Professional Documents
Culture Documents
July 3, 2009
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Is a Registered Investment Advisor
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The collapse of the U.S. housing market,
the world’s largest debt market, is the
defining economic event of our lifetimes.
This presentation explores what happened
and why, where we are today, and what the
future likely holds.
For more detailed information, please read
our new book, More Mortgage Meltdown: 6
Ways to Profit in These Bad Times.
More Mortgage Meltdown Was Released in May
Tilson Mutual Funds
Investment in the Funds is subject to investment risks, including, without limitation, market risk, management style risk, sector focus risk, foreign securities risk,
nondiversified fund risk, portfolio turnover risk, credit risk, interest rate risk, maturity risk, investment-grade securities risk, junk bonds or lower-rated securities risk,
derivative instruments risk and real estate securities risk.
The Tilson Mutual Funds are distributed by Capital Investment Group, Inc., Member FINRA/SIPC, 17 Glenwood Ave, Raleigh, NC, 27603. There is no affiliation between the
Tilson Mutual Funds, including its principals, and Capital Investment Group, Inc.
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Table of Contents
300
Shiller
Lawler
275
Real Home Price Index (1890=100)
250
225
200
175
Trend Line
150
125
100
50
54
58
62
66
70
74
82
90
94
98
7
8
19
19
19
19
19
19
19
19
19
19
19
19
19
Sources: Robert J. Shiller, Irrational Exuberance, Princeton University Press 2000, Broadway Books 2001, 2nd edition, 2005, also Subprime
Solution, 2008, as updated by the author at http://www.econ.yale.edu/~shiller/data.htm; Lawler Economic & Housing Consulting. 10
…And Then Housing Prices Exploded
300
Shiller
Lawler
275
Real Home Price Index (1890=100)
250
225
200
Housing
Bubble
175
Trend Line
150
125
100
62
70
78
86
94
02
50
58
66
06
74
82
90
98
5
19
19
19
19
19
19
19
19
19
19
19
19
20
20
19
Sources: Robert J. Shiller, Irrational Exuberance: Second Edition, as updated by the author; Lawler Economic & Housing Consulting.
11
Prices Exploded Because the Borrowing
Power of a Typical Home Purchaser More
Than Tripled from 2000-2006
$400,000
Pre-Tax Income
Borrowing Power
$100,000
$0
Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08
$12,000 90%
80%
$10,000
70%
1945 50%
$6,000 Mortgage Debt: $18.6 billion
Equity: $97.5 billion
Q109 40%
Mortgage Debt: $10.5 trillion
Equity: $7.4 trillion
$4,000 30%
20%
$2,000
10%
$0 0%
1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
80
Riverside, CA
70 Los Angeles, CA
San Diego, CA
60
Housing Opportunity Index
50
40
30
20
10
0
96
97
98
99
00
02
04
05
06
07
0
19
20
20
20
20
20
19
19
19
20
20
1
3
1
1
Q
Q
Sources: NAHB/Wells Fargo Housing Opportunity Index, which measures percentage of households that could afford the average home with a standard mortgage.
14
There Was a Dramatic Decline in Mortgage
Lending Standards from 2001 through 2006
Combined Loan to Value 100% Financing
86 18%
84
17%
• In 2005, 29% of
84
83
16%
new mortgages
82
81 81
14%
14%
were interest only
80 12% — or less, in the
Combined Loan to Value (%)
Percent of Originations
78 10%
9%
case of Option
76
76
8%
8%
ARMs — vs. 1%
74
74
74 6%
in 2001
72 4%
3% • In 1989, the
70 2%
1%
average down
1%
68
2001 2002 2003 2004 2005 2006 2007
0% payment for first-
2001 2002 2003 2004 2005 2006 2007
60%
• The sale of new
10%
56%
homes costing
49%
50%
45% 8% 8%
$750,000 or more
quadrupled from
Percent of Originations
Percent of Originations
40% 39%
33% 6%
5%
2002 to 2006.
30%
4% The construction
4%
20% of inexpensive
2%
1%
homes costing
10%
0%
$125,000 or less
0%
0%
2001 2002 2003 2004 2005 2006 2007
0%
2001 2002 2003 2004 2005 2006 2007
fell by two-thirds
Sources: Amherst Securities, LoanPerformance; USA Today (www.usatoday.com/money/economy/housing/2008-12-12-homeprices_N.htm). 15
Why Did It Happen?
Among the Many Causes of The Great
Housing Bubble, Two Stand Out
1. The lenders making crazy loans didn’t care if the homeowner ended up
defaulting for two reasons:
– They didn’t hold the loan, but instead sold it to someone else. It was eventually
bought by a Wall Street firm, which packaged it with thousands of other mortgages in
a Residential Mortgage-Backed Security (RMBS), which was then sliced into
numerous tranches that were sold to investors around the world. This entire process
was extraordinarily profitable for all involved, especially the Wall Street firms and the
rating agencies;
– Or, if they did plan to hold the loan, they assumed home prices would keep rising,
such that homeowners could either refinance before loans reset or, if the homeowner
defaulted, the losses (i.e., severity) would be minimal.
2. The entire system – real estate agents, appraisers, mortgage lenders, banks,
Wall St. firms and rating agencies – became corrupted by the vast amounts of
quick money to be made
There were many other reasons, of course – a bubble of this magnitude requires
what Charlie Munger calls “lollapalooza effects”
– Regulators and politicians were blinded by free market ideology and/or the dream that
all Americans should own their homes, causing them to fall asleep at the switch, not
want to take the punch bowl away and/or get bought off by the industries they were
supposed to be overseeing
– Debt became increasingly available and acceptable in our culture
– Millions of Americans became greedy speculators and/or took on too much debt
– Greenspan kept interest rates too low for too long
– Institutional investors stretched for yield, didn’t ask many questions and took on too
much leverage
– In general, everyone was suffering from irrational exuberance, driven by the money
being made
17
When Home Price Appreciation Slows,
Loss Severity Skyrockets
The assumption of
perpetually high HPA led
lenders to give virtually
anyone a loan because
even if they defaulted, the
home could simply be
resold with little or no loss.
Sources: LoanPerformance; OFHEO; Deutsche Bank; “Who's Holding the Bag?”, Pershing Square presentation, 5/23/07.
As Long As Home Prices Rise Rapidly, Even Pools
of Bubble-Era Subprime Mortgages Perform Well
– But If Home Prices Fall, Look Out Below!
50%
40%
Cumulative Loss (%)
30%
20%
10%
0%
20% 15% 10% 5% 0% -5% -10% -15% -20% -25% -30% -35% -40%
Home Price Appreciation
Source: Ariell Reshef, University of Virginia; Thomas Philippon, NYU; Wall St. Journal, 5/14/09. 21
Over the Past 30 Years, We Have Become
a Nation Gorged in Debt – To The Benefit
of Financial Services Firms
3.0% 350%
Low Debt Era Rising Debt Era
Financial Profits as Percent of GDP
2.5%
2.0%
250%
1.5%
Total Debt
150%
0.5%
0.0% 100%
Dec- 51 54 57 60 63 66 69 72 75 78 81 84 87 90 93 96 99 02 05
Source: On Wall Street, Bonuses, Not Profits, Were Real, NY Times, 12/18/08.
