demystifying the mortgage meltdown: what it means for main...

Demystifying the Mortgage Meltdown:What It Means for Main Street,

Wall Street and the U.S. Financial System

Glenn Yago James R. Barth

11

Milken InstituteOctober 2, 2008

Glenn Yago Director of Capital Studies

James R. Barth Senior Fellow

“I have great, great confidence in our capital markets and in our financial institutions. Our financial institutions, banks and investment banks are strong.”

22

Treasury Secretary Henry PaulsonMarch 16, 2008

CNN

… but just six months later…

“The financial security of all Americans … depends on our ability to restore our financial institutions to a sound footing.”

33

Treasury Secretary Henry PaulsonSeptember 19, 2008

Press release

“Any real estate investment is a good investment … ”

44

“Any real estate investment is a good investment … ”

55

… Really?!

Subprime mortgage meltdown timelineDecember 2006–September 2008

550

650

Dow Jones U.S. Financial Index

Dec. 2006: Ownit Mortgage,

Apr. 2007: New Century, a

Feb. 2007: HSBC sets

Mar. 18, 2008: Fed cuts discount rate to 2.4%; Fed funds rate to 2.25%.

Mar. 11, 2008: Fed offers troubled banks as much as $200 billion in loans; Fed introduces Term Securities Lending Facility.

Mar. 16, 2008: JP Morgan Chase offers to buy Bear Stearns; Fed introduces Primary Dealer Credit Facility.

Oct. 24, 2007: Merrill announces $7.9 billion in subprime write-downs, surpassing Citi’s $6.5 billion.

Aug. 1, 2008: First Priority Bank closes.

Feburary–March 2007: More than 25 subprime lenders declare bankruptcy.

Sept. 30, 2007: NetBank goes bankrupt.

Aug. 16, 2007: Countrywide gets emergency loan of $11 billion from a group of banks.

July 30, 2008: President Bush signs a

Sept. 14, 2008: Lehman files for bankruptcy.

Sept. 16, 2008: Fed loans AIG

66Sources: BusinessWeek, S&P, Global Insight, Milken Institute.

250

350

450

Ownit Mortgage, a subprime lender, files for bankruptcy.

Century, a mortgage broker, files for bankruptcy.

HSBC sets aside $10.6 billion for bad loans, including subprime.

July 31, 2007: Two Bear Stearns hedge funds file for bankruptcy.

Aug. 17, 2007: Fed cuts discount rate to 5.75%; Fed introduces Term Discount Window Program.

Jan. 11, 2008: Bank of America agrees to buy Countrywide.

Jan. 30, 2008: Fed cuts discount rate to 3.5%.

June 9, 2008:Lehman announces a $2.8 billion loss.

July 11, 2008: IndyMac is seized by FDIC.

Dec. 12, 2007: Fed introduces Term Auction Facility.

Feb. 13, 2008: President Bush introduces tax rebate stimulus program of $168 billion.

Aug. 6, 2007: American Home Mortgage files for bankruptcy.

Bush signs a housing rescue law.

Sept. 7, 2008: U.S. seizes Fannie Mae and Freddie Mac.

Fed loans AIG $85 billion.

Sept. 23, 2008: Washington Mutual is seized by FDIC.

Sept. 29, 2008: Citigroup agrees to buy Wachovia bank.

Overview

77

Home mortgages: Who borrows, how much has been borrowed, and who funds them?

Government-controlled

46%

Total value of housing stock = $19.3 trillion

Mortgage debt $10.6 trillion

Prime 91.6%

Subprime8.4% Securitized

58%

88

Note: total residential and commercial mortgages = $14.7 trillion; 5 percent = $700 billion

Privatesector-

controlled54%

Equity in housing stock$8.7 trillion

91.6%Non-securitized

42%

Sources: Federal Reserve, Milken Institute.

The mortgage problem in perspective

80 million houses27 million are paid off

53 million have mortgages 48 million are paying on time

99

48 million are paying on time

5 million are behind

This compares to 50% seriously delinquent in the 1930s.

(9.2% of 53 million with 2.8% in foreclosure)

Sources: U.S. Treasury, Milken Institute.

I. Low interest rates and a lending boom

1010

Did the Fed lower interest rates too much and for t oo long?Federal funds rate vs. rates on FRMs and ARMs

5

6

7

8Percent

30-year FRM rate

1111

0

1

2

3

4

2001 2002 2003 2004 2005 2006 2007 2008

Record low from June 25, 2003, to June 30, 2004: 1%

1-year ARM rate

Target federal funds rate

Sources: Federal Reserve, Mortgage Bankers Association, Moody’s Economy.com, Milken Institute.

