making sense of the mortgage meltdown

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1 1 Demystifying the Mortgage Meltdown: What It Means for Main Street, Wall Street and the U.S. Financial System Milken Institute October 2, 2008 Glenn Yago Director of Capital Studies James R. Barth Senior Fellow

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Page 1: Making Sense of the Mortgage Meltdown

11

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

Wall Street and the U.S. Financial System

Milken InstituteOctober 2, 2008

Glenn Yago Director of Capital Studies

James R. Barth Senior Fellow

Page 2: Making Sense of the Mortgage Meltdown

22

“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 PaulsonMarch 16, 2008

CNN

Page 3: Making Sense of the Mortgage Meltdown

33

… 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 PaulsonSeptember 19, 2008

Press release

Page 4: Making Sense of the Mortgage Meltdown

44

“Any real estate investment is a good investment … ”

Page 5: Making Sense of the Mortgage Meltdown

55

… Really?!

“Any real estate investment is a good investment … ”

Page 6: Making Sense of the Mortgage Meltdown

66

Subprime mortgage meltdown timelineDecember 2006–September 2008

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

250

350

450

550

650

Dow Jones U.S. Financial Index

Dec. 2006: Ownit Mortgage, a subprime lender, files for bankruptcy.

Apr. 2007: New Century, a mortgage broker, files for bankruptcy.

Feb. 2007: 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%.

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.

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

July 11, 2008: IndyMacis 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. 1, 2008: First Priority Bank closes.

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

Aug. 6, 2007: American Home Mortgage files for 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 housing rescue law.

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

Sept. 14, 2008: Lehman files for bankruptcy.

Sept. 16, 2008: Fed loans AIG

$85 billion.

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

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

Page 7: Making Sense of the Mortgage Meltdown

77

Overview

Page 8: Making Sense of the Mortgage Meltdown

88

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

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

Government-controlled

46%

Privatesector-

controlled54%

Total value of housing stock = $19.3 trillion

Equity in housing stock$8.7 trillion

Mortgage debt $10.6 trillion

Prime 91.6%

Subprime8.4% Securitized

58%

Non-securitized42%

Sources: Federal Reserve, Milken Institute.

Page 9: Making Sense of the Mortgage Meltdown

99

The mortgage problem in perspective

80 million houses27 million are paid off

53 million have mortgages 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.

Page 10: Making Sense of the Mortgage Meltdown

1010

I. Low interest rates and a lending boom

Page 11: Making Sense of the Mortgage Meltdown

1111

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

0

1

2

3

4

5

6

7

8

2001 2002 2003 2004 2005 2006 2007 2008

Percent

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

30-year FRM rate

1-year ARM rate

Target federal funds rate

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

Page 12: Making Sense of the Mortgage Meltdown

1212

Home price bubble and credit boom

Low interest rates and credit boom

Index, January 2000 = 100

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

2001 2003 2005 20070

50

100

150

200

250US$ trillions

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.

US$ trillions

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

2001 2003 2005 20073.0

3.5

4.0

4.5

5.0

5.5

6.0

1-Year ARM rate (right axis)

Home mortgage

originations (left axis)

Percent

Page 13: Making Sense of the Mortgage Meltdown

1313

II. Homeownership, prices, starts and sales take off

Page 14: Making Sense of the Mortgage Meltdown

1414

64

65

66

67

68

69

70

1998 2000 2002 2004 2006 2008

Percent

Q2 2004: 69.2%Q2 2008: 68.1%

Average, 1965–Q2 2008: 65.2%0

100

200

300

400

500

600

700

1998 2000 2002 2004 2006 2008

US$ thousands

California m edian hom e price

U.S. m edianhom e price

U.S. average, 1987-2008: $121,280

California average1987-2008$229,748

Credit boom pushes homeownership rate

to historic high

Home price bubblepeaks in 2006

California and national home prices reach

record highs

80

130

180

230

280

330

380

1998 2000 2002 2004 2006 2008

Index, January 1987 = 100S&P/

Case-Shille r National Hom e

Price Index

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.

