demystifying the mortgage meltdown: what it means for main...
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Demystifying the Mortgage Meltdown:What It Means for Main Street,
Wall Street and the U.S. Financial System
Glenn Yago James R. Barth
11
Milken InstituteOctober 2, 2008
Glenn Yago Director of Capital Studies
James R. Barth Senior Fellow
“I have great, great confidence in our capital markets and in our financial institutions. Our financial institutions, banks and investment banks are strong.”
22
Treasury Secretary Henry PaulsonMarch 16, 2008
CNN
… but just six months later…
“The financial security of all Americans … depends on our ability to restore our financial institutions to a sound footing.”
33
Treasury Secretary Henry PaulsonSeptember 19, 2008
Press release
“Any real estate investment is a good investment … ”
44
“Any real estate investment is a good investment … ”
55
… Really?!
Subprime mortgage meltdown timelineDecember 2006–September 2008
550
650
Dow Jones U.S. Financial Index
Dec. 2006: Ownit Mortgage,
Apr. 2007: New Century, a
Feb. 2007: HSBC sets
Mar. 18, 2008: Fed cuts discount rate to 2.4%; Fed funds rate to 2.25%.
Mar. 11, 2008: Fed offers troubled banks as much as $200 billion in loans; Fed introduces Term Securities Lending Facility.
Mar. 16, 2008: JP Morgan Chase offers to buy Bear Stearns; Fed introduces Primary Dealer Credit Facility.
Oct. 24, 2007: Merrill announces $7.9 billion in subprime write-downs, surpassing Citi’s $6.5 billion.
Aug. 1, 2008: First Priority Bank closes.
Feburary–March 2007: More than 25 subprime lenders declare bankruptcy.
Sept. 30, 2007: NetBank goes bankrupt.
Aug. 16, 2007: Countrywide gets emergency loan of $11 billion from a group of banks.
July 30, 2008: President Bush signs a
Sept. 14, 2008: Lehman files for bankruptcy.
Sept. 16, 2008: Fed loans AIG
66Sources: BusinessWeek, S&P, Global Insight, Milken Institute.
250
350
450
Ownit Mortgage, a subprime lender, files for bankruptcy.
Century, a mortgage broker, files for bankruptcy.
HSBC sets aside $10.6 billion for bad loans, including subprime.
July 31, 2007: Two Bear Stearns hedge funds file for bankruptcy.
Aug. 17, 2007: Fed cuts discount rate to 5.75%; Fed introduces Term Discount Window Program.
Jan. 11, 2008: Bank of America agrees to buy Countrywide.
Jan. 30, 2008: Fed cuts discount rate to 3.5%.
June 9, 2008:Lehman announces a $2.8 billion loss.
July 11, 2008: IndyMac is seized by FDIC.
Dec. 12, 2007: Fed introduces Term Auction Facility.
Feb. 13, 2008: President Bush introduces tax rebate stimulus program of $168 billion.
Aug. 6, 2007: American Home Mortgage files for bankruptcy.
Bush signs a housing rescue law.
Sept. 7, 2008: U.S. seizes Fannie Mae and Freddie Mac.
Fed loans AIG $85 billion.
Sept. 23, 2008: Washington Mutual is seized by FDIC.
Sept. 29, 2008: Citigroup agrees to buy Wachovia bank.
Overview
77
Home mortgages: Who borrows, how much has been borrowed, and who funds them?
Government-controlled
46%
Total value of housing stock = $19.3 trillion
Mortgage debt $10.6 trillion
Prime 91.6%
Subprime8.4% Securitized
58%
88
Note: total residential and commercial mortgages = $14.7 trillion; 5 percent = $700 billion
Privatesector-
controlled54%
Equity in housing stock$8.7 trillion
91.6%Non-securitized
42%
Sources: Federal Reserve, Milken Institute.
The mortgage problem in perspective
80 million houses27 million are paid off
53 million have mortgages 48 million are paying on time
99
48 million are paying on time
5 million are behind
This compares to 50% seriously delinquent in the 1930s.
(9.2% of 53 million with 2.8% in foreclosure)
Sources: U.S. Treasury, Milken Institute.
I. Low interest rates and a lending boom
1010
Did the Fed lower interest rates too much and for t oo long?Federal funds rate vs. rates on FRMs and ARMs
5
6
7
8Percent
30-year FRM rate
1111
0
1
2
3
4
2001 2002 2003 2004 2005 2006 2007 2008
Record low from June 25, 2003, to June 30, 2004: 1%
1-year ARM rate
Target federal funds rate
Sources: Federal Reserve, Mortgage Bankers Association, Moody’s Economy.com, Milken Institute.
