Making Sense of the Mortgage Meltdown

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

“I have great, great confidence in our capital markets and in our financial institutions. Our financial institutions, banks and investment banks are strong.” Treasury Secretary Henry Paulson March 16, 2008 CNN 2

… but just six months later… “The financial security of all Americans … depends on our ability to restore our financial institutions to a sound footing.” Treasury Secretary Henry Paulson September 19, 2008 Press release 3

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

“Any real estate investment is a good investment … ” … Really?! 5

Subprime mortgage meltdown timeline December 2006–September 2008 Dow Jones U.S. Financial Index Aug. 16, 2007: Sept. 30, 2007: Oct. 24, 2007: Mar. 11, 2008: Fed Mar. 16, 2008: Mar. 18, 2008: Aug. 1, Countrywide gets NetBank goes Merrill announces offers troubled JP Morgan Fed cuts 2008: First 650 Feburary–March 2007: More than 25 subprime lenders declare emergency loan of bankrupt. $7.9 billion in banks as much as Chase offers to discount rate Priority Bank $11 billion from a subprime write- $200 billion in buy Bear to 2.4%; Fed bankruptcy. group of banks. downs, surpassing loans; Fed Stearns; Fed funds rate to closes. Citi’s $6.5 billion. introduces Term introduces 2.25%. Securities Primary Dealer Sept. 14, 2008: Lending Facility. Credit Facility. Lehman files for 550 bankruptcy. July 30, 2008: Dec. 2006: Feb. 2007: Apr. 2007: New Sept. 16, 2008: President Ownit Mortgage, HSBC sets Century, a Fed loans AIG Bush signs a a subprime aside $10.6 mortgage $85 billion. Dec. 12, 2007: housing lender, files for billion for broker, files Fed introduces rescue law. 450 bankruptcy. bad loans, for Aug. 6, 2007: Term Auction Sept. 23, 2008: including bankruptcy. American Home Washington Facility. subprime. Mortgage files Mutual is seized Jan. 11, 2008: July 31, 2007: for bankruptcy. by FDIC. Bank of Two Bear America agrees June 9, 2008: Stearns Feb. 13, 2008: 350 hedge funds Aug. 17, 2007: Fed cuts to buy Countrywide. President Bush Lehman Sept. 29, 2008: announces a $2.8 Citigroup file for introduces tax discount rate to 5.75%; billion loss. agrees to buy bankruptcy. Jan. 30, 2008: Fed rebate stimulus Sept. 7, 2008: U.S. Fed introduces Term Wachovia bank. cuts discount rate program of $168 seizes Fannie Mae Discount Window July 11, 2008: IndyMac to 3.5%. billion. and Freddie Mac. Program. is seized by FDIC. 250 Sources: BusinessWeek, S&P, Global Insight, Milken Institute. 6

Overview 7

Home mortgages: Who borrows, how much has been borrowed, and who funds them? Total value of housing stock = $19.3 trillion Subprime 8.4% Securitized Government- Mortgage debt 58% controlled $10.6 trillion 46% Prime 91.6% Non-securitized Private 42% sector- 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

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 5 million are behind 1930s. (9.2% of 53 million with 2.8% in foreclosure) Sources: U.S. Treasury, Milken Institute. 9

I. Low interest rates and a lending boom 10

Did the Fed lower interest rates too much and for too long? Federal funds rate vs. rates on FRMs and ARMs Percent 8 7 30-year FRM rate 6 5 4 Target federal 3 funds rate 1-year ARM rate 2 1 Record low from June 25, 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

Low interest rates Home price bubble and credit boom and credit boom US$ trillions Percent US$ trillions Index, January 2000 = 100 4.5 6.0 4.0 250 4.0 3.5 5.5 3.5 200 3.0 3.0 5.0 2.5 150 2.5 4.5 Home Home 2.0 2.0 mortgage mortgage originations 100 1.5 4.0 1.5 S&P/Case-Shiller originations (left axis) (left axis) National Home 1.0 1.0 1-Year ARM rate Price Index 50 3.5 0.5 (right axis) 0.5 (right axis) 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