The Rating Agencies Were Making a Fortune
Rating Structured Finance Products
$60.00
$50.00
$40.00
$30.00
$20.00
$10.00
2003 2004 2005 2006
0
1
2
3
4
5
6
7
99
Ju
l-9
9
Ja
n-
00
Ju
l-0
0
Ja
Ja
Too Long, Which Fueled the Housing Bubble
n-
08
Ju
l-0
8
Ja
n-
09
Background on the U.S. Housing Market
There Was a Surge of Toxic Mortgages
From 2000 to Mid-2007
$4,000
Conforming, FHA/VA
Jumbo
$3,500 Alt-A
Subprime
$3,000 Seconds
$2,500
Originations (Bn)
$2,000
$1,500
$1,000
$500
$0
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
Source: Inside Mortgage Finance, published by Inside Mortgage Finance Publications, Inc. Copyright 2009.
29
Private Label Mortgages (Those Securitized by
Wall St.) Are 15% of All Mortgages, But Account
for 51% of Seriously Delinquent Mortgages
Approximately two-thirds of homes have mortgages and, of these, 56% are owned or
guaranteed by the two government-sponsored enterprises (GSEs), Fannie & Freddie
Number of Seriously
Number of Mortgages (million) Delinquent Mortgages (000)
Fannie Mae
Freddie Mac
18
232
Private Label
15% 8
Ginne Mae/FHA
378
Ginne Mae/FHA
6
Private Label
Freddie Mac 1734
13
51%
10.0%
9.0%
8.0%
Percentage of Home Loans
7.0%
6.0%
5.0%
4.0%
3.0%
2.0%
1.0%
0.0%
Q 19 4
Q 19 6
Q 19 8
Q 20 2
Q 20 4
Q 20 0
4 06
4 87
Q 19 1
Q 19 3
Q 19 9
Q 19 5
08
4 01
4 03
4 05
4 07
4 90
4 91
4 92
4 93
4 95
4 97
4 99
4 88
4 89
4 80
4 82
4 84
4 86
4 9
4 9
4 9
4 0
4 0
4 0
4 8
4 8
4 7
4 8
Q 19
Q 20
20
Q 20
Q 20
Q 20
Q 19
Q 19
Q 19
Q 19
Q 19
Q 20
Q 19
Q 19
Q 19
Q 19
Q 19
Q 19
Q 19
Q 19
4
Q
Source: National Delinquency Survey, Mortgage Bankers Association; T2 Partners estimates. Note: Delinquencies (60+ days) are seasonally adjusted.
31
All Types of Loans Are Seeing a Surge in
Delinquencies, Led by Subprime
45%
Alt A
Option ARM
40%
Jumbo
Subprime
35% Prime
Home Equity Lines of Credit
30%
Percent Noncurrent
25%
20%
15%
10%
5%
0%
Q 07
Q 07
Q 08
08
Q 03
Q 04
Q 06
Q 06
Q 00
Q 01
Q 02
Q 03
Q 04
Q 05
Q 99
Q 99
Q 00
Q 01
Q 05
Q 02
20
20
20
20
20
20
20
20
20
20
20
20
20
20
20
20
19
20
20
19
1
3
1
3
3
3
3
1
3
1
1
3
Q
Sources: Amherst Securities, LoanPerformance; National Delinquency Survey, Mortgage Bankers Association; FDIC Quarterly Banking Profile;
T2 Partners estimates. Note: Prime is seasonally adjusted. 32
Foreclosure Filings Have Increased
Dramatically
400,000
350,000
300,000
Number of Foreclosures
250,000
200,000
150,000
100,000
50,000
0
A p 08
Ap 06
De 08
Ju 08
D -06
Ju 06
Fe 06
O 07
O 05
A u 08
Au -05
Au -06
Ap 09
Ap 07
9
Ju 07
D 07
De -05
Fe 08
O 08
Fe 07
Fe 05
O 06
Au -07
r-0
b-
b-
-
r-
-
g-
g-
n-
b-
b-
r-
-
r-
g-
c-
-
c-
g-
ct
ec
ct
n
n
ct
ct
ec
n
Ju
Note: Foreclosure filings are defined as default notices, auction sale notices and bank repossessions. Source: RealtyTrac.com U.S.
Foreclosure Market Report. 33
Credit Suisse Predicts More Than 6 Million
Additional Foreclosures by the End of 2012
11
7.0
10
4.0 million units, equal to 10.2
6.5
months as of the end of April 2009
9
6.0 8
Months
Millions
7
5.5
6
5.0
5
4.7 million units as of the
4.5
end of April 2009 4
3
4.0
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Sources: JP Morgan; CA Assoc. of Realtors (left chart); National Assoc. of Realtors via Moody’s Economy.com, WSJ 6/22/09 (right chart).
36
Nearly Half of Homes Sold Last Month Were
Distressed Sales, Which Pressures Homes Prices
$700 25%
$600
20%
20% 20%
18% % of
$500
T ota l
Origina tions
(Bn)
15%
$400
$300
10% 10% 10%
10% 10%
9% 9%
9%
8%
$200 7% 8%
7%
5%
$100
$0 0%
1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
Source: Reprinted with permission; Inside Mortgage Finance, published by Inside Mortgage
Finance Publications, Inc. Copyright 2009. 38
The Wave of Resets from Subprime
Loans Is Mostly Behind Us
$35
We are
$30 here
$25
Loans with Payment Shock (Bn)
$20
$15
$10
$5
$0
6
07
08
09
0
6
0
06
09
10
0
8
9
-0
-0
-0
-1
l-0
l-0
l-0
l-1
-0
r-0
-0
-0
-1
l-0
n-
n-
n-
n-
r-
n-
ct
pr
pr
pr
ct
ct
ct
ct
Ju
Ju
Ju
Ju
Ju
Ap
Ap
Ja
Ja
Ja
Ja
Ja
O
A
Sources: LoanPerformance, Deutsche Bank; slide from Pershing Square presentation, How to Save the Bond Insurers, 11/28/07. 39
The Mortgage Meltdown Has Moved
Beyond Subprime to Five Other Areas
Prime Mortgage
Alt-A
Other Corporate
Subprime
Jumbo Prime
Home Equity
Credit Card
Auto
Option ARM
Other Consumer
CDO/ CLO
$0.0 $0.5 $1.0 $1.5 $2.0 $2.5 $3.0 $3.5 $4.0 $4.5 $5.0
Amount Outstanding (Trillions)
Sources: Federal Reserve Flow of Funds Accounts of the United States, IMF Global Financial Stability Report October 2008, Goldman Sachs Global Economics
Paper No. 177, FDIC Quarterly Banking Profile, OFHEO, S&P Leverage Commentary & Data, T2 Partners estimates. 40
Two Waves of Losses Are Behind Us…
But Three Are Looming
1. The economy
• Especially unemployment
2. Interest rates
• Ultra-low rates have helped mitigate some of the damage
• But if the recent spike in rates continues, it could lead to an even greater surge
in defaults and losses
3. Behavior of homeowners who are underwater
• Roughly one-fourth of homeowners with mortgages are currently underwater,
some deeply so
• For many, it is economically rational for them to walk – leading to so-called
“jingle mail” – but how many will actually do so?
