Demystifying the Mortgage Meltdown:
     What It Means for Main Street,
Wall Street and the U.S. Financial System

    Jam...
“I have great, great confidence in our capital markets and in
our financial institutions. Our financial institutions, bank...
… but just six months later…


“The financial security of all Americans … depends on our
ability to restore our financial ...
“Any real estate investment is a good investment … ”




                                                       4
“Any real estate investment is a good investment … ”




                  … Really?!
                                    ...
Subprime mortgage meltdown timeline
                                                    December 2006–September 2008
   Do...
Overview




           7
Home mortgages: Who borrows, how much has been
              borrowed, and who funds them?
                               ...
The mortgage problem in perspective

            80 million houses
               27 million are paid off

            53 ...
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 ...
Home price bubble
               Low interest rates
                                                                      ...
II. Homeownership, prices,
  starts and sales take off




                              13
Credit boom pushes                             Home price bubble                     California and national
     homeowne...
Housing starts hit                                                                      Homes sales reach
                ...
III. Subprime borrowers and
     subprime mortgages




                              16
Who is a subprime borrower?
 National FICO scores display wide distribution                              What goes into a ...
Prime and subprime mortgage originations
                            by FICO score reveal substantial overlaps
  Percent o...
ARMs look attractive to many borrowers
    Percent
    8.0

    7.0                                      30-year FRM rate
...
ARM share grows, following low interest rates
         Percent of all outstanding home mortgages
   25


   20


   15


 ...
Largest share of ARMs go to subprime borrowers
        Percent of mortgage type
       60
              FHA ARM Prime ARM ...
Subprimes take an increasing share
                     of all home mortgage originations
         US$ trillions
         ...
Subprime mortgages increase rapidly before big decline
                                                                   ...
IV. Mortgage product innovation




                                  24
Subprime and Alt-A shares quadruple between 2001
                    and 2006, then fall in 2007
                         ...
ARM hybrids dominate subprime originations (2006)

            Prime conventional                           Alt-A
        ...
V. Securitization




                    27
The mortgage model switches from
            originate-to-hold to originate-to-distribute
                Residential mort...
Securitization becomes the dominant funding
                  source for subprime mortgages
    Percent of all subprime mo...
The rise and fall of private-label securitizers
                                                            New securities...
The rise and fall of private-label securitizers
                                                          Outstanding secu...
VI. Affordability




                    32
Ratio of home                                Debt-to-income ratio                         Home mortgage share of
  price t...
VII. Collapse




                34
The recent run-up of home prices was extraordinary
Index, 2000 = 100
 250
                                                ...
Home prices don’t go up forever
                                             Change in home prices in 100 plus years
  Per...
2005: The collapse begins
 Home price indices, percent change on a year earlier
                                          ...
Forty-six states had falling prices
                            in the fourth quarter 2007
                       United S...
If you bought your house…
              One year ago…                                                                     ...
Housing starts                                     Homes sit longer                          … as home
       sharply decl...
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 e...
… their numbers have doubled
 Thousands of foreclosures per year
 2,150

 1,900
                                          ...
Subprime mortgages accounted for half
                          or more of foreclosures since 2006
     Number of home mor...
Subprime ARMs have the worst default record
  Home mortgages delinquent or in foreclosure (percent of number)
  35
       ...
Percentage of homes purchased in Q2 2008
                   that now have negative equity




      United States = 44.8%
...
Percentage of homes sold for a loss (Q2 2008)




      United States = 32.7%
                                  < 15%
    ...
Percentage of homes sold that were in
                             foreclosure (Q2 2008)




      United States = 18.6%
 ...
IX. Damages scorecard




                        49
Losses/write-downs, capital raised, and jobs cut
              by financial institutions worldwide
 US$ billions          ...
What is the cumulative damage?
   Cumulative losses/write-downs, capital raised, and jobs cut by financial institutions wo...
Recent losses/write-downs and capital raised
                     by selected financial institutions
              US$ bil...
Financial stock prices take big hits
     Percentage change in stock price, December 2006–September 2008
           -99.8 ...
Financial market capitalization takes big hit
   Total loss in market value: $728 billion, December 2006–September 2008
  ...
X. Credit crunch and liquidity freeze




