Capital Market Trends and Forecasts Glenn Yago, Ph.D. Director, Capital Studies Milken Institute Los Angeles Fire and Police Pension System Education Retreat January 7, 28 1
Dow Jones U.S. Financial Index 7 6 5 4 3 2 Feburary March 27: More than 25 subprime lenders declare Dec. 26: Ownit Mortgage, a subprime lender, files for Feb. 27: HSBC sets aside $1.6 billion for bad loans, including subprime. Subprime mortgage meltdown timeline December 26 October 28 Aug. 6, 27: American Home Mortgage files for Apr. 27: New Century, a mortgage broker, files for July 31, 27: Two Bear Stearns hedge funds file for Sept. 3, 27: NetBank goes bankrupt. Aug. 16, 27: Countrywide gets emergency loan of $11 billion from a group of banks. Oct. 24, 27: Merrill announces $7.9 billion in subprime writedowns, surpassing Citi s $6.5 billion. 12/26 2/27 4/27 6/27 8/27 1/27 12/27 2/28 4/28 6/28 8/28 1/28 Sources: BusinessWeek, S&P, Global Insight, Milken Institute. Dec. 12, 27: Fed introduces Term Auction Facility. Jan. 11, 28: Bank of America agrees to buy Countrywide. Jan. 3, 28: Fed cuts discount rate to 3.5%. Mar. 11, 28: Fed offers troubled banks as much as $2 billion in loans; Fed introduces Term Securities Lending Facility. Aug. 17, 27: Fed cuts discount rate Feb. 13, 28: to 5.75%; Fed introduces President Bush Term Discount Window introduces tax rebate Program. stimulus program of $168 billion. Mar. 16, 28: JP Morgan Chase offers to buy Bear Stearns; Fed introduces Primary Dealer Credit Facility. June 9, 28: Lehman announces a $2.8 billion loss. July 11, 28: IndyMac is seized by FDIC. July 3, 28: President Bush signs a housing rescue law. Mar. 18, 28: Fed cuts discount rate to 2.5%; Fed funds rate to 2.25%. April. 3, 28: Fed cuts discount rate to 2.25%; Fed funds rate to 2%. Aug. 1, 28: First Priority Bank closes. Sept. 29, 28: Citigroup agrees to buy W achovia. Sept. 23, 28: Washington Mutual is seized by FDIC. Sept. 16, 28: Fed loans AIG $85 billion. Oct. 8, 28: Fed cuts discount rate to 1.75%; Fed funds rate to 1.5%. Oct. 3, 28: President Bush signs Emergency Economic Stabilization Act, authorizing bailout of $7 billion. Also, Citigroup sues after Wachovia agrees tie-up with Wells Fargo. Sept. 7, 28: U.S. seizes Fannie Mae Sept. 14, 28: and Freddie Mac. Lehman files for Oct. 12, 28: Finance leaders endorse G7 plan to calm markets. Oct. 27, 28: Down Jones U.S. Financial Index=23 Oct. 31, 28: Dow Jones U.S. Financial Index=269 2
Home mortgages: Who borrows, how much has been borrowed, and who funds them? Total value of housing stock = $19.3 trillion Mortgage debt $1.6 trillion Equity in housing stock $8.7 trillion Subprime 8.4% Securitized 58% Prime 91.6% Non-securitized 42% Governmentcontrolled 46% Private sectorcontrolled 54% Note: total residential and commercial mortgages = $14.7 trillion; 5 percent = $7 billion Sources: Federal Reserve, Milken Institute. 3
The mortgage problem in perspective 8 million houses 27 million are paid off 53 million have mortgages 48 million are paying on time 5 million are behind (9.2% of 53 million with 2.8% in foreclosure) This compares to 5% seriously delinquent in the 193s. Sources: U.S. Treasury, Milken Institute. 4
Did the Fed lower interest rates too much and for too long? Percent 8 7 6 5 Federal funds rate vs. rates on FRMs and ARMs 3-year FRM rate 4 3 2 1-year ARM rate Target federal funds rate 1 Record low from June 25, 23 to June 3, 24: 1% Oct. 8, 28: 1.5% Oct. 29, 28: 1% 21 22 23 24 25 26 27 28 Sources: Federal Reserve, Mortgage Bankers Association, Moody s Economy.com, Milken Institute. 5
Credit boom pushes homeownership rate to historic high Percent 7 69 68 67 66 65 64 Q2 24: 69.2% Q3 28: 67.9% Average, 1965 Q3 28: 65.2% 1998 2 22 24 26 28 Home price bubble peaks in 26 Index, January 1987 = 1 38 S&P/ 33 Case-Shiller National Hom e 28 Price Index 23 18 13 8 OFHEO Hom e Price Inde x 1998 2 22 24 26 28 California and national home prices reach record highs US$ thousands 7 6 5 4 3 2 1 California m edian home price California average 1987-28 $23,599 U.S. m e dian hom e price U.S. average, 1987-28: $121,714 1998 2 22 24 26 28 Sources: U.S. Census Bureau, OFHEO, Moody s Economy.com, S&P/Case-Shiller, California Association of Realtors, Milken Institute. 6
The mortgage model switches from originate-to-hold to originate-to-distribute Residential mortgage loans 198: Total = $958 billion Residential mortgage loans Q2 28: Total = $11.3 trillion Securitized 15.6% Held in portfolio 41% Held in portfolio 84.4% Securitized 59% Sources: Federal Reserve, Milken Institute. 7
The recent run-up of home prices was extraordinary Index, 2 = 1 25 Annualized growth rate of nominal home index, 189 June 28: 3.3% 2 15 World War I Great Depression World War II 197 s boom 198 s boom Current boom 1 5 Long-term trend line 189 19 191 192 193 194 195 196 197 198 199 2 21 Sources: Robert Shiller, Milken Institute. 8
Home prices don t go up forever Change in home prices in 1-plus years Percentage change in nominal home price, year ago 3 World Great World 25 War I Depression War II 197 s Boom 198 s Boom Current Boom 2 15 Average, 189 June 28: 3.6% 1 5-5 -1-15 +/- one standard deviation -2 189 19 191 192 193 194 195 196 197 198 199 2 21 Sources: Robert Shiller, Milken Institute. 9
Spread between 3-month LIBOR and T-bill rate Basis points 4 October 1, 28: 464 bps 35 3 25 2 15 1 5 August 2, 27: 24 bps Average since August 27: 148 bps Average since 1985:86 bps Liquidity freeze Spread between 3-month LIBOR and overnight index swap rate Basis points 35 3 25 2 15 1 5 October 1, 28: 364 bps Average since August 27: 87 bps Average since Decem ber 21: 25 bps 26 27 28 Sources: Bloomberg, Milken Institute. 26 27 28 1
When is a AAA not a AAA? Origination of mortgage loans Multilayered mortgage products 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 8% AA 11% A 4% Mezzanine CDO BBB 3% CDO-squared BB-unrated 2% Senior AAA 62% Junior AAA 14% Senior AAA 6% 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. 11