• There is little historical precedent – we are in uncharted waters
• As home prices continue to fall and more and more homeowners become
deeper and deeper underwater, they are obviously more likely to default,
thereby creating a vicious cycle, but what exactly will the relationship be?
• Have millions of foreclosures led to a diminution of the stigma of defaulting and
losing one’s home?
• Our best guess is that there will be rough symmetry: for homeowners 5%
underwater, an additional 5% will default due to being underwater; 10%
underwater will lead to 10% more defaults, and so forth…
42
Current Economic Situation
There Have Been 6.5 Million Jobs Lost So Far in This
Recession, More Than 3 Million in the Past 6 Months
600
400
Change in Nonfarm Payroll Employment (000s)
200
-200
-400
Ja 7
Ja 0
Ja 5
Ja 8
Ja 0
Ja 1
Ja 2
Ja 4
Ja 5
Ja 6
Ja 8
Ja 1
Ja 2
Ja 4
Ja 6
Ja 9
Ja 3
Ja 7
09
9
9
0
0
0
9
0
n-
n-
n-
n-
n-
n-
n-
n-
n-
n-
n-
n-
n-
n-
n-
n-
n-
n-
n-
n-
Ja
10%
9%
Unemployment Rate
8%
7%
6%
5%
4%
3%
76
06
70
73
79
82
85
88
91
94
97
03
09
0
n-
n-
n-
n-
n-
n-
n-
n-
n-
n-
n-
n-
n-
n-
Ja
Ja
Ja
Ja
Ja
Ja
Ja
Ja
Ja
Ja
Ja
Ja
Ja
Ja
0.0%
1980 1981 - 83 1990 - 93
1974 - 76 2001 - 05
-0.5%
-1.0%
-1.5%
-2.0%
-2.5%
-3.0%
-3.5%
-4.0%
2007- present
-4.5%
0 6 12 18 24 30 36 42 48
Months after pre-recession peak
160
140
120
Consumer Confidence Index
100
80
60
40
20
0
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Source: www.calculatedriskblog.com/2009/05/mew-consumption-and-personal-saving.html.
Banks are Tightening Consumer Credit and
New Household Borrowing Has Plunged
70%
60%
50%
40%
30%
20%
10%
06
00
04
08
1
3
00
7
04
08
02
06
-0
-0
-0
-0
p-
n-
n-
n-
n-
n-
p-
p-
p-
p-
ay
ay
ay
ay
Ja
Ja
Ja
Ja
Se
Se
Se
Se
Se
Ja
$1,000
Credit Cards Other Consumer Loans
$800
$600
$400
$200
$0
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
10
Jumbo 30 Yr FRM
Jumbo 5/1 Hybrid ARM
9
Conforming 30 Yr FRM
Conforming 5/1 Hybrid ARM
8
10-Year Treasury
7
Rate (%)
2
N 4
Fe 4
N 5
Fe 5
Fe 6
N 6
N 7
N 8
Au 4
Au 5
Au 6
M 04
Fe 7
Fe 8
Au 07
Au 8
M 05
9
M 06
M 7
M 08
M 09
-0
0
0
-0
-0
0
0
-0
-0
-0
-0
0
-0
-0
-0
g-
g-
g-
g-
g-
b-
-
b-
b-
b-
b-
b-
ov
ov
ov
ay
ay
ay
ay
ov
ov
ay
ay
Fe
(Conventional or nonconforming)
Sources: HSHAssociates.com; Ryan ALM via WSJ Market Data Group; Mortgage Bankers Association via
Thomson Reuters; in the Wall St. Journal, 6/11/09. 53
Underwater Homeowners
24% of Homeowners With a Mortgage Owe
More Than the Home Is Worth, Making
Them Much More Likely to Default
Among people who bought homes in the past five years, 30%+ are underwater*
In Bubble Markets, Far More
Homeowners Are Underwater
Price Index Is % of Last 5 Yrs
at Lowest Price Drop Purchasers Who
Metro Area Level Since Since Peak Are Under Water* There Has Been a Dramatic Rise in
New York 2004-Q3 -15.2% 23.0% Homeowners Who Are Underwater
Los Angeles 2003-Q4 -32.0% 56.4%
Boston 2002-Q2 -21.8% 27.8%
25%
24%
Washington 2004-Q1 -24.8% 50.3%
Miami 2004-Q1 -36.6% 65.1%
San Francisco 2003-Q3 -27.8% 51.2%
20%
Atlanta 2004-Q4 -10.4% 23.2%
20%
San Diego 2002-Q4 -34.4% 63.9%
Phoenix 2004-Q3 -37.7% 36.4%
16%
Las Vegas 2003-Q4 -41.8% 61.4%
Percent Underwater
15%
Source: Zillow.com Q4 08 Real Estate Market Report; Moody's Economy.com, First American CoreLogic, T2 Partners estimates 55
Certain Types of Loans Are Severely
Underwater
80%
73%
70%
60%
50%
Percent Underwater
50%
45%
40%
30%
25%
20%
10%
0%
Prime Alt A Subprime Option ARM
Rather than representing a true bottom, recent signs of stabilization are likely
due to five factors that are (or are likely to be) short-term:
1. Ultra-low interest rates
2. A shift from low-end to middle- and upper-end homes defaulting, which has the
effect of raising average home prices – but it’s very bad news
3. Home sales and prices are seasonally strong in April, May and June due to tax
refunds and the spring selling season
4. The new $8,000 tax credit for first-time homebuyers
– But this expires on November 30th
5. A temporary reduction in the inventory of foreclosed homes
– Shortly after Obama was elected, his administration promised a new, more robust plan
to stem the wave of foreclosures so the GSEs and many other lenders imposed a
foreclosure moratorium
– Early this year, the Obama administration unveiled its plan, the Homeowner
Affordability and Stabilization Plan, which is a step in the right direction – but even if it is
hugely successful, we estimate that it might only save 20% of homeowners who would
otherwise lose their homes
– The GSEs and other lenders are now quickly moving to save the homeowners who can
be saved – and foreclose on those who can’t
– This is necessary to work our way through the aftermath of the bubble, but will lead to a
surge of housing inventory later this year, which will further pressure home prices
57
Outlook for Housing Prices
• We think housing prices will reach fair value/trend line, down 40% from the peak based on the
S&P/Case-Shiller national (not 20-city) index, which implies a 5-10% further decline from where
prices where as of the end of Q1 2009. It’s almost certain that prices will reach these levels
• The key question is whether housing prices will go crashing through the trend line and fall well
below fair value. Unfortunately, this is very likely. In the long-term, housing prices will likely settle
around fair value, but in the short-term prices will be driven both by psychology as well as supply
and demand. The trends in both are very unfavorable
– Regarding the former, national home prices have declined for 33 consecutive months since their peak in July
2006 through April 2009 and there’s no end in sight, so this makes buyers reluctant – even when the price
appears cheap – and sellers desperate.