Page 15: Making Sense of the Mortgage Meltdown

1515

0.0

1.4

2.8

4.2

5.6

7.0

1998 2000 2002 2004 2006 20080.0

0.3

0.6

0.9

1.2

1.5Millions Millions

New hom e sales (r ight axis)

Existing hom e sales (le ft axis)

0.0

0.5

1.0

1.5

2.0

1998 2000 2002 2004 2006 2008

January 2006: 1.8 m illion

July 2008: 641,000

Housing units, millions

Average starts , 1959–July 2008: 1.1 m illion

Homes for sale Homes sales reach a new high

Housing starts hit a record in 2005

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

0

1

2

3

4

1998 2000 2002 2004 2006 20080.0

0.2

0.4

0.6

0.8Millions

Existing homes for sale (left axis)

New homes for sale (right axis)

Millions

Page 16: Making Sense of the Mortgage Meltdown

1616

III. Subprime borrowers and subprime mortgages

Page 17: Making Sense of the Mortgage Meltdown

1717

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

Who is a subprime borrower?

Sources: myFICO.com, Milken Institute.

25

812

1518

27

13

0

10

20

30

40

up to499

500-549

550-599

600-649

650-699

700-749

750-799

800+

Percentage of population

Subprime = 21%

Prime = 79%

Amounts owed

30%

Payment history

35%

Length of credit history

15%

New credit10%

Types of credit in use

10%

Page 18: Making Sense of the Mortgage Meltdown

1818

Prime

Subprime

0

4

8

12

16

20

0 - 459

460 - 4

79480

- 499

500 - 5

19520

- 539

540 - 5

59560

- 579

580 - 5

99600

- 619

620 - 6

39640

- 659

660 - 6

79680

- 699

700 - 7

19720

- 739

740 - 7

59760

- 779

780 - 7

99800

- 900

Percent of total originations

FICO score

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

Sources: LoanPerformance, Milken Institute.

Page 19: Making Sense of the Mortgage Meltdown

1919

ARMs look attractive to many borrowers

2.0

3.0

4.0

5.0

6.0

7.0

8.0

2001 2002 2003 2004 2005 2006 2007 2008

Percent

30-year FRM rate

1-year ARM rate

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

Page 20: Making Sense of the Mortgage Meltdown

2020

ARM share grows, following low interest rates

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

0

5

10

15

20

25

2001 2002 2003 2004 2005 2006 2007 2008

Percent of all outstanding home mortgages

Page 21: Making Sense of the Mortgage Meltdown

2121

0

10

20

30

40

50

60

2001 2002 2003 2004 2005 2006 2007 2008

FHA ARM Prime ARM Subprime ARM

Percent of mortgage type

Largest share of ARMs go to subprime borrowers

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

Page 22: Making Sense of the Mortgage Meltdown

2222

Subprimes take an increasing shareof all home mortgage originations

0.0

1.0

2.0

3.0

4.0

2001 2002 2003 2004 2005 2006 2007 Q2 2008

Subprime

Prime

US$ trillions

Subprime'sshare:7.8%

7.4%

8.4%

18.2%21.3%

20.1%

7.9%

0.9%

Sources: Inside Mortgage Finance, Milken Institute.

Page 23: Making Sense of the Mortgage Meltdown

2323

160200

310

540

625 600

191

140

100

200

300

400

500

600

700

2001 2002 2003 2004 2005 2006 2007 Q22008

US$ billions US$ billions

479574

699

973

1,200 1,240

940 895

0

200

400

600

800

1,000

1,200

1,400

2001 2002 2003 2004 2005 2006 2007 Q12008

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

Subprime mortgages increase rapidly before big declineOriginations Outstandings

Sources: Inside Mortgage Finance, Milken Institute.

H22008

Page 24: Making Sense of the Mortgage Meltdown

2424

IV. Mortgage product innovation

Page 25: Making Sense of the Mortgage Meltdown

2525

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

FHA & VAConventional, conforming primeJumbo prime

pSubprimeAlt-A Home equity loans

Sources: Inside Mortgage Finance, Milken Institute.

2001, $2.2 trillion

57.1%

2% 5%7.9%

7%

20%

2006, $3.0 trillion

33.2%

13%

14%2.7%

20% 16%

2007, $2.4 trillion

47.3%

11%

14% 4.9%

8%

14%

Q1 2008, $480 billion

67.2%

4% 9% 9.6%2%

8%

Page 26: Making Sense of the Mortgage Meltdown

2626

ARM hybrids dominate subprime originations (2006)

Other ARM7%

23%

Fixed 70%

Prime conventional

ARM hybrids

Alt-A

Fixed 31%

Other ARM23%

ARM hybrids46%

Sources: Freddie Mac, Milken Institute.

