Demystifying the Mortgage Meltdown:
What It Means for Main Street,
Wall Street and the U.S. Financial System
James R. Barth
Senior Fellow
Glenn Yago
Director of Capital Studies
Milken Institute
October 2, 2008
1
“I have great, great confidence in our capital markets and in
our financial institutions. Our financial institutions, banks
and investment banks are strong.”
Treasury Secretary Henry Paulson
March 16, 2008
CNN
2
… but just six months later…
“The financial security of all Americans … depends on our
ability to restore our financial institutions to a sound footing.”
Treasury Secretary Henry Paulson
September 19, 2008
Press release
3
“Any real estate investment is a good investment … ”
4
“Any real estate investment is a good investment … ”
… Really?!
5
Subprime mortgage meltdown timeline
December 2006–September 2008
Dow Jones U.S. Financial Index
650
Feburary–March 2007: More than 25
subprime lenders declare
bankruptcy.
Aug. 16, 2007:
Countrywide gets
emergency loan of
$11 billion from a
group of banks.
Sept. 30, 2007:
NetBank goes
bankrupt.
Oct. 24, 2007:
Merrill announces
$7.9 billion in
subprime writedowns, surpassing
Citi’s $6.5 billion.
550
450
350
250
Dec. 2006:
Ownit Mortgage,
a subprime
lender, files for
bankruptcy.
Feb. 2007:
HSBC sets
aside $10.6
billion for
bad loans,
including
subprime.
Apr. 2007: New
Century, a
mortgage
broker, files
for
bankruptcy.
July 31, 2007:
Two Bear
Stearns
hedge funds
file for
bankruptcy.
Aug. 6, 2007:
American Home
Mortgage files
for bankruptcy.
Jan. 11, 2008:
Bank of
America agrees
to buy
Countrywide.
Jan. 30, 2008: Fed
cuts discount rate
to 3.5%.
Mar. 16, 2008:
JP Morgan
Chase offers to
buy Bear
Stearns; Fed
introduces
Primary Dealer
Credit Facility.
Mar. 18, 2008:
Fed cuts
discount rate
to 2.4%; Fed
funds rate to
2.25%.
July 30, 2008:
President
Bush signs a
housing
rescue law.
Dec. 12, 2007:
Fed introduces
Term Auction
Facility.
Aug. 17, 2007: Fed cuts
discount rate to 5.75%;
Fed introduces Term
Discount Window
Program.
Sources: BusinessWeek, S&P, Global Insight, Milken Institute.
Mar. 11, 2008: Fed
offers troubled
banks as much as
$200 billion in
loans; Fed
introduces Term
Securities
Lending Facility.
Feb. 13, 2008:
President Bush
introduces tax
rebate stimulus
program of $168
billion.
June 9, 2008:
Lehman
announces a $2.8
billion loss.
July 11, 2008: IndyMac
is seized by FDIC.
Aug. 1,
2008: First
Priority
Bank
closes.
Sept. 14, 2008:
Lehman files for
bankruptcy.
Sept. 16, 2008:
Fed loans AIG
$85 billion.
Sept. 23, 2008:
Washington
Mutual is seized
by FDIC.
Sept. 7, 2008: U.S.
seizes Fannie Mae
and Freddie Mac.
Sept. 29, 2008:
Citigroup
agrees to buy
Wachovia bank.
6
Overview
7
Home mortgages: Who borrows, how much has been
borrowed, and who funds them?
Total value of housing stock = $19.3 trillion
Subprime
8.4%
Mortgage debt
$10.6 trillion
Prime
91.6%
Securitized
58%
Non-securitized
42%
Governmentcontrolled
46%
Private
sectorcontrolled
54%
Equity in housing stock
$8.7 trillion
Note: total residential and commercial mortgages = $14.7 trillion; 5 percent = $700 billion
Sources: Federal Reserve, Milken Institute.
8
The mortgage problem in perspective
80 million houses
27 million are paid off
53 million have mortgages
48 million are paying on time
5 million are behind
(9.2% of 53 million with 2.8% in foreclosure)
Sources: U.S. Treasury, Milken Institute.
This compares to
50% seriously
delinquent in the
1930s.
9
I. Low interest rates
and a lending boom
10
Did the Fed lower interest rates too much and for too long?
Federal funds rate vs. rates on FRMs and ARMs
Percent
8
30-year FRM rate
7
6
5
4
Target federal
funds rate
3
1-year ARM rate
2
Record low from June 25,
2003, to June 30, 2004: 1%
1
0
2001
2002
2003
2004
2005
Sources: Federal Reserve, Mortgage Bankers Association, Moody’s Economy.com, Milken Institute.
