U.S. Subprime Mortgage Market Meltdown

U.S. Subprime Mortgage Market Meltdown James R. Barth Auburn University and Milken Institute jbarth@milkeninstitute.org 14 th Dubrovnik Economic Conference The Croatian National Bank Dubrovnik, Croatia June 25 28, 2008

Any real-estate investment is a good investment

Any real-estate investment is a good investment NOT!

Homeownership Rate Reaches Historic High in 2004 Percent 70 69.2% in September 2004 69 68 67 66 65 67.8% in March 2008 64 63 62 1965 1969 1973 1977 1981 1985 1989 1993 1997 2001 2005 2008 Source: U.S. Census Bureau.

Index, January 1987 = 100 600 Home Prices Peak in 2006 500 California median home price 400 300 S&P/Case-Shiller home price index 200 100 0 OFHEO conventional and conforming home price index 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Sources: U.S. Office of Federal Housing Enterprise Oversight (OFEHO), Standard & Poor's, California Association of Realtors, Moody's Economy.com.

Home Price Appreciation Peaks in 2005 House-price indices, % change on a year earlier 20 15 10 OFHEO S&P/Case- Shiller national S&P/Case- Shiller 10 city 5 0-5 -10-15 1988 1992 1996 2000 2004 2008

A Longer-Term Perspective on Home Prices 1890=100 220 200 Current Boom 220 200 180 160 140 World War I Great Depression World War II 1970 s Boom 1980 s Boom 180 160 140 120 120 100 100 80 80 60 60 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 Source: Robert J. Shiller, 2006.

History Repeats Itself: Home Prices Don t Just Go Up Change in Home Prices in 100 plus years Percentage change, year ago 40% World War I Great World Depression War II 1970 s Boom 1980 s Boom Current Boom 30% 20% 10% 0% -10% -20% 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 Source: Robert J. Shiller, 2006.

4.8 Homes for Sale Take Off Millions Millions 0.8 4.2 0.7 3.6 3.0 Existing homes (Left axis) 0.6 0.5 2.4 0.4 1.8 0.3 1.2 0.6 New homes (Right axis) 0.2 0.1 0.0 0.0 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Source: U.S. Census Bureau.

Single-family Home Sales Reach New High Before Plunging Millions, SAAR 6.5 Millions, SAAR 1.4 6.0 New homes (Right axis) 1.2 5.5 1.0 5.0 0.8 4.5 4.0 1998 1999 Existing homes (Left axis) 2000 2001 2002 2003 2004 2005 2006 2007 2008 0.6 0.4 Sources: U.S. Census, National Association of Realtors, Moody s Economy.com.

Existing Home Sales Are Down Everywhere Over the Past Two Years Percent change in existing home sales Fourth-quarter 2005 through fourth-quarter 2007 Source: Freddie Mac. Existing home sales nationwide down 29%

Median Existing Single-family Home Price: Too Good to Last Percent change, year ago 20 15 10 5 0-5 -10-15 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Sources: National Association of Realtors, Moody s Economy.com.

Forty-six States Had Falling Prices in the Fourth Quarter 2007 United States: - 9.3% (fourth-quarter annualized growth) Source: Freddie Mac.

Percent change, year ago 40 Single-family Housing Starts 20 0-20 -40-60 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Sources: U.S. Census Bureau, Global Insight.

Single-family Building Hit a Record in 2005 But Was 53% Lower Two Years Later Housing starts: Single-family privately owned Thousands, SAAR 2,000 1,800 1,600 1,400 1,200 1,000 800 600 400 200 0 1972 1974 1976 Source: U.S. Census Bureau. 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

Homes Sit Longer on the Market Millions 4.0 3.5 3.0 2.5 Homes available for sale (Left axis) Months 11 10 9 8 7 2.0 1.5 Months supply (Right axis) 6 5 4 1.0 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 3 Sources: National Association of Realtors, Moody s Economy.com.

Home Prices and Credit Boom Index, January 2000 = 100 250 200 Total originations (R) US$ billions 4,500 4,000 3,500 150 100 50 0 1994 1995 S&P/Case- Shiller home price index (L) 1996 1997 1998 1999 2000 2001 2002 2003 Subprime originations (R) 2004 2005 2006 2007 3,000 2,500 2,000 1,500 1,000 500 0

Interest Rates: Too Low Too Long? Fed Funds Rate vs. Rate on Long-term Government Bonds Percent 7 6 5 Government bond rate 4 3 2 Fed funds rate 1 0 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Sources: Federal Reserve, Global Insight.