SubprimeOther ARM 4%

Fixed 9%

30-yearARM balloon

with 40- to 50-year

amortization26%

2- and 3-year hybrids 61%

Page 27: Making Sense of the Mortgage Meltdown

2727

V. Securitization

Page 28: Making Sense of the Mortgage Meltdown

2828

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

Held in portfolio

84.4%

Securitized15.6%

Held in portfolio

41%

Securitized59%

Residential mortgage loans1980: Total = $958 billion

Residential mortgage loansQ2 2008: Total = $11.3 trillion

Sources: Federal Reserve, Milken Institute.

Page 29: Making Sense of the Mortgage Meltdown

2929

31 2933

4045 43 42 45 47 50

5762

65 68 68 68

0

10

20

30

40

50

60

70

80

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

Q22008

Percent of all subprime mortgages securitized since 1994

Securitization becomes the dominant fundingsource for subprime mortgages

Sources: Inside Mortgage Finance, Milken Institute.

Page 30: Making Sense of the Mortgage Meltdown

3030

The rise and fall of private-label securitizers

Ginnie Mae Freddie Mac Fannie Mae Private-label

New securities issuance

Sources: Inside Mortgage Finance, Milken Institute.

21%

2%42%

35%

1985Total = $110B

29%

13%20%

38%

2001Total = $1.3T

18%

4%

56%

22%

2006Total = $2.0T

33%

15%6%

46%

First half 2008Total = $734B

Page 31: Making Sense of the Mortgage Meltdown

3131

The rise and fall of private-label securitizersOutstanding securities

Ginnie Mae Freddie Mac Fannie Mae Private-label

13%

6%

55%

26%

1985Total = $390B

39%

14% 18%

29%

2001Total = $3.3T

33%

35%7%

25%

2006Total = $5.9T

37%

30%7%

26%

First half 2008Total = $6.8T

Sources: Inside Mortgage Finance, Milken Institute.

Page 32: Making Sense of the Mortgage Meltdown

3232

VI. Affordability

Page 33: Making Sense of the Mortgage Meltdown

3333

2.5

3.0

3.5

4.0

4.5

5.0

1998 2001 2004 2007

Median home price/median household income

Average, 1967–2007: 3.38

2005: 4.69

2007: 4.29

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

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

75

100

125

150

1998 2001 2004 2007

Home mortgage debt/disposable personal income

Q4 2007: 139.5%

Average, 1957–2007: 79.7%

60

65

70

75

1998 2001 2004 2007

Percent Q2 2007: 73.7%

Q2 2008: 73.4%

Average, 1952–2008: 64.2%

Page 34: Making Sense of the Mortgage Meltdown

3434

VII. Collapse

Page 35: Making Sense of the Mortgage Meltdown

3535

The recent run-up of home prices was extraordinary

0

50

100

150

200

250

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

WorldWar I World

War II1970’sboom

1980’sboom

Currentboom

Long-term trend line

Annualized growth rate of nominal home index: 3.4%

Index, 2000 = 100

GreatDepression

Sources: Robert Shiller, Milken Institute.

Page 36: Making Sense of the Mortgage Meltdown

3636

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

-20

-15

-10

-5

0

5

10

15

20

25

30

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

WorldWar I

GreatDepression

WorldWar II

1970’sBoom

1980’sBoom

CurrentBoom

Average, 1890–2007: 3.7%

Percentage change in nominal home price, year ago

+/- one standard deviation

Sources: Robert Shiller, Milken Institute.

Page 37: Making Sense of the Mortgage Meltdown

3737

2005: The collapse begins

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

S&P/Case-Shiller 10 city

OFHEO

S&P/Case-Shiller national

-15

-10

-5

0

5

10

15

20

1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

Home price indices, percent change on a year earlier

Page 38: Making Sense of the Mortgage Meltdown

3838

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

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

Source: Freddie Mac.