                                        55
Tightened standards for real estate loans
  Net percentage of domestic respondents tightening standards for commercial rea...
Widening spreads between
                         mortgage-backed and high-yield bonds
      Basis points, spread over 10-...
Liquidity freeze
                                                            Spread between 3-month LIBOR and
          Sp...
Counterparty risk increases
    Basis points spread, basis points
    Average CDS
    500
                                ...
Commercial paper issuance dries up
  Quarterly change in outstanding amount, US$ billions
  150

   100

     50

      0
...
Federal Reserve responds by cutting Fed funds rate,
             but mortgage rates remain relatively flat
  Percent      ...
Congress and White House responses
 HOPE NOW
 The Economic Stimulus Act of 2008
 Housing and Economic Recovery Act of 2008...
XI. When will we hit bottom?




                               63
Looking for a bottom?
                     Economists say the economy isn’t at its low point yet,
                     and...
How far do home prices have to fall?
   Annual rents as percent of home prices
   6.5       Q2 1971: 6.08%
    6.0

    5....
Combinations of rental price growth rates and rent-to-price
  ratios to get home prices back to their Q4 2006 value

     ...
Alternative measures of the affordability of
                      mortgage debt for California
  US$/month
  4,000       ...
XII. What went wrong




                       68
Milken Institute - Mortgage Crisis Overview
Milken Institute - Mortgage Crisis Overview
Milken Institute - Mortgage Crisis Overview
Milken Institute - Mortgage Crisis Overview
Milken Institute - Mortgage Crisis Overview
Milken Institute - Mortgage Crisis Overview
Milken Institute - Mortgage Crisis Overview
Milken Institute - Mortgage Crisis Overview
Milken Institute - Mortgage Crisis Overview
Milken Institute - Mortgage Crisis Overview
Milken Institute - Mortgage Crisis Overview
Milken Institute - Mortgage Crisis Overview
Milken Institute - Mortgage Crisis Overview
Milken Institute - Mortgage Crisis Overview
Milken Institute - Mortgage Crisis Overview
Milken Institute - Mortgage Crisis Overview
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Milken Institute - Mortgage Crisis Overview

