fascinating report on the housing and economic crisis and why there is more pain to come

8/9/2019 Fascinating Report on the Housing and Economic Crisis and Why There is More Pain to Come

http://slidepdf.com/reader/full/fascinating-report-on-the-housing-and-economic-crisis-and-why-there-is-more 1/203

An Overview of the Housing and Economic Crisis

– and Why There Is More Pain to Come

T2 Accredited Fund, LPTilson Offshore Fund, Ltd.

T2 Qualified Fund, LP

February 1, 2010

The latest version of this presentation is regularly updated at www.valueinvestingcongress.com



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Manages Hedge Funds and Mutual Funds

and is a Registered Investment Advisor

145 E. 57th Street, 10th Floor

New York, NY 10022

(212) 386-7160

[email protected]

www.T2PartnersLLC.com



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 happenedand why, where we are today, and what thefuture likely holds.



For More Details, See Our Book:

More Mortgage Meltdown



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What Happened?



For the Second Half of the 20th Century,

Housing Was a Stable Investment

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.

100

125

150

175

200

225

250

275

300

1 9 5 0

1 9 5 4

1 9 5 8

1 9 6 2

1 9 6 6

1 9 7 0

1 9 7 4

1 9 7 8

1 9 8 2

1 9 8 6

1 9 9 0

1 9 9 4

1 9 9 8

R e a l H o m e P r i c e I n d e x ( 1 8

9 0 = 1 0 0 )

Shiller

Lawler

Trend Line

http://www.econ.yale.edu/~shiller/data.htm

http://www.econ.yale.edu/~shiller/data.htm



…And Then Housing Prices Exploded

Sources: Robert J. Shiller, Irrational Exuberance: Second Edition, as updated by the author; Lawler Economic & Housing Consulting.

100

125

150

175

200

225

250

275

300

1 9 5 0

1 9 5 4

1 9 5 8

1 9 6 2

1 9 6 6

1 9 7 0

1 9 7 4

1 9 7 8

1 9 8 2

1 9 8 6

1 9 9 0

1 9 9 4

1 9 9 8

2 0 0 2

2 0 0 6

R

e a l H o m e P r i c e I n d e x ( 1

8 9 0 = 1 0 0 )

Shiller

Lawler

Trend Line

HousingBubble

P i E l d d B th B i



Prices Exploded Because the BorrowingPower of a Typical Home Purchaser MoreThan Tripled from 2000-2006

Source: Amherst Securities.

$0

$100,000

$200,000

$300,000

$400,000

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

Pre-Tax Income

Borrowing Power

3.3x in January 2000

9.2x in January 2006

Factors contributing to the ability to borrow more andmore were:

1. Lenders were willing to allow much higherdebt-to-income ratios

2. Interest-only mortgages (vs. full amortizing)

3. No money down4. Low- and no-documentation loans, which led

to widespread fraud5. Slowly rising income6. Falling interest rates

A i H B d H il A i t Th i H S h Th t



Americans Have Borrowed Heavily Against Their Homes Such Thatthe Percentage of Equity Has Fallen Below 50% for the First TimeThere still appears to be substantial equity protecting the debt – but this is misleading. Given that 1/3 of homes

have no mortgage (i.e., 100% equity), the remaining homes have only 16% equity. A further 10% decline in

home prices would, on average, leave little equity cushion to support U.S. mortgage debt.

Source: Federal Reserve Flow of Fund Accounts of the United States.

$0

$2,000

$4,000

$6,000

$8,000

$10,000

$12,000

1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

M o r t g a g e

D e

b t ( B n )

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

E q u

i t y a s a % of H om eV al u e

1945Mortgage Debt: $18.6 billionEquity: $97.5 billion

Q309Mortgage Debt: $10.3 trillionEquity: $7.9 trillion

H i B U ff d bl i M A U i



Housing Became Unaffordable in Many Areas Using

a Typical 30-Year Fixed-Rate Mortgage, Which Led

Many Borrowers to Take Exotic Mortgages

Sources: NAHB/Wells Fargo Housing Opportunity Index, which measures percentage of households that could afford the average home with a standard mortgage.

