Presentation I gave to the investment partnership on 1/10/2008, almost 8 years ago. On the MBS/CDO/CDS markets

1. The Credit Crunch
Jee Manghani, January 10, 2008

2. Definition
 sudden reduction in the availability of credit
 may be due to:
 An increased perception of risk
 A change in monetary conditions
 An imposition of credit controls

3. Fractional Reserve Banking
 Let’s go over a couple basics on how credit is
created.
 FRB: A way to temporarily increase the money
supply without creating new money.

4. Fractional Reserve Banking
Table 1: $1,000 of actual money loaned out 10 times at 20%
Individual Bank Amount deposited at bank Amount loaned out Reserve left in bank
A $1,000.00 $900.00 $100.00
B $900.00 $810.00 $90.00
C $810.00 $729.00 $81.00
D $729.00 $656.10 $72.90
E $656.10 $590.49 $65.61
F $590.49 $531.44 $59.05
G $531.44 $478.30 $53.14
H $478.30 $430.47 $47.83
I $430.47 $387.42 $43.05
J $387.42 $348.68 $38.74
K $348.68
total reserves:
$651.32
total deposits: total amount loaned out: total reserves + “K” deposit
$6,861.89 $5,861.89 $1,000.00

5. Traditional Lending

6. Securitization
 Traditional lending has risks when the yield to
depositors becomes greater than the yield from
borrowers.
 Especially in the 1970s, when interest rates shot up
and the fixed rate mortgages would not adjust.
 In the 1970s, mortgages were securitized.

7. Securitization
Bank/lender creates a “Special Purpose Vehicle” where mortgages are pooled.
Then bonds of this SPV are sold off to investors, which are called Mortgage-
Backed Securities. The cash from the MBS sale is then deposited back in the
bank’s reserves.

8. Benefits of Mortgage Backed Securities
 Transform illiquid assets into tradeable market
securities.
 Diversify financing sources
 Fund replenishment for more loans
 Quickly remove assets from the balance sheet and
raise cash to improve financial ratios (e.g. Fractional
Reserves)

9. Collateralized Debt Obligation
 Any defaults and less than 100% recovery rates on
houses would theoretically impact all MBSs from the
same SPV evenly.
 Let’s try to make investment in MBS a bit
safer…create a CDO!
 CDOs organize a many MBSs (regardless of their
safety) into tranches.
 The higher risk tranches face the first losses in
foreclosures, but reap the highest returns.
 The lower risk tranches have lower returns, but are
among the last to face losses.

10. Collateralized Debt Obligation
 Let’s try to make
investment in MBS a
bit safer…create a
CDO!
 This is basically a
derivative. Create a
new financial
instrument based on
another financial
instrument.

11. Why Stop There?
 You can take CDOs in tranches and create a new
CDO tranche structure.
 Let’s make Tranche E a bit safer…..

12. Let’s Hedge Our Bets
 Credit Default Swaps can be placed on a CDO within
a tranche.
 This is basically insurance, in case the principal is
eroded through defaults in payments.
 In return, sellers of CDSs get regular payments from
the holders of CDOs, lowering their returns on the
CDOs.

13. The Rabbit Hole Gets Deeper
 CDSs in themselves can be a bit risky.
 Investors are banging on the door to participate.
 CDSs are organized into CDO tranches and sell
them to investors.
 Investors buy them up, since the return on them is
attractive.

14. Can I attempt to summarize the cash flow?
Borrower Bank MBS
CDO
Tranche of
MBS
CDO
Tranche of
CDOs
CDS
CDO
Tranche of
CDSs
Investors
 Derivatives are fun! Very useful in making gold out of
crap.
 Warren Buffett, in his 2003 shareholders report,
referred to derivates as “financial weapons of mass
destruction”.

15. Middle-men Who Have Nothing to Lose

16. Where is the Personal Responsibility?
 By selling mortgages as securities, banks earned
fees or gained value in the securities. Capital
preservation was no longer of first importance.
 Banks and lenders paid high fees independent
mortgage brokers to originate loans. Capital
preservation was not on their radar as long as the
lender/bank approved.
 MBS Investors had little visibility into the credit-
worthiness of borrowers.

17. Everything is roses….
 When the housing market is going up….
 By offering mortgages to prime and subprime
borrowers, demand in homes increases significantly.
 Prices shoot up faster than incomes and rents,
particularly on the coasts.
 Even prime borrowers take out risky loans, and
extract equity.
 Feeling richer, Americans’ savings rate goes
negative for several years.
 Defaults on homes only results in increased home
values and a profit for everyone in the tranches.

18. Real Estate Never Goes Down!
Robert Shiller, an
economist at Yale
University, famous
for the “irrational
exuberance” term
that he coined in
1996. He predicts
a decline of
coastal real estate
on the order of
30-50%.

19. Prices increased faster than incomes
Price to Income Ratio has
never been higher, and
close to twice the average.
The monthly payment
to Income Ratio was
higher in 1980 due to
high mortgage rates,
which placed
downward price
pressure.