2006
2007
2008
11
Home price bubble
and credit boom
Low interest rates
and credit boom
US$ trillions
Percent
6.0
4.5
4.0
5.5
3.5
5.0
2.5
2.0
1.5
0.5
4.0
250
3.5
200
3.0
3.0
1.0
Index, January 2000 = 100
US$ trillions
1-Year ARM rate
(right axis)
Home
mortgage
originations
(left axis)
4.5
2.0
4.0
1.5
1.0
3.5
0.5
0.0
3.0
2001
2003
2.5
2005
2007
S&P/Case-Shiller
National Home
Price Index
(right axis)
Home
mortgage
originations
(left axis)
150
100
50
0
0.0
2001
2003
2005
Sources: Inside Mortgage Finance, Mortgage Bankers Association, Moody’s Economy.com, S&P/Case-Shiller, Milken Institute.
2007
12
II. Homeownership, prices,
starts and sales take off
13
Credit boom pushes
homeownership rate
to historic high
Percent
70
69
Q2 2008: 68.1%
Q2 2004: 69.2%
Home price bubble
peaks in 2006
Index, January 1987 = 100
380
S&P/
330
68
280
67
230
66
180
65
130
Ave rage , 1965–Q2 2008: 65.2%
64
1998 2000 2002 2004 2006 2008
Cas e -Shille r
National Hom e
Price Inde x
California and national
home prices reach
record highs
US$ thousands
700
600
500
400
300
California m e dian
hom e price
California
ave rage
1987-2008
$229,748
U.S. m e dian
hom e price
200
OFHEO Hom e Price Inde x
80
1998 2000 2002 2004 2006 2008
Sources: U.S. Census Bureau, OFHEO, Moody’s Economy.com, S&P/Case-Shiller,
California Association of Realtors, Milken Institute.
100
U.S. ave rage , 1987-2008: $121,280
0
1998 2000 2002 2004 2006 2008
14
Housing starts hit
a record in 2005
Housing units, millions
2.0
Millions
4
Existing homes for
sale (left axis)
January 2006: 1.8 m illion
3
1.5
1.0
Homes for sale
Millions
0.8
July 2008: 641,000
0.0
1998 2000 2002 2004 2006 2008
5.6
1.2
4.2
0.9
2.8
1
Millions
1.5
0.4
Ave rage s tarts ,
1959–July 2008: 1.1 m illion
0.5
Millions
7.0
Exis ting hom e
s ale s (le ft axis )
0.6
2
Homes sales reach
a new high
New homes for
sale (right axis)
0.2
0
0.0
1998 2000 2002 2004 2006 2008
Sources: U.S. Census Bureau, OFHEO, Moody’s Economy.com, Milken Institute.
1.4
Ne w hom e s ale s
(right axis )
0.6
0.3
0.0
0.0
1998 2000 2002 2004 2006 2008
15
III. Subprime borrowers and
subprime mortgages
16
Who is a subprime borrower?
National FICO scores display wide distribution
What goes into a FICO score?
Percentage of population
40
Types of credit in use
Prime = 79%
10%
30
20
New credit
27
Subprime = 21%
35%
18
15
13
12
8
10
Payment history
10%
Length of
credit history
15%
5
2
0
up to 500499 549
550599
600649
650699
700749
750799
800+
Amounts owed
30%
Sources: myFICO.com, Milken Institute.
17
Prime and subprime mortgage originations
by FICO score reveal substantial overlaps
Percent of total originations
FICO below 620
Prime: 6.6%
Subprime: 45.2%
20
16
FICO above 620
Prime: 93.4%
Subprime: 54.8%
Prime
12
Subprime
8
4
00
-9
80
0
-7
99
79
0
-7
78
76
0
-7
59
39
74
0
-7
19
0
-7
72
70
0
-6
99
79
0
68
66
0
-6
-6
59
39
0
-6
64
62
0
-6
19
99
60
0
-5
79
0
-5
58
56
0
-5
59
39
0
-5
54
52
0
-5
19
99
50
0
-4
79
0
-4
48
0
46
0
-4
59
0
FICO score
Sources: LoanPerformance, Milken Institute.
18
ARMs look attractive to many borrowers
Percent
8.0
7.0
30-year FRM rate
6.0
5.0
4.0
1-year ARM rate
3.0
2.0
2001
2002
2003
2004
2005
2006
2007
2008
Sources: Mortgage Bankers Association, Moody’s Economy.com, Milken Institute.
19
ARM share grows, following low interest rates
Percent of all outstanding home mortgages
25
20
15
10
5
0
2001
2002
2003
2004
2005
2006
2007
2008
Sources: Mortgage Bankers Association, Moody’s Economy.com, Milken Institute.
20
Largest share of ARMs go to subprime borrowers
Percent of mortgage type
60
FHA ARM Prime ARM
Subprime ARM
50
40
30
20
10
0
2001
2002
2003
2004
2005
2006
2007
2008
Sources: Mortgage Bankers Association, Moody’s Economy.com, Milken Institute.