Home price bubble and credit boom

Low interest rates and credit boom

Index, January 2000 = 100

2.5

3.0

3.5

4.0

150

200

250

US$ trillions

Home

US$ trillions

2.5

3.0

3.5

4.0

4.5

5.0

5.5

6.0

Percent

1212

0.0

0.5

1.0

1.5

2.0

2001 2003 2005 2007

0

50

100

Home mortgage

originations (left axis)

S&P/Case-Shiller National Home

Price Index (right axis)

Sources: Inside Mortgage Finance, Mortgage Bankers Association, Moody’s Economy.com, S&P/Case-Shiller, Milken Institute.

0.0

0.5

1.0

1.5

2.0

2.5

2001 2003 2005 2007

3.0

3.5

4.0

4.5

1-Year ARM rate (right axis)

Home mortgage

originations (left axis)

II. Homeownership, prices, starts and sales take off

1313

68

69

70Percent

Q2 2004: 69.2%

Q2 2008: 68.1%

400

500

600

700US$ thousands

California m edian hom e pr ice

U.S. m edian

California average1987-2008

Credit boom pushes homeownership rate

to historic high

Home price bubblepeaks in 2006

California and national home prices reach

record highs

280

330

380Index, January 1987 = 100

S&P/ Case-Shille r

National Hom e Price Index

1414

64

65

66

67

1998 2000 2002 2004 2006 2008

Average, 1965–Q2 2008: 65.2%0

100

200

300

400

1998 2000 2002 2004 2006 2008

U.S. m edianhom e pr ice

U.S. ave rage, 1987-2008: $121,280

1987-2008$229,748

80

130

180

230

1998 2000 2002 2004 2006 2008

OFHEO Hom e Price Index

Sources: U.S. Census Bureau, OFHEO, Moody’s Economy.com, S&P/Case-Shiller, California Association of Realtors, Milken Institute.

4.2

5.6

7.0

0.9

1.2

1.5Millions Millions

Exis ting hom e sales (le ft axis )

1.5

2.0January 2006: 1.8 m illion

Housing units, millions

Homes for sale Homes sales reach a new high

Housing starts hit a record in 2005

2

3

4

0.4

0.6

0.8Millions

Existing homes for sale (left axis)

Millions

1515

0.0

1.4

2.8

1998 2000 2002 2004 2006 20080.0

0.3

0.6New hom e sales (right axis )

0.0

0.5

1.0

1998 2000 2002 2004 2006 2008

July 2008: 641,000

Average s tarts , 1959–July 2008: 1.1 m illion

Sources: U.S. Census Bureau, OFHEO, Moody’s Economy.com, Milken Institute.

0

1

2

1998 2000 2002 2004 2006 20080.0

0.2

0.4

New homes for sale (right axis)

III. Subprime borrowers and subprime mortgages

1616

National FICO scores display wide distribution What goes into a FICO score?

Who is a subprime borrower?

18

2730

40

Percentage of population

Subprime = 21%

Prime = 79%

Payment history

35%

New credit

10%

Types of credit in use

10%

1717Sources: myFICO.com, Milken Institute.

25

8

1215

18

13

0

10

20

up to499

500-549

550-599

600-649

650-699

700-749

750-799

800+

Subprime = 21%

Amounts owed

30%

Length of

credit history

15%

Prime

Subprime12

16

20

Percent of total originations

FICO below 620 Prime: 6.6%

Subprime: 45.2%

FICO above 620 Prime: 93.4%

Subprime: 54.8%

Prime and subprime mortgage originations by FICO score reveal substantial overlaps

1818

0

4

8

0 - 459

460 -

479

480 -

499

500 -

519

520 -

539

540 -

559

560 -

579

580 -

599

600 -

619

620 -

639

640 -

659

660 -

679

680 -

699

700 -

719

720 -

739

740 -

759

760 -

779

780 -

799

800 -

900

FICO score

Sources: LoanPerformance, Milken Institute.

ARMs look attractive to many borrowers

5.0

6.0

7.0

8.0Percent

30-year FRM rate

1919

2.0

3.0

4.0

5.0

2001 2002 2003 2004 2005 2006 2007 2008

1-year ARM rate

Sources: Mortgage Bankers Association, Moody’s Economy.com, Milken Institute.

ARM share grows, following low interest rates

15

20

25

Percent of all outstanding home mortgages

2020


0

5

10

2001 2002 2003 2004 2005 2006 2007 2008

30

40

50

60FHA ARM Prime ARM Subprime ARM

Percent of mortgage type

Largest share of ARMs go to subprime borrowers

2121

0

10

20

30

2001 2002 2003 2004 2005 2006 2007 2008


Subprimes take an increasing shareof all home mortgage originations

3.0

4.0

Subprime

Prime

US$ trillions

Subprime'sshare:7.8%

7.4%

8.4%

18.2%21.3%

20.1%

7.9%

2222

0.0

1.0

2.0

2001 2002 2003 2004 2005 2006 2007 Q2 2008

7.8%

0.9%

Sources: Inside Mortgage Finance, Milken Institute.

