The Perfect Storm Notes

Slide 1 Perfect Storm: There is a perfect storm that has been created. It is very complicated but today we want to focus on 4 main factors. 1. The overall weak financial foundation of America 2. The softening real estate market 3. Record Setting percentage of foreclosures 4. The changes in the mortgage market Slide 2: America is in trouble Slide 3: Supply and Demand (A detailed explanation of the Graphic the Case-Shiller slide is written on the Slide itself) Beginning by looking at the real estate from a very broad perspective we can see the last 116 years of real estate home values being represented as a investment. We can clearly see a consistent pattern within the past 3 decades with a boom followed by an associated bust. Looking specifically at the periods in the 1970’s and 1980’s we can see the downturn is in direct proportion to the rise of the boom. The cliché that comes to mind is “The higher we rise the lower we fall”. What is of particular interest is the significant increase in the past boom in comparison to the two most recent boom times. Also, that we have just barely begun to see a correction and if history is any indication of the future we have a long way to go in this correction. Slide 4: Turn Down of the National Real Estate Market: Looking at the National market we can see that all aspects of Real estate are turning down. This shows a sharp decrease in: ­Housing Sales ­Housing Starts ­Real Estate Investment as a Function of the US Gross Domestic Product The turndown has already begun but it is critical to keep in mind that we are at the beginning of the correction and just beginning to see the first signs of downturn Slide 5: Looking At San Diego’s Foreclosure and Default ratios: Moving from a larger National market to the well documented correction in the San Diego market of the late 1980’s through the 1997. We can see clearly that foreclosure activity is already setting a very rapid pace early on in the correction cycle. Again looking back to 1990 we can see that it is the today it is the month over month “rise” of the foreclosure rate that is most alarming. Slide 6: Side-by-side comparison of the 1990 Correction Compared to today’s Correction

Referencing Case- Shillar we can see that the last correction in the San Diego Market saw a drop of 17.5% over a 6-year period. This graph shows two time scales side-by-side. The correction of 1990-1996 showing a decline of 17.5% versus the beginning of the turndown in 2005 through current day. This graph shows that the current correction has already broken below the trend line of the previous correction and beginning to drop faster. Remember how, much higher we have gone and ask yourself can you how much farther can prices drop? Slide 7: The Great Restructuring of the Credit Markets: We are going through a “Great Restructuring” in the Financial Credit markets. Loan products are disappearing as Adjustable Rate Mortgages are beginning to reset. Here we can see the record level of foreclosures has been created by only 197 Billion of what will be 2.5 Trillion in ARM’s resetting over the next 2 years. The beginning of 2008 sees 521 Billion loans resetting in just January-June of next year. Slide 8: Example of Resetting ARM Scenario Slide 9: Graphic of the Schedule of ARM’s resetting: This graph is a visual representation of the Adjustable Rate Mortgage Resets that will be occurring from January 2007 through the beginning of 2012. The Gray bars represent the sub prime mortgages and most of them will be resetting through the end of 2008. Also of note on this slide is the Option ARMS represented by the Turquoise. Most of the Option ARM’s are advertised to be 5 Year mortgages. However because of improper structuring by the mortgage professionals and unbeknownst to the clients these ARM’s end up “recasting” or hitting their negative amortization cap (When the loan amount reaches 100-125% of the original loan amount at which point the minimum payment is no longer allowed) somewhere in the 24-48th months. So effectively you can superimpose the turquoise bars about 18-24 months before they are represented here. Compounding the amount of resets that are going to occur in 2008 Slide 10: Density of Option ARM’s: This graph shows the density of the Option ARMS on a State-by-State basis. California has a density of 25-30%. However, if we look at the general percentage of ARM’s in California over 48% of all mortgages that were originated in 2006 were adjustable rate mortgages. So CA is an area that is very susceptible to the impacts of the resetting mortgages Slide 11: National Composition of the Overall Mortgage Originations: Here we can see the amount of the total mortgage originations that took place in 2006 almost 40% of all mortgages were Alt-A and Subprime mortgages.

Slide 12: Overview of the expansion and Tightening of credit This is the most important factor in the Perfect Storm. The changes of product availability in the Mortgage Market. One of the critical changes about this correction is the dramatic change that have occurred in the Financial capital markets as a result of the high level of defaults in sub prime and Alt-A mortgages. Because of the high level of defaults there is now basically no loan products that exist to provide options for the people who’s ARM’s are adjusting in the coming months. Graphic: Homes increased in value, in large part due to easy credit - to the ability for many marginal buyers to borrow, thereby adding to the pool of potential buyers, and therefore the total demand. However the opposite happens when credit become tight - less cash to borrow decreases the total number of buyers, reducing overall demand. Prices then fall Below is a very simple overview of the expansion and tightening in the Credit markets: One of the biggest factors driving the boom was a unprecedented amount of easy credit in the real estate world. This large amount of credit was extended to everyone but most importantly to consumers who normally would not have been able to participate in the real estate market. The classic examples are: Purchase of a Non-Owner occupied property at a 95% Loan to value loan by a person with a 620 credit score Stated Income Stated Assets verification. A Busboy buying a $750,000 home with 100% financing and 680 credit score providing No documentation of work history. All of this easy credit was based on one basic assumption from the consumers buying homes that they were going to sell in a year for a huge, to the hedge funds that were buying loans full of unqualified buyers, that real estate was going to continue to go up. So in 2005 as the real estate market stalled and prices began to decline “The wheels began to come off the proverbial wagon”. As the famous economist Hyman Minsky says, “Long periods of Stability breed instability” Meaning that has bull markets go on for long periods of time investors become lax in their investing standards and making begin making choices that only a short time ago would have been considered unsafe. This caused the real estate market to increase, as millions of would be renters flocked into the market to buy homes. Companies began to lend to just about anyone and everyone in 2005 and 2006. ARMS’s in this period are the most dangerous and defaulting at incredibly high percentages. The high level of defaults are causing everyone local mortgage banks to the largest hedge funds in the world to lose money. So the period of easy credit is over and we are ain period of over correction because now there is a lack of credit for people who are

qualified to purchase homes as the larger credit markets re-price and readjust their risk models. This process will take several months to stabilize but they will and we will see the markets return to the lending standards of 2003. Slide 13: Summary of the Future of the Real Estate Markets: Slide 14: Remember this is a Cycle. Yes, we think history is repeating itself – and in more ways than one. As the market ahs corrected before it will also come back again. Returning to the San Diego market we can see a decrease home homes prices lasted about 6-7 years but did go up again. This correction represents the single largest buying opportunity that we have seen in California in over 20 years