16193713 T2 Partners Presentation On The Mortgage Crisis

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  • 1. An Overview Of The Housing/Credit Crisis And Why There Is More Pain To Come T2 Accredited Fund, LP Tilson Offshore Fund, Ltd. T2 Qualified Fund, LP June 2, 2009
  • 2. T2 Partners Management L.P. Is A Registered Investment Advisor 145 E. 57th Street 10th Floor New York, NY 10022 (212) 386-7160 Info@T2PartnersLLC.com www.T2PartnersLLC.com
  • 3. For more information… 3
  • 4. More Mortgage Meltdown Has Just Been Released and Is the #1 Selling Investing Book in the Country 4
  • 5. The Next Value Investing Congress is October 19-20 in New York City Register at www.valueinvestingcongress.com 5
  • 6. Value Investor Insight and SuperInvestor Insight 6
  • 7. For the Second Half of the 20th Century, Housing Was a Stable Investment 300 Shiller Lawler 275 Real Home Price Index (1890=100) 250 225 200 175 Trend Line 150 125 100 0 4 8 2 6 0 4 8 2 6 0 4 8 5 5 5 6 6 7 7 7 8 8 9 9 9 19 19 19 19 19 19 19 19 19 19 19 19 19 Source: Robert J. Shiller, Irrational Exuberance, Princeton University Press 2000, Broadway Books 2001, 2nd edition, 2005, also Subprime Solution, 2008, as updated by the author at http://www.econ.yale.edu/~shiller/data.htm; Lawler Economic & Housing Consulting 7
  • 8. …And Then Housing Prices Exploded 300 Shiller Lawler 275 Real Home Price Index (1890=100) 250 225 200 Housing Bubble 175 Trend Line 150 125 100 86 94 02 62 70 78 98 06 82 90 66 74 50 4 58 5 20 19 19 19 19 20 19 19 19 19 19 19 19 19 19 SOURCES: Robert J. Shiller, Irrational Exuberance: Second Edition, as updated by the author; Lawler Economic & Housing Consulting. 8
  • 9. From 2000-2006, the Borrowing Power of a Typical Home Purchaser Nearly Tripled $400,000 Pre-Tax Income Borrowing Power $300,000 $200,000 9.2x in January 2006 $100,000 3.3x in January 2000 $0 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Factors contributing to the ability to borrow more and more were: 1. Slowly rising income 2. Lenders being willing to allow much higher debt-to-income ratios 3. Falling interest rates 4. Interest-only mortgages (vs. full amortizing) 5. No money down Source: Amherst Securities 9
  • 10. Housing Became Unaffordable in Many Areas 80 Riverside, CA 70 Los Angeles, CA San Diego, CA 60 Housing Opportunity Index 50 40 30 20 10 0 96 97 98 99 00 1 05 06 07 02 04 0 20 20 20 19 20 20 19 20 19 19 20 3 3 3 1 3 1 1 1 1 1 1 Q Q Q Q Q Q Q Q Q Q Q SOURCES: NAHB/Wells Fargo Housing Opportunity Index, which measures percentage of households that could afford the average home with a standard mortgage 10
  • 11. Americans Have Borrowed Heavily Against Their Homes Such That the Percentage of Equity in Their Homes Has Fallen Below 50% for the First Time on Record Since 1945 $12,000 90% 80% $10,000 70% Equity as a % of Home Value $8,000 60% Mortgage Debt (Bn) 1945 50% $6,000 Mortgage Debt: $18.6 billion Equity: $97.5 billion 2008 40% Mortgage Debt: $10.5 trillion Equity: $8.5 trillion $4,000 30% 20% $2,000 10% $0 0% 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 SOURCE: Federal Reserve Flow of Fund Accounts of the United States 11
  • 12. There Was a Dramatic Decline in Mortgage Lending Standards from 2001 through 2006 Combined Loan to Value 100% Financing 86 18% 84 17% • In 2005, 29% of 84 83 16% new mortgages 82 81 81 14% 14% were interest only 80 12% — or less, in the Combined Loan to Value (%) Percent of Originations 78 10% 9% case of Option 76 76 8% 8% ARMs — vs. 1% 74 74 74 6% in 2001 72 4% 3% • In 1989, the 70 2% 1% average down 1% 68 2001 2002 2003 2004 2005 2006 2007 0% payment for first- 2001 2002 2003 2004 2005 2006 2007 time home buyers Limited Documentation 100% Financing & Limited Doc was 10%; by 70% 12% 2007, it was 2% 65% 63% 11% 60% • The sale of new 10% 56% homes costing 49% 50% 45% 8% 8% $750,000 or more quadrupled from Percent of Originations Percent of Originations 40% 39% 33% 6% 5% 2002 to 2006. 30% 4% The construction 4% 20% of inexpensive 2% 1% homes costing 10% 0% $125,000 or less 0% 0% 2001 2002 2003 2004 2005 2006 2007 0% 2001 2002 2003 2004 2005 2006 2007 fell by two-thirds SOURCES: Amherst Securities, LoanPerformance; USA Today (www.usatoday.com/money/economy/housing/2008-12-12-homeprices_N.htm) 12
  • 13. Among the Many Causes of The Great Mortgage Bubble, Two Stand Out • The companies making crazy loans didn’t care very much if the homeowner ended up defaulting for two reasons: 1. Either they didn’t plan to hold the loan, but instead intended to pass it along to Wall Street, which would bundle, slice-and-dice it and sell it (along with any subsequent losses) to investors around the world; 2. Or, if they did plan to hold the loan, they assumed home prices would keep rising, such that homeowners could either refinance before loans reset or, if the homeowner defaulted, the losses (i.e., severity) would be minimal. • There were many other reasons, of course – a bubble of this magnitude requires what Charlie Munger calls “Lollapalooza Effects” – The entire system – real estate agents, appraisers, mortgage lenders, banks, Wall St. firms and ratings agencies – became corrupted by the vast amounts of quick money to be made – Regulators and politicians were blinded by free market ideology or the dream that all Americans should own their homes, causing them to fall asleep at the switch, not want to take the punch bowl away and/or get bought off by the industries they were supposed to be overseeing – Debt became increasingly available and acceptable in our culture – Millions of Americans became greedy speculators and/or took on too much debt – Greenspan kept interest rates too low for too long – Institutional investors stretched for yield, didn’t ask many questions and took on too much leverage – In general, everyone was suffering from irrational exuberance 13