540

625600

400

500

600

700

US$ billionsUS$ billions

699

973

1,200 1,240

940 895

800

1,000

1,200

1,400 Average annual growth rates1995–2006: 14%2006–Q1 2008: -23%

Subprime mortgages increase rapidly before big decl ineOriginations Outstandings

2323

160200

310

191

140

100

200

300

400

2001 2002 2003 2004 2005 2006 2007 Q22008

479574

0

200

400

600

2001 2002 2003 2004 2005 2006 2007 Q12008


H22008

IV. Mortgage product innovation

2424

Subprime and Alt-A shares quadruple between 2001 and 2006, then fall in 2007

2001, $2.2 trillion

2% 5%7.9%

7%

2006, $3.0 trillion

33.2%

13%

14%2.7%

2007, $2.4 trillion

11%

14%4.9%

Q1 2008, $480 billion

4% 9% 9.6%2%

8%

2525

FHA & VAConventional, conforming primeJumbo prime

Jumbo primeSubprimeAlt-A Home equity loans


57.1%20%

13%

20% 16% 47.3%

8%

14% 67.2%

ARM hybrids dominate subprime originations (2006)

Other ARM7%

Prime conventional

ARM hybrids

Alt-A

Other ARM23%

Subprime

Other ARM 4%

Fixed 9%

30-yearARM balloon

2626

23%

Fixed 70%

Fixed 31%

ARM hybrids46%

Sources: Freddie Mac, Milken Institute.

with 40- to 50-year

amortization26%

2- and 3-year hybrids 61%

V. Securitization

2727

The mortgage model switches fromoriginate-to-hold to originate-to-distribute

Securitized15.6%

Held in

Residential mortgage loans1980: Total = $958 billion

Residential mortgage loansQ2 2008: Total = $11.3 trillion

2828

Held in portfolio

84.4%

Held in portfolio

41%

Securitized59%

Sources: Federal Reserve, Milken Institute.

4045 43 42 45 47

5057

6265 68 68 68

50

60

70

80Percent of all subprime mortgages securitized since 1994

Securitization becomes the dominant fundingsource for subprime mortgages

2929

31 2933

40

0

10

20

30

40

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Q12008

Q22008


The rise and fall of private-label securitizers

New securities issuance

21%

2%42%

1985Total = $110B

13%20%

2001Total = $1.3T

18%

4%

56%

2006Total = $2.0T

15%6%

First half 2008Total = $734B

3030

Ginnie Mae Freddie Mac Fannie Mae Private-label


35%

Total = $110B

29%38%

Total = $1.3T

22%

Total = $2.0T

33%

46%

Total = $734B

The rise and fall of private-label securitizersOutstanding securities

13%

6%

55%

1985

14% 18%

2001

35%7%

25%

2006

30%7%

26%

First half 2008

3131

Ginnie Mae Freddie Mac Fannie Mae Private-label

26%

Total = $390B

39% 29%

Total = $3.3T

33%

Total = $5.9T

37%

First half 2008Total = $6.8T


VI. Affordability

3232

4.5

5.0

Median home price/median household income

2005: 4.69

Ratio of home price to household

income surges

Home mortgage share of household debts reaches

a new high in 2007

Debt-to-income ratio of households has increased rapidly

125

150

Home mortgage debt/disposable personal incomePercent Q4 2007: 139.5%

70

75Percent

Q2 2007: 73.7%

3333

2.5

3.0

3.5

4.0

1998 2001 2004 2007

Average, 1967–2007: 3.38

2007: 4.29

Sources: U.S. Census Bureau, OFHEO, Federal Reserve, Moody’s Economy.com, Milken Institute.

75

100

125

1998 2001 2004 2007

Average, 1957–2007: 79.7%

60

65

70

1998 2001 2004 2007

Q2 2008: 73.4%

Average, 1952–2008: 64.2%

VII. Collapse

3434

The recent run-up of home prices was extraordinary

150

200

250

WorldWar I

WorldWar II

1970’sboom

1980’sboom

Currentboom

Annualized growth rate of nominal home index: 3.4%

Index, 2000 = 100

GreatDepression

3535

0

50

100

1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010

Long-term trend line

Sources: Robert Shiller, Milken Institute.

