Anatomy of a Credit Collapse

Confidential Presentation to: Kellogg Business School

November 13th, 2007

The Market and Macro Economic Fallout of the Sub Prime Mess

Lehman Brothers MBS and Rates Research

Agenda

Laying the blame– Underwriting practices

– The changing intermediation process

Reaping the whirlwind– The magnitude of losses

– The entities at risk

– ABCP and SIVs

Will bank losses exacerbate the economic weakness?

The Altered Origination Landscape

$2.35trn Sub-Prime and Alt-A / B Mortgages…Composition of the Aggregate Mortgage Universe, $bn

Outstanding by Vintage / Sector ($bn)

Sector   <2003 2004 2005 >2006 Total

Prime Agency 1,485 630 815 820 3,750

Jumbo 830 630 484 456 2,400

Alt-A / Alt-B 94 191 432 433 1,150

Sub-Prime   114 143 392 550 1,200

Total 2,523 1,594 2,123 2,259 8,500

________________Source: Loan Performance, Inside B&C Lending, Lehman Brothers.

1

Excess Capacity in the Origination Industry Led to Loose Underwriting Standards

Origination volumes in late 2005 / 2006 remained high despite the fall in rate incentive The share of high CLTV and lim-doc loans increased significantly Contrary to popular perception, the share of investor properties didn’t change much

0

1,000

2,000

3,000

4,000

2000 2001 2002 2003 2004 2005 2006

Agency Other

Origination Volumes $bn Characteristics of Non-Agencies 1

2003 2004 2005 2006

% CLTV >80 31 42 46 51

% CLTV >90 14 22 25 29

% IO 17 39 51 49

% Lim-doc 43 48 56 64

% Investor 9 11 12 12

________________Source: MBA, Loan performance and Lehman Brothers1. Includes prime jumbo, alt-A and subprime loans.

2

… Risky Lending Practices Continued% Originations to Borrowers with Layered Risks

0.6%

1.8%

2.9%

4.1%

5.9%6.6%

5.2%

1.4%

0%

2%

4%

6%

8%

1H’03 2H’03 1H’04 2H’04 1H’05 2H’05 1H’06 2H’06

(%)

Layered Risk

________________Source: Lehman Brothers. Layered Risk is defined as loans with Limited Documentation, >45% DTI and >95% CLTV.

3

Helped by a Strong Housing MarketNational Quarterly Home Price Appreciation (HPA), Annualized

0%

5%

10%

15%

20%

1Q’00 2Q’01 3Q’02 4Q’03 1Q’05 2Q’06

(%)

________________Source: OFHEO.

4

Most inv-grade subordinates created in recent years have been by absorbed by CDOs The rate impact of CDO demand for borrowers was limited… … The more important effect was the ‘commoditization’ of credit

0

50

100

150

200

2000 2001 2002 2003 2004 2005 2006 2007

($bn)

High Grade Mezzanine

Issuance in ABS CDOs $bn Change in Borrowing Costs

________________Source: Lehman Brothers 1. The 2007 numbers are YTD estimates, but there should be no issuance for the rest of the year.

Securitizations Let Originators Layoff Most of the Risk

(1)

Credit Spreads (bp)

Size % 2003 2006 Change

AAA 81% 35 15 -20

AA 5% 100 32 -68

A 5% 150 40 -110

BBB 6% 325 175 -150

Total 97% 60 26 -34

5

Unlike previous episodes, credit score has proved less important than equity Rating agency assumptions around loans with piggyback seconds were rather benign

Cumulative Non-Performers (1)at 12 WALA Rating Agency Assumptions in 2006 (2)

The Markets Underestimated the Importance of Equity as an Attribute Driving Performance

LTV CLTV Frequency Severity Loss

80 80 1.0x 1.0x 1.0x

80 100 1.5x 1.0x 1.5x

100 100 4.0x 1.6x 6.4x

  Conforming  Non-Conforming

FICO 80 CLTV100

CLTV 80 CLTV100

CLTV

650 3.5% 9.0% 3.4% 19.0%

675 2.0% 6.3% 2.3% 14.5%

700 1.7% 5.7% 2.0% 13.4%

725 1.1% 4.4% 1.8% 10.7%

750 0.6% 3.2% 0.7% 8.5%

________________1. Cumulative non-performers include 60 day + delinquencies (OTS style) and any cum. defaults. We show numbers for 06 originations2. Reprint from the 2006 Securitized Conference.