  • 14. As Long As Home Prices Rise Rapidly, Even Subprime Mortgages Perform Well – But If Home Prices Fall, Look Out Below! Cumulative Five-Year Loss Estimates for a Bubble-Era Pool of Subprime Mortgages 60% 50% 40% Cumulative Loss (%) 30% 20% 10% 0% 20% 15% 10% 5% 0% -5% -10% -15% -20% -25% -30% -35% -40% Home Price Appreciation Source: T2 Partners estimates 14
  • 15. Deregulation of the Financial Sector Led to a Surge of Leverage, Profits and Compensation Ratio of Financial Services Wages to Nonfarm Private-Sector Wages, 1910-2006 • Among the most profitable areas for Wall Street firms was producing Asset-Backed Securities (ABSs) and Collateralized Debt Obligations (CDOs) • To produce ABSs and CDOs, Wall Street needed a lot of loan “product” • Mortgages were a quick, easy, big source • It is easy to generate higher and higher volumes of mortgage loans: simply lend at higher loan-to-value ratios, with ultra-low teaser rates, to uncreditworthy borrowers, and don’t bother to verify their income and assets (thereby inviting fraud) • There’s only one problem: DON’T EXPECT TO BE REPAID! Source: Ariell Reshef, University of Virginia; Thomas Philippon, NYU; Wall St. Journal, 5/14/09 15
  • 16. Over the Past 30 Years, We Have Become a Nation Gorged in Debt – To The Benefit of Financial Services Firms 3.0% 350% Low Debt Era Rising Debt Era Financial Profits as Percent of GDP 2.5% Total Debt as Percent of GDP 300% 2.0% 250% 1.5% Total Debt Financial Profits 200% 1.0% 150% 0.5% 0.0% 100% Dec- 51 54 57 60 63 66 69 72 75 78 81 84 87 90 93 96 99 02 05 Sources: Federal Reserve, BEA, as of Q2 2007, GMO presentation 16
  • 17. There Was a Surge of Toxic Mortgages Over the Past 10 Years $4,000 Conforming, FHA/VA Jumbo $3,500 Alt-A Subprime Seconds $3,000 $2,500 Originations (Bn) $2,000 $1,500 $1,000 $500 $0 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 SOURCE: Inside Mortgage Finance, published by Inside Mortgage Finance Publications, Inc. Copyright 2009. 17
  • 18. Private Label Mortgages (Those Securitized by Wall St.) Are 15% of All Mortgages, But Are 51% of Seriously Delinquent Mortgages Approximately two-thirds of homes have mortgages and of these, 56% are owned or guaranteed by the two government-sponsored enterprises (GSEs), Fannie & Freddie Number of Seriously Number of Mortgages (million) Delinquent Mortgages (000) Banks & Thrifts Banks & Thrifts 397 Fannie Mae 8 444 Fannie Mae Freddie Mac 18 232 Private Label 15% 8 Ginne Mae/FHA 378 Ginne Mae/FHA 6 Private Label Freddie Mac 1734 13 51% SOURCE: Freddie Mac, Q4 2008. 18
  • 19. Percentage of Home Loans Q 4 Q 19 0.0% 1.0% 2.0% 3.0% 4.0% 5.0% 6.0% 7.0% 8.0% 9.0% 10.0% 4 7 Q 19 9 4 80 Q 19 4 8 Q 19 1 4 82 Q 19 4 8 Q 19 3 4 84 Q 19 4 8 Q 19 5 4 86 Q 19 4 87 Q 19 4 88 Q 19 4 89 Q 1 99 4 0 Q 19 4 91 Q 19 4 92 Q 19 4 93 Q 19 4 9 Q 19 4 4 95 Q 19 4 9 Q 19 6 4 97 Q 19 4 9 Q 19 8 4 99 Q 20 4 0 Q 20 0 4 01 Q 20 4 0 Over 9% of Mortgages on 1-to-4-Family Homes Q 20 2 4 03 Were Delinquent or in Foreclosure as of Q1 2009 Q 20 4 0 Q 20 4 4 05 SOURCE: National Delinquency Survey, Mortgage Bankers Association. Note: Delinquencies (60+ days) are seasonally adjusted. Q 20 4 06 Q 2 00 4 7 20 08 19
  • 20. All Types of Loans, Led by Subprime, Are Seeing a Surge in Delinquencies 45% Alt A Option ARM 40% Jumbo Subprime 35% Prime Home Equity Lines of Credit 30% Percent Noncurrent 25% 20% 15% 10% 5% 0% Q 01 Q 01 Q 99 Q 99 Q 00 Q 00 Q 02 Q 03 Q 03 Q 04 Q 04 Q 05 Q 06 Q 06 Q 07 Q 08 08 Q 07 Q 02 Q 05 20 20 20 20 20 20 20 20 20 20 20 19 19 20 20 20 20 20 20 20 3 1 1 3 3 1 1 3 1 3 3 3 1 3 1 3 1 3 1 1 Q SOURCES: Amherst Securities, LoanPerformance; National Delinquency Survey, Mortgage Bankers Association; FDIC Quarterly Banking Profile; T2 Partners estimates. Note: Prime is seasonally adjusted. 20
  • 21. The Decline in Lending Standards Led to a Surge in Subprime Mortgage Origination $700 25% $600 20% 20% 20% 18% % of $500 T ota l Origina tions (Bn) 15% $400 $300 10% 10% 10% 10% 10% 9% 9% 9% 8% $200 7% 8% 7% 5% $100 $0 0% 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Source: Reprinted with permission; Inside Mortgage Finance, published by Inside Mortgage Finance Publications, Inc. Copyright 2009. 21
  • 22. The Wave of Resets from Subprime Loans Is Mostly Behind Us $35 $30 We are here $25 Loans with Payment Shock (Bn) $20 $15 $10 $5 $0 07 7 0 6 08 09 7 0 6 8 8 09 10 0 6 7 9 06 8 9 -0 -0 -1 -0 l-0 l-0 l-1 l-0 r-0 -0 -0 -1 -0 l-0 n- n- n- r- n- n- ct pr pr pr ct ct ct ct Ju Ju Ju Ju Ju Ap Ap Ja Ja Ja Ja Ja O O O O O A A A Sources: LoanPerformance, Deutsche Bank; slide from Pershing Square presentation, How to Save the Bond Insurers, 11/28/07. 22
  • 23. Numerous Areas of the Mortgage Market Will Suffer Significant Losses Going Forward Prime Mortgage Commercial Real Estate Alt-A Other Corporate Commercial & Industrial Subprime High-Yield / Leveraged Loans Jumbo Prime Home Equity Credit Card Auto Option ARM Construction & Development Other Consumer CDO/ CLO $0.0 $0.5 $1.0 $1.5 $2.0 $2.5 $3.0 $3.5 $4.0 $4.5 $5.0 Amount Outstanding (Trillions) SOURCES: Federal Reserve Flow of Funds Accounts of the United States, IMF Global Financial Stability Report October 2008, Goldman Sachs Global Economics Paper No. 177, FDIC Quarterly Banking Profile, OFHEO, S&P Leverage Commentary & Data, T2 Partners estimates. 23