Home prices don’t go up foreverChange in home prices in 100 plus years

5

10

15

20

25

30 WorldWar I

GreatDepression

WorldWar II

1970’sBoom

1980’sBoom

CurrentBoom

Average, 1890–2007: 3.7%

Percentage change in nominal home price, year ago

3636

-20

-15

-10

-5

0

5

1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010

+/- one standard deviation

Sources: Robert Shiller, Milken Institute.

2005: The collapse begins

S&P/Case-Shiller 10 city

OFHEO

S&P/Case-Shiller national

5

10

15

20Home price indices, percent change on a year earlie r

3737Sources: S&P/Case-Shiller, OFHEO, Moody’s Economy.com, Milken Institute.

-15

-10

-5

0

1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

Forty-six states had falling prices in the fourth quarter 2007

United States: - 9.3% (fourth-quarter annualized growth)

3838Source: Freddie Mac.

48.448.0

28.227.926.826.326.326.0

24.422.9

SeattlePortlandWashingtonNew YorkPhoenixLos AngelesTampaMiamiLas VegasCharlotte

One year ago… Five years ago…

If you bought your house…

-1.0-3.2

-4.7-5.2

-5.8-7.1-7.3-7.3

-8.1-9.5

-13.9

CharlotteDallasDenverBostonPortlandSeattleNew YorkClevelandAtlantaChicagoMinneapolis

3939

20.518.6

14.39.1

6.66.56.15.94.8

-0.7-3.8

-21.3

Composite 10Composite 20ChicagoSan FranciscoAtlantaDallasSan DiegoBostonDenverMinneapolisClevelandDetroit

% change in price, June 07-08 % change in price, Jun e 03-08Sources: S&P/Case-Shiller, Milken Institute.

-13.9-15.7-15.9-16.3

-17.0-20.1

-23.7-24.2

-25.3-27.9-28.3-28.6

MinneapolisWashingtonComposite 20 DetroitComposite 10TampaSan FranciscoSan DiegoLos AngelesPhoenixMiamiLas Vegas

Housing startssharply decline

Homes sit longeron the market …

… as home appreciation slows

-15

0

15

30Percent change, year ago

8

10

12

Number of months that homes sit on the market

Existing homes

10

20 0

2

4

Percentage change from year ago in m edian hom e sales price (le ft axis )

Percent Months

4040

Note: Shaded area represents fluctuation within one standard deviation from mean (1.28%)

Sources: Mortgage Bankers Association, OFHEO, Moody’s Economy.com, Milken Institute.

-60

-45

-30

-15

1998 2000 2002 2004 2006 2008

June 2008: -41.9%July 2008: -39.2%

0

2

4

6

1998 2000 2002 2004 2006 2008

New homes

-20

-10

0

1999 2001 2003 2006 2008

6

8

10

12

Num ber of m onths hom es s tay on

m arket (r ight axis )

VIII. Delinquencies and foreclosures

4141

1,150

1,400

1,650

1,900

2,150

Thousands of foreclosures per year

Average 661,362 annual foreclosures from Q2 1999 to Q2 2006

Foreclosures are nothing new, but …

4242

400

650

900

1,150

Q2 199

9Q4 1

999

Q2 200

0Q4 2

000

Q2 200

1Q4 2

001

Q2 200

2Q4 2

002

Q2 200

3Q4 2

003

Q2 200

4Q4 2

004

Q2 200

5Q4 2

005

Q2 200

6Q4 2

006

Q2 200

7Q4 2

007

Q2 200

8


Sources: Mortgage Bankers Association, Milken Institute.

… their numbers have doubled

1,150

1,400

1,650

1,900

2,150

Thousands of foreclosures per year

Average 1,316,220 annual forclosures from Q3 2006 t o Q2 2008

4343Sources: Mortgage Bankers Association, Milken Institute.

400

650

900

1,150

Q2 199

9Q4 1

999

Q2 200

0Q4 2

000

Q2 200

1Q4 2

001

Q2 200

2Q4 2

002

Q2 200

3Q4 2

003

Q2 200

4Q4 2

004

Q2 200

5Q4 2

005

Q2 200

6Q4 2

006

Q2 200

7Q4 2

007

Q2 200

8


Subprime mortgages accounted for half or more of foreclosures since 2006

1,200

1,600

2,000

Subprime

FHA and VA

Prime (includes Alt-A)

Subprime: 12% of mortgages serviced (March 2008)

54%

Number of home mortgage foreclosures started (annua lized, in thousands)