Page 39: Making Sense of the Mortgage Meltdown

3939

48.448.0

28.227.926.826.326.326.0

24.422.9

20.518.6

14.39.1

6.66.56.15.94.8

-0.7-3.8

-21.3

SeattlePortlandWashingtonNew YorkPhoenixLos AngelesTampaMiamiLas VegasCharlotteComposite 10Composite 20ChicagoSan FranciscoAtlantaDallasSan DiegoBostonDenverMinneapolisClevelandDetroit

One year ago… Five years ago…If you bought your house…

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

-1.0-3.2

-4.7-5.2

-5.8-7.1-7.3-7.3

-8.1-9.5

-13.9-15.7-15.9-16.3

-17.0-20.1

-23.7-24.2

-25.3-27.9-28.3-28.6

CharlotteDallasDenverBostonPortlandSeattleNew YorkClevelandAtlantaChicagoMinneapolisWashingtonComposite 20 DetroitComposite 10TampaSan FranciscoSan DiegoLos AngelesPhoenixMiamiLas Vegas

Page 40: Making Sense of the Mortgage Meltdown

4040

Housing startssharply decline

Homes sit longeron the market …

… as home appreciation slows

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

0

15

30

1998 2000 2002 2004 2006 2008

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

Percent change, year ago

0

2

4

6

8

10

12

1998 2000 2002 2004 2006 2008

Number of months that homes sit on the market

Existing homes

New homes

-20

-10

0

10

20

1999 2001 2003 2006 2008

0

2

4

6

8

10

12

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

Num ber of m onths hom es stay on

m arket (r ight axis)

Percent Months

Page 41: Making Sense of the Mortgage Meltdown

4141

VIII. Delinquencies and foreclosures

Page 42: Making Sense of the Mortgage Meltdown

4242

400

650

900

1,150

1,400

1,650

1,900

2,150

Q2 1999

Q4 1999

Q2 2000

Q4 2000

Q2 2001

Q4 2001

Q2 2002

Q4 2002

Q2 2003

Q4 2003

Q2 2004

Q4 2004

Q2 2005

Q4 2005

Q2 2006

Q4 2006

Q2 2007

Q4 2007

Q2 2008

Thousands of foreclosures per year

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

Foreclosures are nothing new, but …

Sources: Mortgage Bankers Association, Milken Institute.

Page 43: Making Sense of the Mortgage Meltdown

4343

… their numbers have doubled

Sources: Mortgage Bankers Association, Milken Institute.

400

650

900

1,150

1,400

1,650

1,900

2,150

Q2 1999

Q4 1999

Q2 2000

Q4 2000

Q2 2001

Q4 2001

Q2 2002

Q4 2002

Q2 2003

Q4 2003

Q2 2004

Q4 2004

Q2 2005

Q4 2005

Q2 2006

Q4 2006

Q2 2007

Q4 2007

Q2 2008

Thousands of foreclosures per year

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

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

Page 44: Making Sense of the Mortgage Meltdown

4444

Subprime mortgages accounted for half or more of foreclosures since 2006

0

400

800

1,200

1,600

2,000

Dec. 2003 June2004

Dec. 2004 June2005

Dec. 2005 June2006

Dec. 2006 June2007

Dec. 2007 March2008

SubprimeFHA and VAPrime (includes Alt-A)

Subprime: 12% of mortgages serviced (March 2008)

37%

29%

34%

36%

29%

35%

37%

29%

34%

44%

22%

34%

47%

20%

33%

52%

17%31%

55%

13%

32%

56%

11%

33%

54%

9%

37%

Number of home mortgage foreclosures started (annualized, in thousands)

50%

8%

42%

Sources: Inside Mortgage Finance, Milken Institute.

Page 45: Making Sense of the Mortgage Meltdown

4545

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

0

5

10

15

20

25

30

35

Q21998

Q11999

Q41999

Q32000

Q22001

Q12002

Q42002

Q32003

Q22004

Q12005

Q42005

Q32006

Q22007

Q12008

Q2 2008, Subprime ARM: 33.4%

Subprime FRM: 11.8%

Prime FRM: 3.0%

FHA and VA: 5.8%

Sources: Mortgage Bankers Association, Milken Institute.

Page 46: Making Sense of the Mortgage Meltdown

4646

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

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

Sources: Zillow.com, Milken Institute.

United States = 44.8%

Page 47: Making Sense of the Mortgage Meltdown

4747

Percentage of homes sold for a loss (Q2 2008)

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

Sources: Zillow.com, Milken Institute.

United States = 32.7%

Page 48: Making Sense of the Mortgage Meltdown

4848

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

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

Sources: Zillow.com, Milken Institute.