  • 24. Two Waves of Losses Are Behind Us… But Three Are Looming Losses Mostly Behind Us • Wave #1: Borrowers committing (or the victim of) fraud & speculators, who defaulted quickly. Timing: beginning in late 2006 (as soon as home prices started to fall) into 2008. Mostly behind us. • Wave #2: Borrowers who defaulted when their mortgages reset due to payment shock. Timing: early 2007 (as two-year teaser subprime loans written in early 2005 started to reset) to the present. Now tapering off as low interest rates mitigate payment shock. Losses Mostly Ahead of Us • Wave #3: Prime loans (most of which are owned or guaranteed by the GSEs) defaulting due to job loss and home price declines (i.e., underwater homeowners). Timing: started to surge in early 2008 to the present. • Wave #4: Jumbo prime, second lien and HELOCs (most of which are on banks’ books) defaulting due to job loss and home price declines/ underwater homeowners. Timing: started to surge in early 2008 to the present. • Wave #5: Losses among loans outside of the housing sector, the largest of which will be in the $3.5 trillion area of commercial real estate. Timing: started to surge in early 2008 to the present. 24
  • 25. Recent Signs of Stabilization Are Likely the Mother of All Head Fakes • Rather than representing a true bottom, recent signs of stabilization are likely due to two short-term factors: 1. Home sales and prices are seasonally strong in April, May and June due to tax refunds and the spring selling season 2. A temporary reduction in the inventory of foreclosed homes – Shortly after Obama was elected, his administration promised a new, more robust plan to stem the wave of foreclosures so the GSEs and many other lenders imposed a foreclosure moratorium – Early this year, the Obama administration unveiled its plan, the Homeowner Affordability and Stabilization Plan, which is a step in the right direction – but even if it is hugely successful, we estimate that it might only save 20% of homeowners who would otherwise lose their homes – The GSEs and other lenders are now quickly moving to save the homeowners who can be saved – and foreclose on those who can’t – This is necessary to work our way through the aftermath of the bubble, but will lead to a surge of housing inventory later this year, which will further pressure home prices 25
  • 26. There Is a Surge of Notices of Default and Foreclosures Among the GSEs Prime Notices of Default Subprime Notices of Default Subprime Foreclosures Prime Foreclosures SOURCE: The Field Check Group. 26
  • 27. Future Losses Will Be Driven By Three Primary Factors 1. The Economy • Especially unemployment 2. Interest rates • Ultra-low rates have helped mitigate some of the damage • But if the recent spike in rates continues, it could lead to an even greater surge in defaults and losses 3. Behavior of homeowners who are underwater • Roughly one-fourth of homeowners with mortgages are currently underwater, some deeply so • For many, it is economically rational for them to walk – so called “jingle mail” – but how many will do so? • There is little historical precedent – we are in uncharted waters • As home prices continue to fall and homeowners become more and more underwater, they are obviously more likely to default, thereby creating a vicious cycle, but what exactly will the relationship be? Have millions of foreclosures led to a diminution of the stigma of losing one’s home? • Our best guess is that there will be rough symmetry: for homeowners 5% underwater, an additional 5% will default due to being underwater; 10% underwater will lead to 10% more defaults, and so forth… 27
  • 28. 24% of Homeowners With a Mortgage Owe More Than the Home Is Worth, Making Them Much More Likely to Default Among people who bought homes in the past five years, 30%+ are underwater* In Bubble Markets, Far More Homeowners Are Underwater Price Index Is % of Last 5 Yrs at Lowest Price Drop Purchasers Who Metro Area Level Since Since Peak Are Under Water* There Has Been a Dramatic Rise in New York 2004-Q3 -15.2% 23.0% Homeowners Who Are Underwater Los Angeles 2003-Q4 -32.0% 56.4% Boston 2002-Q2 -21.8% 27.8% 25% 24% Washington 2004-Q1 -24.8% 50.3% Miami 2004-Q1 -36.6% 65.1% San Francisco 2003-Q3 -27.8% 51.2% 20% Atlanta 2004-Q4 -10.4% 23.2% 20% San Diego 2002-Q4 -34.4% 63.9% Phoenix 2004-Q3 -37.7% 36.4% 16% Las Vegas 2003-Q4 -41.8% 61.4% Percent Underwater 15% * The actual figures are likely even worse, as this data doesn’t capture people who bought since 2003 and subsequently did a 10% cash-out refi or after-the-fact second mortgage. 50% of all subprime and Alt-A 6% loans in existence when the collapse 5% 4% happened were cash-out refis that carried a higher loan balance than the original 0% purchase loan amount. Dec-06 Dec-07 Sep-08 Dec-08 Mar-09 Source: Zillow.com Q4 08 Real Estate Market Report; Moody's Economy.com, First American CoreLogic, T2 Partners estimates 28
  • 29. Certain Types of Loans Are Severely Underwater 80% 73% 70% 60% 50% Percent Underwater 50% 45% 40% 30% 25% 20% 10% 0% Prime Alt A Subprime Option ARM SOURCES: Amherst Securities, LoanPerformance, Standard & Poor’s. 29
  • 30. Outlook for Housing Prices • We think housing prices will reach fair value/trend line, down 40% from the peak based on the S&P/Case-Shiller national (not 20-city) index, which implies a 5-10% further decline from where prices where as of the end of Q1 2009. It’s almost certain that prices will reach these levels • The key question is whether housing prices will go crashing through the trend line and fall well below fair value. Unfortunately, this is very likely. In the long-term, housing prices will likely settle around fair value, but in the short-term prices will be driven both by psychology as well as supply and demand. The trends in both are very unfavorable – Regarding the former, national home prices have declined for 33 consecutive months since their peak in July 2006 through April 2009 and there’s no end in sight, so this makes buyers reluctant – even when the price appears cheap – and sellers desperate. – Regarding the latter, there is a huge mismatch between supply