50%

4444

0

400

800

Dec. 2003 June2004

Dec. 2004 June2005

Dec. 2005 June2006

Dec. 2006 June2007

Dec. 2007 March2008

37%

29%

34%

36%

29%

35%

37%

29%

34%

44%

22%

34%

47%

20%

33%

52%

17%31%

55%

13%

32%

56%

11%

33%

9%

37%

8%

42%


Subprime ARMs have the worst default recordHome mortgages delinquent or in foreclosure (percen t of number)

15

20

25

30

35Q2 2008, Subprime ARM: 33.4%

Subprime FRM: 11.8%

Prime FRM: 3.0%

FHA and VA: 5.8%

4545

0

5

10

15

Q21998

Q11999

Q41999

Q32000

Q22001

Q12002

Q42002

Q32003

Q22004

Q12005

Q42005

Q32006

Q22007

Q12008

Sources: Mortgage Bankers Association, Milken Institute.

Percentage of homes purchased in Q2 2008 that now have negative equity

4646

< 20%>= 20% and < 35%>= 35% and < 50%>= 50%

Sources: Zillow.com, Milken Institute.

United States = 44.8%

Percentage of homes sold for a loss (Q2 2008)

4747

< 15%>= 15% and < 30%>= 30% and < 45%>= 45%



Percentage of homes sold that were in foreclosure (Q2 2008)

4848

< 1%>= 1% and < 25%>= 25% and < 40%>= 40%



IX. Damages scorecard

4949

Losses/write-downs, capital raised, and jobs cut by financial institutions worldwide

120

160

200

36,000

48,000

60,000US$ billions

Capital raised(left axis)

Jobs cut (right axis)

Number of jobs cut

5050

Note: Q3 data are through September 25, 2008.

Sources: Bloomberg, Milken Institute.

0

40

80

Prior quarters Q3 2007 Q4 2007 Q1 2008 Q2 2008 Q3 2008(through

0

12,000

24,000Losses/write-downs(left axis)

(left axis)

What is the cumulative damage?Cumulative losses/write-downs, capital raised, and jobs cut by financial institutions worldwide

400

500

600

80,000

100,000

120,000

140,000Number of jobs cut US$ billions

Capital raised (left axis)

Jobs cut (right axis)

5151

Note: Q3 data are through September 25, 2008.


0

100

200

300

Prior quarters Q3 2007 Q4 2007 Q1 2008 Q2 2008 Q3 2008(through

0

20,000

40,000

60,000

80,000

Losses/write-downs (left axis)

Capital raised (left axis)

Recent losses/write-downs and capital raised by selected financial institutions

US$ billions, through September 25, 2008 Losses /wri te-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

5252

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


Financial stock prices take big hits

-99.8-99.7

-97.5-97.4

-95.4-94.3-93.9

Washington MutualLehman BrothersFreddie MacFannie MaeAIGBear Stearns*Wachovia

Percentage change in stock price, December 2006–Sep tember 2008

5353

Note: * Bear Stearns stock price is to May 2008. ** Countrywide stock price is to June 2008.Sources: Bloomberg, Milken Institute.

-93.9-90.0

-72.8-66.0-65.6

-35.8-34.4

-3.35.5

WachoviaCountrywide**Merrill LynchMorgan StanleyUBS EquityGoldman SachsBank of AmericaJP Morgan & ChaseWells Fargo

-142-101

-80-74

-60-50

-44

AIGWachoviaBank of AmericaUBS EquityMorgan StanleyFannie MaeMerrill Lynch

Total loss in market value: $728 billion, December 2006–September 2008

Financial market capitalization takes big hit

5454

-44-43-42-41

-28-24-21

417

Merrill LynchWashington MutualFreddie MacLehman BrothersGoldman SachsCountrywide**Bear Stearns*Wells FargoJP Morgan & Chase

Note: * Bear Stearns stock price is to May 2008. ** Countrywide stock price is to June 2008.Sources: Bloomberg, Milken Institute.

US$ billions

X. Credit crunch and liquidity freeze

5555

Tightened standards for real estate loans

40

60

80

100

Net percentage of domestic respondents tightening s tandards for commercial real estate loans

LTCM DotcomThe end of S&L crisis

Subprime

5656Sources: Federal Reserve, Milken Institute.

-40

-20

0

20

40

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

Widening spreads betweenmortgage-backed and high-yield bonds

1,000

1,200

1,400

1,600

1,800Basis points, spread over 10-year Treasury bond

Merrill Lynch Mortgage-Backed Securities Index

Merrill Lynch High -Yield Bond Index

Maximum spread: 08/29/2008: 955.8 bps

5757

0

200

400

600

800

01/2004 07/2004 01/2005 07/2005 01/2006 07/2006 01/2007 07/2007 01/2008 07/2008

Merrill Lynch High -Yield Bond Index

Sources: Merrill Lynch, Bloomberg, Milken Institute.