21
Subprimes take an increasing share
of all home mortgage originations
US$ trillions
8.4%
4.0
Subprime
3.0
Subprime's
share:
7.8%
7.4%
18.2%
21.3%
Prime
20.1%
7.9%
2.0
1.0
0.9%
0.0
2001
2002
Sources: Inside Mortgage Finance, Milken Institute.
2003
2004
2005
2006
2007
Q2 2008
22
Subprime mortgages increase rapidly before big decline
Originations
US$ billions
1,400
700
625
600
600
1,200
Average annual growth rates
1,240
1995–2006: 14%
1,200
2006–Q1 2008: -23%
540
973
1,000
500
800
400
310
600
300
200
Outstandings
US$ billions
160
200
191
940
895
699
574
479
400
200
100
14
0
2001 2002 2003 2004 2005 2006 2007
Sources: Inside Mortgage Finance, Milken Institute.
Q2
H2
2008
2008
0
2001 2002 2003 2004 2005 2006 2007
Q1
2008
23
IV. Mortgage product innovation
24
Subprime and Alt-A shares quadruple between 2001
and 2006, then fall in 2007
2006, $3.0 trillion
2001, $2.2 trillion
2%
5%
14%
7.9%
7%
2.7%
14%
4.9%
57.1%
9%
9.6%
8%
11%
20%
4%
2%
33.2%
13%
Q1 2008, $480 billion
2007, $2.4 trillion
8%
20%
16%
14%
47.3%
FHA & VA
Conventional, conforming prime
Jumbo prime
Sources: Inside Mortgage Finance, Milken Institute.
67.2%
p
Subprime
Alt-A
Home equity loans
25
ARM hybrids dominate subprime originations (2006)
Prime conventional
Other
ARM
7%
ARM
hybrids
Alt-A
Subprime
Fixed
9%
Othe r
ARM
23%
30-year
ARM balloon
with 40- to
50-year
amortization
26%
23%
Fixed Fixe d
31%
70%
Sources: Freddie Mac, Milken Institute.
Other
ARM
4%
ARM hybrids
46%
2- and 3-year
hybrids 61%
26
V. Securitization
27
The mortgage model switches from
originate-to-hold to originate-to-distribute
Residential mortgage loans
1980: Total = $958 billion
Residential mortgage loans
Q2 2008: Total = $11.3 trillion
Securitized
15.6%
Held in
portfolio
41%
Held in
portfolio
84.4%
Sources: Federal Reserve, Milken Institute.
Securitized
59%
28
Securitization becomes the dominant funding
source for subprime mortgages
Percent of all subprime mortgages securitized since 1994
80
70
57
60
50
40
30
40
31
29
45
43
42
45
47
62
65
68
68
68
50
33
20
10
0
1994 1995 1996 1997 1998 1999 2000
Sources: Inside Mortgage Finance, Milken Institute.
2001 2002 2003 2004 2005 2006 2007
Q1
Q2
2008 2008
29
The rise and fall of private-label securitizers
New securities issuance
2%
42%
21%
20%
1985
Total = $110B
35%
Ginnie Mae
4%
13%
56%
2001
Total = $1.3T
6%
18%
2006
Total = $2.0T
29%
First half 2008
Total = $734B
Sources: Inside Mortgage Finance, Milken Institute.
33%
22%
46%
38%
Freddie Mac
15%
Fannie Mae
Private-label
30
The rise and fall of private-label securitizers
Outstanding securities
6%
13%
14%
18%
7%
35%
25%
55%
1985
Total = $390B
2001
Total = $3.3T
7%
30%
2006
Total = $5.9T
26%
First half 2008
Total = $6.8T
26%
39%
29%
33%
Ginnie Mae
Freddie Mac
Sources: Inside Mortgage Finance, Milken Institute.
Fannie Mae
37%
Private-label
31
VI. Affordability
32
Debt-to-income ratio
of households has
increased rapidly
Ratio of home
price to household
income surges
Home mortgage debt/disposable
personal income
Q4 2007: 139.5%
150
Median home price/
median household income
5.0
Home mortgage share of
household debts reaches
a new high in 2007
Percent
75
Q2 2007: 73.7%
2005: 4.69
4.5
70
125
Q2 2008: 73.4%
4.0
2007: 4.29
3.5
100
Average, 1957–2007: 79.7%
3.0
Average, 1952–2008: 64.2%
Average, 1967–2007: 3.38
2.5
1998
2001
2004
65
2007
75
1998
2001
2004
2007
Sources: U.S. Census Bureau, OFHEO, Federal Reserve, Moody’s Economy.com, Milken Institute.
60
1998
2001
2004
2007
33
VII. Collapse
34
The recent run-up of home prices was extraordinary
Index, 2000 = 100
250
Annualized growth rate of nominal home index: 3.4%
Current
boom
Great
Depression
200
World
War I
150
World
War II
1970’s
boom
1980’s
boom
100
50
0
1890
Long-term trend line
1900
1910
Sources: Robert Shiller, Milken Institute.