II. Homeownership, prices, starts and sales take off 13

Credit boom pushes Home price bubble California and national homeownership rate peaks in 2006 home prices reach to historic high record highs Percent Index, January 1987 = 100 US$ thousands 70 Q2 2008: 68.1% 380 S&P/ 700 Q2 2004: 69.2% Cas e -Shille r California m e dian 69 330 National Hom e 600 hom e price Price Inde x California 68 280 500 ave rage 400 1987-2008 U.S. m e dian 67 230 $229,748 hom e price 300 66 180 200 65 130 OFHEO Hom e Price Inde x 100 Ave rage , 1965–Q2 2008: 65.2% U.S. ave rage , 1987-2008: $121,280 64 80 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

Housing starts hit Homes sales reach a record in 2005 Homes for sale Millions Millions a new high Housing units, millions Millions 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 1.0 2 0.4 Ave rage s tarts , 2.8 0.6 1959–July 2008: 1.1 m illion Ne w hom e s ale s 1 0.2 (right axis ) 0.5 1.4 0.3 July 2008: 641,000 New homes for 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

III. Subprime borrowers and subprime mortgages 16

Who is a subprime borrower? National FICO scores display wide distribution What goes into a FICO score? Percentage of population 40 Types of credit in use Prime = 79% 10% New credit 30 27 Payment history 10% Subprime = 21% 35% 20 18 15 Length of 12 13 credit history 10 8 5 15% 2 0 up to 500- 550- 600- 650- 700- 750- 800+ Amounts owed 499 549 599 649 699 749 799 30% Sources: myFICO.com, Milken Institute. 17

Prime and subprime mortgage originations by FICO score reveal substantial overlaps Percent of total originations 20 FICO below 620 FICO above 620 Prime: 6.6% Prime: 93.4% 16 Subprime: 45.2% Subprime: 54.8% 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

ARMs look attractive to many borrowers Percent 8.0 7.0 30-year FRM rate 6.0 5.0 4.0 1-year ARM rate 3.0 2.0 2001 2002 2003 2004 2005 2006 2007 2008 Sources: Mortgage Bankers Association, Moody’s Economy.com, Milken Institute. 19

ARM share grows, following low interest rates Percent of all outstanding home mortgages 25 20 15 10 5 0 2001 2002 2003 2004 2005 2006 2007 2008 Sources: Mortgage Bankers Association, Moody’s Economy.com, Milken Institute. 20

Largest share of ARMs go to subprime borrowers Percent of mortgage type 60 FHA ARM Prime ARM Subprime ARM 50 40 30 20 10 0 2001 2002 2003 2004 2005 2006 2007 2008 Sources: Mortgage Bankers Association, Moody’s Economy.com, Milken Institute. 21

Subprimes take an increasing share of all home mortgage originations US$ trillions 8.4% 4.0 Subprime 21.3% Prime 7.4% 18.2% 20.1% 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

Subprime mortgages increase rapidly before big decline Originations US$ billions Outstandings US$ billions 1,400 Average annual growth rates 700 1995–2006: 14% 1,240 625 1,200 600 1,200 2006–Q1 2008: -23% 600 540 973 940 1,000 895 500 800 699 400 310 574 600 300 479 200 191 400 200 160 100 200 14 0 0 2001 2002 2003 2004 2005 2006 2007 Q2 2001 2002 2003 2004 2005 2006 2007 Q1 H2 2008 2008 2008 Sources: Inside Mortgage Finance, Milken Institute. 23

IV. Mortgage product innovation 24

Subprime and Alt-A shares quadruple between 2001 and 2006, then fall in 2007 2001, $2.2 trillion 2006, $3.0 trillion 2007, $2.4 trillion Q1 2008, $480 billion 4.9% 4% 9% 9.6% 2% 5% 2.7% 14% 7.9% 14% 2% 7% 33.2% 11% 8% 13% 8% 20% 47.3% 57.1% 20% 16% 14% 67.2% p FHA & VA Subprime Conventional, conforming prime Alt-A Jumbo prime Home equity loans Sources: Inside Mortgage Finance, Milken Institute. 25

ARM hybrids dominate subprime originations (2006) Prime conventional Alt-A Subprime Other Fixed Other ARM Othe r 9% ARM 7% ARM 4% ARM 23% 30-year hybrids ARM balloon with 40- to 23% 50-year amortization 26% Fixed Fixe d ARM hybrids 2- and 3-year 70% 31% 46% hybrids 61% Sources: Freddie Mac, Milken Institute. 26

V. Securitization 27

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 portfolio 59% 84.4% Sources: Federal Reserve, Milken Institute. 28

Securitization becomes the dominant funding source for subprime mortgages Percent of all subprime mortgages securitized since 1994 80 68 68 68 70 65 62 60 57 50 50 47 45 43 42 45 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

