The Subprime Market Meltdown: Crisis or Opportunity? Jonathan Beinner CIO and Co-Head, US and Global Fixed Income, GSM Tom Teles Head, Mortgage Backed Securities, GSM July 10, 2007
Discussion outline. Subprime Mortgage Overview B. The Subprime Mortgage Meltdown 1
Subprime Mortgage Overview
Size of subprime market Total Industry-Wide Volume for Subprime Mortgage-Backed Securities: $600 500 400 $, billions 300 200 100 0 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 The subprime market grew from $56 billion in 2000 to $508 billion in 2005 (over 800% growth). Today, the subprime market represents approximately 14% of the overall mortgage-backed securities market. Source: Inside Mortgage Finance, Credit Suisse, Loan Performance 3
The subprime borrower Who is the subprime borrower? Subprime borrowers generally exhibit: lower credit scores higher leverage relative to prime borrowers Mortgage Loans 1 Prime Subprime Implication FICO (Credit) Score 2 741 630 Higher likelihood of default Loan-to-Value Ratio 3 (%) 75 87 Less money down, more leverage taken Debt-to-Income Ratio (%) 37 42 Larger portion of income devoted to mortgage payments % RM 45 72 Moderate teaser rates (e.g., 7%) and very high reset rates (e.g., 11%) Source: Citigroup, Deutsche Bank Securities, LoanPerformance, CPR&CDR Technologies 1 Based on 2006 securitizations as of January 2007 2 FICO Score is a standard measure of credit risk developed by Fair Isaac Company; the lower the FICO Score, the higher the likelihood of default 3 Combined Loan-to-Value Ratio, which reflects all known mortgage liens (when available) 4
Subprime investing Individual subprime mortgage loans are packaged and sold in the home equity loan (HEL) asset-backed securities (BS) market. Subordinated HEL BS are further repackaged and sold in the BS collateralized debt obligation (CDO) market. Subprime Mortgage Loans Home Equity Loan (HEL) BS Securities HEL BS Mezzanine Tranches Collateralized Debt Obligation (CDO) - NR - NR - NR - - NR - NR - NR - NR - NR - NR - - - Unrated Source: GSM, Deutsche Bank Securities, Citigroup (Note: security structures are sample representations) 5
The Subprime Mortgage Meltdown
Subprime borrowers have benefited from a virtuous credit cycle Housing Market Lending Standards Credit Losses Demand for Home Equity Loans 2003 2006 Credit Ratings Demand for Home Equity Securities Demand for BS CDO s 7
The virtuous cycle has become a vicious cycle for certain borrowers Housing Market Lending Standards Credit Losses Demand for Home Equity Loans 2007???? Credit Ratings Demand for Home Equity Securities Demand for BS CDO s 8
Falling home prices have increased the likelihood of default Housing Market nnual Home Price ppreciation (%): 35 California 30 U.S. nnual HP % 25 20 15 10 5 0-5 -10 HP increases Less likelihood of default HP decreases Higher likelihood of default nnualized quarterly HP as of 1Q07 U.S. 1.8% C -3.3% Mar-76 Mar-77 Mar-78 Mar-79 Mar-80 Mar-81 Mar-82 Mar-83 Mar-84 Mar-85 Mar-86 Mar-87 Mar-88 Mar-89 Mar-90 Mar-91 Mar-92 Mar-93 Mar-94 Mar-95 Mar-96 Mar-97 Mar-98 Mar-99 Mar-00 Mar-01 Mar-02 Mar-03 Mar-04 Mar-05 Mar-06 Mar-07 When home prices rise, stressed borrowers are more likely to sell their houses at a profit rather than default. When home prices decline, stressed borrowers are more likely to default rather than sell their houses at a loss. Today, home prices are declining due to high supply and poor affordability. Source: OFHEO, Lehman Brothers 9
s home prices have stagnated, easy lending standards have led to higher delinquencies Credit Loans Delinquent 60 Days or More: 20% 2006 18% 2005 16% 2004 2003 Delinquency Rate (%) 14% 12% 10% 8% 6% 4% 2% 0% 1 6 11 16 21 26 31 36 41 46 51 Loan ge (months) Recent vintages have defaulted earlier than older vintages due to home price deceleration and weaker underwriting standards. The percentage of subprime borrowers with 2nd lien loans has increased from 7% in 2003 to 33% in 2006. Higher delinquency levels have led to negative rating outlooks. Source: Credit Suisse, Loan Performance, as of May 2007 10