1920
1930
1940
1950
1960
1970
1980
1990
2000
2010
35
Home prices don’t go up forever
Change in home prices in 100 plus years
Percentage change in nominal home price, year ago
30
Great
World
World
Depression
War II
War
I
25
1970’s
Boom
20
1980’s
Boom
Current
Boom
Average, 1890–2007: 3.7%
15
10
5
0
-5
-10
+/- one standard deviation
-15
-20
1890
1900
1910
Sources: Robert Shiller, Milken Institute.
1920
1930
1940
1950
1960
1970
1980
1990
2000
2010
36
2005: The collapse begins
Home price indices, percent change on a year earlier
S&P/Case-Shiller
20
10 city
15
S&P/Case-Shiller
national
10
OFHEO
5
0
-5
-10
-15
1988
1990
1992
1994
1996
1998
Sources: S&P/Case-Shiller, OFHEO, Moody’s Economy.com, Milken Institute.
2000
2002
2004
2006
2008
37
Forty-six states had falling prices
in the fourth quarter 2007
United States: - 9.3% (fourth-quarter annualized growth)
Source: Freddie Mac.
38
If you bought your house…
One year ago…
Five years ago…
-1.0
-3.2
-4.7
-5.2
-5.8
-7.1
-7.3
-7.3
-8.1
-9.5
-13.9
-15.7
-15.9
-16.3
-17.0
-20.1
-23.7
-24.2
-25.3
-27.9
-28.3
-28.6
% change in price, June 07-08
Sources: S&P/Case-Shiller, Milken Institute.
Charlotte
Dallas
Denver
Boston
Portland
Seattle
New York
Cleveland
Atlanta
Chicago
Minneapolis
W ashington
Composite 20
Detroit
Composite 10
Tampa
San Francisco
San Diego
Los Angeles
Phoenix
Miami
Las Vegas
48.4 Seattle
48.0 Portland
28.2
27.9
26.8
26.3
26.3
26.0
24.4
22.9
20.5
18.6
14.3
9.1
6.6
6.5
6.1
5.9
4.8
-21.3
-0.7
-3.8
Washington
New York
Phoenix
Los Angeles
Tampa
Miami
Las Vegas
Charlotte
Composite 10
Composite 20
Chicago
San Francisco
Atlanta
Dallas
San Diego
Boston
Denver
Minneapolis
Cleveland
Detroit
% change in price, June 03-08
39
Housing starts
sharply decline
Percent change, year ago
30
15
Homes sit longer
on the market …
Number of months that
homes sit on the market
12
Existing homes
10
… as home
appreciation slows
Percent
20
Months
Pe rce ntage change from
ye ar ago in m e dian
hom e s ale s price
(le ft axis )
0
2
10
0
4
8
-15
-30
-45
0
6
June 2008: -41.9%
July 2008: -39.2%
-60
1998 2000 2002 2004 2006 2008
8
4
2
6
-10
New homes
0
1998 2000 2002 2004 2006 2008
-20
1999
Num be r of m onths
hom e s s tay on
m ark e t (right axis )
2001
2003
2006
10
12
2008
Note: Shaded area represents fluctuation within one standard deviation from mean (1.28%)
Sources: Mortgage Bankers Association, OFHEO, Moody’s Economy.com, Milken Institute.
40
VIII. Delinquencies and foreclosures
41
Foreclosures are nothing new, but …
Thousands of foreclosures per year
2,150
1,900
1,650
1,400
1,150
Av erage 661,362 annual foreclosures from Q2 1999 to Q2 2006
900
650
08
Q
2
20
20
07
07
4
Q
Q
2
20
20
06
06
Q
4
20
2
Q
Q
4
20
20
05
05
04
2
Q
Q
4
20
20
04
03
2
Q
Q
4
20
20
2
Q
4
Q
Sources: Mortgage Bankers Association, Milken Institute.
03
02
20
02
20
2
Q
Q
4
20
01
01
20
2
Q
Q
4
20
00
00
20
Q
2
19
4
Q
Q
2
19
99
99
400
42
… their numbers have doubled
Thousands of foreclosures per year
2,150
1,900
Average 1,316,220 annual forclosures from Q3 2006 to Q2 2008
1,650
1,400
1,150
Average 661,362 annual foreclosures from Q2 1999 to Q2 2006
900
650
08
20
07
2
Q
Q
4
20
20
07
06
2
Q
4
Q
2
20
20
06
05
20
Q
4
Q
Q
2
20
05
04
20
04
4
Q
Q
2
20
20
03
03
4
Q
Q
2
20
4
Q
Sources: Mortgage Bankers Association, Milken Institute.
