An Overview of the Housing and Economic Crisis
          – and Why There Is More Pain to Come
                            ...
The Wave of Resets from Subprime
Loans Is Mostly Behind Us

                                            $35

             ...
The Mortgage Crisis is Shifting From One in
Which Defaults Are Driven by Resets to Borrowers
Losing Their Jobs and/or Goin...
The Mortgage Meltdown Has Moved
Beyond Subprime to Five Other Areas
For further details about Jumbo Prime, HELOCs and Opti...
Delinquencies of Prime and Alt-A
Mortgages Are Soaring




Source: New York Times, 5/24/09.
                              ...
Percent Noncurrent (60+ days)
                                                                         Q
                 ...
Fannie Mae and Freddie Mac Serious
Delinquencies Are Soaring


    4.0%

                           Fannie
    3.5%       ...
Freddie Mac’s Delinquency Rate by Vintage
Underscores the Decline in Lending Standards


                    Total Single-...
There Is a Surge of Notices of Default and
Foreclosures Among the GSEs




                                          Prime...
The Foreclosure Problem Is No Longer
Only a Bubble State Phenomenon

                      15 States With the Highest Prim...
Percent Noncurrent (60+ days)
                                                     Ja
                                    ...
Alt-A Delinquencies By Vintage Show the
Collapse in Lending Standards in 2006 and 2007

                                  ...
There Are $2.4 Trillion of Alt-A Mortgages
and Their Resets Are Mostly Ahead of Us




                                   ...
Two Waves of Losses Are Behind Us…
But Three Are Looming

Losses Mostly Behind Us
• Wave #1: Borrowers committing (or the ...
Why Won’t the System Collapse Again?

          Given that the three looming waves are much larger than the two that are m...
The Housing Crisis is Shifting in a
Number of Ways

First Stage of Collapse               Current Stage
1. Subprime & frau...
Current Status of the Housing Market
Foreclosure Filings Have Increased
    Dramatically

•    343,638 foreclosure filings during September were down 4% sequen...
The Delinquency and Foreclosure Problem
Has Spread Far Beyond the Bubble States




 Source: LPS Applied Analytics, WSJ 10...
Credit Suisse Predicts More Than 6 Million
Additional Foreclosures by the End of 2012



                                 ...
Existing Homes Sales Have Risen in Recent Months, Leading
to a Decline in Inventory – But Inventory Is Still at Double
His...
Thanks to Massive Government Stimulus (Mainly the FHA & the
$8,000 First-Time Homebuyers Tax Credit), Sales from June-
Sep...
Thanks to Massive Government Stimulus (Mainly the FHA & the
$8,000 First-Time Homebuyers Tax Credit), Sales from June-
Sep...
Inventory is Moving at the Low End, But As the
High End Tips Over, Sales Are Falling and
Inventories Are Ballooning

     ...
Defaults Are Massively Outpacing
Liquidations, So the Inventory
Overhang Continues to Worsen


                           ...
Defaulted Mortgages Are Taking Longer to
Liquidate, Adding to the Inventory Overhang




 Source: First American CoreLogic...
Cure Rates Have Fallen Such That Once a
Homeowner Misses Two Payments, A
Foreclosure Is Almost Inevitable




Source: Loan...
The Current “Housing Overhang” Is 7 Million Homes –
Which Doesn’t Include Any New Defaults, Which Are
Running at Approxima...
Shadow Inventory for Each of the 20 Cities
in the Case-Shiller Index




Note: Notice of Default data is incomplete or mis...
Outlook for Housing Prices
Home Prices Were in an Unprecedented
Freefall Until A Slight Bounce in Q209

          220
                           S&P/...
Home Prices Look Affordable Due to Price
Declines and Ultra-Low Interest Rates

                             800
         ...
The Housing Affordability Index Shows
Houses Are Now Affordable

                                          26



         ...
Home Prices Need to Fall Another 5-10%
to Reach Trend Line

                                            300
              ...
GMO’s Study of Bubbles Shows That All
of Them Eventually Return to Trend Line
34 Have Returned to Trend; the Only Exceptio...
The Biggest Danger is That Home Prices
Overshoot on the Downside, Which Often
Happens When Bubbles Burst