United States = 18.6%

Page 49: Making Sense of the Mortgage Meltdown

4949

IX. Damages scorecard

Page 50: Making Sense of the Mortgage Meltdown

5050

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

Note: Q3 data are through September 25, 2008.Sources: Bloomberg, Milken Institute.

0

40

80

120

160

200

Prior quarters Q3 2007 Q4 2007 Q1 2008 Q2 2008 Q3 20080

12,000

24,000

36,000

48,000

60,000US$ billions

Losses/write-downs(left axis)

Capital raised(left axis)

Jobs cut (right axis)

Number of jobs cut

Page 51: Making Sense of the Mortgage Meltdown

5151

What is the cumulative damage?

Note: Q3 data are through September 25, 2008.Sources: Bloomberg, Milken Institute.

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

0

100

200

300

400

500

600

Prior quarters Q3 2007 Q4 2007 Q1 2008 Q2 2008 Q3 20080

20,000

40,000

60,000

80,000

100,000

120,000

140,000Number of jobs cut US$ billions

Losses/write-downs (left axis)

Capital raised (left axis)

Jobs cut (right axis)

Page 52: Making Sense of the Mortgage Meltdown

5252

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

379.2521.9World total

23.514.4Royal Bank of Scotland, United Kingdom

12.114.8Washington Mutual, United States

12.315.0IKB Deutsche, Germany

5.615.7Morgan Stanley, United States

20.721.2Bank of America, United States

11.022.7Wachovia, United States

5.127.4HSBC, United Kingdom

28.244.2UBS, Switzerland

29.952.2Merrill Lynch, United States

49.155.1Citigroup, United States

Capital raisedLosses /write-downsUS$ billions, through September 25, 2008

Sources: Bloomberg, Milken Institute.

Page 53: Making Sense of the Mortgage Meltdown

5353

Financial stock prices take big hits

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

-99.8-99.7

-97.5-97.4

-95.4-94.3-93.9

-90.0-72.8

-66.0-65.6

-35.8-34.4

-3.35.5

Washington MutualLehman BrothersFreddie MacFannie MaeAIGBear Stearns*WachoviaCountrywide**Merrill LynchMorgan StanleyUBS EquityGoldman SachsBank of AmericaJP Morgan & ChaseWells Fargo

Percentage change in stock price, December 2006–September 2008

Page 54: Making Sense of the Mortgage Meltdown

5454

-142-101

-80-74

-60-50

-44-43-42-41

-28-24-21

417

AIGWachoviaBank of AmericaUBS EquityMorgan StanleyFannie MaeMerrill LynchWashington MutualFreddie MacLehman BrothersGoldman SachsCountrywide**Bear Stearns*Wells FargoJP Morgan & Chase

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

Financial market capitalization takes big hit

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

US$ billions

Page 55: Making Sense of the Mortgage Meltdown

5555

X. Credit crunch and liquidity freeze

Page 56: Making Sense of the Mortgage Meltdown

5656

Tightened standards for real estate loans

Sources: Federal Reserve, Milken Institute.

-40

-20

0

20

40

60

80

100

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

Net percentage of domestic respondents tightening standards for commercial real estate loans

LTCM DotcomThe end of S&L crisis

Subprime

Page 57: Making Sense of the Mortgage Meltdown

5757

Widening spreads betweenmortgage-backed and high-yield bonds

0

200

400

600

800

1,000

1,200

1,400

1,600

1,800

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

Basis 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

Sources: Merrill Lynch, Bloomberg, Milken Institute.

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Liquidity freeze

0

20

40

60

80

100

120

140

2006 2007 2008

Average s ince Decem ber 2001: 21.1 bps

Septem ber 19, 2008: 127.5 bps

Basis points

Average s ince August 2007: 69.8 bps

Spread between 3-month LIBOR and overnight index swap rate

Sources: Bloomberg, Milken Institute.

Spread between 3-month LIBOR and T-bill rate

0

50

100

150

200

250

300

350

2006 2007 2008

August 20, 2007: 240 bps

Average s ince 1985: 76 bps

Average s ince August 2007: 130 bps

Basis points

Septem ber 18, 2008: 313 bps

Page 59: Making Sense of the Mortgage Meltdown

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Counterparty risk increases

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, CreditSuisse, Deutsche Bank, Goldman Sachs Group, HSBC, Lehman Brothers, JPMorgan Chase, Merrill Lynch, Morgan Stanley, UBS, and Wachovia. Sources: Datastream, Milken Institute.