0

10

20

30

40

50

60

70

80

Q 1 1 9 9

6

Q 1 1 9 9

7

Q 1 1 9 9

8

Q 1 1 9 9

9

Q 1 2 0 0

0

Q 1 2 0 0

1

Q 1 2 0 0

2

Q 3 2 0 0

4

Q 3 2 0 0

5

Q 3 2 0 0

6

Q 3 2 0 0

7

H o u s i n g O p p o r t u n i t y

I n d e x

Riverside, CA

Los Angeles, CA

San Diego, CA



There Was a Dramatic Decline in Mortgage

Lending Standards from 2001 through 2006

• In 2005, 29% ofnew mortgageswere interest only

— or less, in thecase of OptionARMs — vs. 1%in 2001

• In 1989, theaverage downpayment for first-time home buyerswas 10%; by2007, it was 2%

• The sale of new

homes costing$750,000 or morequadrupled from2002 to 2006. Theconstruction ofinexpensivehomes costing$125,000 or less

fell by two-thirds

74

74

76

81

83

84

81

68

70

72

74

76

78

80

82

84

86

2001 2002 2003 2004 2005 2006 2007

CmnLoVu%)

1%1%

3%

9%

14%

17%

8%

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

2001 2002 2003 2004 2005 2006 2007

P

oOrgno

33%

39%

45%

49%

56%

63%65%

0%

10%

20%

30%

40%

50%

60%

70%

2001 2002 2003 2004 2005 2006 2007

P

oOrgno

0%0%

1%

4%

8%

11%

5%

0%

2%

4%

6%

8%

10%

12%

2001 2002 2003 2004 2005 2006 2007

P

oOrgno

Combined Loan to Value 100% Financing

Limited Documentation 100% Financing & Limited Doc

Sources: Amherst Securities, LoanPerformance; USA Today (www.usatoday.com/money/economy/housing/2008-12-12-homeprices_N.htm).



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 updefaulting 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 ina Residential Mortgage-Backed Security (RMBS), which was then sliced intonumerous tranches that were sold to investors around the world. This entire processwas extraordinarily profitable for all involved, especially the Wall Street firms and therating 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 homeownerdefaulted, 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 ofquick money to be made

There were many other reasons, of course – a bubble of this magnitude requireswhat 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, notwant to take the punch bowl away and/or get bought off by the industries they weresupposed 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 moneybeing made



When Home Price Appreciation Slows,

Loss Severity Skyrockets

Sources: LoanPerformance; OFHEO; Deutsche Bank; “Who's Holding the Bag?”, Pershing Square presentation, 5/23/07.

The assumption of perpetuallyrapidly rising home prices ledlenders to give virtually anyone a

loan because even if theydefaulted, the home could simplybe resold with little or no loss.

17

A L A H P i Ri R idl E P l



As Long As Home Prices Rise Rapidly, Even Poolsof Bubble-Era Subprime Mortgages Perform Well– But If Home Prices Fall, Look Out Below!

Source: T2 Partners estimates.

0%

10%

20 %

30 %

40 %

50 %

60 %

20% 15% 10% 5% 0% -5% -10% -15% -20% -25% -30% -35% -40%

Home Price A ppreciation

CmavL%)

Cumulative Five-Year Loss Estimates for a Bubble-Era Pool of Subprime Mortgages



The Enormous Amounts of Money to Be

Made Corrupted Our Financial System

The #1 Immutable Law of the Universe

If you offer people a lot of money to do something, nomatter how foolish, unethical or illegal, a largenumber of them will do it

– Corollary #1: The more money to be made, the more badbehavior that will occur

– Corollary #2: The people engaged in such behavior willrationalize it such that they genuinely believe that whatthey’re doing isn’t foolish, unethical or illegal

The #2 Immutable Law of the Universe

Bad behavior leads to bad consequences

19

D l i f h Fi i l S L d



Deregulation of the Financial Sector Led to a

Surge of Compensation, Leverage and Profits

Source: Ariell Reshef, University of Virginia; Thomas Philippon, NYU; Wall St. Journal, 5/14/09.

Ratio of Financial Services Wages to Nonfarm Private-Sector Wages, 1910-2006

Over the Past 30 Years We Have Become



21Sources: Federal Reserve, BEA, as of Q2 2007, GMO presentation.