Mortgage Rates: ARMs Appear Attractive to Many Percent 9.0 8.0 7.0 30-yr fixed 6.0 5.0 4.0 3.0 1-yr ARM 2.0 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Sources: Mortgage Banker s Association, Moody s Economy.com.

ARM Share of Mortgages Percent 40 35 30 25 Share of all applications 20 15 10 Share of all loans 5 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Sources: U.S. Federal Housing Finance Board, Freddie Mac, Moody s Economy.com.

ARM Share of Mortgages 20.9 20.8 23 21 21.7 21.3 21.4 20.6 20.9 21.1 20.9 20.2 19 17 19.0 17.9 16.9 15 13 11.7 12.0 11.9 11 9 Source: Mortgage Bankers Association. 20.2 14.8 14.4 15.8 Q3 2007 Q4 2007 Percent of all loans Q1 2003 Q2 2003 Q3 2003 Q4 2003 Q1 2004 Q2 2004 Q3 2004 Q4 2004 Q1 2005 Q2 2005 Q3 2005 Q4 2005 Q1 2006 Q2 2006 Q3 2006 Q4 2006 Q1 2007 Q2 2007

Q4 2007 ARM Mortgage Share by Loan Type Percent of loan type 70 60 FHA Prime Subprime 50 40 30 20 10 0 Q1 2003 Q2 2003 Q3 2003 Q4 2003 Q1 2004 Q2 2004 Q3 2004 Q4 2004 Q1 2005 Q2 2005 Q3 2005 Q4 2005 Q1 2006 Q2 2006 Q3 2006 Q4 2006 Q1 2007 Q2 2007 Q3 2007 Source: Mortgage Bankers Association.

Prime and Subprime Home Mortgage Originations Year 2006 2007 Total Originations (US$ Trillions) 2.98 2.43 Prime Originations 79.9 92.1 Share of Total (%) Subprime Originations 1994 0.77 95.5 4.5 1995 0.64 89.8 10.2 1996 0.79 87.7 12.3 1997 0.86 85.5 14.5 1998 1.45 89.7 10.3 1999 1.31 87.8 12.2 2000 1.05 86.8 13.2 2001 2.22 92.2 7.8 2002 2.89 92.6 7.4 2003 3.95 91.6 8.4 2004 2.92 81.8 18.2 2005 3.12 78.7 21.3 2008 Q1 0.48 97.9 2.1 20.1 7.9 Source: Inside Mortgage Finance.

Mortgage Originations by Product Subprime and Alt A shares quadruple between 2001 and 2006, then fall in 2007. 4.6% 2.6% 8.0% 8.4% 14.4% 2.7% 13.4% 33.2% 14.4% 4.9% 11.3% 47.3% 19.4% 56.9% 7.9% 20.1% 16.1% 14.3% 2001 $2.2 trillion Source: Inside Mortgage Finance. 2006 $3.0 trillion Conventional, conforming prime Subprime FHA & VA 2007 $2.4 trillion Jumbo prime Alt-A Home equity loans

2/28 ARMs Dominate Subprime Home-purchase Loan Originations in 2006 Fixed 9% Other ARM Other ARM 4% 30Yr ARM Balloon W/ 2-year & 3-year 40-50-Yr hybrids Amtz 26% 61% Other ARM 23% Fixed 31% ARM hybrids 46% Other ARM 7% ARM Hybrids 23% Fixed 70% Subprime Alt-A Prime conventional Source: Freddie Mac.

Subprime Mortgage Loans Outstanding US$ billions 1,400 1,200 1,000 800 600 400 200 0 290 1995 1996 283 Source: Inside Mortgage Finance. 319 344 382 416 1997 1998 1999 2000 2001 2002 479 699 574 973 1,200 2003 2004 2005 2006 2007 1,240 940 2008 1Q 895

Distribution of Prime and Subprime Residential Mortgage Originations by FICO Score (2006) Percent of Total Originations 16% 14% Subprime Prime 12% 10% 8% 6% 4% 2% 0% 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

National Distribution of FICO Scores Percentage of Population 30 27 25 20 18 15 12 15 13 10 8 5 0 2 up to 499 5 500-549 550-599 600-649 650-699 700-479 750-799 800

Origin of Securitization But I don t know any other word to describe what we are doing. You will have to use it (securitization). Lewis Ranieri The Origins of Securitization, Sources of Its Growth, and Its Future Potential, A Primer on Securitization

Surge in Amount and Diversity of U.S. Asset-backed Securities Outstanding US$ trillions 10.0 9.0 8.0 7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0 Other Student Loans Home Equity Credit Card Automobile Non-agency MBS Agency CMO Agency MBS 1999 2000 2001 2002 2003 2004 2005 2006 2007 Source: Securities Industry and Financial Markets Association.