20. Prices, Payments, Rents, and Income

21. Yay! Free Money!
• Many homeowners extracted equity for
consumption and investment.
• When trouble comes, just sell the house since they
all will be worth $1 million soon!

22. P/E of RE Investment
 Investors comprised 45% of the
activity during the boom, and owner
occupied deals comprised the rest.
 Investors are now in negative cash
flow territory, making new real estate
purchases a bad investment, unless
they could flip them.
 Investors are not buying RE in
overpriced markets. Selling
properties is a better investment
decision now.

23. Fraud is Rampant!
 Homes are over-appraised, and the excess sale amount
is “refunded” back to the buyer, who then pockets the
cash and defaults on the home.
 Investment schemes where scammers pool credit-worthy
investors’ cash to buy homes at inflated prices, default on
the home, and steal the cash.
 Mortgage brokers utilized NINJA loans (No Income, No
Job or Assets)
 Crisp & Cole in Bakersfield (link to story)
 CA Strawberry Picker earning $15k/year buys a $720k
house (link to story)
 A few other “ridiculous mortgage borrower stories” (link)

24. An ARM and a leg
 Those ARMs are now
adjusting.
 People who were
planning on
refinancing can’t
since their home is
worth less than the
loan, unless they
bring a check.
 They can deal with
higher payment.
 They can refinance
and pay the loan gap.
 They can sell their
home as a short sale
(less than the loan
amount).

25. And Musical Chairs Game Stops…

26. Few Greater Fools to be Found to Buy…

27. And Not Just on the Overpriced Coasts

28. But I am still building Equity!
 If you bought a
while ago, yes. If
you recently
bought, nominally,
you will “break
even” eventually.
 This charts is from
Goldman Sachs
report
 Half of all homes
are fully owned.
This chart is the
other half.
• 7% were negative.
• 30% drop – red goes
negative.
• 50% drop – yellow goes
negative.

29. Mortgage Deliquencies are Spiking
 As of October, 16%
of all adjustable
subprime loans
were 90-days into
default or in
foreclosure.
 Foreclosures are
spreading to Alt-A,
Option-Arms and
Prime, due to
rampant
speculation and
equity extraction.
 Many of these were
in the imploding real
estate profession.

30. Hooverville Coming to a Town near You?
 Foreclosure rates have spiked up to unprecedented
levels.
 Recovery rates range from 40-80% of the original
loan amount, eroding CDO value.
 Here is a chart of defaults & foreclosures in San
Diego (Oct. 2007)

31. The Fallout – CDO Value
 When the musical chairs stopped, the buying and
selling of CDOs stopped, causing a liquidity issue in
the financial institutions.
 The values of CDOs were hard to determine.
 How many bad loans and defaulted mortgages are
these CDOs based on?
 What are the recovery rates on foreclosed homes in
a rapidly declining market?
 Only choice was to “mark-to-Market”, and see how
much buyers were willing to buy them for.
 Hedge funds are losing billions to CDOs that lose
anywhere from 5-90% of their value.

32. The Fallout - CDO Charts

33. The Fallout – Conforming Loans
 Conforming loan MBSs are
bought by Fannie Mae and
Freddie Mac
 The FMs are private companies
with shareholders to please, but
their solvency is backed by the
government (i.e. you and me).
 Between them, they back $4.7
trillion dollars in mortgages.
They only have $82 billion of
capital.
 Fannie alone backs $300B of
stated-income loans, $200B of
interest-only, $120B of
subprime.
 No need to worry, we can be
taxed or we can print dollars to
keep them propped up.
 Real Estate Lobbyists are trying
to bring the conforming limit up
from $417k to over $650k.
There were brief mentions of
bringing it up to $1million.
$0
$500
$1,000
$1,500
$2,000
$2,500
$3,000
Freddie
Mac
Fannie
Mae
Loans
Capital
(in Billions)

34. The Fallout – Jumbo Loans
 Jumbo loans are bought by private investors.
 They have lost appetite for MBSs, unless they are
assured of a high downpayment and very high FICO
scores.
 Higher rates are needed to attract buyers.
 Banks can keep the loans on their balance sheets.
With the
 Tougher loan standards means fewer qualified
buyers for overpriced markets.
 Lower demand is leading to long market times for
homes for sale, leading to distressed sellers unable
to sell their home in time to avoid foreclosure.

35. The Fallout – The Federal Reserve
 Ben Bernanke is an expert on the Great Depression.
 Conventional wisdom says that the Depression was
caused by monetary contraction due to the crisis in
the banking system.
 Bernanke is injecting billions into the system so that
banks can continue providing all types of loans.
These loans are provided at the “discount window”
rate.
 Banks were hesitating in publicly taking money from
the Fed, for fear of sending a bad message to their
depositors.
 The Fed is now holding auctions for the loans, to be
awarded anonymously to the banks.