Low Debt Era Rising Debt Era

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

51 54 57 60 63 66 69 72 75 78 81 84 87 90 93 96 99 02 05

F i n a n c i a l P r o f i t s a s P e

r c e n t o f G D P

100%

150%

200%

250%

300%

350%

T o t al D e b

t a sP er c en t of GD P

Dec-

Total Debt

Financial Profits

Over the Past 30 Years, We Have Becomea Nation Gorged in Debt – To The Benefitof Financial Services Firms

P fit d W i th Fi i l S t



Profits and Wages in the Financial Sector

Soared from 1980 Onward

Source: Moody’s Economy.com, NY Times, 12/18/08. 22



23

Wall Street Firms Were Making a Fortune

Securitizing Loans

• Among the most profitable areas for Wall Streetfirms was producing Asset-Backed Securities(ABSs) and Collateralized Debt Obligations (CDOs)

• To produce ABSs and CDOs, Wall Street needed alot of loan “product”

• Mortgages were a quick, easy, big source

• It is easy to generate higher and higher volumes ofmortgage loans: simply lend at higher loan-to-valueratios, with ultra-low teaser rates, to uncreditworthy

borrowers, and don’t bother to verify their incomeand assets (thereby inviting fraud)

• There’s only one problem:

DON’T EXPECT TO BE REPAID!

M W P l d i RMBS



Mortgages Were Pooled into RMBSs,

Tranches of Which Were Pooled into CDOs

This is an example of a“Mezzanine CDO.” A“High-Grade CDO” wouldselect collateral primarilyfrom the A and AAtranches mixed with~25% senior tranches

from other, oftenmezzanine, CDOs

Note: Asset-based securities backed by home mortgages are called Residential Mortgage-Backed Securities (RMBS), those backed by commercial real estate loansare called Commercial Mortgage-Backed Securities (CMBS), etc. Source: Citigroup, All Clogged Up: What’s Ailing the Financial System , 2/13/08.

Loss rates of, say, 20%,in the underlyingRMBS’s can lead tocatastrophic losses for aCDO

Equity

BB B

BB B

BB B

BB B

BB B

BB B

BB B

BB B

BB B

BB B

BB B

BB B

BB B

Equity

BB B

Equity

A

BBB- A

BB B

A

A

A

AA

AA

AA

AA A

AA A

AA A

Super

Senior

0%

10%

20 %

30 %

40 %

50 %

60 %

70 %

80 %

90 %

100%

RMBS CDO Composition CDO Rating

24

A Case Study of Wall Street



A Case Study of Wall StreetCompensation Run Amok:Stan O’Neal, Dow Kim & the Mortgage Team at Merrill Lynch

Source: On Wall Street, Bonuses, Not Profits, Were Real , NY Times, 12/18/08.

25



The Rating Agencies Were Making a Fortune

Rating Structured Finance Products

$10.00

$20.00

$30.00

$40.00

$50.00

$60.00

$70.00

2003 2004 2005 2006

Moody’s Stock Price Reflected Its Surge in Profits

Source: Yahoo! Finance.26



Greenspan Kept Interest Rates Too Low for

Too Long, Which Fueled the Housing Bubble

0

1

2

3

4

5

6

7

Jan-99

Jul-9

9

Jan-00

Jul-0

0

Jan-01

Jul-0

1

Jan-02

Jul-0

2

Jan-03

Jul-0

3

Jan-04

Jul-0

4

Jan-05

Jul-0

5

Jan-06

Jul-0

6

Jan-07

Jul-0

7

Jan-08

Jul-0

8

Jan-09

IneeRe%)

Source: Federal Reserve Bank of St. Louis.27

Extended period of ultra-lowinterest rates



Background on the U.S. Housing Market

Th W S f T i M



29

There Was a Surge of Toxic Mortgages

From 2000 to Mid-2007

Source: Inside Mortgage Finance , published by Inside Mortgage Finance Publications, Inc. Copyright 2009.

$0

$500

$1,000

$1,500

$2,000

$2,500

$3,000

$3,500

$4,000

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

O r i g i n a t i o n s ( B n )

Conforming, FHA/VA

Jumbo

Alt-A

Subprime

Seconds

Private Label Mortgages (Those Securitized by



30

Private Label Mortgages (Those Securitized byWall St.) Are 15% of All Mortgages, But Account

for 28% of Nonperforming Mortgages

15% of the mortgages that weresent to Wall Street account for 28%of the nonperforming loans

Source: Inside Mortgage Finance.

Approximately two-thirds of homes – 56 million – have mortgages, worth a total of $11 trillion

Agency MBS$5.2T

Private Label

Universe$1.7T

Unsecuritized$4.0T

More Than 14% of Mortgages on 1-to-4 Family Homes



31

More Than 14% of Mortgages on 1 to 4 Family Homes

Were Delinquent or in Foreclosure as of Q3 2009

Source: National Delinquency Survey, Mortgage Bankers Association; T2 Partners estimates. Note: Delinquencies (30+ days) are seasonally adjusted.