U.S. Asset-backed Securities Outstanding 1999, Total = US$4,235 Billions 2007, Total = US$9,682 Billions Student Loans 1% Home Equity 3% Credit Card 6% Automobile 3% Non-agency MBS 9% Agency CMO 16% Other 8% Agency MBS 54% Student Loans 3% Home Equity 6% Credit Card 4% Automobile 2% Non-agency MBS 14% Agency CMO 14% Other 11% Agency MBS 46% Source: Securities Industry and Financial Markets Association.

Home Mortgage Security Issuance 1985, Total = $110 Billion 2006, Total = $2.1 Trillion 2007, Total = $1.9 Trillion FNMA 21% Non- Agency 2% GNMA 42% GNMA 4% FHLMC 18% Non- Agency 38% GNMA 5% FHLMC 24% Non- Agency 56% FNMA 22% FHLMC 35% FNMA 33%

Outstanding Home Mortgage Securities 1986, Total = $548 Billion 2006, Total = $5.7 Trillion 2007, Total = $6.6 Trillion Non- Agency MBS Fannie 3% Mae MBS 18% Non- Agency MBS 32% Ginnie Mae MBS 48% Ginnie Mae MBS 7% Freddie Mac PCs 26% Non- Agency MBS 32% Ginnie Mae MBS 7% Freddie Mac PCs 26% Freddie Mac PCs 31% Fannie Mae MBS 35% Fannie Mae MBS 35%

Private-label Mortgage-backed Security Issuance Has Fallen Sharply Dollar amount of Issuance, US$ billions 200 Subprime & other Alt-A 150 100 52 30 37 16 34 8 20 14 19 7 Prime Jumbo Freddie Mac & Fannie Mae 50 85 94 99 97 101 0 March 2007 $191 Billion June 2007 $181 Billion Sep. 2007 $137 Billion Dec. 2007 $109 Billion April 2008 $102 Billion Source: Inside Mortgage Finance.

Origination Shares of Mortgage Brokers Account for Majority of Home Mortgage Originations 1987 Number of mortgage brokers: 7,000 Brokers 20% 2006 Number of mortgage brokers: 53,000 Others 42% Brokers 58% Others 80% Source: Wholesale Access.

Monoline Insurers Financial Guarantees of Securities Increase, But What Happens If They Cannot Be Honored? Net Par Outstanding = $3.5 Trillion December 2006 Structured Finance, $2.2 Trillion, 62% Public Finance, $1.3 Trillion, 38% 11% 19% 19% 6% 45% Mortgage-Backed Securities: U.S. Other Asset- Backed Securities: U.S. Mortgage-Backed Securities: International Other Asset- Backed Securities: International Other 28% 34% 8% 15% 15% General Obligation Utility Revenue Tax-Backed Revenue Transportation Revenue Other

Securitization: Originate to Distribute vs. Originate to Hold 100% 80% 60% Other Government-Sponsored Enterprises and Agencies Non-Agency Issuers 40% Saving Institutions 20% Commercial Banks 0% 1952 1956 1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004 2008

S&P 500 Index 1,600 1,550 1,500 1,450 1,400 1,350 1,300 1,250 2006 Q4 Dec. 06: Ownit Mortgage, a subprime lender, files for bankruptcy Feb. 07: HSBC says it set aside $10.6 billion for bad loans, incl. subprime Subprime Crisis Overview December 2006 March 2008 Apr. 07: New Century, a mortgage broker, files for bankruptcy Jul. 07: Two Bear Stearns hedge funds file for bankruptcy Aug. 07: Fed cuts discount rate to 5.75% Jan. 11, 08: BofA agrees to buy Countrywide Oct. 07: Merrill announces $7.9b in subprime writedowns, surpassing Citi s $6.5 billion Jan. 30, 08: Fed cuts discount rate to 3.5% 2007 Q1 2007 Q2 2007 Q3 2007 Q4 Mar. 11, 08: Fed offers troubled banks as much as $200 billion Mar. 16, 08: JP Morgan offers to buy Bear Stearns Mar. 18, 08: Fed cuts discount rate to 2.4%; Fed funds rate to 2.25% 2008 Q1 Sources: BusinessWeek (March 31, 2008), Standard & Poor s and Global Insight.