Home price bubble and credit boom
Low interest rates and credit boom
Index, January 2000 = 100
2.5
3.0
3.5
4.0
150
200
250
US$ trillions
Home
US$ trillions
2.5
3.0
3.5
4.0
4.5
5.0
5.5
6.0
Percent
1212
0.0
0.5
1.0
1.5
2.0
2001 2003 2005 2007
0
50
100
Home mortgage
originations (left axis)
S&P/Case-Shiller National Home
Price Index (right axis)
Sources: Inside Mortgage Finance, Mortgage Bankers Association, Moody’s Economy.com, S&P/Case-Shiller, Milken Institute.
0.0
0.5
1.0
1.5
2.0
2.5
2001 2003 2005 2007
3.0
3.5
4.0
4.5
1-Year ARM rate (right axis)
Home mortgage
originations (left axis)
II. Homeownership, prices, starts and sales take off
1313
68
69
70Percent
Q2 2004: 69.2%
Q2 2008: 68.1%
400
500
600
700US$ thousands
California m edian hom e pr ice
U.S. m edian
California average1987-2008
Credit boom pushes homeownership rate
to historic high
Home price bubblepeaks in 2006
California and national home prices reach
record highs
280
330
380Index, January 1987 = 100
S&P/ Case-Shille r
National Hom e Price Index
1414
64
65
66
67
1998 2000 2002 2004 2006 2008
Average, 1965–Q2 2008: 65.2%0
100
200
300
400
1998 2000 2002 2004 2006 2008
U.S. m edianhom e pr ice
U.S. ave rage, 1987-2008: $121,280
1987-2008$229,748
80
130
180
230
1998 2000 2002 2004 2006 2008
OFHEO Hom e Price Index
Sources: U.S. Census Bureau, OFHEO, Moody’s Economy.com, S&P/Case-Shiller, California Association of Realtors, Milken Institute.
4.2
5.6
7.0
0.9
1.2
1.5Millions Millions
Exis ting hom e sales (le ft axis )
1.5
2.0January 2006: 1.8 m illion
Housing units, millions
Homes for sale Homes sales reach a new high
Housing starts hit a record in 2005
2
3
4
0.4
0.6
0.8Millions
Existing homes for sale (left axis)
Millions
1515
0.0
1.4
2.8
1998 2000 2002 2004 2006 20080.0
0.3
0.6New hom e sales (right axis )
0.0
0.5
1.0
1998 2000 2002 2004 2006 2008
July 2008: 641,000
Average s tarts , 1959–July 2008: 1.1 m illion
Sources: U.S. Census Bureau, OFHEO, Moody’s Economy.com, Milken Institute.
0
1
2
1998 2000 2002 2004 2006 20080.0
0.2
0.4
New homes for sale (right axis)
III. Subprime borrowers and subprime mortgages
1616
National FICO scores display wide distribution What goes into a FICO score?
Who is a subprime borrower?
18
2730
40
Percentage of population
Subprime = 21%
Prime = 79%
Payment history
35%
New credit
10%
Types of credit in use
10%
1717Sources: myFICO.com, Milken Institute.
25
8
1215
18
13
0
10
20
up to499
500-549
550-599
600-649
650-699
700-749
750-799
800+
Subprime = 21%
Amounts owed
30%
Length of
credit history
15%
Prime
Subprime12
16
20
Percent of total originations
FICO below 620 Prime: 6.6%
Subprime: 45.2%
FICO above 620 Prime: 93.4%
Subprime: 54.8%
Prime and subprime mortgage originations by FICO score reveal substantial overlaps
1818
0
4
8
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
Sources: LoanPerformance, Milken Institute.
ARMs look attractive to many borrowers
5.0
6.0
7.0
8.0Percent
30-year FRM rate
1919
2.0
3.0
4.0
5.0
2001 2002 2003 2004 2005 2006 2007 2008
1-year ARM rate
Sources: Mortgage Bankers Association, Moody’s Economy.com, Milken Institute.
ARM share grows, following low interest rates
15
20
25
Percent of all outstanding home mortgages
2020
Sources: Mortgage Bankers Association, Moody’s Economy.com, Milken Institute.
0
5
10
2001 2002 2003 2004 2005 2006 2007 2008
30
40
50
60FHA ARM Prime ARM Subprime ARM
Percent of mortgage type
Largest share of ARMs go to subprime borrowers
2121
0
10
20
30
2001 2002 2003 2004 2005 2006 2007 2008
Sources: Mortgage Bankers Association, Moody’s Economy.com, Milken Institute.
Subprimes take an increasing shareof all home mortgage originations
3.0
4.0
Subprime
Prime
US$ trillions
Subprime'sshare:7.8%
7.4%
8.4%
18.2%21.3%
20.1%
7.9%
2222
0.0
1.0
2.0
2001 2002 2003 2004 2005 2006 2007 Q2 2008
7.8%
0.9%
Sources: Inside Mortgage Finance, Milken Institute.