6

620 vs. 720 FICO = 5 to 10 times underperformance 70 vs. 100 CLTV = 2 to 5 times underperformance

620 vs. 720 FICO = 3 to 5 times underperformance 70 vs. 100 CLTV = 9 to 13 times underperformance

In 2000 Orig.

In 2006 Orig.

CNP across FICO / CLTV – 2006CNP across FICO / CLTV – 2000CLTV

70 80 90 100

F

I

C

O

620 4.5% 6.5% 9.8% 8.7%

660 3.0% 3.9% 6.1% 6.5%

700 1.4% 1.8% 3.9% 4.1%

740 0.4% 0.8% 2.7% 2.2%

CLTV

70 80 90 100

F

I

C

O

620 2.4% 5.3% 11.2% 15.8%

660 1.4% 3.6% 7.9% 12.3%

700 0.9% 2.5% 4.2% 9.6%

740 0.4% 1.0% 1.9% 6.0%

Credit Score Has Become Less Relevant

12

0

700

1,400

2,100

2,800

Sep-06 Dec-06 Mar-07 Jun-07 Sep-07

AAA AA A BBB BBB-

Buyout requirements created significant problems for subprime originators In recent months, liquidity in the capital markets has dried significantly … … Rates for non-conforming borrowers are now 100–300bp wider

Pricing of the Active ABX Indices (1) Rates Available to Borrowers (2)

Originator Problems and a Highly Visible ABX Index Hastened the Inevitable

Dec 31 Jun 30 Oct 05

Agency 6.25 6.65 6.45

Jumbo 6.50 6.95 7.50

Alt-A 7.10 7.60 8.5–9.0

HEL 8.25 8.80 10.5–11.0

Subprime OriginatorProblems

BSAM’s Hedge Fundsand ABCP Issues

________________1. We show the most current ABX index pricing. We used 2007-1 as the current index through out 2007. 2. Lehman Brothers estimates

7

CDOs – the New Intermediation Technology

The ABS CDO Market Grew Dramatically in 05/06

0

50

100

150

200

2000 2001 2002 2003 2004 2005 2006 2007

High Grade Mezzanine

Issuance in New ABS CDO Deals $bn

11

What Exactly Do ABS CDOs Hold?

a. High Grade CDOs b. Mezzanine CDOs

Assets Liabilities Assets Liabilities

Size Spreads Size Spreads Size Spreads Size Spreads

AAA 8.2% 20 AAA Sen. 85% 20 AAA 0.0% 20 AAA Sen 70% 25

AA 42.3% 35 AAA Jun 10% 40 AA 0.3% 35 AAA Jun 10% 50

A 46.0% 90 AA-BBB 4% 200 A 1.4% 70 AA-BBB 15% 400

BBB 3.5% 150 Total Liab 99% 29 BBB 47.5% 125 Total Liab 95% 83

BBB- 0.0% 250 Mgt Cost (1) 20 BBB- 48.0% 225 Mgt Cost 20

BB 0.0% 400 ROE BB 2.8% 400 ROE

Total 100.0% 63 Equity 1% 19.1% Total 100.0% 180 Equity 5% 20.4%

High grade CDOs own AA/A assets while Mezzanine CDOs own BBB/BBB- assets A large part of the ‘A’ exposure in high-grade CDOs is other CDO liabilities

Balance Sheets of ABS CDOs

12

The Underlying Assets in ABS CDOs Will Likely See Significant Losses

0

20

40

60

80

100

120

-20 -16 -12 -8 -4 0 4

HPA (%)

AA A BBB BBB-

Estimated Price of the ABX Across HPA Scenarios HPA and Losses Implied by ABX07-1 Pricing

PriceImplied

Coll LossImplied

HPA

AA 50.0 24 -22

A 29.5 22 -20

BBB 19.5 20 -17

BBB- 18.5 21 -18

13

Most of these Losses Will be Borne by AAA CDO Holders

Losses Across HPA Scenarios ($bn)

VintageBond Bal.