Ratio of Median Home Price to Median Household Income Surges Median Home Price/Median Household Income 5.0 4.5 4.0 3.5 3.0 2.5 '68 '70 '72 '74 '76 '78 '80 '82 '84 '86 '88 '90 '92 '94 '96 '98 '00 '02 '04 '06

Home Mortgage Share of Household Liabilities Reaches a New High in 2007 Percent 75 70 65 60 55 1952 1957 1962 1967 1972 1977 1982 1987 1992 1997 2002 2007 Source: Federal Reserve.

75 Leverage of U.S. Households has Increased Rapidly Since 1980 Home mortgage debts as % of disposable personal income Percent 70 65 60 55 1952 1956 1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004 2008 Sources: Federal Reserve and Moody s.

Sixty-day plus Home Mortgage Delinquency Rates Are on the Rise 25% 20% Subprime 15% 10% Alt-A A 5% Jumbo prime 0% Jan-00 Jul-00 Jan-01 Jul-01 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07 Sources: First American Corelogic and LoanPerformance databases.

Subprime ARM Defaults Are 12 Times Those for Prime Delinquent or In Foreclosure (Percent of Number) 30 25 Subprime ARM, 26.09 20 15 10 Subprime FRM, 9.82 5 FHA & VA, 5.96 0 Prime, 2.08 Q2 1998 Q4 1998 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

Subprime Loans Accounted for Over Half of Foreclosures Since 2006 Number of foreclosures started (Annualized rate in thousands) 1,800 Subprime: 13% of 1,500 Subprime loans serviced FHA and VA (December) 1,200 Prime (includes Alt-A) 54% 900 600 300 0 37% 29% 34% 2003 H2 36% 29% 35% 2004 H1 37% 29% 34% 2004 H2 44% 22% 34% 2005 H1 Source: Mortgage Bankers Association National Delinquency Survey (data as of December 2007, number expanded to reflect 85% coverage). 47% 20% 33% 2005 H2 52% 17% 31% 2006 H1 55% 13% 32% 2006 H2 56% 11% 33% 2007 H1 9% 37% 2007 H2

Percent Change in Delinquency Rate of Subprime ARM Loans Between 2005Q2 and 2007Q2 Sources: Mortgage Bankers Association, Milken Institute. Less than 60% 60%-110% 110%-180% More than 180%

National Subprime Foreclosure Rates by Origination Year* Foreclosure Rates in Origination Year and Subsequent Years Origination Year 1999 2000 2001 2002 2003 2004 2005 2006 Year to July 2007 Foreclosure Year Originate year 1.30 1.50 1.85 1.07 0.82 0.86 0.97 2.56 3.01 1st year 6.33 6.86 7.17 5.51 4.14 3.93 6.38 7.69 2nd year 5.46 6.01 5.81 4.55 3.11 3.66 4.66 3rd year 4.85 3.35 4.23 2.37 2.23 1.85 4th year 2.29 2.49 1.88 1.56 0.83 5th year 2.05 1.19 1.17 0.59 6th year 0.79 0.71 0.48 7th year 0.56 0.30 8th year 0.24 Total Number of Foreclosures From Origination through September 2007 188,026 165,801 140,195 124,781 127,100 176,729 231,360 140,278 13,272 Total Number of Originations 787,420 739,749 620,945 797,625 1,143,037 1,716,141 1,925,780 1,368,706 440,934 Foreclosure Rate through September 2007 23.88 22.41 22.58 15.64 11.12 10.30 12.01 10.25 3.01 *Foreclosure rates are based on the number of loans starting foreclosure.

California Subprime Foreclosure Rates by Origination Year* Foreclosure Rates in Origination Year and Subsequent Years Origination Year 1999 2000 2001 2002 2003 2004 2005 2006 Year to July 2007 Foreclosure Year Originate year 0.88 0.76 1.01 0.70 0.48 0.50 0.76 5.20 4.88 1st year 4.03 3.72 4.29 3.18 2.08 2.04 5.97 14.10 2nd year 3.01 2.99 2.74 1.68 0.79 1.46 5.51 3rd year 2.66 1.26 1.17 0.36 0.34 0.85 4th year 0.93 0.49 0.22 0.16 0.12 5th year 0.46 0.11 0.12 0.06 6th year 0.12 0.07 0.04 7th year 0.06 0.02 8th year 0.03 Total Number of Foreclosures From Origination through September 2007 9,160 8,389 9,528 9,137 8,944 16,161 39,198 31,295 2,973 Total Number of Originations 75,224 88,915 99,412 148,796 235,065 333,327 320,200 162,134 60,871 Foreclosure Rate through 12.18 9.43 9.58 6.14 3.80 4.85 12.24 19.30 4.88 September 2007 *Foreclosure rates are based on the number of loans starting foreclosure.