and demand, due largely to the tsunami of foreclosures. In March 2009, distressed sales accounted for just over 50% of all existing home sales nationwide – and more than 57% in California. In addition, the “shadow” inventory of foreclosed homes already likely exceeds one year and there will be millions more foreclosures over the next few years, creating a large overhang of excess supply that will likely cause prices to overshoot on the downside, as they are already doing in California. • Therefore, we expect housing prices to decline 45-50% from the peak, bottoming in mid-2010 • We are also quite certain that wherever prices bottom, there will be no quick rebound • There’s too much inventory to work off quickly, especially in light of the millions of foreclosures over the next few years • While foreclosure sales are booming in many areas, regular sales by homeowners have plunged, in part because people usually can’t sell when they’re underwater on their mortgage and in part due to human psychology: people naturally anchor on the price they paid or what something was worth in the past and are reluctant to sell below this level. We suspect that there are millions of homeowners like this who will emerge as sellers at the first sign of a rebound in home prices • Finally, we don’t think the economy is likely to provide a tailwind, as we expect it to contract the rest of 2009, stagnate in 2010, and only then grow tepidly for some time thereafter 30
  • 31. Percent Noncurrent (60+ days) Q 1 0.0% 0.5% 1.0% 1.5% 2.0% 2.5% 3.0% 3.5% 4.0% 4.5% 5.0% 19 Q 99 3 19 Q 99 1 Are Soaring 20 Q 00 3 20 Q 00 1 20 Q 01 3 20 Q 01 1 20 Q 02 3 20 Q 02 1 20 Q 03 SOURCE: Mortgage Bankers Association National Delinquency Survey. 3 20 Q 03 1 20 Q 04 3 20 Q 04 1 20 Q 05 3 Delinquencies of Prime Mortgages 20 Q 05 1 20 Q 06 3 20 Q 06 1 20 Q 07 3 20 Q 07 1 20 Q 08 3 20 08 31
  • 32. 15 States With the Highest Prime Mortgage Foreclosure Rates SOURCE: New York Times, 5/24/09. 32
  • 33. Delinquencies of Prime and Alt-A Mortgages Are Soaring SOURCE: New York Times, 5/24/09. 33
  • 34. There Are $2.4 Trillion of Alt-A Mortgages and Their Resets Are Mostly Ahead of Us $300 $10 We are $9 here $250 Estimated Cumulative Reset Amount (Bn) $8 $7 $200 $6 Amount (Bn) $150 $5 $4 $100 $3 $2 $50 $1 $0 $0 4 0 2 15 13 10 12 5 3 1 14 11 l-1 l-1 l- 1 l-1 l-1 l-1 n- n- n- n- n- n- Ju Ju Ju Ju Ju Ju Ja Ja Ja Ja Ja Ja SOURCES: Credit Suisse, LoanPerformance. 34 NOTE: This chart only shows resets for a small fraction of Alt-A loans, but is representative of all of them.
  • 35. Percent Noncurrent (60+ days) Ja n- 0% 5% 10% 15% 20% 25% 99 Ju l-9 Ja 9 n- 0 Ju 0 l-0 Ja 0 n- 01 Ju SOURCES: Amherst Securities, LoanPerformance. l-0 Ja 1 n- 0 Ju 2 l-0 Mortgages Are Soaring Ja 2 n- 03 Ju l-0 Ja 3 n- 0 Ju 4 l-0 Ja 4 n- 05 Ju l-0 Delinquencies of Securitized Alt-A Ja 5 n- 0 Ju 6 l-0 Ja 6 n- 07 Ju l-0 Ja 7 n- 0 Ju 8 l-0 Ja 8 n- 09 35
  • 36. Alt-A Delinquencies By Vintage Show the Collapse in Lending Standards in 2006 and 2007 30% 2007 2006 25% Percent Noncurrent (60+ days) 20% 15% 2005 10% 2004 5% 2003 0% 0 5 10 15 20 25 30 35 40 45 50 55 60 Months of Seasoning SOURCES: Amherst Securities, LoanPerformance. 36
  • 37. Percent Noncurrent (60+ days) Ja n- 0.0% 0.5% 1.0% 1.5% 2.0% 2.5% 3.0% 3.5% 4.0% 99 Ju l-9 Ja 9 n- 0 Ju 0 l-0 Ja 0 n- 01 Ju SOURCES: Amherst Securities, LoanPerformance. l-0 Ja 1 n- 02 Ju l-0 Mortgages Are Soaring Ja 2 n- 03 Ju l-0 Ja 3 n- 04 Ju l-0 Ja 4 n- 05 Ju l-0 Ja 5 n- 06 Ju l-0 Ja 6 n- 07 Ju l-0 Delinquencies of Securitized Jumbo Prime Ja 7 n- 08 Ju l-0 Ja 8 n- 09 37
  • 38. HELOCs and Home Equity Loans Soared in Popularity During the Bubble $1,000 Closed-End Junior Lien Mortgages $900 Home Equity Lines of Credit $800 $700 $600 Amount (Bn) $500 $400 $300 $200 $100 $0 03 4 05 06 07 08 00 02 01 0 20 20 20 20 20 20 20 20 20 1 1 1 1 1 1 1 1 1 Q Q Q Q Q Q Q Q Q Note: Does not include approximately $200 billion of securitized HELOCs and junior liens. SOURCE: FDIC Quarterly Banking Profile. 38
  • 39. Many Borrowers Used HELOCs to Buy New Cars • As home prices have declined and other funding sources have dried up, millions of consumers have maxed out on home equity debt. • In hot markets like California and Florida, a significant percentage of all consumers tapped into the value of their homes to help finance their new cars, according to CNW Marketing Research. • Clearly this dynamic does not bode well for HELOC recovery rates or new car sales. SOURCE: New York Times 5/27/2008. 39
  • 40. Delinquencies of HELOCs and CESs Are Soaring 4.5% Closed-End Junior Lien Mortgages Home Equity Lines of Credit 4.0% 3.5% Percent Noncurrent (90+ days) 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% 4 Q 04 Q 05 Q 05 Q 06 Q 07 Q 07 Q 08 Q 08 04 Q 004 Q 005 Q 05 Q 06 Q 006 Q 006 Q 07 Q 007 Q 008 Q 008 09 0 20 20 20 20 20 20 20 20 20 20 20 20 20 20 2 2 2 2 2 2 2 3 1 1 2 3 4 1 2 3 4 1 2 4 2 3 4 1 2 3 4 1 Q Q Q SOURCE: FDIC Quarterly Banking Profile. 40
  • 41. A Primer on Option ARMs • An Option ARM is an adjustable rate mortgage typically made to a prime borrower • Sold under various names such as “Pick-A-Pay” • Banks typically relied on the appraised value of the home and the borrower’s high FICO score, so 83% of Option ARMs written in 2004-2007 were low- or no-doc (liar’s loans) • Each month, the borrower can choose to pay: 1) the fully amortizing interest and principal; 2) full interest; or 3) an ultra-low teaser interest-only rate (typically 2-3%), in which case the unpaid interest is added to the balance of the mortgage (meaning it is negatively amortizing) • Approximately 80% of Option ARMs are negatively amortizing • Lenders, however, booked earnings as if the borrowers were making full interest payments • A typical Option ARM is a 30- or 40-year mortgage that resets (“recasts”) after five years, when it becomes fully amortizing • If an Option ARM negatively amortizes to 110-125% of the original balance (depending on the terms of the loan), this triggers a reset even if five years have not elapsed • Upon reset, the average monthly payment can jump significantly, though the payment shock is currently mitigated by ultra-low interest rates • ‘My sense is that many option ARM borrowers are in a worse position than subprime borrowers,’ says Kevin Stein, associate director of the California Reinvestment Coalition, which combats predatory lending. ‘They wind up owing more and the resets are more significant.’ 41