Recent 0 HPA -8 HPA Stress

High-grade

Pre 05 70.2 - - - 0.5

Post 06 88.1 - - 6.8 28.6

Total 158.3 - - 6.8 29.1

Mezzanine

Pre 05 76.8 0.1 5.5 26.4 39.3

Post 06 102.7 1.6 38.4 79.1 86.6

Total 179.5 1.7 44.0 105.5 125.9

All CDOs 337.8 1.7 44.0 112.3 155.0

Distribution of Losses by Rating

Recent 0 HPA -6 HPA Stress

High Grade CDOs

AAA Sen – – – 9.4

Mezz – – 5.8 18.2

Equity – – 1.0 1.4

Total – – 6.8 29.1

Mezzanine CDOs

AAA Sen – 8.7 56.5 76.9

Mezz – 8.3 39.5 39.5

Equity 1.7 9.5 9.5 9.5

Total 1.7 44.0 105.5 125.9

All CDOs 1.7 44.0 112.3 155.0

Losses on ABS CDOs ($bn) 1

Even assuming sequential payments, AAA CDOs take significant losses Our projections here are lower bounds since we don’t account for CDOs in CDOs (most applicable to high-grade

CDOs)

14

Who Owns AAA CDOs?

ABCP/SIV$60bn

Others$65bn

Insurance Cos

$80bn

Bond Insurers$95bn

CDO CP Put Providers

$60bn

Estimated Holdings of AAA CDOs Composition of Bond Insurer Portfolios

The largest holders of AAAs are bond insurers Their loss exposures in stress scenarios could be high in relation to capitalization (1)

________________Source: Based on 10-Qs of AMBAC, MBIA, ACA, XLCA, FGIC and rating agency reports on bond insurers. 1. The total capitalization of the bond insurance sector is about $18bn.

Total Portfolio Size: $1,600bnTotal AAA ABS CDOs: $360bn

15

Who will Eat the Loss?

Aggregate Residential Mortgage Losses Can be as Much as $250bn in Stress Scenarios …

This Appears Manageable in Itself

Expected Losses Across Housing Scenarios ($bn)

The Timing of Losses on Residential Mortgages ($bn)

0

20

40

60

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012Historical Recent HPA 0 HPA -6 HPA Stress

Size Recent 0 HPA -6 HPA StressAgency 4,250 7.9 13.6 21.8 28.6

Prime 2,350 2.7 6.0 10.0 13.9

Alt-A 1,200 4.9 11.6 19.6 27.9

Subprime 1,200 22.8 77.8 122.5 171.3

Total 9,000 38.3 109.0 174.0 241.7

________________Source: Lehman Brothers Estimates.

8

… the Risk Is that Large Holders of Credit Exposure Are Not Sufficiently Capitalized

Who Owns Residential Credit Exposure?

1–4 Family Residential Mortgages $9,000bn

100bn600bn

REITS$150bn

GN$400bn

FN / FH$3,650bn

Mtg. Ins.$600bn

Banks$1,500bn

Thrifts$800bn

GSEs $350bn

ABX Sellers(Synthetics)

Equity$60bn

AAAs$1,580bn

Overseas $320bn

Banks $300bn

ABCP $100bn

Others $470bn(money mgr.,

sec-lenders, dealers)

Others$60bn

ABS CDOs$430bn130bn

40bn

CDO AAAs $360bn

CDO Mezz.$60bn

CDO Equity$10bn

CDO CP Puts$60bn

Insurance Co. $80bn

Bond Insurers $95bn

ABCP / SIV $60bn

CMBS / ABS$60bn

Inv-Grade$260bn

Agency$4,250bn

Securities$1,900bn

9

The Largest Loan Holders Look Okay Except for MI Providers

The GSEs and commercial banks are rather well capitalized vs. loss expectations MI companies look susceptible – there are some offsets from slowing speeds Securitizations house most of the losses in residential mortgage