– Regarding the latter, there is a huge mismatch between supply and demand, due largely to the tsunami of
foreclosures. In March 2009, distressed sales accounted for just over 50% of all existing home sales
nationwide – and more than 57% in California. In addition, the “shadow” inventory of foreclosed homes
already likely exceeds one year and there will be millions more foreclosures over the next few years,
creating a large overhang of excess supply that will likely cause prices to overshoot on the downside, as
they are already doing in California.
• Therefore, we expect housing prices to decline 45-50% from the peak, bottoming in mid-2010
• We are also quite certain that wherever prices bottom, there will be no quick rebound
• There’s too much inventory to work off quickly, especially in light of the millions of foreclosures
over the next few years
• While foreclosure sales are booming in many areas, regular sales by homeowners have plunged,
in part because people usually can’t sell when they’re underwater on their mortgage and in part
due to human psychology: people naturally anchor on the price they paid or what something was
worth in the past and are reluctant to sell below this level. We suspect that there are millions of
homeowners like this who will emerge as sellers at the first sign of a rebound in home prices
• Finally, we don’t think the economy is likely to provide a tailwind, as we expect it to contract the
rest of 2009, stagnate in 2010, and only then grow tepidly for some time thereafter
58
Detailed Information on
Five Types of Mortgages:
Prime, Alt-A, Jumbo Prime,
CES/HELOCs and Option ARMs
Percent Noncurrent (60+ days)
Q
1
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
3.5%
4.0%
4.5%
5.0%
19
Q 99
3
19
Q 99
1
Are Soaring
20
Q 00
3
20
Q 00
1
20
Q 01
3
20
Q 01
1
20
Q 02
3
20
Q 02
1
20
20
Q 05
1
20
Q 06
3
20
Q 06
1
20
Q 07
3
20
Q 07
1
20
Q 08
3
20
08
60
There Is a Surge of Notices of Default and
Foreclosures Among the GSEs
Subprime Foreclosures
Prime Foreclosures
$300
$10
We are $9
here
$250
Estimated Cumulative Reset Amount (Bn)
$8
$7
$200
$6
Amount (Bn)
$150
$5
$4
$100
$3
$2
$50
$1
$0
$0
2
4
0
5
0
3
1
5
14
11
-1
-1
-1
l-1
-1
-1
-1
-1
l-1
l-1
n-
n-
l
l
n
n
n
Ju
Ju
Ju
Ju
Ju
Ju
Ja
Ja
Ja
Ja
Ja
Ja
0%
5%
10%
15%
20%
25%
-9
9
Ju
l-9
Ja 9
n-
0
Ju 0
l-0
Ja 0
n-
01
Ja 2
n-
03
Ju
l-0
Ja 3
n-
0
Ju 4
l-0
Ja 4
n-
05
Ju
l-0
Delinquencies of Securitized Alt-A
Ja 5
n-
0
Ju 6
l-0
Ja 6
n-
07
Ju
l-0
Ja 7
n-
0
Ju 8
l-0
Ja 8
n-
09
65
Alt-A Delinquencies By Vintage Show the
Collapse in Lending Standards in 2006 and 2007
30%
2007 2006
25%
Percent Noncurrent (60+ days)
20%
15%
2005
10%
2004
5%
2003
0%
0 5 10 15 20 25 30 35 40 45 50 55 60
Months of Seasoning
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
3.5%
4.0%
99
Ju
l-9
Ja 9
n-
0
Ju 0
l-0
Ja 0
n-
Ja 2
n-
03
Ju
l-0
Ja 3
n-
04
Ju
l-0
Ja 4
n-
05
Ju
l-0
Ja 5
n-
06
Ju
l-0
Ja 6
n-
07
Ju
l-0
Delinquencies of Securitized Jumbo Prime
Ja 7
n-
08
Ju
l-0
Ja 8
n-
09
67
As the Credit Crisis Worsened, the Spread Between
Jumbo and Conforming Loans Widened Dramatically
Sources: Mortgage Bankers Association via Thomson Reuters; HSHAssociates.com, in the WSJ 6/11/09.
68
HELOCs and Home Equity Loans Soared
in Popularity During the Bubble
$1,000
Closed-End Junior Lien Mortgages
$900 Home Equity Lines of Credit
$800
$700
$600
Amount (Bn)
$500
$400
$300
$200
$100
$0
00
02
03
06
07
08
4
05
01
0
20
20
20
20
20
20
20
20
20
1
1
1
1
1
1
Q
Q
Note: Does not include approximately $200 billion of securitized HELOCs and junior liens. Source: FDIC Quarterly Banking Profile.
69
Many Borrowers Used HELOCs to Buy
New Cars
• As home prices have declined and other funding sources have dried up,
millions of consumers have maxed out on home equity debt.
• In hot markets like California and Florida, a significant percentage of all
consumers tapped into the value of their homes to help finance their new
cars, according to CNW Marketing Research.
• Clearly this dynamic does not bode well for HELOC recovery rates or new
car sales.
Source: New York Times 5/27/2008.
70
Delinquencies of HELOCs and CESs
Are Soaring
4.5%
Closed-End Junior Lien Mortgages
Home Equity Lines of Credit
4.0%
3.5%
Percent Noncurrent (90+ days)
3.0%
2.5%
2.0%
1.5%
1.0%
0.5%
0.0%
Q 07
4
Q 08
Q 05
Q 06
Q 07
Q 08
09
04
04
05
Q 05
Q 06
Q 006
Q 07
Q 007
Q 006
Q 008
Q 008
0
20
20
20
20
20
20
20
20
20
20
20
20
20
20
20
20
2
2
2
3
1
1
1
1
3
Q
On one second lien deal, Ambac expected losses of 10-12% when it guaranteed the senior
tranche. A year ago, Ambac admitted that the pool would likely lose 81.8% of its value – and
based on the pool’s performance since then, this will almost certainly prove to be conservative.
3.0%
Ambac Projection April 2008
Actual
0.5%
0.0%
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 45 47 49 51 53 55 57 59
Months Since Close
Sources: Ambac Q1 08 presentation, Amherst Securities; funds managed by T2 Partners are short Ambac.