  1. 1. Demystifying the Mortgage Meltdown: What It Means for Main Street, Wall Street and the U.S. Financial System James R. Barth Glenn Yago Senior Fellow Director of Capital Studies Milken Institute October 2, 2008 1
  2. 2. “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
  3. 3. … 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
  4. 4. “Any real estate investment is a good investment … ” 4
  5. 5. “Any real estate investment is a good investment … ” … Really?! 5
  6. 6. Subprime mortgage meltdown timeline December 2006–September 2008 Dow Jones U.S. Financial Index Aug. 1, Aug. 16, 2007: Sept. 30, 2007: Oct. 24, 2007: Mar. 11, 2008: Fed Mar. 16, 2008: Mar. 18, 2008: 2008: First Countrywide gets NetBank goes Merrill announces offers troubled JP Morgan Fed cuts 650 Priority Feburary–March 2007: More than 25 emergency loan of bankrupt. $7.9 billion in banks as much as Chase offers to discount rate Bank subprime lenders declare $11 billion from a subprime write- $200 billion in buy Bear to 2.4%; Fed closes. bankruptcy. group of banks. downs, surpassing loans; Fed Stearns; Fed funds rate to Citi’s $6.5 billion. introduces Term introduces 2.25%. Sept. 14, 2008: Securities Primary Dealer Lehman files for Lending Facility. Credit Facility. 550 bankruptcy. July 30, 2008: Sept. 16, 2008: Dec. 2006: Apr. 2007: New Feb. 2007: President Fed loans AIG Ownit Mortgage, Century, a HSBC sets Bush signs a $85 billion. a subprime mortgage aside $10.6 Dec. 12, 2007: housing lender, files for broker, files billion for Fed introduces rescue law. 450 bankruptcy. for bad loans, Aug. 6, 2007: Sept. 23, 2008: Term Auction bankruptcy. including American Home Washington Facility. subprime. Mortgage files Mutual is seized Jan. 11, 2008: for bankruptcy. by FDIC. July 31, 2007: Bank of Two Bear America agrees June 9, 2008: Stearns Feb. 13, 2008: 350 to buy Sept. 29, 2008: Lehman hedge funds President Bush Countrywide. Aug. 17, 2007: Fed cuts Citigroup announces a $2.8 file for introduces tax discount rate to 5.75%; agrees to buy billion loss. bankruptcy. Sept. 7, 2008: U.S. rebate stimulus Jan. 30, 2008: Fed Fed introduces Term Wachovia bank. seizes Fannie Mae program of $168 cuts discount rate Discount Window July 11, 2008: IndyMac and Freddie Mac. billion. to 3.5%. Program. is seized by FDIC. 250 Sources: BusinessWeek, S&P, Global Insight, Milken Institute. 6
  7. 7. Overview 7
  8. 8. Home mortgages: Who borrows, how much has been borrowed, and who funds them? Total value of housing stock = $19.3 trillion Subprime Securitized 8.4% Government- 58% Mortgage debt controlled $10.6 trillion 46% Prime 91.6% Non-securitized Private sector- 42% controlled 54% Equity in housing stock $8.7 trillion Note: total residential and commercial mortgages = $14.7 trillion; 5 percent = $700 billion Sources: Federal Reserve, Milken Institute. 8
  9. 9. The mortgage problem in perspective 80 million houses 27 million are paid off 53 million have mortgages 48 million are paying on time This compares to 50% seriously delinquent in the 1930s. 5 million are behind (9.2% of 53 million with 2.8% in foreclosure) Sources: U.S. Treasury, Milken Institute. 9
  10. 10. I. Low interest rates and a lending boom 10
  11. 11. Did the Fed lower interest rates too much and for too long? Federal funds rate vs. rates on FRMs and ARMs Percent 8 30-year FRM rate 7 6 5 4 Target federal funds rate 3 1-year ARM rate 2 Record low from June 25, 1 2003, to June 30, 2004: 1% 0 2001 2002 2003 2004 2005 2006 2007 2008 Sources: Federal Reserve, Mortgage Bankers Association, Moody’s Economy.com, Milken Institute. 11
  12. 12. Home price bubble Low interest rates and credit boom and credit boom Index, January 2000 = 100 US$ trillions Percent US$ trillions 4.5 6.0 4.0 250 4.0 3.5 5.5 200 3.5 3.0 3.0 5.0 2.5 150 2.5 Home 4.5 2.0 Home mortgage 2.0 mortgage 100 originations 1.5 S&P/Case-Shiller 1.5 4.0 originations (left axis) National Home (left axis) 1.0 1.0 Price Index 1-Year ARM rate 50 3.5 (right axis) (right axis) 0.5 0.5 0.0 3.0 0.0 0 2001 2003 2005 2007 2001 2003 2005 2007 Sources: Inside Mortgage Finance, Mortgage Bankers Association, Moody’s Economy.com, S&P/Case-Shiller, Milken Institute. 12