Projected Losses Across Major Sectors

Losses Across HPA Scenarios

($bn) Portfolio

Size Capital(2) Annual Revs. (3) 10 HPA 0 HPA -6 HPA Stress

GSEs 3,650 45 8.0 2.9 4.7 7.4 9.5

Banks 1,500 1,050 37.5 5.3 16.9 27.5 38.7

Thrifts 800 230 20.0 2.1 5.8 9.6 13.5

MI Companies 700 25 5.2 5.7 10.2 16.6 22.3

Securities(1) 1,800 300 33.3 21.5 68.3 107.9 150.7

Others 550 – – 0.9 3.0 4.9 6.9

Total 9,000 1,650 104.0 38.3 109.0 174.0 241.7

________________1. Includes non-agency and subprime deals. Excludes any deals consolidated on balance sheets to avoid double-counting.2. Is the book value of equity for all entities except securities. For securities, we show the size of subordinates and equity pieces.3. 2006 estimates of net revenues associated with just their mortgage portfolio.

10

ABCP Conduits and SIVs

Multi-Seller Conduits

Single-Seller Conduits

Sec-Arb.

ConduitsStructured Inv. Vehicles (SIVs)

Type of Assets Loans Loans Securities Securities

Total Assets ($bn) 680 190 195 350

Total CP Issued ($bn) 650 175 180 100(1)

Mark-to-Market? No No Yes Yes

US Residential Assets ($bn) 68 72 60 18

Liquidity Protection Put Provider (Usually a AA bank)

Extendible, Market value

swap

Put Provider (Usually a AA bank)

Liquidity Provision (Usually

a bank line)

________________Source: Based on Moody’s and S&P reports on ABCP conduits / SIVs. As of August 6, 20071. SIVs have 100bn in ABCP and 250bn in MTNs

The Various Flavors of ABCP Conduits

Multi-seller and single-seller vehicles are loan conduits In ABS CDOs about $60bn in AAAs are financed as ABCP

16

________________Source: Based on Moody’s and S&P reports on ABCP conduits / SIVs. As of August 6, 2007. SIVs have 100bn in ABCP and 250bn in MTNs

What Exactly Do ABCP Vehicles Hold?Multi-Seller Conduits (680bn)

Sec-Arb Conduits (195bn)

Single-Seller Conduits (190bn)

SIVs (350bn)

17

Concerns around ABCP Conduits and SIVs

900

975

1,050

1,125

1,200

Mar-07 May-07 Jul-07 Sep-07 Sep-07 Oct-07

ABCP Unsecured CP

Outstanding Balance of ABCP, $bn

Two key questions Will CP roll in coming months? In the event CP doesn’t roll, is there risk of asset sales?

________________Source: Federal Reserve. We quote the non-seasonally adjusted balance.

18

Outstanding Balance(1) Type of Liquidity Provision

% Mortgage Assets Jul-31 Oct-3 Change Extendable Put Provider

Liquidity Provision

Multi-seller 10650 625

-25 – 100% –

Single-seller 38175 80

-95 100% – –

Sec-arbitrage 31180 135

-45 10% 90% –

SIVs 5100 85

-15 – – 100%

CDOs with CP 9045 0

-45 – 100% –

Total 181,150 925

-225 94 740 85

ABCP Conduits with Significant Mortgage/CDO exposure Saw Roll Problems and in Some Cases, Asset Sales

Problems have so far been concentrated in single-seller and sec-arb conduits These vehicles have the greatest concentration of mortgages and ABS CDOs

________________1. Based on data from rating agency reports on ABCP conduits and the Federal Reserve. The change in balance across sectors are

estimates from Lehman Brothers.2. Extendable vehicles usually have a market value swap provider who assumes the market risk of current loans.