The rise and fall of private-label securitizers New securities issuance 2% 4% 13% 6% 15% 42% 20% 21% 56% 18% 1985 2001 2006 First half 2008 Total = $110B Total = $1.3T Total = $2.0T Total = $734B 29% 22% 33% 35% 38% 46% Ginnie Mae Freddie Mac Fannie Mae Private-label Sources: Inside Mortgage Finance, Milken Institute. 30

The rise and fall of private-label securitizers Outstanding securities 6% 7% 7% 14% 18% 30% 35% 13% 55% 25% 26% 1985 2001 2006 First half 2008 Total = $390B Total = $3.3T 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

VI. Affordability 32

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 3.5 2007: 4.29 100 Average, 1957–2007: 79.7% 65 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

VII. Collapse 34

The recent run-up of home prices was extraordinary Index, 2000 = 100 250 Annualized growth rate of nominal home index: 3.4% Current boom 200 Great Depression World World 1970’s 1980’s 150 War I 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

Home prices don’t go up forever Change in home prices in 100 plus years Percentage change in nominal home price, year ago 30 World Great World 1970’s 1980’s Current 25 War I Depression War II Boom Boom Boom 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

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

Forty-six states had falling prices in the fourth quarter 2007 United States: - 9.3% (fourth-quarter annualized growth) Source: Freddie Mac. 38

If you bought your house… One year ago… Five years ago… -1.0 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 26.8 Phoenix -7.1 Seattle 26.3 Los Angeles -7.3 New York 26.3 Tampa -7.3 Cleveland 26.0 Miami -8.1 Atlanta 24.4 Las Vegas -9.5 Chicago 22.9 Charlotte -13.9 Minneapolis 20.5 Composite 10 -15.7 W ashington 18.6 Composite 20 -15.9 Composite 20 14.3 Chicago -16.3 Detroit 9.1 San Francisco -17.0 Composite 10 6.6 Atlanta -20.1 Tampa Dallas 6.5 -23.7 San Francisco 6.1 San Diego -24.2 San Diego 5.9 Boston -25.3 Los Angeles 4.8 Denver -27.9 Phoenix -0.7 Minneapolis -28.3 Miami -28.6 -3.8 Cleveland 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

Housing starts Homes sit longer … as home sharply decline on the market … appreciation slows Percent change, year ago Number of months that Percent Months 30 homes sit on the market Pe rce ntage change from 12 20 ye ar ago in m e dian 0 15 Existing homes hom e s ale s price 10 (le ft axis ) 2 0 10 8 4 -15 6 0 6 -30 8 4 June 2008: -41.9% -10 Num be r of m onths -45 July 2008: -39.2% 10 2 New homes hom e s s tay on m ark e t (right axis ) -60 0 -20 12 1998 2000 2002 2004 2006 2008 1998 2000 2002 2004 2006 2008 1999 2001 2003 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

VIII. Delinquencies and foreclosures 41

Foreclosures are nothing new, but … Thousands of foreclosures per year 2,150 1,900 1,650 1,400 1,150 Av erage 661,362 annual foreclosures from Q2 1999 to Q2 2006 900 650 400 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

… 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

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) 1,600 FHA and VA 50% Prime (includes Alt-A) 54% 1,200 56% 800 55% 8% 9% 37% 36% 37% 44% 47% 52% 42% 11% 37% 400 29% 29% 29% 22% 20% 13% 17% 31% 33% 34% 35% 34% 34% 33% 32% 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

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

Percentage of homes purchased in Q2 2008 that now have negative equity United States = 44.8% < 20% >= 20% and < 35% >= 35% and < 50% >= 50% Sources: Zillow.com, Milken Institute. 46

Percentage of homes sold for a loss (Q2 2008) United States = 32.7% < 15% >= 15% and < 30% >= 30% and < 45% >= 45% Sources: Zillow.com, Milken Institute. 47

Percentage of homes sold that were in foreclosure (Q2 2008) United States = 18.6% < 1% >= 1% and < 25% >= 25% and < 40% >= 40% Sources: Zillow.com, Milken Institute. 48

IX. Damages scorecard 49

Losses/write-downs, capital raised, and jobs cut by financial institutions worldwide US$ billions Number of jobs cut 200 60,000 Jobs cut (right axis) 160 48,000 120 Capital raised 36,000 (left axis) 80 Losses/write-downs 24,000 (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