A Primer on Option ARMs
$300 9%
9%
8%
$250 8%
7%
$200 6%
Originations (Bn)
Percent of Total
5% 5%
$150 5%
4%
$100 3%
2%
$50
1% 1%
$0 0%
2004 2005 2006 2007 2008
Sources: 2008 Mortgage Market Statistical Annual, published by Inside Mortgage Finance Publications, Inc. Copyright 2008. T2 Partners estimates.
75
Options ARMs Were a Bubble State
Phenomenon
Other
25%
Arizona
3%
California
Nevada 58%
3%
Florida
10%
8.5
Fannie Mae 30 Year FRM Index
Option ARM Index
8.0
6.5
6.0
5.5
5.0
4.5
4.0
2
03
07
3
04
08
2
6
3
7
02
06
3
4
05
7
5
4
-0
-0
-0
-0
-0
-0
l-0
l-0
l-0
l-0
l-0
-0
-0
r-0
-0
-0
-0
l-0
n-
n-
n-
n-
n-
n-
n-
pr
pr
ct
pr
pr
pr
ct
ct
ct
ct
ct
Ju
Ju
Ju
Ju
Ju
Ju
Ap
Ja
Ja
Ja
Ja
Ja
Ja
Ja
O
O
O
O
A
A
Source: Amherst Securities, BloombergFinance, L.P.
Option ARMs are Recasting Much Faster Than
Expected Due to Negative Amortization
$18
$12
$10
$8
$6
$4
$2
$-
O 0
O 9
O 1
2
O 8
A 9
A 0
A 1
A 2
A 8
Ju 0
Ju 1
2
9
Ju 8
Fe 0
Fe 9
Fe 1
Fe 8
A 1
A 0
A 2
A 9
D 9
D 0
D 1
D 8
-1
-1
-1
-0
-0
1
0
-1
-1
-1
-0
-0
-1
-0
-0
-1
1
1
1
0
1
0
n-
n-
n-
n-
n-
b-
b-
b-
b-
ct-
ct-
ct-
ct-
ug
ug
ug
ug
ug
pr
pr
pr
pr
pr
ec
ec
ec
ec
Ju
Ju
A
35%
25%
more and the resets are more significant.”
20% -- Kevin Stein, associate director of the
California Reinvestment Coalition
15%
10%
5%
0%
Ja 0
9
Ju 0
02
04
06
08
Ja 1
9
Ja 2
Ja 3
Ja 4
Ja 6
Ja 5
Ja 7
Ja 8
01
03
05
07
09
l-0
l- 0
l- 0
l- 0
-9
l-0
l-0
l-9
l-0
l-0
l-0
n-
n-
n-
n-
n-
n-
n-
n-
n-
n-
n
Ju
Ju
Ju
Ju
Ju
Ju
Ju
Ju
Ju
Ja
Ja
220
S&P/Case-Shiller U.S. National Home Price Index
S&P/Case-Shiller 20-City Composite
OFHEO Purchase-Only Index
200
NAR Median Sales Price of Existing Homes
180
160
140
120
100
Q 08
09
Q 04
Q 05
Q 05
Q 06
01
02
0
Q 08
Q 06
Q 07
Q 07
03
Q 03
Q 04
02
0
0
0
0
20
20
20
20
20
20
20
20
20
20
20
20
20
20
20
20
20
20
20
1
3
1
1
1
3
1
3
1
Q
Q
Q
Q
Sources: Standard & Poor’s, OFHEO Purchase-Only Index, NATIONAL ASSOCIATION OF REALTORS® Existing Home Sales data series.
82
Home Prices Need to Fall Another 5-10%
to Reach Trend Line
300
Shiller
Lawler
275
Real Home Price Index (1890=100)
250
225
200
Housing
Bubble
175
Trend Line
150
125
100
94
02
62
70
78
86
98
66
74
82
90
06
50
58
5
19
19
19
20
20
19
19
19
19
19
19
19
19
19
19
Sources: Robert J. Shiller, Irrational Exuberance: Second Edition, as updated by the author; Lawler Economic & Housing Consulting.
83
A Study of Bubbles Shows That All of
Them Eventually Return to Trend Line
Relative Return
1.8 2.0
2.0
1.5
1.3 1.5 1.6
Tre nd Line 1.0
Tre nd Line 1.0
0.8 0.5 1.2
0.5 Tre nd Line Trend Line
0.3 0.0 0.0 0.8
20 21 22 23 24 25 26 27 28 29 30 31 46 50 54 58 62 66 70 74 78 82 81 83 85 87 89 91 93 95 97 99 92 94 96 98 00 02 04 06 08
Cumulative Return
Cumulative Return
Cumulative Return
Cumulative Return
Real Price
400
Real Price
1200 150
40 300
800 100
200
400 20 50 100
0 0 0 0
70 74 78 82 86 90 94 98 62 66 70 74 78 82 86 90 94 98 79 81 83 85 87 89 91 93 95 97 70 74 78 82 86 90 94 98
Source: GMO LLC. Note: For S&P charts, trend is 2% real price appreciation per year. Source: GMO. Data through 10//10/08.
* Detrended Real Price is the price index divided by CPI+2%, since the long-term trend increase in the price of the S&P 500 has been on the order of 2% real. 84
The Biggest Danger is That Home Prices
Overshoot on the Downside, Which Often
Happens When Bubbles Burst
2.00
1.75
1.50
1.25
1.00
S&P 500 1955-1986
2.25
0.75
Overrun: 45%
2.00 Fair Value to Bottom: 7 Years
0.50
Fair Value to Fair Value: 12 Years
0.00 1.50
1927 1930 1933 1936 1939 1942 1945 1948 1951 1954
1.25
1.00
0.75
0.50
-45%
0.25
0.00
1955 1957 1959 1961 1963 1965 1967 1969 1971 1973 1976 1978 1980 1982 1984 1986
California
$500 70%
60%
$400
50%
Median Home Price (000s)
Foreclosure Resale %
$300
40%
30%
$200
20%
$100
10%
$0 0%
7
6
09
6
9
07
8
6
8
7
6
8
r-0
r-0
0
r-0
r-0
-0
-0
l-0
l-0
l-0
-0
-0
n-
n-
n-
n
ct
ct
ct
Ju
Ju
Ju
Ap
Ap
Ap
Ap
Ja
Ja
Ja
Ja
O
+42%
2,000
1,154
Resale Homes
-12% Normal
1,500
Foreclosure
1,000 1,312
+232%
1,254
500
(22% (52%
378 Foreclosure) Foreclosure)
0
November
1/1/20072007 November 2008
1/1/2008
Source: San Diego Union-Tribune, MDA Dataquick. Note: Excludes new construction. 87
Home Prices Have Crashed Through Trend Line in
California, But Stabilized in March and April
$600
Median Sales Price
4% Trend
$500
Median Price ($000s)
$400
$300
$200
$100
$0
05
07
1
93
5
9
3
09
03
97
9
85
91
79
0
9
8
8
-9
-8
-8
n-
n-
n-
n-
n-
n-
n-
n-
n-
n-
n-
n-
n-
n
n
n
Ja
Ja
Ja
Ja
Ja
Ja
Ja
Ja
Ja
Ja
Ja
Ja
Ja
Ja
Ja
Ja
Source: California Association of REALTORS ® . All rights reserved. www.rebsonline.com, T2 Partners estimates.