20
02
02
20
2
Q
Q
4
20
01
01
20
00
Q
2
20
4
Q
2
20
00
99
19
Q
4
Q
Q
2
19
99
400
43
Subprime mortgages accounted for half
or more of foreclosures since 2006
Number of home mortgage foreclosures started (annualized, in thousands)
2,000
Subprime: 12% of mortgages
serviced (M arch 2008)
Subprime
1,600
FHA and VA
50%
Prime (includes Alt-A)
54%
1,200
55%
800
37%
400
0
36%
37%
44%
47%
29%
29%
29%
34%
35%
34%
34%
33%
Dec. 2003
June
2004
Dec. 2004
June
2005
Dec. 2005
Sources: Inside Mortgage Finance, Milken Institute.
22%
20%
52%
17%
31%
June
2006
13%
32%
Dec. 2006
56%
9%
11%
37%
8%
42%
33%
June
2007
Dec. 2007
M arch
2008
44
Subprime ARMs have the worst default record
Home mortgages delinquent or in foreclosure (percent of number)
35
Q2 2008, Subprime ARM: 33.4%
30
Subprime FRM: 11.8%
25
FHA and VA: 5.8%
20
Prime FRM: 3.0%
15
10
5
0
Q2
1998
Q1
1999
Q4
1999
Q3
2000
Q2
2001
Sources: Mortgage Bankers Association, Milken Institute.
Q1
2002
Q4
2002
Q3
2003
Q2
2004
Q1
2005
Q4
2005
Q3
2006
Q2
2007
Q1
2008
45
Percentage of homes purchased in Q2 2008
that now have negative equity
United States = 44.8%
< 20%
>= 20% and < 35%
>= 35% and < 50%
>= 50%
Sources: Zillow.com, Milken Institute.
46
Percentage of homes sold for a loss (Q2 2008)
United States = 32.7%
< 15%
>= 15% and < 30%
>= 30% and < 45%
>= 45%
Sources: Zillow.com, Milken Institute.
47
Percentage of homes sold that were in
foreclosure (Q2 2008)
United States = 18.6%
< 1%
>= 1% and < 25%
>= 25% and < 40%
>= 40%
Sources: Zillow.com, Milken Institute.
48
IX. Damages scorecard
49
Losses/write-downs, capital raised, and jobs cut
by financial institutions worldwide
US$ billions
200
Number of jobs cut
60,000
Jobs cut (right axis)
48,000
160
120
80
Capital raised
(left axis)
36,000
24,000
Losses/write-downs
(left axis)
12,000
40
0
0
Prior quarters
Q3 2007
Q4 2007
Q1 2008
Q2 2008
Q3 2008
Note: Q3 data are through September 25, 2008.
Sources: Bloomberg, Milken Institute.
50
What is the cumulative damage?
Cumulative losses/write-downs, capital raised, and jobs cut by financial institutions worldwide
US$ billions
600
Number of jobs cut
140,000
120,000
500
Jobs cut (right axis)
400
300
200
100,000
Capital raised (left axis)
80,000
Losses/write-downs (left axis)
60,000
40,000
100
20,000
0
0
Prior quarters
Q3 2007
Q4 2007
Q1 2008
Q2 2008
Q3 2008
Note: Q3 data are through September 25, 2008.
Sources: Bloomberg, Milken Institute.
51
Recent losses/write-downs and capital raised
by selected financial institutions
US$ billions, through September 25, 2008
Losses /write-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
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.
52
Financial stock prices take big hits
Percentage change in stock price, December 2006–September 2008
-99.8
-99.7
-97.5
-97.4
-95.4
-94.3
-93.9
-90.0
-72.8
-66.0
-65.6
-35.8
-34.4
-3.3
5.5
Note: * Bear Stearns stock price is to May 2008. ** Countrywide stock price is to June 2008.
Sources: Bloomberg, Milken Institute.
W ashington Mutual
Lehman Brothers
Freddie Mac
Fannie Mae
AIG
Bear Stearns*
W achov ia
Countrywide**
Merrill Lynch
Morgan Stanley
UBS Equity
Goldman Sachs
Bank of America
JP Morgan & Chase
W ells Fargo
53
Financial market capitalization takes big hit
Total loss in market value: $728 billion, December 2006–September 2008
-142
-101
-80
-74
-60
-50
-44
-43
-42
-41
-28
-24
-21
4
US$ billions
Note: * Bear Stearns stock price is to May 2008. ** Countrywide stock price is to June 2008.
Sources: Bloomberg, Milken Institute.
17
AIG
W achov ia
Bank of America
UBS Equity
Morgan Stanley
Fannie Mae
Merrill Lynch
W ashington Mutual
Freddie Mac
Lehman Brothers
Goldman Sachs
Countrywide**
Bear Stearns*
W ells Fargo
JP Morgan & Chase
54
X. Credit crunch and liquidity freeze
55
Tightened standards for real estate loans
Net percentage of domestic respondents tightening standards for commercial real estate loans
100
80
The end of S&L crisis
Dotcom
LTCM
60
Subprime
40
20
0
-20
-40
1990
1992
1994
Sources: Federal Reserve, Milken Institute.