                ...
Recent Signs of Stabilization Are Likely
the Mother of All Head Fakes
Rather than representing a true bottom, recent signs...
The Average Loan Size of Defaulted Loans is Rising
Rapidly, Reflecting the Spread of Defaults Away From
Smaller Subprime L...
Another Wave of Resetting Loans Is On the Horizon
The Last Wave Was Driven By Subprime Loans;
This Time, It Will be Option...
Banks Are Selling Their REO, But
Foreclosures Have Plunged By More Than
Half, Ballooning the Inventory Pipeline

         ...
One Third of All New Single Family Home
Sales Are Financed With FHA or VA Loans

       Number of FHA Loans Insured




  ...
FHA’s Loan Book Is a Rapidly Growing Disaster
17.9% of Loans Are in Some Stage of Default;
For 2007 Loans, It’s 32.4%




...
Existing Home Sales Are Highly Seasonal




 Source: National Association of Realtors.
                                   ...
Existing Home Sales Are Highly Seasonal



                               HPA Seasonality Coefficient -- Deviation From Me...
M
                                                 ar




                                                           -3.5%...
T2 Partners Presentation On The Housing Crisis 11 9 09
T2 Partners Presentation On The Housing Crisis 11 9 09
T2 Partners Presentation On The Housing Crisis 11 9 09
T2 Partners Presentation On The Housing Crisis 11 9 09
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Housing Crisis is not over, the REO market is set to continue.

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T2 Partners Presentation On The Housing Crisis 11 9 09