  13. 13. II. Homeownership, prices, starts and sales take off 13
  14. 14. Credit boom pushes Home price bubble California and national homeownership rate peaks in 2006 home prices reach to historic high record highs Index, January 1987 = 100 Percent US$ thousands 70 380 Q2 2008: 68.1% 700 S&P/ California m e dian Cas e -Shille r Q2 2004: 69.2% 330 69 600 hom e price National Hom e Price Inde x California 500 280 68 ave rage 400 1987-2008 U.S. m e dian 230 67 hom e price $229,748 300 180 66 200 130 OFHEO Hom e Price Inde x 65 100 Ave rage , 1965–Q2 2008: 65.2% U.S. ave rage , 1987-2008: $121,280 80 64 0 1998 2000 2002 2004 2006 2008 1998 2000 2002 2004 2006 2008 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. 14
  15. 15. Housing starts hit Homes sales reach Homes for sale a record in 2005 a new high Millions Millions Millions Millions Housing units, millions 4 0.8 7.0 1.5 2.0 Existing homes for Exis ting hom e January 2006: 1.8 m illion sale (left axis) s ale s (le ft axis ) 5.6 1.2 3 0.6 1.5 4.2 0.9 2 0.4 1.0 Ave rage s tarts , 2.8 0.6 1959–July 2008: 1.1 m illion Ne w hom e s ale s (right axis ) 1 0.2 0.5 1.4 0.3 New homes for July 2008: 641,000 sale (right axis) 0.0 0.0 0 0.0 0.0 1998 2000 2002 2004 2006 2008 1998 2000 2002 2004 2006 2008 1998 2000 2002 2004 2006 2008 Sources: U.S. Census Bureau, OFHEO, Moody’s Economy.com, Milken Institute. 15
  16. 16. III. Subprime borrowers and subprime mortgages 16
  17. 17. 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% New credit 30 27 Payment history 10% 35% Subprime = 21% 18 20 15 Length of 13 12 credit history 8 10 15% 5 2 0 Amounts owed up to 500- 550- 600- 650- 700- 750- 800+ 499 549 599 649 699 749 799 30% Sources: myFICO.com, Milken Institute. 17
  18. 18. Prime and subprime mortgage originations by FICO score reveal substantial overlaps Percent of total originations FICO below 620 FICO above 620 20 Prime: 6.6% Prime: 93.4% Subprime: 45.2% Subprime: 54.8% 16 Prime 12 Subprime 8 4 0 59 79 99 19 39 59 79 99 19 39 59 79 99 19 39 59 79 99 00 -4 -4 -4 -5 -5 -5 -5 -5 -6 -6 -6 -6 -6 -7 -7 -7 -7 -7 -9 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 46 48 50 52 54 56 58 60 62 64 66 68 70 72 74 76 78 80 FICO score Sources: LoanPerformance, Milken Institute. 18
  19. 19. 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
  20. 20. 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
  21. 21. 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
  22. 22. Subprimes take an increasing share of all home mortgage originations US$ trillions 8.4% 4.0 Subprime 21.3% Prime 7.4% 20.1% 18.2% 3.0 Subprime's share: 7.9% 7.8% 2.0 1.0 0.9% 0.0 2001 2002 2003 2004 2005 2006 2007 Q2 2008 Sources: Inside Mortgage Finance, Milken Institute. 22
  23. 23. Subprime mortgages increase rapidly before big decline Outstandings Originations US$ billions US$ billions 1,400 Average annual growth rates 700 1,240 1995–2006: 14% 1,200 625 600 2006–Q1 2008: -23% 1,200 600 540 973 940 1,000 895 500 800 699 400 310 574 600 300 479 200 191 400 200 160 200 100 14 0 0 2001 2002 2003 2004 2005 2006 2007 Q1 2001 2002 2003 2004 2005 2006 2007 Q2 H2 2008 2008 2008 Sources: Inside Mortgage Finance, Milken Institute. 23
  24. 24. IV. Mortgage product innovation 24
  25. 25. Subprime and Alt-A shares quadruple between 2001 and 2006, then fall in 2007 Q1 2008, $480 billion 2006, $3.0 trillion 2007, $2.4 trillion 2001, $2.2 trillion 9% 4% 4.9% 9.6% 2.7% 5% 2% 14% 14% 7.9% 2% 33.2% 7% 8% 11% 13% 8% 20% 47.3% 67.2% 16% 57.1% 14% 20% p Subprime FHA & VA Alt-A Conventional, conforming prime Home equity loans Jumbo prime Sources: Inside Mortgage Finance, Milken Institute. 25