0

100

200

300

400

500

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

Basis points

Bear Stearns acquired

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

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Commercial paper issuance dries up

Sources: Federal Reserve, Milken Institute.

-200

-150

-100

-50

0

50

100

150

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

Quarterly change in outstanding amount, US$ billions

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

0

12

3

45

6

7

89

10

01/2007 03/2007 06/2007 09/2007 12/2007 02/2008 05/2008 08/20080.0

0.51.0

1.5

2.02.5

3.0

3.5

4.04.5

5.0

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

Federal funds rate (left axis)

Percent Percent

30-year FRM rate (left axis)

Spread (right axis)

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

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Congress and White House responsesHOPE NOWThe Economic Stimulus Act of 2008Housing and Economic Recovery Act of 2008 Conservatorship of Fannie Mae and Freddie MacTemporary guaranty program for money market fundsTemporary ban on short selling in selected companies Bailout package?

Page 63: Making Sense of the Mortgage Meltdown

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XI. When will we hit bottom?

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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 to a downturn?

Yes 27%

No 73%

When will home prices hit bottom?

4%

17%

38%

29%

6%

1st half2008

2nd half2008

1st half2009

2nd half2009

1st half2010

Source: Wall Street Journal.

Page 65: Making Sense of the Mortgage Meltdown

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How far do home prices have to fall?

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

3.0

3.5

4.0

4.5

5.0

5.5

6.0

6.5

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

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

Q4 2006: 3.48%

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

Average, 2000–Q1 2008: 4.06%

Page 66: Making Sense of the Mortgage Meltdown

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

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

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 ra

tio

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

Annual home price decline required

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

Page 67: Making Sense of the Mortgage Meltdown

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0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

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

US$/month

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

Maximum affortablility limit is 38% of median household

Mortgage payment assumptions: Every month, a home is 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

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

Page 68: Making Sense of the Mortgage Meltdown

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XII. What went wrong

Page 69: Making Sense of the Mortgage Meltdown

6969

2,443

879

1,410

2,067

944886

0

500

1,000

1,500

2,000

2,500

3,000

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

US$ billions

The importance of Fannie Mae and Freddie Mac

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

Page 70: Making Sense of the Mortgage Meltdown

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

Sources: Freddie Mac, Fannie Mae, Milken Institute.

133 41

1,022803 844 805 886 879

288 316

1,301

752

1,778

1,123

2,443

1,410

0

500

1,000

1,500

2,000

2,500

3,000

Fannie Mae1990

Freddie Mac1990

Fannie Mae2003

Freddie Mac2003

Fannie Mae2006

Freddie Mac2006

Fannie Mae2Q 2008

Freddie Mac2Q 2008

US$ billions

Total assets

Total MBS outstanding

Page 71: Making Sense of the Mortgage Meltdown

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

56x

167x

65x

244x

59x

0

50

100

150

200

250

300

Core capital Fair value Core capital Fair value

2005 2006 2007 2008Q2

Mortgage book of business over capital measures

Fannie Mae Freddie Mac

-393x

Fannie Mae and Freddie Mac are highly leveraged

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

Page 72: Making Sense of the Mortgage Meltdown

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

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

Fannie Mae, 2007

Fannie Mae, 2006

Fannie Mae, 2005

Freddie Mac, 2007

Freddie Mac, 2006

Subprime Alt-A All others

33.8% 4.3% 32.0%

46.4% 36.1% 17.5%

32.1% 37.4% 30.5%

57.4% 13.1% 29.5%

61.2% 25.0% 13.8%

$122.2 billio

$76.1 billion

$86.9 billion

$97.3 billion

$94.8 billion

Page 73: Making Sense of the Mortgage Meltdown

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9.1

9.8

9.4

31.6

23.7

21.5

67.9

Credit unions

Commercial banks

Savings institutions

Brokers/hedge funds

Federal Home Loan Banks

Fannie Mae

Freddie Mac

Leverage ratio, total assets/common equtity

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

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

Page 74: Making Sense of the Mortgage Meltdown

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

Sources: Bloomberg, FDIC, Milken Institute.