  • 42. About $750 Billion of Option ARMs Were Written, Nearly All at the Peak of the Bubble $300 9% 9% 8% $250 8% 7% $200 6% Originations (Bn) Percent of Total 5% 5% $150 5% 4% $100 3% 2% $50 1% 1% $0 0% 2004 2005 2006 2007 2008 SOURCES: 2008 Mortgage Market Statistical Annual, published by Inside Mortgage Finance Publications, Inc. Copyright 2008. T2 Partners estimates. 42
  • 43. Options ARMs Were a Bubble State Phenomenon Other 25% Arizona 3% California Nevada 58% 3% Florida 10% SOURCES: Amherst Securities, LoanPerformance. 43
  • 44. Beginning in March 2005, High-FICO-Score Borrowers Opted for an Above-Market-Rate Option ARM in Exchange for the Low Teaser Rate 8.5 Fannie Mae 30 Year FRM Index Option ARM Index 8.0 Nearly all option ARM borrowers during 7.5 this period (when nearly all option ARMS were written) can’t afford a fully- 7.0 amortizing mortgage – otherwise they would have taken one Interest Rate (%) 6.5 6.0 5.5 5.0 4.5 4.0 6 07 7 08 2 03 3 04 6 2 3 7 4 05 5 5 06 02 2 3 4 6 7 4 5 -0 -0 -0 -0 -0 -0 l-0 l-0 l-0 l-0 l-0 -0 -0 -0 -0 -0 r-0 l-0 n- n- n- n- n- n- n- pr pr ct pr pr pr ct ct ct ct ct Ju Ju Ju Ju Ju Ju Ap Ja Ja Ja Ja Ja Ja Ja O O O O O O A A A A A SOURCE: Amherst Securities, BloombergFinance, L.P. 44
  • 45. Percent Noncurrent (60+ days) Ja n- 0% 5% 10% 15% 20% 25% 30% 35% 99 Ju l-9 Ja 9 Are Soaring n- 0 Ju 0 l-0 Ja 0 n- 01 Ju l-0 Ja 1 n- 02 Ju l-0 Ja 2 n- 03 SOURCES: Amherst Securities, LoanPerformance, T2 Partners estimates. Ju l-0 Ja 3 n- 04 Ju l-0 Ja 4 n- 05 Ju l-0 Ja 5 n- 06 Ju l-0 Ja 6 n- 07 Ju l-0 Delinquencies of Securitized Option ARMs Ja 7 n- 08 Ju l-0 Ja 8 n- 09 45
  • 46. Option ARM Delinquencies By Vintage Show the Collapse in Lending Standards in 2005-2007 45% 2006 40% 35% 2007 Percent Noncurrent (60+ days) 30% 2005 25% 20% 2004 15% 10% 2003 5% 0% 0 5 10 15 20 25 30 35 40 45 50 55 60 Months of Seasoning SOURCE: Amherst Securities, LoanPerformance. 46
  • 47. Existing Homes Sales Are Falling and Foreclosures Are Rising, Leading to a Surge in Inventories Existing Home Sales 7.5 7.0 6.5 6.0 Millions 5.5 Months Supply 12 11 5.0 4.7 million units as of the 10 4.0 million units, equal to 10.2 4.5 end of April 2009 months as of the end of April 2009 9 4.0 8 Months 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 7 6 5 4 3 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 SOURCE: NATIONAL ASSOCIATION OF REALTORS® Existing Home Sales data series. 47
  • 48. Foreclosure Filings Have Increased Dramatically • Foreclosures in April rose 32% year-over-year, but only 1% sequentially • April was the highest monthly total since RealtyTrac began issuing its report in January 2005 despite a decrease in bank repossessions (REOs) • RealtyTrac estimates that over 1.5 million bank-owned properties are on the market, representing around a third of all properties for sale in the U.S. 400,000 350,000 300,000 Number of Foreclosures 250,000 200,000 150,000 100,000 50,000 0 Ap 06 A p 08 Ju 0 6 D -06 Ju 0 8 De 08 O 05 F e 06 O 07 Au -05 Au 06 Au -08 Ap 07 Ap 09 De 05 Ju 0 7 D 07 9 Fe 05 O 06 Fe 07 O 08 Fe 08 A u 07 r- 0 b- b- r- - g- - g- n- b- b- - r- r- - c- g- - g- c- n- ct ec n n ct ct ct ec Ju Note: Foreclosure filings are defined as default notices, auction sale notices and bank repossessions. SOURCE: RealtyTrac.com U.S. Foreclosure Market Report. 48
  • 49. Home Prices Are in an Unprecedented Freefall 220 S&P/Case-Shiller U.S. National Home Price Index S&P/Case-Shiller 20-City Composite OFHEO Purchase-Only Index 200 NAR Median Sales Price of Existing Homes 180 160 140 120 100 Q 00 Q 01 Q 01 Q 02 Q 04 Q 05 Q 05 Q 06 Q 08 09 0 Q 02 Q 03 Q 03 Q 04 Q 06 Q 07 Q 07 Q 08 0 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 1 3 1 3 3 1 1 3 1 3 1 3 1 3 1 3 1 3 1 Q Q SOURCES: Standard & Poor’s, OFHEO Purchase-Only Index, NATIONAL ASSOCIATION OF REALTORS® Existing Home Sales data series. 49
  • 50. Home Prices Need to Fall Another 5-10% to Reach Trend Line 300 Shiller Lawler 275 Real Home Price Index (1890=100) 250 225 200 Housing Bubble 175 Trend Line 150 125 100 62 70 78 86 94 02 50 4 58 66 74 82 90 98 06 5 19 19 19 19 19 19 19 19 19 19 19 19 20 20 19 SOURCES: Robert J. Shiller, Irrational Exuberance: Second Edition, as updated by the author; Lawler Economic & Housing Consulting. 50
  • 51. A Study of Bubbles Shows That All of Them Eventually Return to Trend Line S&P 500 Japan vs. EAFE ex-Japan S&P 500 S&P 500 Stocks 1981-1999 1920-1932 1946-1984 1992-October 2008 2.3 2.5 3.0 2.4 Detrended Real Price Detrended Real Price Detrended Real Price 2.0 2.5 Relative Return 1.8 2.0 2.0 1.5 1.3 1.5 1.6 Tre nd Line 1.0 Tre nd Line 1.0 0.8 0.5 1.2 0.5 Tre nd Line Trend Line 0.3 0.0 0.0 0.8 20 21 22 23 24 25 26 27 28 29 30 31 46 50 54 58 62 66 70 74 78 82 81 83 85 87 89 91 93 95 97 99 92 94 96 98 00 02 04 06 08 U.S. Dollar U.K. Pound Currencies Japanese Yen Japanese Yen 1979-1992 1979-1985 1983-1990 1992-1998 2.0 1.4 1.4 1.4 Cumulative Return Cumulative Return Cumulative Return Cumulative Return 1.8 1.3 1.3 1.3 1.6 1.2 1.2 1.2 1.4 1.1 1.1 1.1 1.2 1.0 1.0 1.0 1.0 0.9 0.9 0.9 0.8 0.8 0.8 0.8 79 81 83 85 87 89 91 79 80 81 82 83 84 83 84 85 86 87 88 89 90 92 93 94 95 96 97 Gold Crude Oil Commodities Nickel Cocoa 1970-1999 1962-1999 1979-1999 1970-1999 2000 250 80 600 1600 200 500 60 Real Price Real Price Real Price 400 Real Price 1200 150 40 300 800 100 200 400 20 50 100 0 0 0 0 70 74 78 82 86 90 94 98 62 66 70 74 78 82 86 90 94 98 79 81 83 85 87 89 91 93 95 97 70 74 78 82 86 90 94 98 SOURCE: GMO LLC. Note: For S&P charts, trend is 2% real price appreciation per year. Source: GMO. Data through 10//10/08. * Detrended Real Price is the price index divided by CPI+2%, since the long-term trend increase in the price of the S&P 500 has been on the order of 2% real. 51