540
625600
400
500
600
700
US$ billionsUS$ billions
699
973
1,200 1,240
940 895
800
1,000
1,200
1,400 Average annual growth rates1995–2006: 14%2006–Q1 2008: -23%
Subprime mortgages increase rapidly before big decl ineOriginations Outstandings
2323
160200
310
191
140
100
200
300
400
2001 2002 2003 2004 2005 2006 2007 Q22008
479574
0
200
400
600
2001 2002 2003 2004 2005 2006 2007 Q12008
Sources: Inside Mortgage Finance, Milken Institute.
H22008
IV. Mortgage product innovation
2424
Subprime and Alt-A shares quadruple between 2001 and 2006, then fall in 2007
2001, $2.2 trillion
2% 5%7.9%
7%
2006, $3.0 trillion
33.2%
13%
14%2.7%
2007, $2.4 trillion
11%
14%4.9%
Q1 2008, $480 billion
4% 9% 9.6%2%
8%
2525
FHA & VAConventional, conforming primeJumbo prime
Jumbo primeSubprimeAlt-A Home equity loans
Sources: Inside Mortgage Finance, Milken Institute.
57.1%20%
13%
20% 16% 47.3%
8%
14% 67.2%
ARM hybrids dominate subprime originations (2006)
Other ARM7%
Prime conventional
ARM hybrids
Alt-A
Other ARM23%
Subprime
Other ARM 4%
Fixed 9%
30-yearARM balloon
2626
23%
Fixed 70%
Fixed 31%
ARM hybrids46%
Sources: Freddie Mac, Milken Institute.
with 40- to 50-year
amortization26%
2- and 3-year hybrids 61%
V. Securitization
2727
The mortgage model switches fromoriginate-to-hold to originate-to-distribute
Securitized15.6%
Held in
Residential mortgage loans1980: Total = $958 billion
Residential mortgage loansQ2 2008: Total = $11.3 trillion
2828
Held in portfolio
84.4%
Held in portfolio
41%
Securitized59%
Sources: Federal Reserve, Milken Institute.
4045 43 42 45 47
5057
6265 68 68 68
50
60
70
80Percent of all subprime mortgages securitized since 1994
Securitization becomes the dominant fundingsource for subprime mortgages
2929
31 2933
40
0
10
20
30
40
1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Q12008
Q22008
Sources: Inside Mortgage Finance, Milken Institute.
The rise and fall of private-label securitizers
New securities issuance
21%
2%42%
1985Total = $110B
13%20%
2001Total = $1.3T
18%
4%
56%
2006Total = $2.0T
15%6%
First half 2008Total = $734B
3030
Ginnie Mae Freddie Mac Fannie Mae Private-label
Sources: Inside Mortgage Finance, Milken Institute.
35%
Total = $110B
29%38%
Total = $1.3T
22%
Total = $2.0T
33%
46%
Total = $734B
The rise and fall of private-label securitizersOutstanding securities
13%
6%
55%
1985
14% 18%
2001
35%7%
25%
2006
30%7%
26%
First half 2008
3131
Ginnie Mae Freddie Mac Fannie Mae Private-label
26%
Total = $390B
39% 29%
Total = $3.3T
33%
Total = $5.9T
37%
First half 2008Total = $6.8T
Sources: Inside Mortgage Finance, Milken Institute.
VI. Affordability
3232
4.5
5.0
Median home price/median household income
2005: 4.69
Ratio of home price to household
income surges
Home mortgage share of household debts reaches
a new high in 2007
Debt-to-income ratio of households has increased rapidly
125
150
Home mortgage debt/disposable personal incomePercent Q4 2007: 139.5%
70
75Percent
Q2 2007: 73.7%
3333
2.5
3.0
3.5
4.0
1998 2001 2004 2007
Average, 1967–2007: 3.38
2007: 4.29
Sources: U.S. Census Bureau, OFHEO, Federal Reserve, Moody’s Economy.com, Milken Institute.
75
100
125
1998 2001 2004 2007
Average, 1957–2007: 79.7%
60
65
70
1998 2001 2004 2007
Q2 2008: 73.4%
Average, 1952–2008: 64.2%
VII. Collapse
3434
The recent run-up of home prices was extraordinary
150
200
250
WorldWar I
WorldWar II
1970’sboom
1980’sboom
Currentboom
Annualized growth rate of nominal home index: 3.4%
Index, 2000 = 100
GreatDepression
3535
0
50
100
1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010
Long-term trend line
Sources: Robert Shiller, Milken Institute.