Determinants of Delinquency and Foreclosure Rates in CBSAs January 1999 December 2006 60+ Days Delinquent 90+ Days Delinquent Variables and In Foreclosure and In Foreclosure In Foreclosure C -16.868*** -8.036*** -7.780*** -3.035*** -10.365*** -6.498*** ARM 21.771*** 22.567*** 11.523*** 12.191*** 10.089*** 10.202*** FICO < 620 9.757*** 1.563* 3.266*** -1.068** 7.767*** 4.017*** LTV > 80 53.410*** 33.103*** 27.963*** 17.067*** 24.812*** 15.692*** LOWNODOC 17.031*** 20.549*** 7.628*** 10.058*** 9.867*** 11.075*** Interaction of All Four Loan Characteristics 201.692*** 164.110*** 118.785*** 89.430*** 73.308*** 62.224*** Population 1.688*** 0.823** 0.949*** Median Family Income Growth -2.048*** -0.768** -1.719*** Home Price Growth -25.700*** -13.091*** -11.435*** Unemployment 1.340*** 0.719*** 0.613*** Average Loan Size -0.049*** -0.028*** -0.021*** Adjusted R-square 0.6466 0.7043 0.6200 0.6768 0.6395 0.6962 Number of Observations 34224 34224 34224 34224 34224 34224 Number of CBSAs 360 360 360 360 360 360 Note: ***, **, and * denote significance at 1, 5, and 10 percent levels, respectively. CBSA denotes corebased statistical area. Includes CBSA fixed effects.

Determinants of Delinquency and Foreclosure Rates in CBSAs January 1999 December 2005 60+ Days Delinquent 90+ Days Delinquent Variables and In Foreclosure and In Foreclosure In Foreclosure C -20.594*** -14.972*** -10.032*** -7.082*** -11.168*** -8.664*** ARM 23.762*** 24.692*** 12.482*** 13.304*** 11.056*** 11.228*** FICO < 620 10.678*** 5.818*** 4.407*** 1.788*** 6.731*** 4.553*** LTV > 80 60.163*** 41.033*** 31.243*** 20.929*** 27.730*** 19.273*** LOWNODOC 12.880*** 20.157*** 6.113*** 10.506*** 7.556*** 10.328*** Interaction of All Four Loan Characteristics 307.380*** 187.290*** 166.440*** 92.650*** 128.897*** 84.331*** Population 2.161*** 1.351*** 0.964*** Median Family Income Growth -2.213*** -1.101*** -1.320*** Home Price Growth -18.750*** -9.630*** -8.970*** Unemployment 1.480*** 0.796*** 0.650*** Average Loan Size -0.057*** -0.033*** -0.023*** Adjusted R-square 0.6396 0.6927 0.6085 0.6626 0.6355 0.6852 Number of Observations 30036 30036 30036 30036 30036 30036 Number of CBSAs 360 360 360 360 360 360 Note: ***, **, and * denote significance at 1, 5, and 10 percent levels, respectively. CBSA denotes core-based statistical area. Includes CBSA fixed effects.

Determinants of Delinquency and Foreclosure Rates in CBSAs January 1999 December 2004 60+ Days Delinquent 90+ Days Delinquent Variables and In Foreclosure and In Foreclosure In Foreclosure C -16.427*** -15.111*** -7.510*** -6.824*** -9.204*** -8.671*** ARM 26.290*** 27.469*** 13.680*** 14.619*** 12.423*** 12.364*** FICO < 620 1.228 0.125-0.868-1.482** 2.051*** 1.617*** LTV > 80 61.173*** 48.908*** 31.379*** 24.678*** 28.574*** 23.128*** LOWNODOC 3.752*** 9.777*** 1.451* 5.173*** 2.487*** 4.438*** Interaction of All Four Loan Characteristics 521.907*** 351.432*** 280.018*** 178.666*** 237.738*** 174.602*** Population 2.254** 1.346*** 0.877** Median Family Income Growth -2.403*** -1.251*** -1.402*** Home Price Growth -13.716*** -6.812*** -6.535*** Unemployment 1.478*** 0.799*** 0.684*** Average Loan Size -0.061*** -0.035*** -0.025*** Adjusted R-square 0.6329 0.6746 0.5987 0.6417 0.6328 0.6730 Number of Observations 25848 25848 25848 25848 25848 25848 Number of CBSAs 360 360 360 360 360 360 Note: ***, **, and * denote significance at 1, 5, and 10 percent levels, respectively. CBSA denotes core-based statistical area. Includes CBSA fixed effects.