Outstanding Balance in ABCP and the Liquidity Provisions

19

Asset Distribution of SIVs(1)

0

30

60

90

120

AB

CP

Mar

-08

Sep

-08

Mar

-09

Sep

-09

Mar

-10

>=

Mar

-10

Estimated Maturity of Liabilties(1)

Share of Balance (%)MTM Losses

Asset Class AAA AA A Total (%)

Financials8.4 24.7

7.8 41.0 -1.36

RMBS (US)5.2 0.4

0.1 5.7 -4.70

RMBS (UK)15.7 1.3

0.1 17.2 -1.27

CDO / CLO10.2 0.4

0.1 10.7 -3.50

Cons. ABS12.3 0.1

0.2 12.7 -0.95

Other10.8 1.2

0.6 12.7 -0.60

Total62.7 28.1

8.9 100.0 -1.70

MTM Losses and The Lack of a Liquidity Backstop Have Made SIVs a Source of Concern

Total Assets: $350bn

________________1. Based on rating agency reports. MTM losses are based on spread changes from 6/30 to 10/05.

20

Buyers of Last Resort : Do Banks have Enough Balance Sheet

FOMC September Meeting Minutes

“…Given existing commitments to customers and the increased resistance of investors to purchasing some securitized products, banks might need to take a large volume of assets onto their balance sheets over coming weeks, including leveraged loans, asset-backed commercial paper, and some types of mortgages.

Banks' concerns about the implications of rapid growth in their balance sheets for their capital ratios and for their liquidity, as well as the recent deterioration in various term funding markets, might well lead banks to tighten the availability of credit to households and firms…”

1

Banks are significant for credit creation

Banks are significant for Credit creation

– Average growth in US bank financial assets over 2004-06 = $600bn

– Share of bank asset growth in overall (non-financial) credit growth is around 25% Asset growth at banks had slowed in the first two quarters

Large share of credit creation

________________Source: Flow of Funds Data; Only US Chartered Commercial banks. Left Panel: Share of banks computed as ratio of average 3-year growth in bank financial assets versus that in domestic non-financial debt. Right panel: y-o-y growth in %

Bank asset growth had slowed

10%

15%

20%

25%

30%

35%

40%

1983 1986 1989 1992 1995 1998 2001 2004

Share of Banks in non-Financial Credit Growth

3%4%5%6%7%8%9%

10%11%12%

2001 2002 2003 2004 2005 2006 June2007

Domestic Non-Financial Debt Bank Financial Assets

(Annual Growth)

2

Banks are as significant as in the early 1990s Banks are at least as significant in overall credit creation By sector

– Less significant in consumer debt

– Slightly less significant in corporate

– More significant in household mortgage debt

Banks are slightly more significant than in 1990

________________Source: Flow of Funds Left Panel: Ratio of US chartered commercial banks financial assets to total domestic non-financial debt. Right panel: Proportion of debt owed by various entities which rests on bank balance sheets

Less in consumer loans, more in mortgages

1990, 23%

2007, 25%

20%

21%

22%

23%

24%

25%

26%

1988 1992 1996 2000 2004

Bank Financial Assets / Total Non-Financial Debt

20%

25%

30%

35%

40%

45%

50%

1989 1991 1993 1995 1997 1999 2001 2003 2005 2007

Corporate Household Mortgage

Household Non-Mortgage

% Debt held by Banks

11

And have had to take on additional assets Assets

– HY Bond/Loan pipeline not yet brought to market

– Liquidity puts on ABCP assets Additional assets and potential losses on these are significant compared with typical asset growth / earnings

Additional assets & losses

________________Source: Lehman Brothers; Left panel: HY loans/bonds notional estimated using pipeline and league table share of US banks in 2007. ABCP notional estimated from amount of decline in ABCP and US banks share of liquidity puts. Losses assumed at 5% of notional. Right panel: financial assets of banks from flow of funds data. Earnings from FDIC.