Home prices don’t go up foreverChange in home prices in 100 plus years
5
10
15
20
25
30 WorldWar I
GreatDepression
WorldWar II
1970’sBoom
1980’sBoom
CurrentBoom
Average, 1890–2007: 3.7%
Percentage change in nominal home price, year ago
3636
-20
-15
-10
-5
0
5
1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010
+/- one standard deviation
Sources: Robert Shiller, Milken Institute.
2005: The collapse begins
S&P/Case-Shiller 10 city
OFHEO
S&P/Case-Shiller national
5
10
15
20Home price indices, percent change on a year earlie r
3737Sources: S&P/Case-Shiller, OFHEO, Moody’s Economy.com, Milken Institute.
-15
-10
-5
0
1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008
Forty-six states had falling prices in the fourth quarter 2007
United States: - 9.3% (fourth-quarter annualized growth)
3838Source: Freddie Mac.
48.448.0
28.227.926.826.326.326.0
24.422.9
SeattlePortlandWashingtonNew YorkPhoenixLos AngelesTampaMiamiLas VegasCharlotte
One year ago… Five years ago…
If you bought your house…
-1.0-3.2
-4.7-5.2
-5.8-7.1-7.3-7.3
-8.1-9.5
-13.9
CharlotteDallasDenverBostonPortlandSeattleNew YorkClevelandAtlantaChicagoMinneapolis
3939
20.518.6
14.39.1
6.66.56.15.94.8
-0.7-3.8
-21.3
Composite 10Composite 20ChicagoSan FranciscoAtlantaDallasSan DiegoBostonDenverMinneapolisClevelandDetroit
% change in price, June 07-08 % change in price, Jun e 03-08Sources: S&P/Case-Shiller, Milken Institute.
-13.9-15.7-15.9-16.3
-17.0-20.1
-23.7-24.2
-25.3-27.9-28.3-28.6
MinneapolisWashingtonComposite 20 DetroitComposite 10TampaSan FranciscoSan DiegoLos AngelesPhoenixMiamiLas Vegas
Housing startssharply decline
Homes sit longeron the market …
… as home appreciation slows
-15
0
15
30Percent change, year ago
8
10
12
Number of months that homes sit on the market
Existing homes
10
20 0
2
4
Percentage change from year ago in m edian hom e sales price (le ft axis )
Percent Months
4040
Note: Shaded area represents fluctuation within one standard deviation from mean (1.28%)
Sources: Mortgage Bankers Association, OFHEO, Moody’s Economy.com, Milken Institute.
-60
-45
-30
-15
1998 2000 2002 2004 2006 2008
June 2008: -41.9%July 2008: -39.2%
0
2
4
6
1998 2000 2002 2004 2006 2008
New homes
-20
-10
0
1999 2001 2003 2006 2008
6
8
10
12
Num ber of m onths hom es s tay on
m arket (r ight axis )
VIII. Delinquencies and foreclosures
4141
1,150
1,400
1,650
1,900
2,150
Thousands of foreclosures per year
Average 661,362 annual foreclosures from Q2 1999 to Q2 2006
Foreclosures are nothing new, but …
4242
400
650
900
1,150
Q2 199
9Q4 1
999
Q2 200
0Q4 2
000
Q2 200
1Q4 2
001
Q2 200
2Q4 2
002
Q2 200
3Q4 2
003
Q2 200
4Q4 2
004
Q2 200
5Q4 2
005
Q2 200
6Q4 2
006
Q2 200
7Q4 2
007
Q2 200
8
Average 661,362 annual foreclosures from Q2 1999 to Q2 2006
Sources: Mortgage Bankers Association, Milken Institute.
… their numbers have doubled
1,150
1,400
1,650
1,900
2,150
Thousands of foreclosures per year
Average 1,316,220 annual forclosures from Q3 2006 t o Q2 2008
4343Sources: Mortgage Bankers Association, Milken Institute.
400
650
900
1,150
Q2 199
9Q4 1
999
Q2 200
0Q4 2
000
Q2 200
1Q4 2
001
Q2 200
2Q4 2
002
Q2 200
3Q4 2
003
Q2 200
4Q4 2
004
Q2 200
5Q4 2
005
Q2 200
6Q4 2
006
Q2 200
7Q4 2
007
Q2 200
8
Average 661,362 annual foreclosures from Q2 1999 to Q2 2006
Subprime mortgages accounted for half or more of foreclosures since 2006
1,200
1,600
2,000
Subprime
FHA and VA
Prime (includes Alt-A)
Subprime: 12% of mortgages serviced (March 2008)
54%
Number of home mortgage foreclosures started (annua lized, in thousands)
50%
4444
0
400
800
Dec. 2003 June2004
Dec. 2004 June2005
Dec. 2005 June2006
Dec. 2006 June2007
Dec. 2007 March2008
37%
29%
34%
36%
29%
35%
37%
29%
34%
44%
22%
34%
47%
20%
33%
52%
17%31%
55%
13%
32%
56%
11%
33%
9%
37%
8%
42%
Sources: Inside Mortgage Finance, Milken Institute.