The Mortgage Problem in Perspective 80 million houses 25 million are paid off 55 million have mortgages 51 million are paying on-time 4 million are behind (8% of 55 million with 2% in foreclosure) This compares to 50% seriously delinquent in the 1930s Source: U.S. Treasury Department.

A A billion here, a billion there, and pretty soon you re talking real money. -- U.S. Senator Everett Dirksen,, 1961

A billion^here,, a billion^there, and pretty soon you re talking real money. -- U.S. Senator Everett Dirksen, 1961

Estimates of Losses From Subprime Crisis Date 7/19/2007 10/17/2007 11/8/2007 11/15/2007 11/16/2007 12/19/2007 1/31/2008 2/11/2008 3/3/2008 3/3/2008 3/10/2008 3/13/2008 Estimate $50-100 billion $100-200 billion $150 billion $400 billion $400 billion $200-300 billion $120 billion $400 billion $170 billion $600 billion $215 billion $285 billion Source Bernanke testimony before congress William C. Dudley, NY Fed Bernanke testimony before Congress Deutsche Bank Goldman Sachs The Economist Wall Street Journal German finance minister at G7 meeting Wikipedia Geraud Charpin, head of European credit strategy at UBS in London Head of Japan's financial regulator Standard and Poor s

Supbrime s Biggest Losers Citigroup UBS Merrill Lynch HSBC IKB Deutsche Royal Bank of Scotland Bank of America Morgan Stanley JPMorgan Chase Credit Suisse Washington Mutual Credit Agricole Deutsche Bank Wachovia Source: Bloomberg. Losses/write-downs through May 27, 2008, US$ billions 19.5 16.1 15.4 14.8 12.6 9.8 9.7 9.1 8.4 7.7 7.0 42.9 38.2 37.0 The collapse of credit markets in the United States, driven by the subprime loan crisis, has led to major losses for banks worldwide.

Recent Losses/Write-downs and Capital Raised by Financial Institutions Citigroup, United States UBS, Switzerland Merrill Lynch, United States HSBC, United Kingdom IKB Deutsche, Germany Royal Bank of Scotland, United Kingdom Bank of America, United States Morgan Stanley, United States JPMorgan Stanley, United States Credit Suisse, Switzerland World total (US$ billions) Loss /Writedown 42.9 38.2 37.0 19.5 16.1 15.4 14.8 12.6 9.8 9.7 382.8 Total Capital Raised 44.1 28.8 17.9 2.0 13.3 23.8 19.7 5.6 708.0 1.5 269.9 2Q 2008 (through May 27) Loss /Writedown 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.9 Capital Raised 12.9 16.2 4.3 2.0 0.0 23.8 6.7 0.0 7.8 0.0 139.0 Source: Bloomberg.

Financial Stocks Take Big Hits in Subprime Crisis Percentage change in price, December 2006 March 2008-94% -87% -77% -63% -56% -56% -53% -52% -52% -40% -32% -29% -18% -17% -11% Bear Stearns Countrywide Washington Mutual Freddie Mac Merrill Lynch Fannie Mae Wachovia UBS Lehman Brothers AIG Morgan Stanley Bank of America Wells Fargo Goldman Sachs JP Morgan & Chase -1-0.8-0.6-0.4-0.2 0 Source: Bloomberg.

Leverage Ratios of Different Types of Financial Firms 2007 Government-sponsored enterprises 24.7 Brokers and hedge funds 31.6 Credit unions 8.4 Savings institutions 8.4 Commerical banks 9.8 0 5 10 15 20 25 30 35 Source: David Greenlaw, Jan Hatzius, Anil K Kashyap, Hyun Song Shin, 2008 Asset/Capital

Too Much Dependence on Debt? Leverage Ratios At Biggest Investment Banks Total assets to total shareholder equity 40 March 2008 35 March 2001 30 25 20 15 Bear Stearns Note: * the latest figure is as of December 2007 Sources: Bloomberg. Morgan Stanley Merrill Lynch Lehman Bros.* Goldman Sachs