1996
1998
2000
2002
2004
2006
2008
56
Widening spreads between
mortgage-backed and high-yield bonds
Basis points, spread over 10-year Treasury bond
1,800
Maximum spread: 08/29/2008: 955.8 bps
1,600
1,400
Merrill Lynch Mortgage-Backed Securities Index
1,200
1,000
Merrill Lynch High-Yield Bond Index
800
600
400
200
0
01/2004 07/2004 01/2005 07/2005 01/2006 07/2006 01/2007 07/2007 01/2008 07/2008
Sources: Merrill Lynch, Bloomberg, Milken Institute.
57
Liquidity freeze
Spread between 3-month LIBOR
and T-bill rate
Basis points
350
Se pte m be r 18, 2008: 313 bps
300
100
80
200
100
Basis points
140
120
Augus t 20, 2007: 240 bps
250
150
Spread between 3-month LIBOR and
overnight index swap rate
Ave rage s ince
Augus t 2007: 130 bps
Ave rage s ince
Augus t 2007: 69.8 bps
60
40 Ave rage s ince
Ave rage s ince
1985: 76 bps
De ce m be r 2001: 21.1 bps
20
50
0
0
2006
Se pte m be r 19, 2008:
127.5 bps
2007
Sources: Bloomberg, Milken Institute.
2008
2006
2007
2008
58
Counterparty risk increases
Average
CDS spread, basis points
Basis
points
500
AIG rescued
400
Lehman Brother files for bankruptcy
and Merrill Lynch acquired
300
Government announces support for
Fannie Mae and Freddie Mac
200
Bear Stearns acquired
100
0
07/2007
09/2007
11/2007
01/2008
03/2008
05/2008
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.
07/2008
09/2008
59
Commercial paper issuance dries up
Quarterly change in outstanding amount, US$ billions
150
100
50
0
-50
-100
Issuers of asset-backed securities
-150
Other issuers
-200
Q1 2006 Q2 2006 Q3 2006 Q4 2006 Q1 2007 Q2 2007 Q3 2007 Q4 2007 Q1 2008 Q2 2008
Sources: Federal Reserve, Milken Institute.
60
Federal Reserve responds by cutting Fed funds rate,
but mortgage rates remain relatively flat
Percent
10
9
8
Percent
5.0
4.5
Freddie Mac 30-year
fixed rate
mortgage
rate (left axis)
30-year FRM
(left axis)
4.0
7
3.5
6
3.0
5
2.5
4
2.0
Federal funds rate (left axis)
3
1.5
2
1.0
Spread (right axis)
1
0.5
0
01/2007
0.0
03/2007
06/2007
09/2007
12/2007
Sources: Freddie Mac, Federal Reserve, Moody’s Economy.com, Milken Institute.
02/2008
05/2008
08/2008
61
Congress and White House responses
z
HOPE NOW
z
The Economic Stimulus Act of 2008
z
Housing and Economic Recovery Act of 2008
z
Conservatorship of Fannie Mae and Freddie Mac
z
Temporary guaranty program for money market funds
z
Temporary ban on short selling in selected
companies
z
Bailout package?
62
XI. When will we hit bottom?
63
Looking for a bottom?
Economists say the economy isn’t at its low point yet,
and house prices likely won’t get there until 2009
Does this feel like the bottom
to a downturn?
Yes
27%
When will home prices hit bottom?
1st half
2010
6%
2nd half
2009
29%
1st half
2009
No
73%
Source: Wall Street Journal.
38%
2nd half
2008
1st half
2008
17%
4%
64
How far do home prices have to fall?
Annual rents as percent of home prices
6.5
Q2 1971: 6.08%
6.0
5.5
5.0
Q1 2008:
3.93%
4.5
4.0
Average, 1960–Q1 2008: 5.04%
Average, 2000–Q1 2008: 4.06%
3.5
3.0
1960
Q4 2006: 3.48%
1965
1970
1975
Sources: Davisa, Lehnertb, Martin (2007), Milken Institute.
1980
1985
1990
1995
2000
2005
2010
65
Combinations of rental price growth rates and rent-to-price
ratios to get home prices back to their Q4 2006 value
Rent-to-price ratio
Annual
homehome
price price
decline
required
Annual
decline
-2.0%
-5.0%
-10.0%
-15.0%
-20.0%
3.80%
2010 Q3
2008 Q4
2008 Q2
2008 Q2
2008 Q2
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
6.00%
2026 Q4
2017 Q3
2012 Q3
2010 Q4
2009 Q4
Sources: Davisa, Lehnertb, Martin (2007), Milken Institute.
66
Alternative measures of the affordability of
mortgage debt for California
US$/month
4,000
Payment with 100% LT V
Payment with 90% LT V
Payment with 80% LT V
3,500
3,000
2,500
2,000
M ortgage payment assumptions: Every month, a home is purchased at
median price, buyer takes out a 30-year conforming, fixed-rate loan with 80%
LT V. Payment also includes 1% property tax per year, 0.1% property
insurance.