4%

6%

8%

10%

12%

14%

16%

P e r c e n t a g e o f H o m e

L o a n s

All T f L A S i S i



32

All Types of Loans Are Seeing a Surge in

Delinquencies, Led by Subprime

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

Q 1 1 9 9

9

Q 3 1 9 9

9

Q 1 2 0 0

0

Q 3 2 0 0

0

Q 1 2 0 0

1

Q 3 2 0 0

1

Q 1 2 0 0

2

Q 3 2 0 0

2

Q 1 2 0 0

3

Q 3 2 0 0

3

Q 1 2 0 0

4

Q 3 2 0 0

4

Q 1 2 0 0

5

Q 3 2 0 0

5

Q 1 2 0 0

6

Q 3 2 0 0

6

Q 1 2 0 0

7

Q 3 2 0 0

7

Q 1 2 0 0

8

Q 3 2 0 0

8

P e r c e n t N o n c u r r

e n t

Alt A

Option ARM

Jumbo

Subprime

Prime

Home Equity Lines of Credit

Sources: Amherst Securities, LoanPerformance; National Delinquency Survey, Mortgage Bankers Association; FDIC Quarterly Banking Profile;T2 Partners estimates. Note: Prime is seasonally adjusted.



An Examination of Subprime,

Prime and Alt-A Loans

The Decline in Lending Standards Led to a



34

The Decline in Lending Standards Led to a

Surge in Subprime Mortgage Origination

Source: Reprinted with permission; Inside Mortgage Finance, published by Inside MortgageFinance Publications, Inc. Copyright 2009.

10%9%

9%

10%9%

10%10%

7%

7%

8%

18%

20%

20%

8%

$0

$100

$200

$300

$400

$500

$600

$700

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Originations

(Bn)

0%

5%

10%

15%

20%

25%

% of

Total

The Wave of Resets from Subprime



35

$0

$5

$10

$15

$20

$25

$30

$35

Jan-06

Apr-06

Jul-0

6

Oct-06

Jan-07

Apr-07

Jul-0

7

Oct-07

Jan-08

Apr

-08

Jul-0

8

Oct-08

Jan-09

Apr-09

Jul-0

9

Oct-09

Jan-10

Apr

-10

Jul-1

0

Oct-10

L

whPmeS

B

Sources: LoanPerformance, Deutsche Bank; slide from Pershing Square presentation, How to Save the Bond Insurers, 11/28/07.

The Wave of Resets from Subprime

Loans Is Mostly Behind Us

We are

here

The Mortgage Crisis is Shifting From One in



36Sources: Amherst Securities.

The Mortgage Crisis is Shifting From One inWhich Defaults Are Driven by Resets to BorrowersLosing Their Jobs and/or Going Underwater

Example:First-lien

mortgages inCalifornia thatwere originated in2006 went from$165,000 ofequity to anaverage negative equity of$149,000 bySept. 2009.The cumulative

default ratetracked this lossof equity, risingfrom 1.0% to48.5%. 0%

10%

20%

30%

40%

50%

60%

J a n - 0 7

M a r - 0 7

M a y - 0 7

J u l - 0 7

S e p - 0 7

N o v - 0 7

J a n - 0 8

M a r - 0 8

M a y - 0 8

J u l - 0 8

S e p - 0 8

N o v - 0 8

J a n - 0 9

M a r - 0 9

M a y - 0 9

J u l - 0 9

S e p - 0 9

C u m u l a t i v e D e f a u l t %

($250,000)

($200,000)

($150,000)

($100,000)

($50,000)

$0

$50,000

$100,000

$150,000

$200,000

E q u i t y R e l a t i v e T o F i r s t L

i e n ( $ )

Equity Relative to First Lien(Right Axis Inverted)

Cumulative Default (Left Axis)

2006 Origination California Mortgages

The Mortgage Meltdown Has Moved



37

The Mortgage Meltdown Has Moved

Beyond Subprime to Five Other Areas

Sources: Federal Reserve Flow of Funds Accounts of the United States, IMF Global Financial Stability Report October 2008, Goldman Sachs Global EconomicsPaper No. 177, FDIC Quarterly Banking Profile, OFHEO, S&P Leverage Commentary & Data, T2 Partners estimates.