  • 52. The Biggest Danger is That Home Prices Overshoot on the Downside, Which Often Happens When Bubbles Burst S&P 500 1927-1954 2.50 Overrun: 59% 2.25 Fair Value to Bottom: 1.5 Years Fair Value to Fair Value: 23 Years Detrended Real S&P 500 Stock Price Index 2.00 1.75 1.50 1.25 1.00 S&P 500 1955-1986 2.25 0.75 Overrun: 45% 2.00 Fair Value to Bottom: 7 Years 0.50 Fair Value to Fair Value: 12 Years Detrended Real S&P 500 Stock Price Index 0.25 -59% 1.75 0.00 1.50 1927 1930 1933 1936 1939 1942 1945 1948 1951 1954 1.25 1.00 0.75 0.50 -45% 0.25 0.00 1955 1957 1959 1961 1963 1965 1967 1969 1971 1973 1976 1978 1980 1982 1984 1986 SOURCE: GMO LLC, T2 Partners calculations. 52
  • 53. In Bubble Markets, Prices Are Way Down, Driven By a Surge in the Number of Homes Sold Out of Foreclosure $500 California 70% 60% $400 50% Median Home Price (000s) Foreclosure Resale % $300 40% 30% $200 20% $100 10% $0 0% 7 6 09 9 6 8 07 8 6 7 8 6 7 8 r-0 r-0 0 r-0 r-0 -0 -0 l-0 l-0 l-0 -0 -0 n- n- n- n ct ct ct Ju Ju Ju Ap Ap Ap Ap Ja Ja Ja Ja O O O SOURCE: MDA Dataquick. Note: Includes new construction 53
  • 54. Home Prices Have Crashed Through the Trend Line in California, But Stabilized in March $600 Median Sales Price 4% Trend $500 Median Price ($000s) $400 $300 $200 $100 $0 1 3 9 93 05 07 5 03 09 79 1 85 7 91 97 9 0 8 8 9 -9 -8 -8 n- n- n- n- n- n- n- n- n- n- n- n- n- n n n Ja Ja Ja Ja Ja Ja Ja Ja Ja Ja Ja Ja Ja Ja Ja Ja SOURCE: California Association of REALTORS ® . All rights reserved. www.rebsonline.com, T2 Partners estimates. 54
  • 55. The Housing Affordability Index Shows Houses Are Now Affordable Before concluding that houses are cheap, however, there are three big caveats: first, low rates are only available to those who qualify for conforming mortgages, which doesn’t help millions of homeowners or potential homeowners who have spotty credit histories or are underwater on their current mortgages. Second, with low enough interest rates, almost anything looks affordable; if rates rise, houses won’t look so reasonably priced based on these metrics. Finally, in light of the severe economic downturn, average income may fall for quite some time. 26 24 Mortgage Payment on Median Priced Home as % of Family Income 22 20 18 16 14 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 19 19 19 19 19 19 19 19 19 19 19 20 20 20 20 20 20 20 20 20 20 SOURCE: NATIONAL ASSOCIATION OF REALTORS® Housing Affordability Index 55
  • 56. Mortgage Rates Have Fallen Recently 10 Jumbo 30 Yr FRM Jumbo 5/1 Hybrid ARM 9 Conforming 30 Yr FRM Conforming 5/1 Hybrid ARM 8 10-Year Treasury 7 Rate (%) 6 5 4 3 2 N 5 Fe 5 N 8 N 4 Fe 4 N 6 Fe 6 N 7 Au 5 Au 6 Au 4 Fe 7 Fe 8 M 4 Au 07 Au 8 9 M 06 M 09 M 05 M 07 M 8 0 -0 0 -0 0 0 0 -0 -0 -0 -0 -0 -0 0 -0 0 -0 g- g- g- g- g- b- - b- b- b- b- b- ov ov ov ay ay ay ay ov ov ay ay Fe SOURCES: HSH ASSOCIATES, Freddie Mac PMMS, Yahoo! Finance. 56
  • 57. The Home Price-to-Rent Ratio Has Returned to Normal Levels 27 25 Median Home Price to Median Gross Rent 23 21 19 17 15 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 SOURCE NATIONAL ASSOCIATION OF REALTORS® Existing Home Sales data series, U.S. Census Bureau, T2 Partners estimates 57
  • 58. Are We Seeing the Beginnings of a Bottom in Hard-Hit Markets? SOURCE: NY Times, 5/4/09. 58
  • 59. Home Prices in Sacramento More Than Tripled in Six Years – And Have Now Fallen 47% SOURCE: Zillow.com. 59
  • 60. The Vast Majority of Sacramento Homeowners Who Purchased During the Bubble Years Are Now Underwater SOURCE: Zillow.com. 60
  • 61. In Sacramento Country, Home Sales Have Rebounded – But Are Still Outweighed by Defaults Monthly Notices-of-Default in Sacramento SOURCES: MDA Dataquick; The Field Check Group -- data provided by ForeclosureRadar.com. Note: Includes new construction. 61
  • 62. Home Prices Are Stabilizing in Sacramento Country, In Part Due to More Higher End Homes Being Sold Off Sacramento House Prices at the Sacramento Mix of Houses at Time of Foreclosure/REO the Time of Foreclosure/REO SOURCE: The Field Check Group -- data provided by ForeclosureRadar.com. 62
  • 63. Comments From Mark Hanson (1) The Field Check Group, May 5, 2009 California housing – at the low end – is 'bottoming' mostly because: a) median prices are down 55% from their peak over the past two years, thereby making the low end affordable; b) foreclosures have temporarily been cut by 66% through moratoriums reducing supply; and c) demand is picking up going into the busy season. But the moratoriums are ending and the number of foreclosures in the pipeline is massive – they will start showing themselves as REO over the near to mid-term. The Obama plan held the foreclosure wave back, creating a huge backlog and now the servicers are testing hundreds of thousands of defaults against the new loss mitigation initiatives. We presently see the Notice of Defaults at record highs and Notice of Trustee Sales back up to nine-month highs – there is no reason for a loan to go to the Notice of Trustee Sale stage if indeed it wasn't a foreclosure. However, the new 'batch' are not only from the low end but a wide mix all the way up to several million dollars in present value. Because the majority of buyers are in ultra low and low-mid prices ranges, the supply- demand imbalance from foreclosures and organic supply will crush the mid-to-upper priced properties in 2009. We already have early seasonal hard data proving this. As the mid-to-upper end go through their respective implosions this year and the volume of sales in these bands increase as prices tumble, the mix shift will raise median and average house prices creating the ultimate in false bottoms. We also have data proving this phenomenon. 63