Subprime ARMs have the worst default recordHome mortgages delinquent or in foreclosure (percen t of number)
15
20
25
30
35Q2 2008, Subprime ARM: 33.4%
Subprime FRM: 11.8%
Prime FRM: 3.0%
FHA and VA: 5.8%
4545
0
5
10
15
Q21998
Q11999
Q41999
Q32000
Q22001
Q12002
Q42002
Q32003
Q22004
Q12005
Q42005
Q32006
Q22007
Q12008
Sources: Mortgage Bankers Association, Milken Institute.
Percentage of homes purchased in Q2 2008 that now have negative equity
4646
< 20%>= 20% and < 35%>= 35% and < 50%>= 50%
Sources: Zillow.com, Milken Institute.
United States = 44.8%
Percentage of homes sold for a loss (Q2 2008)
4747
< 15%>= 15% and < 30%>= 30% and < 45%>= 45%
Sources: Zillow.com, Milken Institute.
United States = 32.7%
Percentage of homes sold that were in foreclosure (Q2 2008)
4848
< 1%>= 1% and < 25%>= 25% and < 40%>= 40%
Sources: Zillow.com, Milken Institute.
United States = 18.6%
IX. Damages scorecard
4949
Losses/write-downs, capital raised, and jobs cut by financial institutions worldwide
120
160
200
36,000
48,000
60,000US$ billions
Capital raised(left axis)
Jobs cut (right axis)
Number of jobs cut
5050
Note: Q3 data are through September 25, 2008.
Sources: Bloomberg, Milken Institute.
0
40
80
Prior quarters Q3 2007 Q4 2007 Q1 2008 Q2 2008 Q3 2008(through
0
12,000
24,000Losses/write-downs(left axis)
(left axis)
What is the cumulative damage?Cumulative losses/write-downs, capital raised, and jobs cut by financial institutions worldwide
400
500
600
80,000
100,000
120,000
140,000Number of jobs cut US$ billions
Capital raised (left axis)
Jobs cut (right axis)
5151
Note: Q3 data are through September 25, 2008.
Sources: Bloomberg, Milken Institute.
0
100
200
300
Prior quarters Q3 2007 Q4 2007 Q1 2008 Q2 2008 Q3 2008(through
0
20,000
40,000
60,000
80,000
Losses/write-downs (left axis)
Capital raised (left axis)
Recent losses/write-downs and capital raised by selected financial institutions
US$ billions, through September 25, 2008 Losses /wri te-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
5252
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.
Financial stock prices take big hits
-99.8-99.7
-97.5-97.4
-95.4-94.3-93.9
Washington MutualLehman BrothersFreddie MacFannie MaeAIGBear Stearns*Wachovia
Percentage change in stock price, December 2006–Sep tember 2008
5353
Note: * Bear Stearns stock price is to May 2008. ** Countrywide stock price is to June 2008.Sources: Bloomberg, Milken Institute.
-93.9-90.0
-72.8-66.0-65.6
-35.8-34.4
-3.35.5
WachoviaCountrywide**Merrill LynchMorgan StanleyUBS EquityGoldman SachsBank of AmericaJP Morgan & ChaseWells Fargo
-142-101
-80-74
-60-50
-44
AIGWachoviaBank of AmericaUBS EquityMorgan StanleyFannie MaeMerrill Lynch
Total loss in market value: $728 billion, December 2006–September 2008
Financial market capitalization takes big hit
5454
-44-43-42-41
-28-24-21
417
Merrill LynchWashington MutualFreddie MacLehman BrothersGoldman SachsCountrywide**Bear Stearns*Wells FargoJP Morgan & Chase
Note: * Bear Stearns stock price is to May 2008. ** Countrywide stock price is to June 2008.Sources: Bloomberg, Milken Institute.
US$ billions
X. Credit crunch and liquidity freeze
5555
Tightened standards for real estate loans
40
60
80
100
Net percentage of domestic respondents tightening s tandards for commercial real estate loans
LTCM DotcomThe end of S&L crisis
Subprime
5656Sources: Federal Reserve, Milken Institute.
-40
-20
0
20
40
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008
Widening spreads betweenmortgage-backed and high-yield bonds
1,000
1,200
1,400
1,600
1,800Basis points, spread over 10-year Treasury bond
Merrill Lynch Mortgage-Backed Securities Index
Merrill Lynch High -Yield Bond Index
Maximum spread: 08/29/2008: 955.8 bps
5757
0
200
400
600
800
01/2004 07/2004 01/2005 07/2005 01/2006 07/2006 01/2007 07/2007 01/2008 07/2008
Merrill Lynch High -Yield Bond Index
Sources: Merrill Lynch, Bloomberg, Milken Institute.