88
The Housing Affordability Index Shows
Houses Are Now Affordable
26
24
Mortgage Payment on Median Priced
Home as % of Family Income
22
20
18
Before concluding that houses are cheap, however, there are three big caveats: first, low rates
are only available to those who qualify for conforming mortgages, which doesn’t help millions of
16 homeowners or potential homeowners who have spotty credit histories or are underwater on their
current mortgages. Second, with low enough interest rates, almost anything looks affordable; if
rates rise, houses won’t look so reasonably priced based on these metrics. Finally, in light of the
severe economic downturn, average income may fall for quite some time.
14
89
90
91
92
93
94
95
96
97
98
99
00
01
02
03
04
05
06
07
08
09
19
19
19
19
19
19
19
19
19
19
19
20
20
20
20
20
20
20
20
20
20
Source: NATIONAL ASSOCIATION OF REALTORS® Housing Affordability Index. 89
The Home Price-to-Rent Ratio Has
Returned to Normal Levels
27
25
Median Home Price to Median Gross Rent
23
21
19
17
15
1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
Source NATIONAL ASSOCIATION OF REALTORS® Existing Home Sales data series, U.S. Census Bureau, T2 Partners estimates.
90
The Timing Indicates That We Are Still in the
Middle Innings of the Bursting of the Great
Housing Bubble
• Mortgage lending standards became progressively worse starting in 2000, but really went off a cliff
beginning in early 2005
• The worst loans were subprime ones, which generally had two-year teaser rates and are now
defaulting at unprecedented rates
• Such loans made in Q1 2005 started to default in high numbers upon reset in Q1 2007, which not
surprisingly was the beginning of the current crises
• The crisis has continued to worsen as even lower quality subprime loans made over the
remainder of 2005 reset over the course of 2007, triggering more and more defaults
• It takes an average of 15 months from the date of the first missed payment by a homeowner to a
liquidation (generally a sale via auction) of the home
• Thus, the Q1 2005 subprime loans that defaulted in Q1 2007 led to foreclosures and auctions in
early 2008
• Given that lending standards got much worse in late 2005 through 2006 and into the first half of
2007, and the many other types of loans that are now with longer reset dates that are now starting
to default at catastrophic rates, there are sobering implications for expected defaults, foreclosures
and auctions in 2009 and beyond, which promise to drive home prices down further
91
Total Losses
Total Losses Are Now Estimated at $2.1-$3.8
Trillion – And Only a Fraction of This Has Been
Realized To Date
$4,000
$3,778 Corporate
$3,552
$3,500 Consumer
Commercial
$3,000 Real Estate
$2,632 Residential
Mortgages
$2,500
Amount (Bn)
$2,083
$2,000
$1,473
$1,500 $1,214
GSEs
$1,000 Insurers
$500 Banks/
Brokers
$0
Goldman Roubini Jan T2 Partners IMF Apr 2009 Writedowns to Capital Raised
Sachs Jan 2009 Mar 2009 Date
2009
Sources: Goldman Sachs, International Monetary Fund, RGE Monitor, Bloomberg Finance L.P., T2 Partners estimates.
93
A Breakdown of Our Financial Sector
Loss Estimates
Amount (Bn)
$0 $100 $200 $300 $400 $500 $600 $700 $800
CDO/ CLO
Other Consumer
Total Estimated
Construction & Development Financial Sector
Option ARM Losses = $3.8 trillion
Auto
Credit Card
Home Equity
Jumbo Prime
High-Yield / Leveraged Loans
Subprime
Alt-A
$1,500
Losses & Writedowns
Capital Raised
$1,250
$1,000
Amount (Bn)
$750
$500
$250
$0
Prior Q3 2007 Q4 2007 Q1 2008 Q2 2008 Q3 2008 Q4 2008 Q1 2009 Q2 2009
Source: Ned Davis Research; WSJ Market Data Group; appeared in WSJ 6/16/09
96
Where We Are Finding Opportunities
• Blue-chips. The stocks of some of the greatest businesses, with strong balance sheets and dominant
competitive positions, are trading at their cheapest levels in years – due primarily to the overall market
decline and weak economic conditions rather than any company-specific issues. In this category, we’d
put Wal-Mart (which we own), Coca-Cola, McDonald’s, Altria, ExxonMobil, Johnson & Johnson, and
Microsoft.
• Out of favor blue-chips. For somewhat more adventurous investors looking to buy great companies in the
most out-of-favor sectors such as financials, retailers and healthcare, we own Berkshire Hathaway, Wells
Fargo, American Express, Target and Pfizer. All are great businesses, but their stocks have suffered
mightily thanks to the economic downturn. We think they’re good bets to rebound when things stabilize.
• Balance sheet plays. For investors who are comfortable with lower-quality businesses but want downside
protection, there are many companies trading near or even below net cash on the balance sheet.
Examples in our portfolio include digital media equipment company EchoStar Corp. and clothing retailer
dELiA*s. Berkshire is the best of both worlds: a premier company but also a balance sheet play.
• Turnarounds. There are countless companies that have gotten clobbered by the economic downturn and
are reporting dismal results – with stock prices to match. Investors in those that survive and return to
anything close to former levels of profitability will be well rewarded – but picking these stocks isn’t easy.
Among our holdings in this category are Wendy’s restaurants, Winn-Dixie supermarkets, Huntsman, a
specialty chemical maker, Crosstex, a pipeline company, and Resource America, a specialty finance
company.
• Special situations. This is somewhat of a catch-all category that, for us, includes Contango Oil & Gas, a
stock that’s declined due to an aborted attempt to sell the company and the sharp drop in the price of
natural gas.
• Mispriced options. Every once in a while we take a tiny position in a highly speculative situation – often
where the stock price is below $1 – in which there’s a real chance that the outcome is zero, but also a
decent chance, in our opinion, of making many multiples of our money. On an expected value basis,
therefore, a small portfolio of such investments is attractive. Our holdings include General Growth
Properties, TravelCenters of America, Ambassadors International, Borders Group and PhotoChannel
Networks.
97
Appendix
More Background Data on
the Housing Market
The Housing Bubble Helped Many People
Achieve the Dream of Home Ownership –
Which is Now Turning Into a Nightmare
69
68
67
66
%
65
64
63
62
61
60
65
67
69
71
73
75
77
79
81
83
85
87
89
91
93
95
97
99
01
03
05
07
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
20
20
20
20
Source: Census Bureau.
