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

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
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

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

-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

2
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

2
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

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

-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
Average
Basis CDS spread, basis points
points
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

-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 fixed rate
30-year FRM mortgage rate (left axis)
(left axis)
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
z HOPE NOW
z The Economic Stimulus Act of 2008
z Housing and Economic Recovery Act of 2008
z Conservatorship of Fannie Mae and Freddie Mac
z Temporary guaranty program for money market funds
z Temporary ban on short selling in selected
companies
z 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 homehome
Annual price price
decline required
decline
-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