Liquidity freeze

100

120

140Septem ber 19, 2008: 127.5 bps

Basis points

Average s ince

Spread between 3-month LIBOR and overnight index swap rate

Spread between 3-month LIBOR and T-bill rate

250

300

350

Augus t 20, 2007: 240 bps

Basis points

Septem ber 18, 2008: 313 bps

5858

0

20

40

60

80

2006 2007 2008

Average s ince Decem ber 2001: 21.1 bps

August 2007: 69.8 bps


0

50

100

150

200

2006 2007 2008

Average s ince 1985: 76 bps

Average s ince August 2007: 130 bps

Counterparty risk increases

300

400

500Basis points

Government announces support for Fannie Mae and Freddie Mac

Lehman Brother files for bankruptcy and Merrill Lynch acquired

AIG rescued

Average CDS spread, basis points

5959

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.

0

100

200

07/2007 09/2007 11/2007 01/2008 03/2008 05/2008 07/2008 09/2008

Bear Stearns acquired

Commercial paper issuance dries up

0

50

100

150Quarterly change in outstanding amount, US$ billion s

6060Sources: Federal Reserve, Milken Institute.

-200

-150

-100

-50

Q1 2006 Q2 2006 Q3 2006 Q4 2006 Q1 2007 Q2 2007 Q3 2007 Q4 2007 Q1 2008 Q2 2008

Issuers of asset-backed securities

Other issuers

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

5

6

7

8

9

10

2.5

3.0

3.5

4.0

4.5

5.0

Freddie Mac 30-year fixed mortgage rate (left axis)

Percent Percent

30-year FRM rate (left axis)

6161

0

1

2

3

4

5

01/2007 03/2007 06/2007 09/2007 12/2007 02/2008 05/2008 08/2008

0.0

0.5

1.0

1.5

2.0

2.5

Federal funds rate (left axis)

Spread (right axis)

Sources: Freddie Mac, Federal Reserve, Moody’s Economy.com, Milken Institute.

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

6262

� Temporary guaranty program for money market funds

� Temporary ban on short selling in selected companies

� Bailout package?

XI. When will we hit bottom?

6363

Looking for a bottom?Economists say the economy isn’t at its low point y et, and house prices likely won’t get there until 2009

Does this feel like the bottom to a downturn?

Yes 27%

When will home prices hit bottom?

6%

2nd half

1st half2010

6464

No 73%

4%

17%

38%

29%

1st half2008

2nd half2008

1st half2009

2nd half2009

Source: Wall Street Journal.

How far do home prices have to fall?

5.0

5.5

6.0

6.5 Q2 1971: 6.08%Annual rents as percent of home prices

6565Sources: Davisa, Lehnertb, Martin (2007), Milken Institute.

3.0

3.5

4.0

4.5

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

Q4 2006: 3.48%

Q1 2008: 3.93%Average, 1960–Q1 2008: 5.04%

Average, 2000–Q1 2008: 4.06%

Combinations of rental price growth rates and rent- to-price ratios to get home prices back to their Q4 2006 val ue

Annual home price decline

-2.0% -5.0% -10.0% -15.0% -20.0%

3.80% 2010 Q3 2008 Q4 2008 Q2 2008 Q2 2008 Q2

rat

io

Annual home price decline required

6666

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% average 2024 Q3 2014 Q2 2010 Q4 2009 Q3 2009 Q1

Ren

t-to

-pric

e r

atio

6.00% 2026 Q4 2017 Q3 2012 Q3 2010 Q4 2009 Q4

Sources: Davisa, Lehnertb, Martin (2007), Milken Institute.

2,500

3,000

3,500

4,000

US$/month

Payment with 100% LTVPayment with 90% LTVPayment with 80% LTV

Mortgage payment assumptions: Every month, a home i s purchased at median price, buyer takes out a 30-year conforming, fixed-rate loan with 80% LTV. Payment also includes 1% property tax per year , 0.1% property insurance.

Alternative measures of the affordability of mortgage debt for California

6767

0

500

1,000

1,500

2,000

1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007

Maximum affortablility limit is 38% of median household

insurance.

Sources: Moody’s Economy.com, Milken Institute.

XII. What went wrong

6868

2,443

879

1,410

2,067

944886 1,000

1,500

2,000

2,500

3,000US$ billions

The importance of Fannie Mae and Freddie Mac

6969

0

500

1,000

Fannie Mae:total assets

Fannie Mae:total MBS

outstanding

Freddie Mac:total assets

Freddie Mac:total MBS

outstanding

Commercialbanks: total

residential realestate assets

Savingsinstitutions:

totalresidential realestate assets

Sources: Freddie Mac, Fannie Mae, FDIC, Milken Institute.