1,500
1,000
500
Maximum affortablility limit is
38% of median household
0
1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007
Sources: Moody’s Economy.com, Milken Institute.
67
XII. What went wrong
68
The importance of Fannie Mae and Freddie Mac
US$ billions
3,000
2,443
2,500
2,067
2,000
1,410
1,500
1,000
886
879
944
500
0
Fannie Mae:
total assets
Fannie Mae:
total MBS
outstanding
Sources: Freddie Mac, Fannie Mae, FDIC, Milken Institute.
Freddie Mac:
total assets
Freddie Mac: Commercial
Savings
total MBS
banks: total
institutions:
outstanding residential real
total
estate assets residential real
estate assets
69
Fannie Mae and Freddie Mac: Too big with too little capital?
US$ billions
3,000
Total assets
2,500
Total MBS outstanding
2,000
1,500
1,778
1,410
1,301
1,123
1,022
1,000
500
2,443
803 752
133
844
805
886
879
316
288
41
0
Fannie Mae Freddie Mac Fannie Mae Freddie Mac Fannie Mae Freddie Mac Fannie Mae Freddie Mac
1990
1990
2003
2003
2006
2006
2Q 2008
2Q 2008
Sources: Freddie Mac, Fannie Mae, Milken Institute.
70
Fannie Mae and Freddie Mac are highly leveraged
Mortgage book of business over capital measures
300
250
Fannie Mae
Freddie Mac
244x
200
167x
150
100
60x 60x 64x 65x
56x 58x
81x
50
48x 52x 56x
59x
55x 57x
-393x
0
Core capital
Fair value
2005
Sources: Freddie Mac, Fannie Mae, FDIC, Milken Institute.
2006
Core capital
2007
Fair value
2008Q2
71
Freddie Mac’s and Fannie Mae's retained private-label
portfolios
Subprime
Alt-A
All others
$122.2 billio
Freddie Mac, 2006
61.2%
25.0%
13.8%
$76.1 billion
Freddie Mac, 2007
57.4%
13.1%
29.5%
Fannie Mae, 2005
$86.9 billion
32.1%
37.4%
30.5%
Fannie Mae, 2006
$97.3 billion
46.4%
36.1%
17.5%
$94.8 billion
Fannie Mae, 2007
33.8%
Sources: Freddie Mac, Fannie Mae, FDIC, Milken Institute.
4.3%
32.0%
72
Leverage ratios of different types
of financial firms (June 2008)
Lev erage ratio, total assets/common equtity
Freddie Mac
67.9
21.5
Fannie Mae
23.7
Federal Home Loan Banks
31.6
Brokers/hedge funds
Savings institutions
9.4
Commercial banks
9.8
Credit unions
9.1
Sources: Federal Deposit Insurance Corporation, Office of Federal Housing Enterprise Oversight,
National Credit Union Administration, Bloomberg, Google Finance, Milken Institute.
73
Too much dependence on debt?
Leverage ratios at biggest investment banks
Total assets/total shareholder equity
40
34
35
30
2000
32
28 27
31
28
25
19 19
20
2005
33
June 2008
31
30
26
22
2007
24
24
23 22 22
18
15
10
5
0
n.a.
Bear Stearns
Merrill Lynch
Sources: Bloomberg, FDIC, Milken Institute.
Morgan Stanley Lehman Brothers Goldman Sachs
74
Most new securities issued in
2007 were rated AAA by S&P
Number of securities rated
1,000
2,000
3,000
4,000
0
AAA
AA+
AA
AAA+
A
ABBB+
BBB
BBBBB+
BB
BBB+
B
BCCC+
CCC+
CCCCC
C
D
4,090, or 51%, of new
securities rated by
S&P w ere rated AAA
Sources: Bloomberg, Inside Mortgage Finance, Milken Institute.
5,000
56 percent of MBS issued from
2005 to 2007 were eventually
downgraded
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%
BBB(+/-)
2,954
2,248
76.1%
789
683
86.6%
B(+/-)
8
7
87.5%
Total
11,261
6,310
56.0%
BB(+/-)
Note: A bond is considered investment grade if its credit rating
is BBB- or higher by S&P
75
When is a AAA not a AAA?
Multilayered mortgage products
Origination of
mortgage loans
High-grade CDO
Senior AAA
Junior AAA
AA
A
BBB
Unrated
Pool of mortgage
loans: prime or subprime
88%
5%
3%
2%
1%
1%
Mortgage bonds
AAA
AA
A
BBB
BB-unrated
80%
11%
4%
3%
2%
Sources: International Monetary Fund, Milken Institute.