Banks Depend Less on Debt Leverage Ratios At Bank Holding Companies Total assets to total shareholder equity 21 March 2001 December 2007 17 March 2008 13 9 5 Sources: Bloomberg. Citigroup JP Morgan Chase Bank of America

What Broke the Cycle? Fraud: by borrowers, brokers, appraisers, lenders. Cracks in most overheated markets (LA, Las Vegas, Miami) quickly spread everywhere. Most highly leveraged vehicles (CLOs) collapsed first Followed by second most leveraged institutions banks (not hedge funds). Difference this time: Primary losers are those who own AAA debt. Downgrades in the Asset-Backed Securities Markets AAA Downgrades In the Asset-Backed Securities Markets 7,000 6,566 160 6,000 5,000 4,000 3,000 1986 0 1987 1 1988 15 1989 0 1990 13 1991 12 1992 30 1993 12 1994 3 1995 1 1996 0 1997 4 1998 140 1999 80 2000 171 2001 122 2002 539 2003 1,635 2004 1,215 2005 210 2006 415 2007 2,000 1,000 0 1 0 0 0 0 0 0 0 0 5 6 6 8 7 9 15 23 78 92 134 140 120 0 100 80 60 40 20 0 85 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Source: Moody s Source: Moody s

Number 1,400 Most New Securities Were Rated AAA by S&P in 2007 1,200 1,000 800 1,295 or 45% of new securities rated by S&P were rated AAA in 2007 600 400 200 AAA AA A A+ AA- BBB A- BBB AA+ B A1+ B- B+ CCC BB- BB+ B BB CCC C

When is a AAA not a AAA? Multilayered structured credit products Mortgage loans Mortgage bonds High-grade structured-finance CDO Senior AAA 88% Junior AAA 5% AA 3% A 2% BBB 1% Unrated 1% AAA 80% AA 11% A 4% BBB 3% BB-unrated 2% Source: International Monetary Fund. Mezzanine structuredfinance CDO Senior AAA 62% Junior AAA 14% AA 8% A 6% BBB 6% Unrated 4% CDO-Squared Senior AAA Junior AAA AA A BBB Unrated 60% 27% 4% 3% 3% 2%

Most Texas Banks Were AAA in the 1980s First RepublicBank Corporation

Foreclosures in Houston 30,000 20,000 10,000 1,000 Source: Harris County Foreclosure Listing Service. 1980 1986 1992

1200 1000 Widening Spreads Mortgage-backed and High-yield Bonds Basis point spread above 10-year treasury bond ML BBB Mortgage-Backed Securities Index 800 ML High-Yield Bond Index 600 400 200 0 Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Source: Bloomberg.

Widening Spreads Municipal Bonds Basis point spread over 10-year treasury bond 120 ML municipal master index yield spread 80 40 0-40 -80 Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Source: Bloomberg.

Market for Liquidity Freezes Percent 6.5 6.0 5.5 Thirty-Day AA Rated Commercial Paper Rates Asset-backed Commercial Paper 5.0 4.5 4.0 3.5 3.0 2.5 2.0 Nonfinancial Commercial Paper Financial Commercial Paper 1.5 May 07 Jun 07 Source: Federal Reserve. Jul 07 Aug 07 Sep 07 Oct 07 Nov 07 Dec 07 Jan 08 Feb 08 Mar 08 Apr 08 May 08

Thousands 60 Mortgage Loan Fraud Surges 50 40 30 20 10 0 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Source: Financial Crimes Enforcement Network.

Dollar Losses in Reported Cases of Mortgage Fraud US$ Millions 1,200 1,000 1,014 946 800 813 600 400 200 293 225 429 0 2002 2003 2004 2005 2006 2007 Source: Federal Bureau of Investigation.

Tightened Standards For Real Estate Loans Net percentage of domestic respondents tightening Percent standards for commercial real estate loans 100 The end of S&L crisis Subprime 80 LTCM Dotcom 60 40 20 0-20 -40 Mar-90 Mar-93 Mar-96 Mar-99 Mar-02 Mar-05 Mar-08 Source: Federal Reserve.

Despite Federal Funds Rate Cuts, Mortgage Rates Remain Relatively Flat 4.0 3.5 3.0 2.5 2.0 1.5 Freddie Mac 30-year fixed mortgage rate Federal funds rate 8.0 7.0 6.0 5.0 4.0 3.0 1.0 0.5 Spread 2.0 1.0 0.0 0.0 January 2007 June 2007 November 2007 April 2008 Sources: Federal Reserve, Freddie Mac.