28

1922

26

18

27

19

31

24 23

34 32 3331

22

2830

2422

n.a.0

5

10

15

20

25

30

35

40

Bear Stearns Merrill Lynch Morgan Stanley Lehman Brothers Goldman Sachs

2000 2005 2007 June 2008Total assets/total shareholder equity

Page 75: Making Sense of the Mortgage Meltdown

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AAAAA+

AAAA-A+

AA-

BBB+BBBBBB-

BB+BBBB-B+BB-CCC+

CCC+CCC-CCC

D

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

56.0%6,31011,261Total

87.5%78B(+/-)

86.6%683789BB(+/-)

76.1%2,2482,954BBB(+/-)

63.2%1,8862,983A(+/-)

38.1%1,3303,495AA(+/-)

15.1%1561,032AAA

Downgraded/ Total

DowngradedTotalS&P

56 percent of MBS issued from 2005 to 2007 were eventually

downgraded

Sources: Bloomberg, Inside Mortgage Finance, Milken Institute.

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

Page 76: Making Sense of the Mortgage Meltdown

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When is a AAA not a AAA?Multilayered mortgage products

Sources: International Monetary Fund, Milken Institute.

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%

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%

Page 77: Making Sense of the Mortgage Meltdown

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Dollar losses in reported cases of mortgage fraud

US$ millions

293225

429

1,014946

813

0

200

400

600

800

1,000

1,200

2002 2003 2004 2005 2006 2007

Mortgage loan fraud surges

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

37.3

52.9

0

10

20

30

40

50

60

1997 1999 2001 2003 2005 2007

Number of cases reported, thousands

1.7

2.3 2.9 3.5 4.7 5.49.5

18.4

26.0

37.3

52.9

0

10

20

30

40

50

60

1997 1999 2001 2003 2005 2007

Number of cases reported, thousands

Page 78: Making Sense of the Mortgage Meltdown

7878

Is adequate information disclosed to consumers?

Sources: Federal Trade Commission, Milken Institute.

20202123

303233

3751

6874

7984

8795

APR amountCash due at closing amount

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

Balloon payment (presence and amount)Interest rate amount

Whether loan amount included finances settlement chargesWhich loan was less expensive

Loan amountPresence of prepayment penalty for refinance in two years

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

Total up-front cost amountPrepayment penalty amount

Percent of respondents who could not correctly identify various loan costs using current disclosure forms

Page 79: Making Sense of the Mortgage Meltdown

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Drivers of foreclosures:Strong appreciation or weak economies?

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

0

5

10

15

20

25

-20 0 20 40 60 80 100 120 140

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

Detroit

MiamiBakersfield

Riverside

Fresno

Fort Lauderdale

Orlando

Phoenix

Las Vegas

Palm Beach

Tampa

Stockton

San Diego

Oakland

Sacramento

Atlanta

MemphisColumbus

Indianapolis

ToledoDaytonDenver

Cleveland

Akron

Warren

Weak economies Housing bubbles

Foreclosures per 1,000 homes

National average

Page 80: Making Sense of the Mortgage Meltdown

8080

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

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

0

5

10

15

20

25

30

35

40

45

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

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

Weak economies strengthenStockton

Miami

Orlando

Bakersfield

Phoenix

RiversideLas Vegas

Fort Lauderdale

Fresno

SacramentoOakland

San DiegoDetroit

Warren ClevelandDayton

Columbus Indianapolis

Palm BeachTampa

ToledoAkron

Denver

Atlanta

Memphis

Foreclosures per 1,000 homes

National average

Collaping housing bubbles

Page 81: Making Sense of the Mortgage Meltdown

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XIII. Where do we go from here?

Page 82: Making Sense of the Mortgage Meltdown

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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

• 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

Fed is the umbrella or consolidated regulator

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

• Federal Housing Finance Agency

Fannie Mae, Freddie Mac, and Federal Home Loan Banks

Financial, bank and thrift holding companies

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

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Many different options and innovations…

Covered BondsCovered Bonds

Alternative Mortgage ProductsAlternative Mortgage Products

Shared Equity MortgagesShared Equity Mortgages

Real Estate DerivativesReal Estate Derivatives

Classical Insurance Products Classical Insurance Products

OthersOthers

Page 84: Making Sense of the Mortgage Meltdown

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

Wall Street and the U.S. Financial System

Milken InstituteOctober 2, 2008

Glenn Yago Director of Capital Studies

James R. Barth Senior Fellow