Mezzanine CDO
CDO-squared
Senior AAA
Junior AAA
AA
A
BBB
Unrated
62%
14%
8%
6%
6%
4%
Senior AAA
Junior AAA
AA
A
BBB
Unrated
60%
27%
4%
3%
3%
2%
CDO-cubed…
76
Dollar losses in reported
cases of mortgage fraud
Mortgage loan fraud surges
US$ millions
Number of cases reported, thousands
60
52.9
50
1,200
1,014
1,000
946
813
37.3
40
30
600
26.0
18.4
20
400
9.5
10
0
800
1.
7
1997
2001
293
225
200
4.7 5.4
2.3 2.9 3.5
1999
429
0
2003
2005
2007
2002
Sources: Financial Crimes Enforcement Network, Federal Bureau of Investigation, Milken Institute.
2003
2004
2005
2006
2007
77
Is adequate information disclosed to consumers?
Percent of respondents who could not correctly identify various loan costs using current disclosure forms
Prepayment penalty amount
Total up-front cost amount
Property tax and homeowner’s insurance cost amount
Reason why the interest rate and APR sometimes differ
Presence of charges for optional credit insurance
Presence of prepayment penalty for refinance in two years
Loan amount
Which loan was less expensive
Whether loan amount included finances settlement charges
Interest rate amount
Balloon payment (presence and amount)
Settlement charges amount
Monthly payment (including whether it includes taxes and insurance)
Cash due at closing amount
APR amount
Sources: Federal Trade Commission, Milken Institute.
95
87
84
79
74
68
51
37
33
32
30
23
21
20
20
78
Drivers of foreclosures:
Strong appreciation or weak economies?
Foreclosures per 1,000 homes
25
Weak economies
Housing bubbles
Stockton
20
Detroit
15
Las Vegas
Cleveland
Akron
10
Atlanta
Warren
5
National average
0
-20
0
Sacramento
Toledo
Dayton
Denver
Memphis
Columbus
Indianapolis
20
Riverside
Fort Lauderdale
Bakersfield
Miami
Phoenix
Oakland
San Diego
Tampa
Fresno
Orlando
Palm Beach
40
60
80
100
120
140
Five-year price gain, Q3 2002–Q3 2007 (percent)
Sources: U.S. Treasury Department, RealtyTrac, Office of Federal Housing Enterprise Oversight, Milken Institute.
79
After housing bubble burst in 2007: Foreclosures
highest for areas with biggest price declines
Foreclosures per 1,000 homes
45
40
Collaping housing bubbles
Stockton
35
Riverside
30
Las Vegas
Bakersfield
25
Fort Lauderdale
Sacramento
20
15
Detroit
San Diego
Tampa
Palm Beach
10
W arren
5
0
-25
-20
Denver
Oakland
Phoenix
Fresno
-30
W eak
economies
strengthen
National average
-15
-10
Toledo
Miami
Akron
Orlando
Cleveland
Dayton
Columbus
-5
Atlanta
Memphis
Indianapolis
0
5
Price change, 2007–June 2008 (percent, annualized)
Sources: RealtyTrac, Office of Federal Housing Enterprise Oversight, Milken Institute.
80
XIII. Where do we go from here?
81
The U.S. regulatory regime: In need of reform?
Financial, bank and thrift
holding companies
Fannie Mae, Freddie Mac, and
Federal Home Loan Banks
• Fed
• OTS
• Federal Housing Finance
Agency
Fed is the umbrella or consolidated regulator
National banks
Primary/
secondary
functional
regulator
• OCC
• FDIC
Federal
branch
• OCC
• Host county
regulator
State commercial Federal savings Insurance
and savings banks
banks
companies
Securities
brokers/dealers
Other financial companies,
including mortgage
companies and brokers
• OTS
• FDIC
• FINRA
• SEC
• CFTC
• State securities
regulators
• Fed
• State licensing
(if needed)
• U.S. Treasury
for some products
• State bank
regulators
• FDIC
• Fed--state member
commerical banks
Foreign
branch
• Fed
• Host county
regulator
• 50 State insurance
regulators plus
District of Columbia
and Puerto Rico
Limited foreign
branch
• OTS
• Host county
regulator
Sources: Financial Services Roundtable (2007), Milken Institute.
Notes:
Justice Department: Assesses effects of mergers and acquisitions on competition
Federal Courts: Ultimate decider of banking, securities, and insurance products
CFTC: Commodity Futures Trading Commission
FDIC: Federal Deposit Insurance Corporation
Fed: Federal Reserve
FINRA: Financial Industry Regulatory Authority
GSEs: Government Sponsored Enterprises
OCC: Comptroller of the Currency
OTS: Office of Thrift Supervision
SEC: Securities and Exchange Commission
82
Many different options and innovations…
Covered Bonds
Alternative Mortgage Products
Shared Equity Mortgages
Real Estate Derivatives
Classical Insurance Products
Others
83
Demystifying the Mortgage Meltdown:
What It Means for Main Street,
Wall Street and the U.S. Financial System
James R. Barth
Senior Fellow
Glenn Yago
Director of Capital Studies
Milken Institute
October 2, 2008
84