Is Adequate Information Disclosed to Consumers? Percentage of people in a study who could not correctly identify various loan terms using current mortgage disclosure forms Annual percentage rate: 20 Monthly payment: 21 Loan amount: 51 Existence of prepayment penalty: 68 Total upfront Cost: 87 0 20 40 60 80 100 Percent Source: Los Angeles Times, June 14, 2007.

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 of a downturn? Yes: 27% When will home prices hit bottom? 1 st half 6% 2010 2 nd half 29% 2009 No: 73% 1 st half 2009 38% 2 nd half 2008 17% 1 st half 2008 4% Source: The Wall Street Journal, April 11, 2008.

How Far Do Home Prices Have to Fall? Annual rents as % of house prices 6.50 6.00 5.50 5.00 4.50 4.00 3.50 3.00 1960 Q1 1962 Q3 1965 Q1 1967 Q3 1970 Q1 1972 Q3 1975 Q1 1977 Q3 1980 Q1 1982 Q3 1985 Q1 1987 Q3 1990 Q1 1992 Q3 1995 Q1 1997 Q3 2000 Q1 2002 Q3 2005 Q1 2007 Q3 2010 Q1 Source: : The Rent-Price Ratio for the Aggregate Stock of Owner-Occupied Housing, December 2007.

History of Credit Disruptions: 1998 Today Recent credit disruption was preceded by 5 years of benign credit market Nov - Aug 1998 4Q 2001-2002 Jul 2007- Present Key Causes Russian credit default Long Term Capital Weak credit fundamentals Major corporate defaults and accounting scandals (Enron, WorldCom) Deteriorating housing/subprime market Market de-leveraging Investment Grade Spread Widening 70+ bps 80+ bps 1200+ bps Key Issues Significant counterpart y risk Corporate scandals and fraud Tremendous supply/demand imbalance Recapitalization of financial institutions

What Went Wrong: 1960s 1980s Today 2020s?

Enough Blame to Go Around Nonresident speculators Regulators/central bankers Brokers/other intermediaries Rating agencies Institutional investors Home buyers Appraisers

$1 Trillion Losses The Nifty Fifty stocks - early 1970s Sovereign debt: 1980s Texas banks/southwest real estate: 1980s Japanese real estate/equities: 1980s-90s Technology: 2000 Housing-related investments: 2007-8

Credit Issues Ratings consistency Real estate price fluctuation Interest rate volatility Sovereign debt risk Leverage Business volatility Liquidity risk Counterparty risk Currency risk Unexpected regulatory requirements Complexity

1974: The most important year in financial history since World War II.

1974: Interest rates double in one year; highest level in recent recorded U.S. history Regulation restricts lending Energy prices skyrocket U.S. stock market plunges 50%

1974: RESULT Companies with the highest returns on capital, fastest rates of market share and employment growth, greatest contributions to technological and new- product innovation were denied access to equity and debt capital.

For 1975 through 1976, the return on investment non-investment debt-grade portfolios to investors was 100% unleveraged. Fewer than 1 percent of those companies projected to be candidates for bankruptcies actually defaulted.

Index 1,100 1,000 I ll Never Own a Stock Again Dow Jones Industrial Average 1052 on 11 Jan. 1973 900 800 700 600 500 578 on 6 Dec. 1974 1973 1974 1975 1976

Index 1,100 1,000 I ll Never Own a Stock Again Dow Jones Industrial Average 1052 on 11 Jan. 1973 900 800 700 600 500 578 on 6 Dec. 1974 1973 1974 1975 1976

The $55 Billion Misunderstanding Investing in the Nifty Fifty 12/31/72 12/31/81 90% of the Nifty Fifty showed a negative return over nine years. The average inflation-adjusted rate of return was -46%.

The $55 Billion Misunderstanding Investing in the Nifty Fifty 12/31/72 12/31/81 The average P/E ratio of these 16 companies dropped from 66 to 11. Avon ADP Coke Disney Dr. Pepper Kodak H-P J&J Eli Lilly Marriott McDonald s Merck Polaroid Rite-Aid Wal-Mart Xerox

Imperial Palace (Tokyo) 1990 US$5.1 trillion Residential Property (California) 1990 US$2.4 trillion

Imperial Palace (Tokyo) 2006 US$1.7 trillion Residential Property (California) 2006 US$6.5 trillion

Real estate prices collapsed, credit dried up, house building stopped...

Real estate prices collapsed, credit dried up, house building stopped... in 1792.