$0.0 $0.5 $1.0 $1.5 $2.0 $2.5 $3.0 $3.5 $4.0 $4.5 $5.0

CDO/ CLO

Other Consumer

Construction & Development

Option ARM

Auto

Credit Card

Home Equity

Jumbo Prime

High-Yield / Leveraged Loans

Subprime

Commercial & Industrial

Other Corporate

Alt-A

Commercial Real Estate

Prime Mortgage

Amount Outstanding (Trillions)

For further details about Jumbo Prime, HELOCs and Option ARMs, see the Appendix

Subprime is only a small

part of the problem

Delinquencies of Prime and Alt A



38

Delinquencies of Prime and Alt-A

Mortgages Are Soaring

Source: New York Times, 5/24/09.

Delinquencies of Prime Mortgages



39

Delinquencies of Prime Mortgages

Are Soaring

Source: Mortgage Bankers Association National Delinquency Survey.

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

4.5%

5.0%

Q 1 1 9 9

9

Q 3 1 9 9

9

Q 1 2 0 0

0

Q 3 2 0 0

0

Q 1 2 0 0

1

Q 3 2 0 0

1

Q 1 2 0 0

2

Q 3 2 0 0

2

Q 1 2 0 0

3

Q 3 2 0 0

3

Q 1 2 0 0

4

Q 3 2 0 0

4

Q 1 2 0 0

5

Q 3 2 0 0

5

Q 1 2 0 0

6

Q 3 2 0 0

6

Q 1 2 0 0

7

Q 3 2 0 0

7

Q 1 2 0 0

8

Q 3 2 0 0

8

P e r c e n t N o n c u r r e n t ( 6 0 + d a y s )



There Is a Surge of Notices of Default and



42

There Is a Surge of Notices of Default and

Foreclosures Among the GSEs

Prime Notices of Default

Subprime Notices of Default

Prime ForeclosuresSubprime Foreclosures

Source: The Field Check Group.

The Foreclosure Problem Is No Longer



43

The Foreclosure Problem Is No Longer

Only a Bubble State Phenomenon

Source: New York Times, 5/24/09.

15 States With the Highest Prime Mortgage Foreclosure Rates

Delinquencies of Securitized Alt-A



44

Delinquencies of Securitized Alt-A

Mortgages Are Soaring

Sources: Amherst Securities, LoanPerformance.

0%

5%

10%

15%

20%

25%

J a n -

9 9

J u l - 9

9

J a n -

0 0

J u l - 0

0

J a n -

0 1

J u l - 0

1

J a n -

0 2

J u l - 0

2

J a n -

0 3

J u l - 0

3

J a n -

0 4

J u l - 0

4

J a n -

0 5

J u l - 0

5

J a n -

0 6

J u l - 0

6

J a n -

0 7

J u l - 0

7

J a n -

0 8

J u l - 0

8

J a n -

0 9

P e r c e n t N o n c u r r e n t ( 6

0 + d a y s )

Alt A Delinquencies By Vintage Show the



45

Alt-A Delinquencies By Vintage Show the

Collapse in Lending Standards in 2006 and 2007


0%

5%

10%

15%

20%

25%

30%

0 5 10 15 20 25 30 35 40 45 50 55 60

Months of Seasoning

P e r c e n t N o n c u r r e n t ( 6

0 + d a y s )

2007 2006

2005

2004

2003

There Are $2 4 Trillion of Alt-A Mortgages --



46

There Are $2.4 Trillion of Alt-A Mortgages --

And Their Resets Are Mostly Ahead of Us

$0

$1

$2

$3

$4

$5

$6

$7

$8

$9

$10

J a n -

1 0

J u l - 1

0

J a n -

1 1

J u l - 1

1

J a n -

1 2

J u l - 1

2

J a n -

1 3

J u l - 1

3

J a n -

1 4

J u l - 1

4

J a n -

1 5

J u l - 1

5

A m o u n

t ( B n )

$ 0

$ 5 0

$ 1 0 0

$ 1 5 0

$ 2 0 0

$ 2 5 0

$ 3 0 0

E s t i m a t e d C u

m ul a t i v eR e s e t A m o un t

( B n )

We are

here

Sources: Credit Suisse, LoanPerformance.

NOTE: This chart only shows resets for a small fraction of Alt-A loans, but is representative of all of them.