  1. 1. An Overview of the Housing and Economic Crisis – and Why There Is More Pain to Come T2 Accredited Fund, LP Tilson Offshore Fund, Ltd. T2 Qualified Fund, LP November 9, 2009 The latest version of this presentation is regularly updated at www.valueinvestingcongress.com
  2. 2. The Wave of Resets from Subprime Loans Is Mostly Behind Us $35 We are $30 here $25 Loans with Payment Shock (Bn) $20 $15 $10 $5 $0 6 7 8 9 06 07 08 09 6 7 8 9 6 7 8 9 0 10 0 0 r-0 r-0 r-0 r-0 -0 -0 -0 -0 l-0 l-0 l-0 l-0 r-1 -1 l-1 n- n- n- n- n- ct ct ct ct ct Ju Ju Ju Ju Ju Ap Ap Ap Ap Ap Ja Ja Ja Ja Ja O O O O O Sources: LoanPerformance, Deutsche Bank; slide from Pershing Square presentation, How to Save the Bond Insurers, 11/28/07. 35
  3. 3. The Mortgage Crisis is Shifting From One in Which Defaults Are Driven by Resets to Borrowers Losing Their Jobs and/or Going Underwater 60% ($250,000) 2006 Origination California Mortgages Example: Equity Relative to First Lien ($200,000) First-lien (Right Axis Inverted) 50% mortgages in Cumulative Default (Left Axis) ($150,000) California that were originated in Equity Relative To First Lien ($) Cumulative Default % 2006 went from 40% ($100,000) $165,000 of equity to an ($50,000) average negative 30% equity of $0 $149,000 by Sept. 2009. 20% $50,000 The cumulative default rate $100,000 tracked this loss 10% of equity, rising $150,000 from 1.0% to 48.5%. 0% $200,000 Jul-07 Nov-07 Jul-08 Nov-08 Jul-09 Jan-07 May-07 Jan-08 May-08 Jan-09 May-09 Mar-07 Sep-07 Mar-08 Sep-08 Mar-09 Sep-09 Sources: Amherst Securities. 36
  4. 4. The Mortgage Meltdown Has Moved Beyond Subprime to Five Other Areas For further details about Jumbo Prime, HELOCs and Option ARMs, see the Appendix Prime Mortgage Commercial Real Estate Alt-A Other Corporate Commercial & Industrial Subprime Subprime is only a small High-Yield / Leveraged Loans part of the problem 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. 37
  5. 5. Delinquencies of Prime and Alt-A Mortgages Are Soaring Source: New York Times, 5/24/09. 38
  6. 6. 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 Source: Mortgage Bankers Association National Delinquency Survey. Q 03 3 20 Q 03 1 20 Q 04 3 20 Q 04 1 20 Q 05 3 20 Delinquencies of Prime Mortgages 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 39
  7. 7. Fannie Mae and Freddie Mac Serious Delinquencies Are Soaring 4.0% Fannie 3.5% Freddie 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% 7 7 7 8 8 8 07 07 08 08 08 08 08 08 08 08 08 09 09 09 09 09 09 09 09 /0 /0 /0 /0 /0 /0 8/ 9/ 1/ 2/ 3/ 4/ 5/ 6/ 7/ 8/ 9/ 1/ 2/ 3/ 4/ 5/ 6/ 7/ 8/ 10 11 12 10 11 12 Note: Serious delinquencies are loans that have missed three or more consecutive payments (90+ days). Source: Company filings. 40
  8. 8. Freddie Mac’s Delinquency Rate by Vintage Underscores the Decline in Lending Standards Total Single-Family Portfolio Cumulative Default Rates* by Book Year * Represents the cumulative transition rate of loans to a default event, and is calculated for each year of origination as the number of loans that have proceeded to foreclosure, acquisition or other disposition events, excluding liquidations through voluntary pay-off, divided by the number of loans in our single-family mortgage 41 portfolio. Excludes certain Structured Transactions. Source: Company filing.
  9. 9. 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. 42
  10. 10. The Foreclosure Problem Is No Longer Only a Bubble State Phenomenon 15 States With the Highest Prime Mortgage Foreclosure Rates Source: New York Times, 5/24/09. 43
  11. 11. Percent Noncurrent (60+ days) Ja n- 10% 15% 20% 25% 0% 5% 99 Ju l-9 Ja 9 n- 00 Ju l-0 Ja 0 n- 01 Sources: Amherst Securities, LoanPerformance. Ju 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 Delinquencies of Securitized Alt-A Ja 5 n- 06 Ju l-0 Ja 6 n- 07 Ju l-0 Ja 7 n- 08 Ju l-0 Ja 8 n- 09 44
  12. 12. 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. 45
  13. 13. There Are $2.4 Trillion of Alt-A Mortgages and Their Resets Are Mostly Ahead of Us $300 $10 We are here $9 $250 Estimated Cumulative Reset Amount (Bn) $8 $7 $200 $6 Amount (Bn) $150 $5 $4 $100 $3 $2 $50 $1 $0 $0 10 11 12 13 14 15 0 1 2 3 4 5 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. 46 NOTE: This chart only shows resets for a small fraction of Alt-A loans, but is representative of all of them.