What is the cumulative damage? Cumulative losses/write-downs, capital raised, and jobs cut by financial institutions worldwide US$ billions Number of jobs cut 600 140,000 500 120,000 Jobs cut (right axis) 100,000 400 Capital raised (left axis) 80,000 300 Losses/write-downs (left axis) 60,000 200 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

Recent losses/write-downs and capital raised by selected financial institutions US$ billions, through September 25, 2008 Losses /write-downs Capital raised Citigroup, United States 55.1 49.1 Merrill Lynch, United States 52.2 29.9 UBS, Switzerland 44.2 28.2 HSBC, United Kingdom 27.4 5.1 Wachovia, United States 22.7 11.0 Bank of America, United States 21.2 20.7 Morgan Stanley, United States 15.7 5.6 IKB Deutsche, Germany 15.0 12.3 Washington Mutual, United States 14.8 12.1 Royal Bank of Scotland, United Kingdom 14.4 23.5 World total 521.9 379.2 Sources: Bloomberg, Milken Institute. 52

Financial stock prices take big hits Percentage change in stock price, December 2006–September 2008 -99.8 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

Financial market capitalization takes big hit Total loss in market value: $728 billion, December 2006–September 2008 -142 AIG -101 W achov ia -80 Bank of America -74 UBS Equity -60 Morgan Stanley -50 Fannie Mae -44 Merrill Lynch -43 W ashington Mutual -42 Freddie Mac -41 Lehman Brothers -28 Goldman Sachs -24 Countrywide** -21 Bear Stearns* 4 W ells Fargo US$ billions 17 JP Morgan & Chase Note: * Bear Stearns stock price is to May 2008. ** Countrywide stock price is to June 2008. Sources: Bloomberg, Milken Institute. 54

X. Credit crunch and liquidity freeze 55

Tightened standards for real estate loans Net percentage of domestic respondents tightening standards for commercial real estate loans 100 80 The end of S&L crisis Dotcom Subprime LTCM 60 40 20 0 -20 -40 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 Sources: Federal Reserve, Milken Institute. 56

Widening spreads between mortgage-backed and high-yield bonds Basis points, spread over 10-year Treasury bond 1,800 Maximum spread: 08/29/2008: 955.8 bps 1,600 1,400 Merrill Lynch Mortgage-Backed Securities Index 1,200 1,000 Merrill Lynch High-Yield Bond Index 800 600 400 200 0 01/2004 07/2004 01/2005 07/2005 01/2006 07/2006 01/2007 07/2007 01/2008 07/2008 Sources: Merrill Lynch, Bloomberg, Milken Institute. 57

Liquidity freeze Spread between 3-month LIBOR Spread between 3-month LIBOR and and T-bill rate overnight index swap rate Basis points Basis points 350 140 Se pte m be r 18, 2008: 313 bps Se pte m be r 19, 2008: 300 120 127.5 bps Augus t 20, 2007: 240 bps 250 100 Ave rage s ince 80 Augus t 2007: 69.8 bps 200 Ave rage s ince 150 60 Augus t 2007: 130 bps Ave rage s ince 40 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

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

Commercial paper issuance dries up Quarterly change in outstanding amount, US$ billions 150 100 50 0 -50 -100 Issuers of asset-backed securities -150 Other issuers -200 Q1 2006 Q2 2006 Q3 2006 Q4 2006 Q1 2007 Q2 2007 Q3 2007 Q4 2007 Q1 2008 Q2 2008 Sources: Federal Reserve, Milken Institute. 60

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

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

XI. When will we hit bottom? 63

Looking for a bottom? Economists say the economy isn’t at its low point yet, and house prices likely won’t get there until 2009 Does this feel like the bottom When will home prices hit bottom? to a downturn? Yes 1st half 6% 27% 2010 2nd half 29% 2009 1st half 38% 2009 2nd half 17% No 2008 73% 1st half 4% 2008 Source: Wall Street Journal. 64

How far do home prices have to fall? Annual rents as percent of home prices 6.5 Q2 1971: 6.08% 6.0 5.5 5.0 4.5 Q1 2008: 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

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

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

XII. What went wrong 68

The importance of Fannie Mae and Freddie Mac US$ billions 3,000 2,443 2,500 2,067 2,000 1,410 1,500 886 879 944 1,000 500 0 Fannie Mae: Fannie Mae: Freddie Mac: Freddie Mac: Commercial Savings total assets total MBS total assets total MBS banks: total institutions: outstanding outstanding residential real total estate assets residential real estate assets Sources: Freddie Mac, Fannie Mae, FDIC, Milken Institute. 69