Fannie Mae and Freddie Mac: Too big with too little capital?

1,301

1,778

2,443

1,4101,500

2,000

2,500

3,000US$ billions

Total assets

Total MBS outstanding

7070Sources: Freddie Mac, Fannie Mae, Milken Institute.

133 41

1,022803 844 805 886 879

288 316

1,301

752

1,123

0

500

1,000

1,500

Fannie Mae1990

Freddie Mac1990

Fannie Mae2003

Freddie Mac2003

Fannie Mae2006

Freddie Mac2006

Fannie Mae2Q 2008

Freddie Mac2Q 2008

167x

244x

150

200

250

300

Mortgage book of business over capital measures

Fannie Mae Freddie Mac

Fannie Mae and Freddie Mac are highly leveraged

7171

60x 56x 48x 55x60x 58x 52x 57x64x81x

56x65x 59x

0

50

100

150

Core capital Fair value Core capital Fair value

2005 2006 2007 2008Q2

-393x

Sources: Freddie Mac, Fannie Mae, FDIC, Milken Institute.

Freddie Mac’s and Fannie Mae's retained private-lab el portfolios

Freddie Mac, 2007

Freddie Mac, 2006

Subprime Alt-A All others

57.4% 13.1% 29.5%

61.2% 25.0% 13.8%

$122.2 billion

$76.1 billion

7272Sources: Freddie Mac, Fannie Mae, FDIC, Milken Institute.

Fannie Mae, 2007

Fannie Mae, 2006

Fannie Mae, 2005

33.8% 4.3% 32.0%

46.4% 36.1% 17.5%

32.1% 37.4% 30.5%

57.4% 13.1% 29.5%

$86.9 billion

$97.3 billion

$94.8 billion

23.7

21.5

67.9

Federal Home Loan Banks

Fannie Mae

Freddie Mac

Leverage ratio, total assets/common equtity

Leverage ratios of different types of financial firms (June 2008)

7373

9.1

9.8

9.4

31.6

Credit unions

Commercial banks

Savings institutions

Brokers/hedge funds

Sources: Federal Deposit Insurance Corporation, Office of Federal Housing Enterprise Oversight, National Credit Union Administration, Bloomberg, Google Finance, Milken Institute.

Too much dependence on debt?Leverage ratios at biggest investment banks

28

1922

2627

19

31

2423

34 32 3331

22

2830

242225

30

35

40 2000 2005 2007 June 2008Total assets/total shareholder equity

7474Sources: Bloomberg, FDIC, Milken Institute.

1918

19

n.a.0

5

10

15

20

Bear Stearns Merrill Lynch Morgan Stanley Lehman Broth ers Goldman Sachs

AAAAA+

AAAA-A+

AA-

BBB+

0 1,000 2,000 3,000 4,000 5,000Number of securities rated

4,090, or 51%, of new securities rated by S&P were rated AAA

Most new securities issued in 2007 were rated AAA by S&P

S&P Total Downgraded Downgraded/ Total

AAA 1,032 156 15.1%

AA(+/-) 3,495 1,330 38.1%

A(+/-) 2,983 1,886 63.2%

56 percent of MBS issued from 2005 to 2007 were eventually

downgraded

7575

BBB+BBBBBB-

BB+BBBB-B+BB-CCC+

CCC+CCC-CCC

D

S&P were rated AAA A(+/-) 2,983 1,886 63.2%

BBB(+/-) 2,954 2,248 76.1%

BB(+/-) 789 683 86.6%

B(+/-) 8 7 87.5%

Total 11,261 6,310 56.0%

Sources: Bloomberg, Inside Mortgage Finance, Milken Institute.

Note: A bond is considered investment grade if its credit rating is BBB- or higher by S&P

When is a AAA not a AAA?Multilayered mortgage products

Origination ofmortgage 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%

7676Sources: International Monetary Fund, Milken Institute.

Mortgage bonds

AAA 80%AA 11%A 4% Mezzanine CDO

BBB 3% CDO-squaredBB-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%

Dollar losses in reported cases of mortgage fraud

US$ millions

1,014946

813800

1,000

1,200

Mortgage loan fraud surges

37.3

52.9

40

50

60Number of cases reported, thousands

37.3

52.9

40

50

60Number of cases reported, thousands

7777

293225

429

0

200

400

600

2002 2003 2004 2005 2006 2007

Sources: Financial Crimes Enforcement Network, Federal Bureau of Investigation, Milken Institute.