Higher credit losses have led to lower demand for CDOs CDO Demand CDO Issuance ($, bn) 300 250 200 $, billions 150 100 50 0 2001 2001 2002 2002 2003 2003 2004 2004 2005 2005 2006 2006 2007 2007* We believe a significant portion of 2007 CDO issuance remains unsold. The negative ratings outlook has led investors to rethink purchases of riskier CDO segments. Source: GSM, Lehman Brothers * 2007 CDO issuance through pril 30, 2007; dashed box indicates GSM s estimate for total 2007 CDO issuance. This information discusses general market activity, industry or sector trends, or other broad-based economic, market or political conditions and should not be construed as research or investment advice. Please see additional disclosures. 11
Weak loan performance has led to subprime loan originator fall-out Selected Originator News: Originator Timeline Headline News Loan Demand Ownit Dec 2006 Ceased operations; ultimately filed for bankruptcy Popular Jan 2007 Closed origination business ResMae Feb 2007 Filed for bankruptcy; acquired by hedge fund (exited bankruptcy Jun-07) MLN Feb 2007 Filed for bankruptcy HSBC Feb 2007 Chargeoffs 20% higher than initial forecast, $1.76bn increase in reserves Fremont Mar 2007 FDIC cease and desist order, exited subprime origination business ccredited Mar 2007 Liquidity issues; sold whole loans to meet cash requirements New Century Mar 2007 Stopped originating new loans due to liquidity issues, restated 2006 earnings; ultimately filed for bankruptcy Originators representing approximately 25% of 2006 volume have either filed for bankruptcy or have exited the business. n additional 20% have either been sold or are on the market as of May 2007. significant number of remaining originators have announced losses and cutbacks in origination. Source: Lehman Brothers, National Mortgage News, BSnet, GSM estimates 12
Banks have started to tighten their lending standards Lending Standards Lending Standards 40% 30% Net % Banks Tightening Mortgage Standards 20% 10% 0% -10% -20% Sep-90 Jun-91 Mar-92 Dec-92 Sep-93 Jun-94 Mar-95 Dec-95 Sep-96 Jun-97 Mar-98 Dec-98 Sep-99 Jun-00 Mar-01 Dec-01 Sep-02 Jun-03 Mar-04 Dec-04 Sep-05 Jun-06 Mar-07 56% of senior bank loan officers reported tighter standards on subprime mortgages in 1Q07. Banks have started to tighten their lending standards as: Home price appreciation has decelerated. Delinquencies have increased. Source: Federal Reserve, as of March 31, 2007 13
Is the worst yet to come? Lending Standards Demand for Home Equity Loans Housing Market Lending 2007 Standards???? Demand for Home Equity Securities Credit Losses Demand for BS CDO s Credit Ratings Subprime RM resets may exacerbate the vicious cycle 60 Subprime RMs Resets 50 40 $ billions 30 20 10 0 Jan-07 Feb-07 Mar-07 pr-07 May-07 Jun-07 Jul-07 ug-07 Sep-07 Oct-07 Nov-07 Dec-07 Jan-08 Feb-08 Mar-08 pr-08 May-08 Jun-08 Jul-08 ug-08 Sep-08 Oct-08 Nov-08 Dec-08 Subprime RMs will reset from a low teaser rate of ~7-8% to a much higher rate of ~11%. In order to avoid a payment shock, subprime borrowers will need to refinance. Due to more stringent lending standards, subprime borrowers may not be able to find a willing lender. Loan modifications and subsidized refinancing assistance may ease the burden for certain borrowers. Source: Lehman Brothers, Loan Performance 14