Two Waves of Losses Are Behind Us



47

Two Waves of Losses Are Behind Us…

But Three Are Looming

Losses Mostly Behind Us• Wave #1: Borrowers committing (or the victim of) fraud, as well as

speculators, who defaulted quickly. Timing: beginning in late 2006 (assoon as home prices started to fall) into 2008. Mostly behind us.

• Wave #2: Mostly subprime borrowers who defaulted when theirmortgages reset due to payment shock. Timing: early 2007 (as two-year teaser subprime loans written in early 2005 started to reset) to thepresent. Now tapering off as low interest rates mitigate payment shock.

Losses Mostly Ahead of Us• Wave #3: Prime loans (most of which are owned or guaranteed by the

GSEs) defaulting due to job loss and home price declines (i.e.,underwater homeowners). Timing: started to surge in early 2008 to thepresent.

• Wave #4: Jumbo prime, second lien and HELOCs (most of which areon banks’ books) defaulting due to job loss and home price declines/ underwater homeowners. Timing: started to surge in early 2008 to thepresent.

• Wave #5: Losses among loans outside of the housing sector, thelargest of which will be in the $3.5 trillion area of commercial real estate.

Timing: started to surge in early 2008 to the present.



48

Why Won’t the System Collapse Again?

Given that the three looming waves are much larger than the two that are mostly behind us, why

won’t they trigger a collapse of our financial system similar to what happened in late 2008?Answer: Last year’s collapse was triggered in part by the magnitude of the losses, but alsobecause of the suddenness. Financial institutions can withstand even large losses if they trickle in overtime because they can offset losses each quarter with profits earned during the quarter – but this isn’tpossible if losses are sudden.

The suddenness of last year’s losses was due in part to rapidly rising defaults, especially amongsubprime mortgages, but in fact, realized losses were still quite low. The real culprit was the fact thatmost subprime loans had been securitized into RMBSs and CDOs, turning them into tradable debtinstruments.

According to GAAP accounting rules, traded instruments like stocks and bonds have to be markedto market, and in only a few months in 2008, the market price for hundreds of billions of dollars of AAA-rated RMBS and CDO securities went from close to 100 cents on the dollar to the 20-30 cent range(even though the underlying pools of mortgages hadn’t yet realized much in the way of losses). Thisrequired every institution holding these securities to immediately book enormous losses, which causedmany of them to collapse.

Why did Merrill Lynch, Citigroup, Lehman and Bear Stearns fall, but Wells Fargo didn’t? BecauseWells had almost nothing on its balance sheet that had to be marked to market.

Big mark to market losses are now behind us, so it’s unlikely that there will be any sudden shocks

to the system. Instead, hundreds of billions of dollars of additional losses from trillions of dollars of badloans will be realized over many, many years.

This is both good news and bad news: the good news is that while future losses will surelybankrupt many banks, especially smaller ones exposed to commercial real estate, they likely won’tthreaten the system because banks are earning so much money currently that most should be able tooutrun their losses.

The bad news is that very high losses will plague our financial system for many years to come – our best guess is current extremely high levels for another two years, and then slowly declining for threemore years before finally returning to normal levels in five years. This drip torture of high losses every

quarter, year after year, will likely keep banks extremely cautious in their lending, making robusteconomic growth unlikely.

The Housing Crisis is Shifting in a



49

The Housing Crisis is Shifting in a

Number of Ways

First Stage of Collapse1. Subprime & fraudulent loans

account for most defaults

2. Defaults driven by loansresetting

3. Defaults mainly in sand and ruststates

4. Mark-to-market losses due tobad loans being securitized

5. Little government intervention

Current Stage1. Prime, Alt-A and other loans to

better borrowers drive defaults

2. Defaults driven by job losses andunderwater mortgages

3. Defaults occurring across a broadswath of the country

4. Losses from on-balance-sheetloans (not marked to market)

5. Massive government intervention



Current Status of the Housing Market



The Delinquency and Foreclosure Problem



52

The Delinquency and Foreclosure Problem

Has Spread Far Beyond the Bubble States

Source: LPS Applied Analytics, WSJ 10/22/09.

Credit Suisse Predicts More Than 6 Million



Additional Foreclosures by the End of 2012

Sources: Credit Suisse, 9/08; http://calculatedrisk.blogspot.com 53

This chart is quite dated, butaccurately shows how theforeclosure crisis is shifting

away from subprime.