  26. 26. ARM hybrids dominate subprime originations (2006) Prime conventional Alt-A Subprime Other Other Fixed Othe r ARM ARM 9% ARM 7% 4% 23% ARM 30-year hybrids ARM balloon with 40- to 23% 50-year amortization 26% ARM hybrids 2- and 3-year Fixed Fixe d 46% hybrids 61% 31% 70% Sources: Freddie Mac, Milken Institute. 26
  27. 27. V. Securitization 27
  28. 28. The mortgage model switches from originate-to-hold to originate-to-distribute Residential mortgage loans Residential mortgage loans 1980: Total = $958 billion Q2 2008: Total = $11.3 trillion Securitized 15.6% Held in portfolio 41% Held in Securitized 59% portfolio 84.4% Sources: Federal Reserve, Milken Institute. 28
  29. 29. Securitization becomes the dominant funding source for subprime mortgages Percent of all subprime mortgages securitized since 1994 80 68 68 68 65 70 62 57 60 50 47 50 45 45 43 42 40 40 33 31 29 30 20 10 0 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Q1 Q2 2008 2008 Sources: Inside Mortgage Finance, Milken Institute. 29
  30. 30. The rise and fall of private-label securitizers New securities issuance 4% 2% 15% 6% 13% 20% 42% 56% 21% 18% 1985 2001 2006 First half 2008 Total = $110B Total = $1.3T Total = $2.0T Total = $734B 33% 29% 22% 35% 46% 38% Ginnie Mae Freddie Mac Fannie Mae Private-label Sources: Inside Mortgage Finance, Milken Institute. 30
  31. 31. The rise and fall of private-label securitizers Outstanding securities 7% 7% 6% 14% 18% 30% 35% 25% 13% 55% 26% 1985 2001 2006 First half 2008 Total = $3.3T Total = $390B Total = $5.9T Total = $6.8T 26% 39% 29% 33% 37% Ginnie Mae Freddie Mac Fannie Mae Private-label Sources: Inside Mortgage Finance, Milken Institute. 31
  32. 32. VI. Affordability 32
  33. 33. Ratio of home Debt-to-income ratio Home mortgage share of price to household of households has household debts reaches income surges increased rapidly a new high in 2007 Home mortgage debt/disposable Percent Median home price/ Q2 2007: 73.7% personal income 75 median household income Q4 2007: 139.5% 150 5.0 2005: 4.69 4.5 70 125 Q2 2008: 73.4% 4.0 2007: 4.29 3.5 Average, 1957–2007: 79.7% 65 100 3.0 Average, 1952–2008: 64.2% Average, 1967–2007: 3.38 2.5 75 60 1998 2001 2004 2007 1998 2001 2004 2007 1998 2001 2004 2007 Sources: U.S. Census Bureau, OFHEO, Federal Reserve, Moody’s Economy.com, Milken Institute. 33
  34. 34. VII. Collapse 34
  35. 35. The recent run-up of home prices was extraordinary Index, 2000 = 100 250 Current Annualized growth rate of nominal home index: 3.4% boom Great 200 Depression World World 1970’s 1980’s War I 150 War II boom boom 100 50 Long-term trend line 0 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 Sources: Robert Shiller, Milken Institute. 35
  36. 36. 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 1970’s 1980’s Current Depression War II War I Boom Boom Boom 25 20 Average, 1890–2007: 3.7% 15 10 5 0 -5 -10 +/- one standard deviation -15 -20 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 Sources: Robert Shiller, Milken Institute. 36
  37. 37. 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 2000 2002 2004 2006 2008 Sources: S&P/Case-Shiller, OFHEO, Moody’s Economy.com, Milken Institute. 37
  38. 38. Forty-six states had falling prices in the fourth quarter 2007 United States: - 9.3% (fourth-quarter annualized growth) Source: Freddie Mac. 38
  39. 39. If you bought your house… One year ago… Five years ago… -1.0 Charlotte 48.4 Seattle -3.2 Dallas 48.0 Portland -4.7 Denver 28.2 Washington -5.2 Boston 27.9 New York -5.8 Portland Phoenix 26.8 -7.1 Seattle Los Angeles 26.3 -7.3 New York 26.3 Tampa -7.3 Cleveland Miami 26.0 -8.1 Atlanta Las Vegas 24.4 -9.5 Chicago Charlotte 22.9 -13.9 Minneapolis 20.5 Composite 10 -15.7 W ashington Composite 20 18.6 -15.9 Composite 20 Chicago 14.3 -16.3 Detroit 9.1 San Francisco -17.0 Composite 10 6.6 Atlanta -20.1 Tampa Dallas 6.5 -23.7 San Francisco San Diego 6.1 -24.2 San Diego 5.9 Boston -25.3 Los Angeles Denver 4.8 -27.9 Phoenix Minneapolis -0.7 -28.3 Miami Cleveland -3.8 -28.6 Las Vegas -21.3 Detroit % change in price, June 07-08 % change in price, June 03-08 Sources: S&P/Case-Shiller, Milken Institute. 39