Fannie Mae and Freddie Mac: Too big with too little capital? US$ billions 3,000 Total assets 2,443 2,500 Total MBS outstanding 2,000 1,778 1,500 1,410 1,301 1,123 1,022 1,000 803 752 844 805 886 879 500 288 316 133 41 0 Fannie Mae Freddie Mac Fannie Mae Freddie Mac Fannie Mae Freddie Mac Fannie Mae Freddie Mac 1990 1990 2003 2003 2006 2006 2Q 2008 2Q 2008 Sources: Freddie Mac, Fannie Mae, Milken Institute. 70

Fannie Mae and Freddie Mac are highly leveraged Mortgage book of business over capital measures 300 Fannie Mae 244x Freddie Mac 250 200 167x 150 100 81x 60x 60x 64x 65x 56x 58x 59x 55x 57x 48x 52x 56x 50 -393x 0 Core capital Fair value Core capital Fair value 2005 2006 2007 2008Q2 Sources: Freddie Mac, Fannie Mae, FDIC, Milken Institute. 71

Freddie Mac’s and Fannie Mae's retained private-label portfolios Subprime Alt-A All others Freddie Mac, 2006 $122.2 billio 61.2% 25.0% 13.8% Freddie Mac, 2007 $76.1 billion 57.4% 13.1% 29.5% Fannie Mae, 2005 $86.9 billion 32.1% 37.4% 30.5% Fannie Mae, 2006 $97.3 billion 46.4% 36.1% 17.5% Fannie Mae, 2007 $94.8 billion 33.8% 4.3% 32.0% Sources: Freddie Mac, Fannie Mae, FDIC, Milken Institute. 72

Leverage ratios of different types of financial firms (June 2008) Lev erage ratio, total assets/common equtity Freddie Mac 67.9 Fannie Mae 21.5 Federal Home Loan Banks 23.7 Brokers/hedge funds 31.6 Savings institutions 9.4 Commercial banks 9.8 Credit unions 9.1 Sources: Federal Deposit Insurance Corporation, Office of Federal Housing Enterprise Oversight, National Credit Union Administration, Bloomberg, Google Finance, Milken Institute. 73

Too much dependence on debt? Leverage ratios at biggest investment banks Total assets/total shareholder equity 2000 2005 2007 June 2008 40 35 34 33 32 31 31 30 30 28 27 28 26 24 24 25 22 23 22 22 19 19 20 18 15 10 5 n.a. 0 Bear Stearns Merrill Lynch Morgan Stanley Lehman Brothers Goldman Sachs Sources: Bloomberg, FDIC, Milken Institute. 74

Most new securities issued in 56 percent of MBS issued from 2007 were rated AAA by S&P 2005 to 2007 were eventually Number of securities rated downgraded 0 1,000 2,000 3,000 4,000 5,000 AAA AA+ S&P Total Downgraded Downgraded AA / Total AA- A+ AAA 1,032 156 15.1% A 4,090, or 51%, of new A- AA(+/-) 3,495 1,330 38.1% BBB+ securities rated by BBB S&P w ere rated AAA A(+/-) 2,983 1,886 63.2% BBB- BB+ BBB(+/-) 2,954 2,248 76.1% BB BB- BB(+/-) 789 683 86.6% B+ B B(+/-) 8 7 87.5% B- CCC+ Total 11,261 6,310 56.0% CCC+ CCC- CC Note: A bond is considered investment grade if its credit rating C is BBB- or higher by S&P D Sources: Bloomberg, Inside Mortgage Finance, Milken Institute. 75

When is a AAA not a AAA? Multilayered mortgage products Origination of mortgage loans High-grade CDO Senior AAA 88% Junior AAA 5% Pool of mortgage AA 3% loans: prime or subprime A 2% BBB 1% Unrated 1% Mortgage bonds AAA 80% AA 11% A 4% Mezzanine CDO BBB 3% CDO-squared BB-unrated 2% Senior AAA 62% Junior AAA 14% Senior AAA 60% AA 8% Junior AAA 27% A 6% AA 4% CDO-cubed… BBB 6% A 3% Unrated 4% BBB 3% Unrated 2% Sources: International Monetary Fund, Milken Institute. 76