Existing Homes Sales Have Risen in Recent Months, Leading

http://calculatedrisk.blogspot.com/

http://calculatedrisk.blogspot.com/



54

to a Decline in Inventory – But Inventory Is Still Well AboveHistorical Levels – And Shadow Inventory Lurks

Source: NATIONAL ASSOCIATION OF REALTORS® Existing Home Sales data series; estimates prepared for TheWall Street Journal by LPS Applied Analytics, WSJ, 9/23/09

Months SupplyAnnualized Rate of Existing Home Sales

Actual inventory levels are significantly higher due to “shadow inventory.” “As of July, mortgage companieshadn't begun the foreclosure process on 1.2 million loans that were at least 90 days past due…Anadditional 1.5 million seriously delinquent loans were somewhere in the foreclosure process, though thelender hadn't yet acquired the property…Moreover, there were 217,000 loans where the borrower hadn'tmade a payment in at least a year but the lender hadn't begun the foreclosure process. In other words, 17%of home mortgages that are at least 12 months overdue aren't in foreclosure, up from 8% a year earlier.”

4.0

4.5

5.0

5.5

6.0

6.5

7.0

7.5

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

M i l l i o n

s

5.5 million units as of theend of December 2009

3

4

5

6

7

8

9

10

11

12

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

M o n t h

s

3.2 million units, equal to 7.2 months

as of the end of December 2009

Thanks to Massive Government Stimulus (Mainly the FHA & the$8 000 First Time Homebuyers Tax Credit) Sales from June



55

$8,000 First-Time Homebuyers Tax Credit), Sales from June-Sept. 2009 Were Higher Than 2008, But This May Not Last

Source: Mark Hanson Advisors.

Note how seasonal home sales are

Thanks to Massive Government Stimulus (Mainly the FHA & the$8 000 First Time Homebuyers Tax Credit) Sales from June



56

$8,000 First-Time Homebuyers Tax Credit), Sales from June-Sept. 2009 Were Higher Than 2008, But This May Not Last

Source: Mark Hanson Advisors.

Note how seasonal home sales are

Organic sales are highly seasonal,while distressed sales are have fallenin recent months due to loan mods

Inventory is Moving at the Low End, But As theHi h E d Ti O S l A F lli d



57

High End Tips Over, Sales Are Falling and

Inventories Are Ballooning

Sources: JP Morgan; CA Assoc. of Realtors (left chart); National Assoc. of Realtors via Moody’s Economy.com, WSJ 6/22/09 (right chart).

Months Inventory in CA By Home Price

Another example: based on the rate of sales over the seven months ending in May2009, there is five years of housing inventory in Greenwich, CT

Sudbury, MA (July data)

Months ofPrice Inventory>$250K 6

$250-500 8$500-750 5$750-1M 14$1M+ 51

Defaults Are Massively OutpacingLiquidations So the Inventory



58

Liquidations, So the InventoryOverhang Continues to Worsen

Note: This data is based on approximately 28 million loans. Total first-time defaults are running at 300,000/month.

Source: First American CoreLogic Loan-Level Servicing Data, Amherst Securities.

First time defaults

Liquidations

Defaulted Mortgages Are Taking Longer to



59

g g g g

Liquidate, Adding to the Inventory Overhang

Source: First American CoreLogic Loan-Level Servicing Data, Amherst Securities.

Cure Rates Have Fallen Such That Once aHomeowner Misses Two Payments A



60

Homeowner Misses Two Payments, AForeclosure Is Almost Inevitable

Source: Loan Performance, Amherst Securities.

The Current “Housing Overhang” Is 7 Million Homes –Whi h D s ’t I l d A N D f lts Whi h A



61

Which Doesn’t Include Any New Defaults, Which Are

Running at Approximately 300,000/Month!

Source: Mortgage Bankers Association, Loan Performance, Amherst Securities.

Shadow Inventory for Each of the 20 Cities



62

y

in the Case-Shiller Index

Note: Notice of Default data is incomplete or missing for many cities.Source: www.trulia.com, Amherst Securities.



Outlook for Housing Prices

Home Prices Were in an Unprecedented



64

Freefall Until A Slight Bounce in Q209

Sources: Standard & Poor’s, OFHEO Purchase-Only Index, NATIONAL ASSOCIATION OF REALTORS® Existing Home Sales data series.