Not trivial

Notional ($bn) Potential Losses

HY Bonds/Loans 120 6

ABCP Assets 85 4

Total 205 10

($bn)

Financial Assets (June 2007) 7,419

2006 growth in Assets 696

Additional Assets 205

% of 2006 growth 29%

2006 Earnings 91

Potential Losses 10

% of 2006 earnings 11%

3

Capital ratios matter for asset growth

Desire to remain better than “adequately capitalized” Capital Ratios constrained growth in the early 1990s A 1 pp reduction in capital ratio slowed asset growth by 2.6%

Capital ratios matter for asset growth

________________Source: Bernanke & Lown, “The Credit Crunch”, Brookings papers on economic activity, 2:1991. . Table is only for New Jersey Banks, 2.6% figure is for banks nationwide.

Loan Growth in 1990-91 Less than 6% 6% - 8%

Small Banks -2.8 0.6

Large Banks -8.8 -7.4

Capital/Asset Ratio in end 1989

6

Large banks are reasonably well capitalized Focus on Large banks

– They have most of the additional exposure

– Their capital ratios were more affected in the early 1990s Capital ratios of large banks healthier versus history Last time we saw a significant deterioration in capital ratios was in 1990-92

But large banks have more healthy capital ratios

________________Source: Left panel: FDIC data for all commercial banks. Right panel: Lehman Brothers Equity Research, top 30 banks by assets

Capital ratio for banking system is lower than averages

9.6%

9.9%

9.0%

9.5%

10.0%

10.5%

11.0%

1992 1994 1996 1998 2000 2002 2004 2006

All Banks' Tier1 Capital Ratio

June 2007, 8.28%

5%

6%

7%

8%

9%

10%

1990 1992 1994 1996 1998 2000 2002 2004 2006

Tier 1 Capital Ratio (Large Banks)

Average since 1994 - 8.35%

7

But effect on large banks is still significant Banks are reasonably well capitalized to begin with, though their ratios have reduced over the past year Taking on HY/ABCP assets has two implications for ratios

– Increases the asset base

– Losses from these assets reduce capital Banks could take additional losses from mortgage exposure

Reasonably well capitalized to begin with

________________Source: Left panel: Lehman Brothers equity research, top 30 banks by assets; Right panel: HY loans/bonds notional estimated using pipeline and league table share of US banks in 2007. ABCP notional estimated from amount of decline in ABCP and US banks share of liquidity puts. Losses assumed at 5% of notional. Potential losses from mortgage assets as estimated by the Mortgage Strategy group under a -12% HPA scenario.

Additional assets and losses

June 2007 Status ($bn)Assets 8361Equity 691Equity/Assets Ratio 8.26%

Risk Weighted Assets 5863Tier 1 Capital 486Tier 1 Ratio 8.28%

Assets ($bn)

Risk Weight

Weighted Assets

HY Loans/Bonds 120 100% 120ABCP Assets 85 20% 17

205 137Losses @ 5% 10Mortgage Losses 15Reduction in Capital 25

8

And could reduce asset growth appreciably

Banks would like tier-1 ratio to remain above 7.5 - 8% Immediate deterioration in ratios is significant, but not catastrophic No need to sell assets immediately; more likely a slowing in future asset growth To maintain ratios at 8%, a $250 billion reduction in asset growth is necessary

Immediate deterioration in ratios is significant

________________Source: Lehman Brothers, Lehman Brothers Equity Research. Assets/capital as of June 2007 for top 30 banks. Forecast asset growth at 7.7%

And could entail a large reduction in asset growth

Forecast Asset Growth for 2008 685 bn

Reduction in Asset Growth Necessary to maintain 8% ratio

246 bn

Proportion of Projected Growth 36%

Forecasted Asset Growth (%) 7.7%Constrained Asset Growth (%) 4.9%Reduction in Asset Growth 2.8%Reduction in Asset Growth (early 90s) 3.7%

Increased Assets 8566 bnEquity 666 bnEquity/Assets Ratio 7.77%Deterioration in Ratio -0.49%

Increased Risk Weighted Assets 6000 bnTier 1 Capital 460 bnTier 1 Ratio 7.67%Deterioration in Ratio -0.61%

9

DisclaimerAnalyst Certification

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