  • 64. Comments From Mark Hanson (2) The Field Check Group, May 5, 2009 After a year or so the real pain will occur when the mid to upper bands are down 40% from where they are now, and the price compression has made the low to low-mid bands much less attractive – the very same bands that are so hot right now. Rents are tumbling and those that bought these properties for investment will be at risk of default (investors have been buying all the way down). Investors have just started to get taken to the woodshed from all of the supply and this will get much worse. Mid-to- upper end rental supply is also flooding on the market making it much better to rent a beautiful million dollar house than putting $300,000 down and buying. After investors are punished -- and with move-up buyers gone for years – it will leave first-time homeowners to fix the housing market on their own. Good luck and good night. Five years from now when things look to be stabilizing, all of these terrible kick-the-can-down-the-road modifications that leave borrowers in 5-year-teaser, ultra-high-leverage, 150% LTV, balloon loans will start adjusting upward and it will be Mortgage Implosion 2.0. These loan mods will turn millions of homeowners into over-levered, underwater, renters and ensure housing is a dead asset class for years to come. Due to a confluence of events including a national foreclosure moratorium and near-zero sales in the mid to upper end during the off season, the broader housing data show signs of stabilization. Taken in context, it is a blip. There are no silver linings or green shoots in housing whatsoever other than by these first-time homeowners – former renters – who now find it cheaper to own than rent. This is a very good thing, but it only applies to a small segment of the population and will not be able to support the market. In addition, the first-time buyers who come out of the rental market put continuous pressure on rents. Our data shows that the mid-to-upper end housing market is on the precipice of the exact cliff that the market fell off of in 2007, led by new loan defaults. What happens to the economy when you hit the mid- to-upper end earners the same way the low-to-mid end was hit with the subprime implosion? We will find out soon enough. When we look back on housing at the end of 2009, anyone that made positive housing predictions this year will not believe how far off they were. 64
  • 65. There Have Been 5.7 Million Jobs Lost So Far in This Recession, More Than 3 Million in the Past Five Months 600 400 Change in Nonfarm Payroll Employment (000s) 200 0 -200 -400 -600 There have been job losses every month -800 since December 2007 -1000 90 Ja 2 Ja 4 Ja 6 Ja 8 Ja 0 Ja 2 Ja 4 Ja 6 Ja 8 Ja 1 Ja 3 Ja 5 Ja 7 Ja 5 Ja 9 Ja 1 Ja 3 Ja 7 09 9 9 9 9 9 9 9 9 9 0 0 0 0 0 0 0 0 0 n- n- n- n- n- n- n- n- n- n- n- n- n- n- n- n- n- n- n- n- Ja Ja SOURCE: Bureau of Labor Statistics. 65
  • 66. The Unemployment Rate Jumped to 8.9% in April, the Highest Level Since 1983 If part-time and discouraged workers are factored in, the unemployment rate 12% would have been 15.8% in April. In addition, the average work week in April was 33.2 hours, a record low. 11% 10% 9% Unemployment Rate 8% 7% 6% 5% 4% 3% 03 06 09 91 94 79 73 76 00 88 82 85 97 70 n- n- n- n- n- n- n- n- n- n- n- n- n- n- Ja Ja Ja Ja Ja Ja Ja Ja Ja Ja Ja Ja Ja Ja SOURCE: Bureau of Labor Statistics. 66
  • 67. The Decline from Peak Employment Now Exceeds the Past Five Recessions 0.0% 1980 1981 - 83 1990 - 93 1974 - 76 2001 - 05 -0.5% -1.0% -1.5% -2.0% -2.5% -3.0% -3.5% -4.0% 2007- -4.5% 0 6 12 18 24 30 36 42 48 Months after pre-recession peak SOURCE: Bureau of Labor Statistics 67
  • 68. Consumer Confidence Rebounded in April and May 160 140 120 Consumer Confidence Index 100 80 60 40 20 0 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Note: 1985=100. SOURCE: The Conference Board (www.pollingreport.com/consumer.htm) 68
  • 69. Banks are Tightening Consumer Credit and New Household Borrowing Has Plunged Percent of US Banks Tightening Consumer Credit 70% 60% 50% 40% 30% 20% 10% 0% Household Borrowing 1990-2008 (Seasonally-Adjusted Annual Rate) -10% $1,200 -20% ($ billions) 02 06 00 04 08 1 3 5 7 00 04 08 02 06 -0 -0 -0 -0 p- n- n- n- n- n- p- p- p- p- ay ay ay ay Ja Ja Ja Ja Se Se Se Se Se Ja M M M M $1,000 Credit Cards Other Consumer Loans $800 $600 $400 $200 $0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 SOURCE: Federal Reserve Board. 69
  • 70. Pools of HELOCs and CESs Can Suffer Astronomical Losses Due to 100%+ Severities On one second lien deal, Ambac expected losses of 10-12% when it guaranteed the senior tranche. A year ago, Ambac admitted that the pool would likely lose 81.8% of its value – and based on the pool’s performance since then, this will almost certainly prove to be conservative. 3.0% Ambac Projection April 2008 Actual 2.5% From Ambac slide, April 2008: • Second lien deal that closed in April 2007 Monthly Loss Rate (3m average) • Loss to date 9.9%; projected loss: 81.8% 2.0% • Projected collateral loss as a % of current collateral: 86% • A reasonable estimate of projected collateral 1.5% loss for the above transaction might have been 10-12%, with the transaction having an A+ rating at inception and being structured to withstand 28-30% collateral loss 1.0% 0.5% 0.0% 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 45 47 49 51 53 55 57 59 Months Since Close SOURCES: Ambac Q1 08 presentation, Amherst Securities; funds managed by T2 Partners are short Ambac. 70