Liquidity freeze
100
120
140Septem ber 19, 2008: 127.5 bps
Basis points
Average s ince
Spread between 3-month LIBOR and overnight index swap rate
Spread between 3-month LIBOR and T-bill rate
250
300
350
Augus t 20, 2007: 240 bps
Basis points
Septem ber 18, 2008: 313 bps
5858
0
20
40
60
80
2006 2007 2008
Average s ince Decem ber 2001: 21.1 bps
August 2007: 69.8 bps
Sources: Bloomberg, Milken Institute.
0
50
100
150
200
2006 2007 2008
Average s ince 1985: 76 bps
Average s ince August 2007: 130 bps
Counterparty risk increases
300
400
500Basis points
Government announces support for Fannie Mae and Freddie Mac
Lehman Brother files for bankruptcy and Merrill Lynch acquired
AIG rescued
Average CDS spread, basis points
5959
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.
0
100
200
07/2007 09/2007 11/2007 01/2008 03/2008 05/2008 07/2008 09/2008
Bear Stearns acquired
Commercial paper issuance dries up
0
50
100
150Quarterly change in outstanding amount, US$ billion s
6060Sources: Federal Reserve, Milken Institute.
-200
-150
-100
-50
Q1 2006 Q2 2006 Q3 2006 Q4 2006 Q1 2007 Q2 2007 Q3 2007 Q4 2007 Q1 2008 Q2 2008
Issuers of asset-backed securities
Other issuers
Federal Reserve responds by cutting Fed funds rate, but mortgage rates remain relatively flat
5
6
7
8
9
10
2.5
3.0
3.5
4.0
4.5
5.0
Freddie Mac 30-year fixed mortgage rate (left axis)
Percent Percent
30-year FRM rate (left axis)
6161
0
1
2
3
4
5
01/2007 03/2007 06/2007 09/2007 12/2007 02/2008 05/2008 08/2008
0.0
0.5
1.0
1.5
2.0
2.5
Federal funds rate (left axis)
Spread (right axis)
Sources: Freddie Mac, Federal Reserve, Moody’s Economy.com, Milken Institute.
Congress and White House responses
� HOPE NOW
� The Economic Stimulus Act of 2008
� Housing and Economic Recovery Act of 2008
� Conservatorship of Fannie Mae and Freddie Mac
6262
� Temporary guaranty program for money market funds
� Temporary ban on short selling in selected companies
� Bailout package?
XI. When will we hit bottom?
6363
Looking for a bottom?Economists say the economy isn’t at its low point y et, and house prices likely won’t get there until 2009
Does this feel like the bottom to a downturn?
Yes 27%
When will home prices hit bottom?
6%
2nd half
1st half2010
6464
No 73%
4%
17%
38%
29%
1st half2008
2nd half2008
1st half2009
2nd half2009
Source: Wall Street Journal.
How far do home prices have to fall?
5.0
5.5
6.0
6.5 Q2 1971: 6.08%Annual rents as percent of home prices
6565Sources: Davisa, Lehnertb, Martin (2007), Milken Institute.
3.0
3.5
4.0
4.5
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
Q4 2006: 3.48%
Q1 2008: 3.93%Average, 1960–Q1 2008: 5.04%
Average, 2000–Q1 2008: 4.06%
Combinations of rental price growth rates and rent- to-price ratios to get home prices back to their Q4 2006 val ue
Annual home price decline
-2.0% -5.0% -10.0% -15.0% -20.0%
3.80% 2010 Q3 2008 Q4 2008 Q2 2008 Q2 2008 Q2
rat
io
Annual home price decline required
6666
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% average 2024 Q3 2014 Q2 2010 Q4 2009 Q3 2009 Q1
Ren
t-to
-pric
e r
atio
6.00% 2026 Q4 2017 Q3 2012 Q3 2010 Q4 2009 Q4
Sources: Davisa, Lehnertb, Martin (2007), Milken Institute.
2,500
3,000
3,500
4,000
US$/month
Payment with 100% LTVPayment with 90% LTVPayment with 80% LTV
Mortgage payment assumptions: Every month, a home i s purchased at median price, buyer takes out a 30-year conforming, fixed-rate loan with 80% LTV. Payment also includes 1% property tax per year , 0.1% property insurance.
Alternative measures of the affordability of mortgage debt for California
6767
0
500
1,000
1,500
2,000
1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007
Maximum affortablility limit is 38% of median household
insurance.
Sources: Moody’s Economy.com, Milken Institute.
