac, Office of Federal Housing Enterprise Oversight, Milken Institute.

79

After housing bubble burst in 2007: Foreclosures highest for areas with biggest price declines Foreclosures per 1,000 homes 45 40

Collaping housing bubbles

Stockton

35

Riverside

30

Las Vegas

Bakersfield

25

Fort Lauderdale

Sacramento

20 15

Detroit

San Diego

Tampa

Palm Beach

10

W arren

5 0 -25

-20

Denver

Oakland Phoenix

Fresno

-30

W eak economies strengthen

National average

-15

-10

Toledo Miami

Akron

Orlando Cleveland Dayton Columbus -5

Atlanta Memphis

Indianapolis 0

5

Price change, 2007–June 2008 (percent, annualized) Sources: RealtyTrac, Office of Federal Housing Enterprise Oversight, Milken Institute.

80

XIII. Where do we go from here?

81

The U.S. regulatory regime: In need of reform? Financial, bank and thrift holding companies

Fannie Mae, Freddie Mac, and Federal Home Loan Banks

• Fed • OTS

• Federal Housing Finance Agency Fed is the umbrella or consolidated regulator

National banks

Primary/ secondary functional regulator

• OCC • FDIC

Federal branch • OCC • Host county regulator

State commercial Federal savings Insurance and savings banks banks companies

Securities brokers/dealers

Other financial companies, including mortgage companies and brokers

• OTS • FDIC

• FINRA • SEC • CFTC • State securities regulators

• Fed • State licensing (if needed) • U.S. Treasury for some products

• State bank regulators • FDIC • Fed--state member commerical banks Foreign branch • Fed • Host county regulator

• 50 State insurance regulators plus District of Columbia and Puerto Rico

Limited foreign branch • OTS • Host county regulator

Sources: Financial Services Roundtable (2007), Milken Institute.

Notes: Justice Department: Assesses effects of mergers and acquisitions on competition Federal Courts: Ultimate decider of banking, securities, and insurance products CFTC: Commodity Futures Trading Commission FDIC: Federal Deposit Insurance Corporation Fed: Federal Reserve FINRA: Financial Industry Regulatory Authority GSEs: Government Sponsored Enterprises OCC: Comptroller of the Currency OTS: Office of Thrift Supervision SEC: Securities and Exchange Commission

82

Many different options and innovations… Covered Bonds Alternative Mortgage Products Shared Equity Mortgages Real Estate Derivatives Classical Insurance Products Others 83

Demystifying the Mortgage Meltdown: What It Means for Main Street, Wall Street and the U.S. Financial System James R. Barth Senior Fellow

Glenn Yago Director of Capital Studies Milken Institute October 2, 2008

84