  14. 14. Two Waves of Losses Are Behind Us… But Three Are Looming Losses Mostly Behind Us • Wave #1: Borrowers committing (or the victim of) fraud, as well as speculators, who defaulted quickly. Timing: beginning in late 2006 (as soon as home prices started to fall) into 2008. Mostly behind us. • Wave #2: Mostly subprime 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. 47
  15. 15. Why Won’t the System Collapse Again? Given that the three looming waves are much larger than the two that are mostly behind us, why won’t they trigger a collapse of our financial system similar to what happened in late 2008? Answer: Last year’s collapse was triggered in part by the magnitude of the losses, but also because of the suddenness. Financial institutions can withstand even large losses if they trickle in over time because they can offset losses each quarter with profits earned during the quarter – but this isn’t possible if losses are sudden. The suddenness of last year’s losses was due in part to rapidly rising defaults, especially among subprime mortgages, but in fact, realized losses were still quite low. The real culprit was the fact that most subprime loans had been securitized into RMBSs and CDOs, turning them into tradable debt instruments. According to GAAP accounting rules, traded instruments like stocks and bonds have to be marked to market, and in only a few months in 2008, the market price for hundreds of billions of dollars of AAA- rated RMBS and CDO securities went from close to 100 cents on the dollar to the 20-30 cent range (even though the underlying pools of mortgages hadn’t yet realized much in the way of losses). This required every institution holding these securities to immediately book enormous losses, which caused many of them to collapse. Why did Merrill Lynch, Citigroup, Lehman and Bear Stearns fall, but Wells Fargo didn’t? Because Wells had almost nothing on its balance sheet that had to be marked to market. Big mark to market losses are now behind us, so it’s unlikely that there will be any sudden shocks to the system. Instead, hundreds of billions of dollars of additional losses from trillions of dollars of bad loans will be realized over many, many years. This is both good news and bad news: the good news is that while future losses will surely bankrupt many banks, especially smaller ones exposed to commercial real estate, they likely won’t threaten the system because banks are earning so much money currently that most should be able to outrun their losses. The bad news is that very high losses will plague our financial system for many years to come – our best guess is current extremely high levels for another two years, and then slowly declining for three more years before finally returning to normal levels in five years. This drip torture of high losses every quarter, year after year, will likely keep banks extremely cautious in their lending, making robust economic growth unlikely. 48
  16. 16. The Housing Crisis is Shifting in a Number of Ways First Stage of Collapse Current Stage 1. Subprime & fraudulent loans 1. Prime, Alt-A and other loans to account for most defaults better borrowers drive defaults 2. Defaults driven by loans 2. Defaults driven by job losses and resetting underwater mortgages 3. Defaults mainly in sand and rust 3. Defaults occurring across a broad states swath of the country 4. Mark-to-market losses due to 4. Losses from on-balance-sheet bad loans being securitized loans (not marked to market) 5. Little government intervention 5. Massive government intervention 49
  17. 17. Current Status of the Housing Market
  18. 18. Foreclosure Filings Have Increased Dramatically • 343,638 foreclosure filings during September were down 4% sequentially and up 29% year-over-year. • 1.2% of all U.S. housing units (one in 84) received at least one foreclosure filing in the first half of this year. 400,000 350,000 300,000 Number of Foreclosures 250,000 200,000 150,000 100,000 50,000 0 Au -05 Ap -06 Ap -07 Ap -08 Ju -06 Au -06 Ju -07 Au 07 Ju -08 Au 08 Ap -09 Ju -09 Au 09 O -05 Fe -05 O -06 Fe -06 O -07 Fe -07 O -08 Fe -08 09 D -05 D -06 D -07 D -08 n- n- n- g- b b b b n r n r r r ec ec ec ec g ct g ct g ct g ct Ju Note: Foreclosure filings are defined as default notices, auction sale notices and bank repossessions. Source: RealtyTrac.com U.S. Foreclosure Market Report. 51