XII. What went wrong
6868
2,443
879
1,410
2,067
944886 1,000
1,500
2,000
2,500
3,000US$ billions
The importance of Fannie Mae and Freddie Mac
6969
0
500
1,000
Fannie Mae:total assets
Fannie Mae:total MBS
outstanding
Freddie Mac:total assets
Freddie Mac:total MBS
outstanding
Commercialbanks: total
residential realestate assets
Savingsinstitutions:
totalresidential realestate assets
Sources: Freddie Mac, Fannie Mae, FDIC, Milken Institute.
Fannie Mae and Freddie Mac: Too big with too little capital?
1,301
1,778
2,443
1,4101,500
2,000
2,500
3,000US$ billions
Total assets
Total MBS outstanding
7070Sources: Freddie Mac, Fannie Mae, Milken Institute.
133 41
1,022803 844 805 886 879
288 316
1,301
752
1,123
0
500
1,000
1,500
Fannie Mae1990
Freddie Mac1990
Fannie Mae2003
Freddie Mac2003
Fannie Mae2006
Freddie Mac2006
Fannie Mae2Q 2008
Freddie Mac2Q 2008
167x
244x
150
200
250
300
Mortgage book of business over capital measures
Fannie Mae Freddie Mac
Fannie Mae and Freddie Mac are highly leveraged
7171
60x 56x 48x 55x60x 58x 52x 57x64x81x
56x65x 59x
0
50
100
150
Core capital Fair value Core capital Fair value
2005 2006 2007 2008Q2
-393x
Sources: Freddie Mac, Fannie Mae, FDIC, Milken Institute.
Freddie Mac’s and Fannie Mae's retained private-lab el portfolios
Freddie Mac, 2007
Freddie Mac, 2006
Subprime Alt-A All others
57.4% 13.1% 29.5%
61.2% 25.0% 13.8%
$122.2 billion
$76.1 billion
7272Sources: Freddie Mac, Fannie Mae, FDIC, Milken Institute.
Fannie Mae, 2007
Fannie Mae, 2006
Fannie Mae, 2005
33.8% 4.3% 32.0%
46.4% 36.1% 17.5%
32.1% 37.4% 30.5%
57.4% 13.1% 29.5%
$86.9 billion
$97.3 billion
$94.8 billion
23.7
21.5
67.9
Federal Home Loan Banks
Fannie Mae
Freddie Mac
Leverage ratio, total assets/common equtity
Leverage ratios of different types of financial firms (June 2008)
7373
9.1
9.8
9.4
31.6
Credit unions
Commercial banks
Savings institutions
Brokers/hedge funds
Sources: Federal Deposit Insurance Corporation, Office of Federal Housing Enterprise Oversight, National Credit Union Administration, Bloomberg, Google Finance, Milken Institute.
Too much dependence on debt?Leverage ratios at biggest investment banks
28
1922
2627
19
31
2423
34 32 3331
22
2830
242225
30
35
40 2000 2005 2007 June 2008Total assets/total shareholder equity
7474Sources: Bloomberg, FDIC, Milken Institute.
1918
19
n.a.0
5
10
15
20
Bear Stearns Merrill Lynch Morgan Stanley Lehman Broth ers Goldman Sachs
AAAAA+
AAAA-A+
AA-
BBB+
0 1,000 2,000 3,000 4,000 5,000Number of securities rated
4,090, or 51%, of new securities rated by S&P were rated AAA
Most new securities issued in 2007 were rated AAA by S&P
S&P Total Downgraded Downgraded/ Total
AAA 1,032 156 15.1%
AA(+/-) 3,495 1,330 38.1%
A(+/-) 2,983 1,886 63.2%
56 percent of MBS issued from 2005 to 2007 were eventually
downgraded
7575
BBB+BBBBBB-
BB+BBBB-B+BB-CCC+
CCC+CCC-CCC
D
S&P were rated AAA A(+/-) 2,983 1,886 63.2%
BBB(+/-) 2,954 2,248 76.1%
BB(+/-) 789 683 86.6%
B(+/-) 8 7 87.5%
Total 11,261 6,310 56.0%
Sources: Bloomberg, Inside Mortgage Finance, Milken Institute.
Note: A bond is considered investment grade if its credit rating is BBB- or higher by S&P
When is a AAA not a AAA?Multilayered mortgage products
Origination ofmortgage 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%
7676Sources: International Monetary Fund, Milken Institute.
Mortgage bonds
AAA 80%AA 11%A 4% Mezzanine CDO
BBB 3% CDO-squaredBB-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%
Dollar losses in reported cases of mortgage fraud
US$ millions
1,014946
813800
1,000
1,200
Mortgage loan fraud surges
37.3
52.9
40
50
60Number of cases reported, thousands
37.3
52.9
40
50
60Number of cases reported, thousands
7777
293225
429
0
200
400
600
2002 2003 2004 2005 2006 2007
Sources: Financial Crimes Enforcement Network, Federal Bureau of Investigation, Milken Institute.