  40. 40. Housing starts Homes sit longer … as home sharply decline on the market … appreciation slows Percent Months Number of months that Percent change, year ago 30 homes sit on the market Pe rce ntage change from 20 0 ye ar ago in m e dian 12 Existing homes 15 hom e s ale s price 2 (le ft axis ) 10 10 0 4 8 -15 0 6 6 -30 8 4 -10 June 2008: -41.9% Num be r of m onths -45 10 July 2008: -39.2% 2 hom e s s tay on New homes m ark e t (right axis ) -60 -20 12 0 1998 2000 2002 2004 2006 2008 1999 2001 2003 2006 2008 1998 2000 2002 2004 2006 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
  41. 41. VIII. Delinquencies and foreclosures 41
  42. 42. 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 900 650 400 99 99 00 00 01 01 02 02 03 03 04 04 05 05 06 06 07 07 08 19 19 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 2 4 2 4 2 4 2 4 2 4 2 4 2 4 2 4 2 4 2 Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Sources: Mortgage Bankers Association, Milken Institute. 42
  43. 43. … 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 900 650 400 99 99 00 00 01 01 02 02 03 03 04 04 05 05 06 06 07 07 08 19 19 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 2 4 2 4 2 4 2 4 2 4 2 4 2 4 2 4 2 4 2 Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Sources: Mortgage Bankers Association, Milken Institute. 43
  44. 44. 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 Subprime serviced (M arch 2008) FHA and VA 1,600 50% Prime (includes Alt-A) 54% 1,200 56% 8% 55% 800 9% 37% 37% 36% 44% 47% 52% 42% 11% 37% 400 13% 29% 29% 29% 22% 20% 17% 33% 31% 32% 34% 34% 35% 34% 33% 0 Dec. 2003 June Dec. 2004 June Dec. 2005 June Dec. 2006 June Dec. 2007 M arch 2004 2005 2006 2007 2008 Sources: Inside Mortgage Finance, Milken Institute. 44
  45. 45. 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 Q1 Q4 Q3 Q2 Q1 Q4 Q3 Q2 Q1 Q4 Q3 Q2 Q1 1998 1999 1999 2000 2001 2002 2002 2003 2004 2005 2005 2006 2007 2008 Sources: Mortgage Bankers Association, Milken Institute. 45
  46. 46. 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
  47. 47. 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
  48. 48. 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
  49. 49. IX. Damages scorecard 49
  50. 50. Losses/write-downs, capital raised, and jobs cut by financial institutions worldwide US$ billions Number of jobs cut 200 60,000 Jobs cut (right axis) 160 48,000 Capital raised 120 36,000 (left axis) 80 24,000 Losses/write-downs (left axis) 40 12,000 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. 50
  51. 51. What is the cumulative damage? Cumulative losses/write-downs, capital raised, and jobs cut by financial institutions worldwide US$ billions Number of jobs cut 600 140,000 120,000 500 Jobs cut (right axis) 100,000 400 80,000 Capital raised (left axis) 300 60,000 Losses/write-downs (left axis) 200 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
  52. 52. 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
  53. 53. Financial stock prices take big hits Percentage change in stock price, December 2006–September 2008 -99.8 W ashington Mutual -99.7 Lehman Brothers -97.5 Freddie Mac -97.4 Fannie Mae -95.4 AIG -94.3 Bear Stearns* -93.9 W achov ia -90.0 Countrywide** -72.8 Merrill Lynch -66.0 Morgan Stanley -65.6 UBS Equity -35.8 Goldman Sachs -34.4 Bank of America -3.3 JP Morgan & Chase 5.5 W ells Fargo Note: * Bear Stearns stock price is to May 2008. ** Countrywide stock price is to June 2008. Sources: Bloomberg, Milken Institute. 53