  19. 19. The Delinquency and Foreclosure Problem Has Spread Far Beyond the Bubble States Source: LPS Applied Analytics, WSJ 10/22/09. 52
  20. 20. Credit Suisse Predicts More Than 6 Million Additional Foreclosures by the End of 2012 This chart is quite dated, but accurately shows how the foreclosure crisis is shifting away from subprime. Sources: Credit Suisse, 9/08; http://calculatedrisk.blogspot.com 53
  21. 21. Existing Homes Sales Have Risen in Recent Months, Leading to a Decline in Inventory – But Inventory Is Still at Double Historical Levels – And Shadow Inventory Lurks Annualized Rate of Existing Home Sales Months Supply 7.5 12 11 7.0 10 6.5 3.6 million units, equal to 7.8 months 9 as of the end of September 2009 6.0 8 Millions Months 5.5 7 6 5.0 5.6 million units as of the 5 end of September 2009 4.5 4 4.0 3 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Actual inventory levels are significantly higher due to “shadow inventory.” “As of July, mortgage companies hadn't begun the foreclosure process on 1.2 million loans that were at least 90 days past due…An additional 1.5 million seriously delinquent loans were somewhere in the foreclosure process, though the lender hadn't yet acquired the property…Moreover, there were 217,000 loans where the borrower hadn't made a payment in at least a year but the lender hadn't begun the foreclosure process. In other words, 17% of home mortgages that are at least 12 months overdue aren't in foreclosure, up from 8% a year earlier.” Source: NATIONAL ASSOCIATION OF REALTORS® Existing Home Sales data series; estimates prepared for The Wall Street Journal by LPS Applied Analytics, WSJ, 9/23/09 54
  22. 22. Thanks to Massive Government Stimulus (Mainly the FHA & the $8,000 First-Time Homebuyers Tax Credit), Sales from June- Sept. 2009 Were Higher Than 2008, But This May Not Last Note how seasonal home sales are Source: Mark Hanson Advisors. 55
  23. 23. Thanks to Massive Government Stimulus (Mainly the FHA & the $8,000 First-Time Homebuyers Tax Credit), Sales from June- Sept. 2009 Were Higher Than 2008, But This May Not Last Note how seasonal home sales are Organic sales are highly seasonal, while distressed sales are have fallen in recent months due to loan mods Source: Mark Hanson Advisors. 56
  24. 24. Inventory is Moving at the Low End, But As the High End Tips Over, Sales Are Falling and Inventories Are Ballooning Months Inventory in CA By Home Price Sudbury, MA (July data) Months of Price Inventory >$250K 6 $250-500 8 $500-750 5 $750-1M 14 $1M+ 51 Another example: based on the rate of sales over the seven months ending in May 2009, there is five years of housing inventory in Greenwich, CT Sources: JP Morgan; CA Assoc. of Realtors (left chart); National Assoc. of Realtors via Moody’s Economy.com, WSJ 6/22/09 (right chart). 57
  25. 25. Defaults Are Massively Outpacing Liquidations, So the Inventory Overhang Continues to Worsen First time defaults Liquidations Note: This data is based on approximately 28 million loans. Total first-time defaults are running at 300,000/month. Source: First American CoreLogic Loan-Level Servicing Data, Amherst Securities. 58
  26. 26. Defaulted Mortgages Are Taking Longer to Liquidate, Adding to the Inventory Overhang Source: First American CoreLogic Loan-Level Servicing Data, Amherst Securities. 59
  27. 27. Cure Rates Have Fallen Such That Once a Homeowner Misses Two Payments, A Foreclosure Is Almost Inevitable Source: Loan Performance, Amherst Securities. 60
  28. 28. The Current “Housing Overhang” Is 7 Million Homes – Which Doesn’t Include Any New Defaults, Which Are Running at Approximately 300,000/Month! Source: Mortgage Bankers Association, Loan Performance, Amherst Securities. 61
  29. 29. Shadow Inventory for Each of the 20 Cities in the Case-Shiller Index Note: Notice of Default data is incomplete or missing for many cities. Source: www.trulia.com, Amherst Securities. 62