1.7
2.3 2.9 3.5 4.7 5.49.5
18.4
26.0
0
10
20
30
1997 1999 2001 2003 2005 2007
1.7
2.3 2.9 3.5 4.7 5.49.5
18.4
26.0
0
10
20
30
1997 1999 2001 2003 2005 2007
Is adequate information disclosed to consumers?
5168
7479
8487
95
Loan amountPresence of prepayment penalty for refinance in two years
Presence of charges for optional credit insuranceReason why the interest rate and APR sometimes diff erProperty tax and homeowner’s insurance cost amount
Total up-front cost amountPrepayment penalty amount
Percent of respondents who could not correctly iden tify various loan costs using current disclosure fo rms
7878Sources: Federal Trade Commission, Milken Institute.
20202123
303233
3751
APR amountCash due at closing amount
Monthly payment (including whether it includes taxe s and insurance)Settlement charges amount
Balloon payment (presence and amount)Interest rate amount
Whether loan amount included finances settlement ch argesWhich loan was less expensive
Loan amount
Drivers of foreclosures:Strong appreciation or weak economies?
15
20
25
Detroit
Bakersfield
Riverside
Fort Lauderdale
Las Vegas
Stockton
SacramentoToledoCleveland
Weak economies Housing bubbles
Foreclosures per 1,000 homes
7979Sources: U.S. Treasury Department, RealtyTrac, Office of Federal Housing Enterprise Oversight, Milken Institute.
0
5
10
-20 0 20 40 60 80 100 120 140
Five-year price gain, Q3 2002–Q3 2007 (percent)
Miami
Bakersfield
Fresno
Fort Lauderdale
Orlando
Phoenix
Palm Beach
TampaSan Diego
Oakland
Sacramento
Atlanta
MemphisColumbus
Indianapolis
ToledoDaytonDenver
Cleveland
Akron
Warren
National average
After housing bubble burst in 2007: Foreclosures highest for areas with biggest price declines
25
30
35
40
45Weak
economies strengthen
Stockton
Bakersfield
RiversideLas Vegas
Fort Lauderdale
SacramentoOakland
Denver
Foreclosures per 1,000 homes
National average
Collaping housing bubbles
8080Sources: RealtyTrac, Office of Federal Housing Enterprise Oversight, Milken Institute.
0
5
10
15
20
25
-30 -25 -20 -15 -10 -5 0 5
Price change, 2007–June 2008 (percent, annualized)
Miami
Orlando
Phoenix
Fresno
Sacramento
San Diego
Detroit
Warren ClevelandDayton
Columbus Indianapolis
Palm BeachTampa
Toledo
Akron Atlanta
Memphis
XIII. Where do we go from here?
8181
The U.S. regulatory regime: In need of reform?
National banks State commercial and savings banks
Federal savings banks
Insurance companies
Securities brokers/dealers
Other financial companies, including mortgage
companies and brokers
• Fed• OTS
Fed is the umbrella or consolidated regulator
• Federal Housing Finance Agency
Fannie Mae, Freddie Mac, and Federal Home Loan Banks
Financial, bank and thrift holding companies
8282
• OCC• FDIC
• State bank regulators• FDIC• Fed--state member commerical banks
• OTS• FDIC
• 50 State insurance regulators plus District of Columbia and Puerto Rico
• FINRA• SEC• CFTC• State securities regulators
• Fed• State licensing (if needed)• U.S. Treasury for some products
• OCC• Host county regulator
• Fed• Host county regulator
• OTS• Host county regulator
Federal branch
Foreign branch
Limited foreign branch
Primary/secondaryfunctionalregulator
Notes:Justice Department: Assesses effects of mergers and acquisitions on competitionFederal Courts: Ultimate decider of banking, securities, and insurance productsCFTC: Commodity Futures Trading CommissionFDIC: Federal Deposit Insurance CorporationFed: Federal ReserveFINRA: Financial Industry Regulatory Authority GSEs: Government Sponsored Enterprises OCC: Comptroller of the CurrencyOTS: Office of Thrift SupervisionSEC: Securities and Exchange Commission
Sources: Financial Services Roundtable (2007), Milken Institute.
Many different options and innovations…
Covered BondsCovered Bonds
Alternative Mortgage ProductsAlternative Mortgage Products
Shared Equity MortgagesShared Equity Mortgages
8383
Real Estate DerivativesReal Estate Derivatives
Classical Insurance Products Classical Insurance Products
OthersOthers
Demystifying the Mortgage Meltdown:What It Means for Main Street,
Wall Street and the U.S. Financial System
Glenn Yago James R. Barth
8484
Milken InstituteOctober 2, 2008
Glenn Yago Director of Capital Studies
James R. Barth Senior Fellow