1.7

2.3 2.9 3.5 4.7 5.49.5

18.4

26.0

0

10

20

30

1997 1999 2001 2003 2005 2007

1.7

2.3 2.9 3.5 4.7 5.49.5

18.4

26.0

0

10

20

30

1997 1999 2001 2003 2005 2007

Is adequate information disclosed to consumers?

5168

7479

8487

95

Loan amountPresence of prepayment penalty for refinance in two years

Presence of charges for optional credit insuranceReason why the interest rate and APR sometimes diff erProperty tax and homeowner’s insurance cost amount

Total up-front cost amountPrepayment penalty amount

Percent of respondents who could not correctly iden tify various loan costs using current disclosure fo rms

7878Sources: Federal Trade Commission, Milken Institute.

20202123

303233

3751

APR amountCash due at closing amount

Monthly payment (including whether it includes taxe s and insurance)Settlement charges amount

Balloon payment (presence and amount)Interest rate amount

Whether loan amount included finances settlement ch argesWhich loan was less expensive

Loan amount

Drivers of foreclosures:Strong appreciation or weak economies?

15

20

25

Detroit

Bakersfield

Riverside

Fort Lauderdale

Las Vegas

Stockton

SacramentoToledoCleveland

Weak economies Housing bubbles

Foreclosures per 1,000 homes

7979Sources: U.S. Treasury Department, RealtyTrac, Office of Federal Housing Enterprise Oversight, Milken Institute.

0

5

10

-20 0 20 40 60 80 100 120 140

Five-year price gain, Q3 2002–Q3 2007 (percent)

Miami

Bakersfield

Fresno

Fort Lauderdale

Orlando

Phoenix

Palm Beach

TampaSan Diego

Oakland

Sacramento

Atlanta

MemphisColumbus

Indianapolis

ToledoDaytonDenver

Cleveland

Akron

Warren

National average

After housing bubble burst in 2007: Foreclosures highest for areas with biggest price declines

25

30

35

40

45Weak

economies strengthen

Stockton

Bakersfield

RiversideLas Vegas

Fort Lauderdale

SacramentoOakland

Denver

Foreclosures per 1,000 homes

National average

Collaping housing bubbles

8080Sources: RealtyTrac, Office of Federal Housing Enterprise Oversight, Milken Institute.

0

5

10

15

20

25

-30 -25 -20 -15 -10 -5 0 5

Price change, 2007–June 2008 (percent, annualized)

Miami

Orlando

Phoenix

Fresno

Sacramento

San Diego

Detroit

Warren ClevelandDayton

Columbus Indianapolis

Palm BeachTampa

Toledo

Akron Atlanta

Memphis

XIII. Where do we go from here?

8181

The U.S. regulatory regime: In need of reform?

National banks State commercial and savings banks

Federal savings banks

Insurance companies

Securities brokers/dealers

Other financial companies, including mortgage

companies and brokers

• Fed• OTS

Fed is the umbrella or consolidated regulator

• Federal Housing Finance Agency

Fannie Mae, Freddie Mac, and Federal Home Loan Banks

Financial, bank and thrift holding companies

8282

• OCC• FDIC

• State bank regulators• FDIC• Fed--state member commerical banks

• OTS• FDIC

• 50 State insurance regulators plus District of Columbia and Puerto Rico

• FINRA• SEC• CFTC• State securities regulators

• Fed• State licensing (if needed)• U.S. Treasury for some products

• OCC• Host county regulator

• Fed• Host county regulator

• OTS• Host county regulator

Federal branch

Foreign branch

Limited foreign branch

Primary/secondaryfunctionalregulator

Notes:Justice Department: Assesses effects of mergers and acquisitions on competitionFederal Courts: Ultimate decider of banking, securities, and insurance productsCFTC: Commodity Futures Trading CommissionFDIC: Federal Deposit Insurance CorporationFed: Federal ReserveFINRA: Financial Industry Regulatory Authority GSEs: Government Sponsored Enterprises OCC: Comptroller of the CurrencyOTS: Office of Thrift SupervisionSEC: Securities and Exchange Commission

Sources: Financial Services Roundtable (2007), Milken Institute.

Many different options and innovations…

Covered BondsCovered Bonds

Alternative Mortgage ProductsAlternative Mortgage Products

Shared Equity MortgagesShared Equity Mortgages

8383

Real Estate DerivativesReal Estate Derivatives

Classical Insurance Products Classical Insurance Products

OthersOthers

Demystifying the Mortgage Meltdown:What It Means for Main Street,

Wall Street and the U.S. Financial System

Glenn Yago James R. Barth

8484

Milken InstituteOctober 2, 2008

Glenn Yago Director of Capital Studies

James R. Barth Senior Fellow

demystifying the mortgage meltdown: what it means for main...

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