  30. 30. Outlook for Housing Prices
  31. 31. Home Prices Were in an Unprecedented Freefall Until A Slight Bounce in Q209 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 00 00 Q 01 Q 01 Q 02 Q 02 Q 03 Q 03 Q 04 Q 04 Q 05 Q 05 Q 06 Q 06 Q 07 Q 07 Q 08 Q 08 09 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 1 3 1 3 1 3 1 3 1 3 1 3 1 3 1 3 1 3 1 Q Q Q Sources: Standard & Poor’s, OFHEO Purchase-Only Index, NATIONAL ASSOCIATION OF REALTORS® Existing Home Sales data series. 64
  32. 32. Home Prices Look Affordable Due to Price Declines and Ultra-Low Interest Rates 800 CASE SHILLER USA (1975 = 100) Modeled Home Prices - Interest Only 700 Modeled Home Prices - 30yr Fully Amortizing 600 500 Index Value 400 300 200 100 0 Date S C Shill B fL b St ti ti Bl b A h tS iti Source: Case-Shiller, Bureau of Labor Statistics, Amherst Securities. 65
  33. 33. The Housing Affordability Index Shows Houses Are Now Affordable 26 24 Mortgage Payment on Median Priced Home as % of Family Income 22 20 18 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 16 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. 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. 66
  34. 34. 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 50 54 58 62 66 70 74 78 82 86 90 94 98 02 06 09 19 19 19 19 19 19 19 19 19 19 19 19 19 20 20 20 Sources: Robert J. Shiller, Irrational Exuberance: Second Edition, as updated by the author; Lawler Economic & Housing Consulting, T2 estimates. 67
  35. 35. GMO’s Study of Bubbles Shows That All of Them Eventually Return to Trend Line 34 Have Returned to Trend; the Only Exception, British Housing, Is On Its Way 12 Examples GMO calls this “the greatest sucker’s rally in history” S&P 500 S&P 500 Stocks Japan vs. EAFE ex-Japan S&P 500 1920-1932 1946-1984 1981-1999 1992-October 2008 2.3 2.5 3.0 2.4 Detrended Real Price Detrended Real Price Detrended Real Price 2.5 Relative Return 1.8 2.0 2.0 2.0 1.5 1.3 1.5 1.6 Trend Line 1.0 Trend Line 1.0 0.8 0.5 1.2 0.5 Trend 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 Real Price 1200 150 400 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. 68
  36. 36. 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% 0.50 2.00 Fair Value to Bottom: 7 Years 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. 69
  37. 37. 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 seven factors that are (or are likely to be) short-term: 1. Ultra-low interest rates 2. The $8,000 tax credit for first-time homebuyers – This expires on November 30th, but will likely be renewed and perhaps expanded – Current cost: $1 billion/month 3. More middle- and upper-end homes are being sold (either voluntarily or via foreclosure), which has the effect of raising the price at which the average home is sold – but more defaults of higher priced homes is very bad news for mortgage holders 4. A decline in resets (which will ramp up again over the next few years) 5. A temporary reduction in the inventory of foreclosed homes – There are currently big delays in foreclosures due to four reasons (in descending order of importance): A) Loan modifications via the HAMP program; B) Political pressure on banks and servicers; C) The system is overwhelmed with the unprecedented volume of defaulting homeowners; and D) Some banks, weakened by losses, may be motivated to drag out the process so that losses/write- downs can be delayed, giving them more time to earn their way out of trouble. – “For now, the delays have led to what is probably a temporary drop in the supply of bank-owned homes in California and other places where investors and first-time home buyers have been competing for bargains. In Orange County, Calif., the number of bank-owned homes listed for sale dropped to 322 in early September from 1,404 in November 2008, according to Altera Real Estate. But the number of foreclosures is expected to increase in the fourth quarter as mortgage-servicing companies determine who is eligible for a loan modification and who isn't. ‘We are going to see a spike from now to the end of the year in foreclosures as we take people out of the running’ for a loan modification or other alternatives, says a Bank of America Corp. spokeswoman. ‘Foreclosure sales had dropped to ‘abnormally low’ levels in response to government efforts to stem foreclosures, she adds.’ – WSJ, 9/23/09 6. The FHA is providing massive support to the housing market, in part by doing extremely risky lending – FHA’s market share has risen from 2% in 2005 to 23% of all mortgages, in part because of lax lending standards: only 3.5% down for people with 600 (subprime) FICO scores and 10% down for people with 500 (deep subprime) FICO scores – Thousands of shady subprime mortgage lenders rebranded themselves and are now doing FHA-backed business. Approved FHA lenders grew from just over 9,600 at the end of FY07 to nearly 14,000 today, according to HUD – FHA has very poor systems and controls – there’s not even a Chief Risk Officer! – It’s no surprise, therefore, that defaults are skyrocketing – 17.9% of all FHA-guaranteed loans are now in some stage of delinquency – HUD's audit for FY08 (which ended 9/30/08) showed that the FHA capital ratio declined dramatically from 6.4% to 3.0%, but projected that it would remain above its statutory minimum of 2% going forward – this is highly unlikely – FHA will likely need additional funding from Congress in the near future – one analyst estimated $54 billion – and a condition of this might be a requirement of tighter lending standards, in which case it’s highly unlikely that any other lender would step in to fill the gap; it’s possible, however, that Congress might decide to continue the subsidy to help stabilize the housing market 7. Home sales and prices are seasonally strong in April-July due to tax refunds and the spring selling season 70
  38. 38. The Average Loan Size of Defaulted Loans is Rising Rapidly, Reflecting the Spread of Defaults Away From Smaller Subprime Loans Toward Alt-A and Prime Loans This Has the Effect of Raising the Average Home Price Reported By Many Data Providers Note: Data is only for loans that were securitized. Source: LoanPerformance, Amherst Securities. 71
  39. 39. Another Wave of Resetting Loans Is On the Horizon The Last Wave Was Driven By Subprime Loans; This Time, It Will be Option ARMs Option ARM Alt A Prime Subprime 20 We are Total Loan Balance ($Bil) here 15 10 5 0 Source: Loan Performance, Amherst Securities. 72
  40. 40. Banks Are Selling Their REO, But Foreclosures Have Plunged By More Than Half, Ballooning the Inventory Pipeline 25% Monthly Roll Rates Non-Performing to Foreclosure 20% REO to Liquidation Monthly Roll Rates (%) 15% 10% 5% Foreclosure to REO Inventory Pipeline 0% 1,400,000 1,200,000 90 Days & Foreclosure 1,000,000 Non Performing to Foreclosure Foreclosure to REO REO to Liquidation 800,000 600,000 400,000 REO 200,000 0 REO 90 Days PLUS Foreclosure Source: Loan Performance, Amherst Securities. 73
  41. 41. One Third of All New Single Family Home Sales Are Financed With FHA or VA Loans Number of FHA Loans Insured FHA/VA Share of New SF Home Sales 40% 35% 30% 25% 20% 15% 10% 5% 0% 19 1 19 1 19 1 19 1 19 1 19 1 19 1 19 1 19 1 19 1 19 1 20 1 20 1 20 1 20 1 20 1 20 1 20 1 20 1 20 1 20 1 1 Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 19 Source: HUD/FHA, through August 31, 2009, NY Times, 10/8/09; Commerce Department through Q3 09. 74
  42. 42. FHA’s Loan Book Is a Rapidly Growing Disaster 17.9% of Loans Are in Some Stage of Default; For 2007 Loans, It’s 32.4% Source: HUD/FHA, through August 31, 2009, NY Times, 10/8/09. 75
  43. 43. Existing Home Sales Are Highly Seasonal Source: National Association of Realtors. 76
  44. 44. Existing Home Sales Are Highly Seasonal HPA Seasonality Coefficient -- Deviation From Mean Source: National Association of Realtors. 77
  45. 45. M ar -3.5% -3.0% -2.5% -2.0% -1.5% -1.0% -0.5% 0.0% 0.5% 1.0% 1.5% 2.0% M -05 ay August… -0 Ju 5 l Se -05 p N - 05 ov - Source: S&P Case-Shiller 20-city index. J a 05 n M - 06 ar M -06 ay -0 Ju 6 l Se -06 p N - 06 ov - J a 06 n M - 07 ar M -07 ay -0 Ju 7 l Se -07 p N - 07 ov - J a 07 Home Prices Bounced From April- n- M 08 ar M -08 ay -0 Ju 8 l Se -08 p N - 08 ov Sequential Home Prices March 2005-August 2009 - J a 08 n M - 09 ar August 2009: +1.2% M -09 ay -0 Ju 9 l-0 9 78

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