Dollar losses in reported Mortgage loan fraud surges cases of mortgage fraud US$ millions Number of cases reported, thousands 60 1,200 52.9 1,014 50 1,000 946 813 40 37.3 800 30 26.0 600 429 20 18.4 400 293 225 9.5 200 10 4.7 5.4 1. 2.3 2.9 3.5 0 7 0 1997 1999 2001 2003 2005 2007 2002 2003 2004 2005 2006 2007 Sources: Financial Crimes Enforcement Network, Federal Bureau of Investigation, Milken Institute. 77

Is adequate information disclosed to consumers? Percent of respondents who could not correctly identify various loan costs using current disclosure forms Prepayment penalty amount 95 Total up-front cost amount 87 Property tax and homeowner’s insurance cost amount 84 Reason why the interest rate and APR sometimes differ 79 Presence of charges for optional credit insurance 74 Presence of prepayment penalty for refinance in two years 68 Loan amount 51 Which loan was less expensive 37 Whether loan amount included finances settlement charges 33 Interest rate amount 32 Balloon payment (presence and amount) 30 Settlement charges amount 23 Monthly payment (including whether it includes taxes and insurance) 21 Cash due at closing amount 20 APR amount 20 Sources: Federal Trade Commission, Milken Institute. 78

Drivers of foreclosures: Strong appreciation or weak economies? Foreclosures per 1,000 homes 25 Weak economies Housing bubbles Stockton 20 Detroit Las Vegas Riverside 15 Cleveland Toledo Sacramento Fort Lauderdale Dayton Bakersfield 10 Akron Denver Miami Atlanta Phoenix Oakland Fresno Warren Memphis Tampa 5 Orlando San Diego Columbus Indianapolis Palm Beach National average 0 -20 0 20 40 60 80 100 120 140 Five-year price gain, Q3 2002–Q3 2007 (percent) Sources: U.S. Treasury Department, RealtyTrac, Office of Federal Housing Enterprise Oversight, Milken Institute. 79

After housing bubble burst in 2007: Foreclosures highest for areas with biggest price declines Foreclosures per 1,000 homes 45 Collaping housing bubbles W eak 40 National average economies Stockton strengthen 35 Riverside Las Vegas 30 Fort Lauderdale Bakersfield Denver 25 Oakland Sacramento Phoenix Toledo 20 Atlanta Fresno Miami Akron Detroit 15 San Diego Orlando Memphis Tampa 10 Palm Beach W arren Cleveland 5 Dayton Columbus Indianapolis 0 -30 -25 -20 -15 -10 -5 0 5 Price change, 2007–June 2008 (percent, annualized) Sources: RealtyTrac, Office of Federal Housing Enterprise Oversight, Milken Institute. 80

XIII. Where do we go from here? 81

The U.S. regulatory regime: In need of reform? Financial, bank and thrift Fannie Mae, Freddie Mac, and holding companies Federal Home Loan Banks • Fed • Federal Housing Finance • OTS Agency Fed is the umbrella or consolidated regulator National banks State commercial Federal savings Insurance Securities Other financial companies, and savings banks banks companies brokers/dealers including mortgage companies and brokers Primary/ • OCC • State bank • OTS • 50 State insurance • FINRA • Fed secondary • FDIC regulators • FDIC regulators plus • SEC • State licensing functional • FDIC District of Columbia • CFTC (if needed) regulator • Fed--state member and Puerto Rico • State securities • U.S. Treasury commerical banks regulators for some products Notes: Justice Department: Assesses effects of mergers and acquisitions on competition Federal Foreign Limited foreign Federal Courts: Ultimate decider of banking, securities, and insurance products branch branch branch CFTC: Commodity Futures Trading Commission FDIC: Federal Deposit Insurance Corporation • OCC • Fed • OTS Fed: Federal Reserve • Host county • Host county • Host county FINRA: Financial Industry Regulatory Authority regulator regulator regulator GSEs: Government Sponsored Enterprises OCC: Comptroller of the Currency OTS: Office of Thrift Supervision SEC: Securities and Exchange Commission Sources: Financial Services Roundtable (2007), Milken Institute. 82

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

Demystifying the Mortgage Meltdown: What It Means for Main Street, Wall Street and the U.S. Financial System James R. Barth Glenn Yago Senior Fellow Director of Capital Studies Milken Institute October 2, 2008 84

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Making Sense of the Mortgage Meltdown

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Making Sense of the Mortgage Meltdown Presentation Transcript