These factors have resulted in dramatic declines in subprime bond prices Subprime BS Credit Default Swap Index (BX.HE 06-2 -) Price 110 100 90 80 70 60 50 40 30 Credit quality weakens Financial crisis for lenders Market attempts to price in future expectations 10% 9% 8% 7% 6% 5% 4% 3% 2% 1% 7/19/06 8/17/06 9/15/06 10/14/06 11/12/06 12/11/06 1/9/07 2/7/07 3/8/07 4/6/07 5/5/07 6/3/07 7/2/07 0% -1% -2% -3% -4% -5% -6% -7% -8% -9% -10% 2-year HP% Scenario* We believe that the current price is not stressed enough, given: Future home price expectations. Tighter lending standards, and Looming RM resets. Source: JP Morgan, Markit Partners, Lehman Brothers * Reflects projected index price to indicated home price appreciation over the next two years, as of June 12, 2007. HP reverts to 4% at the end of Year 4. This information discusses general market activity, industry or sector trends, or other broad-based economic, market or political conditions and should not be construed as research or investment advice. Please see additional disclosures. 15
Subprime: yesterday and today Subprime borrowers benefited from a virtuous credit cycle (2003-2006), but the virtuous cycle is becoming a vicious cycle: Borrowers are overleveraged due to easy credit availability and expectations of future home price growth. Weak underwriting and slower home price growth has led to significantly higher delinquencies. Looming RM resets will further strain subprime borrowers, due to: Higher interest rates, Slowing home price growth, Tighter lending standards, and Limited refinancing options. Loan defaults and tighter credit conditions may prolong housing market weakness, resulting in additional credit losses. This information discusses general market activity, industry or sector trends, or other broad-based economic, market or political conditions and should not be construed as research or investment advice. Please see additional disclosures. 16
Is this a crisis or opportunity? We believe current pricing still reflects optimistic assumptions regarding home price growth. Continued deterioration in credit trends will likely lead to significant rating downgrades and additional selling pressure for securities backed by subprime loans. Be prepared to allocate investment capital as housing market and subprime sector re-price to a more attractive risk-adjusted return profile over next several quarters. This information discusses general market activity, industry or sector trends, or other broad-based economic, market or political conditions and should not be construed as research or investment advice. Please see additional disclosures. 17
Goldman Sachs sset Management Conference Call Series Survey The Subprime Market Meltdown: Crisis or Opportunity? Jonathan Beinner, CIO and Co-Head, US and Global Fixed Income, GSM Tom Teles, Head, Mortgage Backed Securities, GSM Please fill out the following questionnaire and fax it back to us at 212-428-3278. Your input will help us improve future conference calls. 1. How relevant was this topic for you: 2. How helpful was the conference overall: 3. Were the speaker s remarks: Jonathan Beinner: Tom Teles: 4. Were the slide materials: 5. Were the questions in the Q& answered/handled: Very Relevant Relevant Fairly Relevant Not Very Relevant Irrelevant Very Helpful Helpful Fairly Helpful Not Very Helpful Not Helpful Very Helpful Helpful Fairly Helpful Not Very Helpful Not Helpful Very Helpful Helpful Fairly Helpful Not Very Helpful Not Helpful Very Helpful Helpful Fairly Helpful Not Very Helpful Not Helpful Very Well Well Fine Okay Not Well 6. fter participating in this call are you more or less likely to participate in a future call of interest to you: Very Likely Likely Fairly Likely Not Very Likely Not Likely 7. What related information should we have covered? 8. What other improvements would you suggest in terms of content, delivery or materials? 9. What topics would you like us to cover in future conference calls? 10. Other comments: Name: (Optional) Company: (Optional) Thank you for taking the time to complete this survey. Please fax your response to 212-428-3278. 18
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