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
1956-1
1957-4
1992-4
Home Vacancies Are at an All-Time High
1994-3
1996-2
1998-1
1999-4
2001-3
2003-2
2005-1
2006-4
2008-3
Nearly 10% of Homes Built This Decade
Are Vacant
9.5%
2.2%
2000
Starts
Comple tions
1800 N e w H ome s Sold
1600
1400
1200
1000
800
600
400
200
1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009
70%
Q1 2008
Q2 2008
Percent of Modified Loans 30+ Days Delinquent
20%
18.2%
10%
0%
1 2 3 4 5 6 7 8 9
Months Since Modification
Source: Office of the Comptroller of the Currency and the Office of Thrift Supervision Mortgage Metrics
Most Loan Modifications Fail Because the
Homeowner Is So Deep Underwater
Among foreclosures
in California in May,
the average amount
owed was $412,000,
yet the home was
worth only $235,000.
This means the
homeowner was 43%
underwater and the
home price would
have to rise 75% to
equal the amount of
the debt.
Source: Zillow.com.
109
The Vast Majority of Sacramento Homeowners Who
Purchased During the Bubble Years Are Now Underwater
Source: Zillow.com.
110
In Sacramento County, Home Sales Have
Rebounded – But Are Still Outweighed by Defaults
Sources: MDA Dataquick; The Field Check Group -- data provided by ForeclosureRadar.com. Note:
Includes new construction. 111
Home Prices Are Stabilizing in Sacramento Country,
In Part Due to More Higher End Homes Being Sold Off
California housing – at the low end – is 'bottoming' mostly because: a) median prices
are down 55% from their peak over the past two years, thereby making the low end
affordable; b) foreclosures have temporarily been cut by 66% through moratoriums
reducing supply; and c) demand is picking up going into the busy season.
But the moratoriums are ending and the number of foreclosures in the pipeline is
massive – they will start showing themselves as REO over the near to mid-term. The
Obama plan held the foreclosure wave back, creating a huge backlog and now the
servicers are testing hundreds of thousands of defaults against the new loss mitigation
initiatives. We presently see the Notice of Defaults at record highs and Notice of Trustee
Sales back up to nine-month highs – there is no reason for a loan to go to the Notice of
Trustee Sale stage if indeed it wasn't a foreclosure. However, the new 'batch' are not only
from the low end but a wide mix all the way up to several million dollars in present value.
Because the majority of buyers are in ultra low and low-mid prices ranges, the supply-
demand imbalance from foreclosures and organic supply will crush the mid-to-upper
priced properties in 2009. We already have early seasonal hard data proving this. As the
mid-to-upper end go through their respective implosions this year and the volume of
sales in these bands increase as prices tumble, the mix shift will raise median and
average house prices creating the ultimate in false bottoms. We also have data proving
this phenomenon.
Comments From Mark Hanson (2)
The Field Check Group, May 5, 2009
After a year or so the real pain will occur when the mid to upper bands are down 40% from where
they are now, and the price compression has made the low to low-mid bands much less attractive – the
very same bands that are so hot right now. Rents are tumbling and those that bought these properties
for investment will be at risk of default (investors have been buying all the way down). Investors have
just started to get taken to the woodshed from all of the supply and this will get much worse. Mid-to-
upper end rental supply is also flooding on the market making it much better to rent a beautiful million
dollar house than putting $300,000 down and buying.
After investors are punished -- and with move-up buyers gone for years – it will leave first-time
homeowners to fix the housing market on their own. Good luck and good night. Five years from now
when things look to be stabilizing, all of these terrible kick-the-can-down-the-road modifications that
leave borrowers in 5-year-teaser, ultra-high-leverage, 150% LTV, balloon loans will start adjusting
upward and it will be Mortgage Implosion 2.0. These loan mods will turn millions of homeowners into
over-levered, underwater, renters and ensure housing is a dead asset class for years to come.
Due to a confluence of events including a national foreclosure moratorium and near-zero sales in the
mid to upper end during the off season, the broader housing data show signs of stabilization. Taken in
context, it is a blip. There are no silver linings or green shoots in housing whatsoever other than by these
first-time homeowners – former renters – who now find it cheaper to own than rent. This is a very good
thing, but it only applies to a small segment of the population and will not be able to support the market.
In addition, the first-time buyers who come out of the rental market put continuous pressure on rents.
Our data shows that the mid-to-upper end housing market is on the precipice of the exact cliff that the
market fell off of in 2007, led by new loan defaults. What happens to the economy when you hit the mid-
to-upper end earners the same way the low-to-mid end was hit with the subprime implosion? We will find
out soon enough. When we look back on housing at the end of 2009, anyone that made positive
housing predictions this year will not believe how far off they were.
A Closer Look at Mortgages That
Were Securitized: Quantity and Quality
Hundreds of Billions of Dollars of Mortgages
Were Securitized, Many On Terms With No
Historical Precedent
Securitized First Liens – Origination Volume
These are the worst
loans: $828 billion worth
Fixed Full Doc – June 2005 Production 2/28 Full Doc – June 2005 Production
Total Volume: $ 8.1 billion Total Volume: $16.4 billion
Green: 70.0%; Yellow: 9.3%; Red: 5.4% Green: 39.9%; Yellow: 25.2%; Red: 26.1%
Loan-to-Value Loan-to-Value
FICO
Note: Green: Loans with historical precedent; Yellow: Loans with limited historical precedent;
Red: Loans with no historical precedent
* 2-28 loans are those with two-year teaser interest rates that then reset, often to higher rates, causing payment
shock and a surge in defaults. Because they offer the lowest monthly payments (for the first two years), they
are generally the lowest-quality loans, preferred by speculators and the most over-stretched borrowers.
Source: Amherst Securities Group, L.P.
Volume of June 2005 Fixed Rate and 2/28
Low Doc Securitized Mortgage Loans
Fixed Low Doc – June 2005 Production 2/28 Low Doc – June 2005 Production
Total Volume: $ 7.7 billion Total Volume: $14.1 billion
Green: 49.2%; Yellow: 25.8%; Red: 8.0% Green: 17.0%; Yellow: 33.4%; Red: 31.1%
Prime Alt-A
Subprime
Origination Volume of Fixed Rate, Full Doc
Securitized Mortgage Loans, June 2005
Fixed Full Doc – June 2005 Production 2/28 Full Doc – June 2005 Production
Total Volume: $ 8.1 billion Total Volume: $16.4 billion
Green: 70.0%; Yellow: 9.3%; Red: 5.4% Green: 39.9%; Yellow: 25.2%; Red: 26.1%
Loan-to-Value Loan-to-Value
FICO
Fixed Low Doc – June 2005 Production 2/28 Low Doc – June 2005 Production
Total Volume: $ 7.7 billion Total Volume: $14.1 billion
Green: 49.2%; Yellow: 25.8%; Red: 8.0% Green: 17.0%; Yellow: 33.4%; Red: 31.1%
Loan-to-Value Loan-to-Value
FICO
Default rates are much higher for no/low doc “liars” loans
Source: Amherst Securities, May 25th reports, reflecting payments through 4/30/09.