  • 71. The Timing Indicates That We Are Still in the Middle Innings of the Bursting of the Great Housing Bubble • Mortgage lending standards became progressively worse starting in 2000, but really went off a cliff beginning in early 2005 • The worst loans were subprime ones, which generally had two-year teaser rates and are now defaulting at unprecedented rates • Such loans made in Q1 2005 started to default in high numbers upon reset in Q1 2007, which not surprisingly was the beginning of the current crises • The crisis has continued to worsen as even lower quality subprime loans made over the remainder of 2005 reset over the course of 2007, triggering more and more defaults • It takes an average of 15 months from the date of the first missed payment by a homeowner to a liquidation (generally a sale via auction) of the home • Thus, the Q1 2005 subprime loans that defaulted in Q1 2007 led to foreclosures and auctions in early 2008 • Given that lending standards got much worse in late 2005 through 2006 and into the first half of 2007, and the many other types of loans that are now with longer reset dates that are now starting to default at catastrophic rates, there are sobering implications for expected defaults, foreclosures and auctions in 2009 and beyond, which promise to drive home prices down further In summary, today we are only in the middle innings of an enormous wave of defaults, foreclosures and auctions that is hitting the United States. We predicted in early 2008 that it would get so bad that it would require large-scale federal government intervention – which has occurred, and we’re not finished yet. 71
  • 72. Total Losses Are Now Estimated at $2.1-$3.8 Trillion – And Only a Fraction of This Has Been Realized To Date $4,000 $3,778 Corporate $3,552 $3,500 Consumer Commercial $3,000 Real Estate $2,632 Residential Mortgages $2,500 Amount (Bn) $2,083 $2,000 $1,473 $1,500 $1,214 GSEs $1,000 Insurers $500 Banks/ Brokers $0 Goldman Roubini Jan T2 Partners IMF Apr 2009 Writedowns to Capital Raised Sachs Jan 2009 Mar 2009 Date 2009 SOURCES: Goldman Sachs, International Monetary Fund, RGE Monitor, Bloomberg Finance L.P., T2 Partners estimates. 72
  • 73. A Breakdown of Our Financial Sector Loss Estimates Amount (Bn) $0 $100 $200 $300 $400 $500 $600 $700 $800 CDO/ CLO Other Consumer Total Estimated Construction & Development Financial Sector Option ARM Losses = $3.8 trillion Auto Credit Card Home Equity Jumbo Prime High-Yield / Leveraged Loans Subprime Commercial & Industrial Other Corporate Alt-A Commercial Real Estate Prime Mortgage SOURCE: T2 Partners estimates. 73
  • 74. Institutions Have Been Able to Raise Capital to Mostly Keep Up With Writedowns, But This Will Likely Not Continue $1,500 Losses & Writedowns Capital Raised $1,250 $1,000 Amount (Bn) $750 $500 $250 $0 Prior Q3 2007 Q4 2007 Q1 2008 Q2 2008 Q3 2008 Q4 2008 Q1 2009 Q2 2009 SOURCE: Bloomberg Finance L.P. 74
  • 75. Where We Are Finding Opportunities • Blue-chips. The stocks of some of the greatest businesses, with strong balance sheets and dominant competitive positions, are trading at their cheapest levels in years – due primarily to the overall market decline and weak economic conditions rather than any company-specific issues. In this category, we’d put Coca-Cola, McDonald’s, Wal-Mart, Altria, ExxonMobil, Johnson & Johnson, and Microsoft. • Out of favor blue-chips. For somewhat more adventurous investors looking to buy great companies in the most out-of-favor sectors such as financials and retailers, we own Berkshire Hathaway, Wells Fargo, American Express and Target. All are great businesses, but their stocks have suffered mightily thanks to the economic downturn. We think they’re good bets to rebound when things stabilize. • Balance sheet plays. For investors who are comfortable with lower-quality businesses but want downside protection, there are many companies trading near or even below net cash on the balance sheet. Examples in our portfolio include digital media equipment company EchoStar Corp. and clothing retailer dELiA*s. Berkshire is the best of both worlds: a premier company but also a balance sheet play. • Turnarounds. There are countless companies that have gotten clobbered by the economic downturn and are reporting dismal results – with stock prices to match. Investors in those that survive and return to anything close to former levels of profitability will be well rewarded – but picking these stocks isn’t easy. Among our holdings in this category are Wendy’s restaurants, Winn-Dixie supermarkets, Huntsman, a specialty chemical maker, Crosstex, a pipeline company, and Resource America, a specialty finance company. • Special situations. This is somewhat of a catch-all category that, for us, includes Contango Oil & Gas, a stock that’s declined due to an aborted attempt to sell the company and the sharp drop in the price of natural gas. • Mispriced options. Every once in a while we take a tiny position in a highly speculative situation – often where the stock price is below $1 – in which there’s a real chance that the outcome is zero, but also a decent chance, in our opinion, of making many multiples of our money. On an expected value basis, therefore, a small portfolio of such investments is attractive. Our holdings include General Growth Properties, TravelCenters of America, Ambassadors International, Borders Group and PhotoChannel Networks. 75