  54. 54. Financial market capitalization takes big hit Total loss in market value: $728 billion, December 2006–September 2008 -142 AIG -101 W achov ia -80 Bank of America -74 UBS Equity -60 Morgan Stanley -50 Fannie Mae -44 Merrill Lynch -43 W ashington Mutual -42 Freddie Mac -41 Lehman Brothers -28 Goldman Sachs -24 Countrywide** -21 Bear Stearns* 4 W ells Fargo 17 JP Morgan & Chase US$ billions Note: * Bear Stearns stock price is to May 2008. ** Countrywide stock price is to June 2008. Sources: Bloomberg, Milken Institute. 54
  55. 55. X. Credit crunch and liquidity freeze 55
  56. 56. Tightened standards for real estate loans Net percentage of domestic respondents tightening standards for commercial real estate loans 100 The end of S&L crisis 80 Dotcom Subprime LTCM 60 40 20 0 -20 -40 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 Sources: Federal Reserve, Milken Institute. 56
  57. 57. 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
  58. 58. Liquidity freeze Spread between 3-month LIBOR and Spread between 3-month LIBOR overnight index swap rate and T-bill rate Basis points Basis points 350 140 Se pte m be r 18, 2008: 313 bps Se pte m be r 19, 2008: 300 127.5 bps 120 Augus t 20, 2007: 240 bps 250 100 Ave rage s ince Augus t 2007: 69.8 bps 80 200 Ave rage s ince 60 150 Augus t 2007: 130 bps 40 Ave rage s ince Ave rage s ince 100 De ce m be r 2001: 21.1 bps 1985: 76 bps 20 50 0 0 2006 2007 2008 2006 2007 2008 Sources: Bloomberg, Milken Institute. 58
  59. 59. Counterparty risk increases Basis points spread, basis points Average CDS 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 07/2008 09/2008 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. 59
  60. 60. 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
  61. 61. Federal Reserve responds by cutting Fed funds rate, but mortgage rates remain relatively flat Percent Percent 10 5.0 9 4.5 Freddie Mac 30-year FRM rate (left axis) (left axis) 30-year fixed mortgage rate 8 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 0.0 01/2007 03/2007 06/2007 09/2007 12/2007 02/2008 05/2008 08/2008 Sources: Freddie Mac, Federal Reserve, Moody’s Economy.com, Milken Institute. 61
  62. 62. Congress and White House responses HOPE NOW The Economic Stimulus Act of 2008 Housing and Economic Recovery Act of 2008 Conservatorship of Fannie Mae and Freddie Mac Temporary guaranty program for money market funds Temporary ban on short selling in selected companies Bailout package? 62
  63. 63. XI. When will we hit bottom? 63
  64. 64. 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 When will home prices hit bottom? to a downturn? 1st half Yes 6% 2010 27% 2nd half 29% 2009 1st half 38% 2009 2nd half 17% 2008 No 73% 1st half 4% 2008 Source: Wall Street Journal. 64
  65. 65. 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: 4.5 3.93% Average, 1960–Q1 2008: 5.04% 4.0 Average, 2000–Q1 2008: 4.06% 3.5 Q4 2006: 3.48% 3.0 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 Sources: Davisa, Lehnertb, Martin (2007), Milken Institute. 65
  66. 66. Combinations of rental price growth rates and rent-to-price ratios to get home prices back to their Q4 2006 value Annual home price price decline Annual home decline required -2.0% -5.0% -10.0% -15.0% -20.0% 3.80% 2010 Q3 2008 Q4 2008 Q2 2008 Q2 2008 Q2 Rent-to-price ratio 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% 2024 Q3 2014 Q2 2010 Q4 2009 Q3 2009 Q1 average 6.00% 2026 Q4 2017 Q3 2012 Q3 2010 Q4 2009 Q4 Sources: Davisa, Lehnertb, Martin (2007), Milken Institute. 66
  67. 67. Alternative measures of the affordability of mortgage debt for California US$/month 4,000 Payment with 100% LT V Payment with 90% LT V 3,500 Payment with 80% LT V 3,000 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% 2,500 LT V. Payment also includes 1% property tax per year, 0.1% property insurance. 2,000 1,500 1,000 Maximum affortablility limit is 500 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
  68. 68. XII. What went wrong 68
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