Monthly Default Rate for Fixed Rate
Securitized Mortgage Loans (Green)
12/04
In this chart, late 2004 and early 2005 vintage loans have
sTrs of approximately 1.5%, which translates into a 16.6%
cumulative default rate in one year, whereas more recent
vintage loans are quickly spiking up to a 3% sTr, which
translates into a 30.6% cumulative default rate in one year.
In this chart, late 2004 and early 2005 vintage loans have sTrs
of approximately 2%, which translates into a 21.5% cumulative
default rate in one year, whereas more recent vintage loans
are quickly spiking up to a 4-5% sTr, which translates into a
38-46% cumulative default rate in one year.
9/06
(pre-reset)
(1 yr):
Voluntary Prepayment
Rate (VPR)
Total:
An average of 47.6% of the On average, 5.1% of the
loans have already defaulted The monthly prepay
performing loans in the pools
rate only averaged 0.5%
defaulted during the month
Source: Amherst Securities, May 25th reports, reflecting payments through 4/30/09.
Where Did the Securitized Mortgages End Up?
A Primer on ABSs and CDOs
Wall Street Firms Bought Loans and Securitized
Them, First Into Asset-Backed Securities Called
Residential Mortgage Backed Securities (RMBSs)
Quick Review: What is a Securitization?
Source: Deutsche Bank Securitization Research; “How to Save the Bond Insurers”, Pershing Square presentation, 11/28/07.
Mortgages Were Pooled into RMBSs,
Tranches of Which Were Pooled into CDOs
BBB
10% A AAA
BBB
BBB
A AA
Equity BBB- Equity Equity
0%
Note: Asset-based securities backed by home mortgages are called Residential Mortgage-Backed Securities (RMBS), those backed by commercial real estate loans
are called Commercial Mortgage-Backed Securities (CMBS), etc. Source: Citigroup, All Clogged Up: What’s Ailing the Financial System, 2/13/08.
Trillions of Dollars of ABSs and CDOs
Were Created and Distributed
Throughout the Financial System
Note: This is all ABSs and CDOs, not just those related to mortgages
Source: Lehman Brothers, 4/08; Carlyle presentation 10/15/08.
What Should the Government Do in the
Case of Distressed Financial Institutions?
Answer: The problem isn’t lack of capital, but lack of the right kind of
capital. They have too much debt and not enough equity.
Therefore the solution is to convert some of the debt to equity.
First, One Must Understand the Capital
Structure of Financial Institutions – And
How Highly Leveraged They Are
Taxpayers will
suffer all losses
above preferred
stock
Taxpayers will
suffer all losses
above preferred
stock
• The U.S. financial system likely faces losses of at least $1 trillion, most of which is likely
to be realized within the next 2-3 years
• There is almost no equity cushion left to cover these losses, so somebody is going to
have to come up with $1 trillion to save the system
• THE QUESTION IS: WHO?
• Current government policy (in the cases of Fannie, Freddie, AIG, Citigroup and Bank of
America) is to invest (or guarantee assets) senior to the equity, but junior to all debt,
even junior/unsecured/subordinated debt
• Absent the government, debt holders would bear the $1 trillion cost (as they did with
Lehman), but under current policy, taxpayers will bear this entire cost
• This is unfair and unwise
– Fairness: Debt holders were paid higher interest than, for example, buying Treasuries in
exchange for knowingly taking more risk. These investors made bad decisions, lending to highly
leveraged companies that made bad decisions, so why should they be protected?
– Moral Hazard: The reckless behavior of debt investors was a major contributor to the bubble. It
was low-cost debt with virtually no strings attached that allowed borrowers, especially the world's
major financial institutions, to become massively overleveraged, fueling the greatest asset
bubble in history. This was not an equity bubble – unlike the internet bubble, for example, stock
market valuations never got crazy – it was a debt bubble, so it would be particularly perverse
and ironic if government bailouts allowed equity holders to take a beating, yet fully protected
debt holders.
• The solution: debt should be converted into equity
But What About Systemic Risk?
• What about the lessons from Lehman? Unless we protect the debt holders, won’t
the financial system shut down again, as it nearly did in the wake of the Lehman
bankruptcy? No. The lessons from Lehman have been misunderstood.
– The mistake wasn't the failure to protect the debt, but rather allowing Lehman to go
bankrupt, which not only impacted Lehman's equity and debt holders, but also stiffed
Lehman's countless clients and counterparties. It's the latter that caused the true chaos.
– Lehman should have been seized and put into conservatorship, so that all of Lehman's
clients and counterparties could have relied on Lehman (as was done with AIG) - but debt
holders would have taken losses as they were realized (which is not being done with AIG).
• If debt holders take a hit, might other financial institutions who own the debt might
become insolvent, creating a domino effect? And might debt markets freeze up
such that even currently healthy banks might not be able to access debt and
collapse?
– Regarding the former, the debt is owned by a wide range of institutions all over the world:
sovereign wealth funds, pension funds, endowments, insurance companies and, to be sure,
other banks. Some of them would no doubt be hurt if they take losses on the debt they hold
in troubled financial institutions - but that's no reason to protect all of them 100% with
taxpayer money.
– As for the latter concern that debt markets might freeze up, causing even healthy banks to
collapse, it's important to understand that right now there is no junior debt available to any
financial institution with even a hint of weakness - there's very high cost equity and
government-guaranteed debt. Neither of these will be affected if legacy debt holders are
forced to bear some of the cost of the failure of certain institutions.
Case Study: Bank of America
• As of the end of 2008 (not including Merrill Lynch), BofA had $1.82 trillion in assets
($1.72 trillion excluding goodwill and intangibles), supported by a mere $86.6 billion
in tangible equity – 5.0% of tangible assets or 20:1 leverage – and $48.9 billion of
tangible common equity – 2.8% of tangible assets or 35:1 leverage
• Among the company's loans are many in areas of great stress including:
– $342.8 billion of commercial loans ($6.5 billion of which is nonperforming, up from $2.2 billion
a year earlier)
– $253.5 billion of residential mortgages ($7.0 billion of which is nonperforming, up from $2.0
billion a year earlier)
– $152.5 billion of home equity loans (HELOCs; about $33 billion of which were Countrywide's)
– $18.2 billion of Option ARMs (all Countrywide’s)
• BofA is acknowledging a significant increase in losses, but its reserving has actually
become more aggressive over the past year. From the end of 2007 to the end of
2008, nonperforming assets more than tripled from $5.9 billion to $18.2 billion, yet
the allowance for credit losses didn't even double, from $12.1 billion to $23.5 billion.
As a result, the allowance for loan and lease losses as a percentage of total
nonperforming loans and leases declined from 207% to 141%
• BofA has $268.3 billion of long-term debt, $158.1 of commercial paper and other
short-term borrowings
– In addition, Merrill Lynch at the time of acquisition had $5.3 billion of junior subordinated
notes, $31.2 billion of short-term debt and $206.6 billion of long-term debt
What the Government Should Do If a
Company Blows Up and Can’t Find a Buyer?