100

120

140

160

180

200

220

Q 1 2 0 0

0

Q 3 2 0 0

0

Q 1 2 0 0

1

Q 3 2 0 0

1

Q 1 2 0 0

2

Q 3 2 0 0

2

Q 1 2 0 0

3

Q 3 2 0 0

3

Q 1 2 0 0

4

Q 3 2 0 0

4

Q 1 2 0 0

5

Q 3 2 0 0

5

Q 1 2 0 0

6

Q 3 2 0 0

6

Q 1 2 0 0

7

Q 3 2 0 0

7

Q 1 2 0 0

8

Q 3 2 0 0

8

Q 1 2 0 0

9

S&P/Case-Shiller U.S. National Home Price Index

S&P/Case-Shiller 20-City Composite

OFHEO Purchase-Only Index

NAR Median Sales Price of Existing Homes

Home Prices Look Affordable Due to Price



65

Declines and Ultra-Low Interest Rates

Source: Case-Shiller, Bureau of Labor Statistics, Amherst Securities.

0

100

200

300

400

500

600

700

800

I n d e x V a l u e

Date

CASE SHILLER USA (1975 = 100)

Modeled Home Prices - Interest Only

Modeled Home Prices - 30yr Fully Amortizing

The Housing Affordability Index Shows



66

Houses Are Now Affordable

14

16

18

20

22

24

26

1 9 8 9

1 9 9 0

1 9 9 1

1 9 9 2

1 9 9 3

1 9 9 4

1 9 9 5

1 9 9 6

1 9 9 7

1 9 9 8

1 9 9 9

2 0 0 0

2 0 0 1

2 0 0 2

2 0 0 3

2 0 0 4

2 0 0 5

2 0 0 6

2 0 0 7

2 0 0 8

2 0 0 9

M o r t g a g e

P a y m e n

t o n

M e

d i a n

P r i c e

d

H o m e a s

% o

f F a m

i l y

I n c o m e

Before concluding that houses are cheap, however, there are three big caveats: first, low ratesare only available to those who qualify for conforming mortgages, which doesn’t help millions ofhomeowners or potential homeowners who have spotty credit histories or are underwater on theircurrent mortgages. Second, with low enough interest rates, almost anything looks affordable; ifrates rise, houses won’t look so reasonably priced based on these metrics. Finally, in light of thesevere economic downturn, average income may fall for quite some time.

Source: NATIONAL ASSOCIATION OF REALTORS® Housing Affordability Index.

Home Prices Need to Fall Another 5-10%



67

to Reach Trend Line

Sources: Robert J. Shiller, Irrational Exuberance: Second Edition, as updated by the author; Lawler Economic & Housing Consulting, T2 estimates.

100

125

150

175

200

225

250

275

300

1 9 5 0

1 9 5 4

1 9 5 8

1 9 6 2

1 9 6 6

1 9 7 0

1 9 7 4

1 9 7 8

1 9 8 2

1 9 8 6

1 9 9 0

1 9 9 4

1 9 9 8

2 0 0 2

2 0 0 6

2 0 0 9

R e a l H o m e P r i c e I n d e x

( 1 8 9 0 = 1 0 0 )

Shiller

Lawler

Trend Line

HousingBubble

GMO’s Study of Bubbles Shows That Allf Th E t ll R t t T d Li



68

of Them Eventually Return to Trend Line34 Have Returned to Trend; the Only Exception, British Housing, Is On Its Way

StocksS&P 5001920-1932

0.3

0.8

1.3

1.8

2.3

202122232425262728 293031

D e t r e n d e d R e a l P r i c e

Trend Line

S&P 5001946-1984

0.0

0.5

1.0

1.5

2.0

2.5

46 50 54 58 62 66 70 74 78 82


Trend Line

Japan vs. EAFE ex-Japan1981-1999

0.0

0.5

1.0

1.5

2.0

2.5

3.0

81 83 85 87 89 91 93 95 97 99

R e l a t i v e R e t u r n

Trend Line

S&P 5001992-October 2008

0.8

1.2

1.6

2.0

2.4

92 94 96 98 00 02 04 06 08


Trend Line

CurrenciesU.S. Dollar1979-1992

0.8

1.0

1.2

1.4

1.6

1.8

2.0

79 81 83 85 87 89 91

C u m u l a t i v e R e t u r n

U.K. Pound1979-1985

0.8

0.9

1.0

1.1

1.2

1.3

1.4

79 80 81 82 83 84


Japanese Yen1983-1990

0.8

0.9

1.0

1.1

1.2

1.3

1.4

83 84 85 86 87 88 89 90


Japanese Yen1992-1998

0.8

0.9

1.0

1.1

1.2

1.3

1.4

92 93 94 95 96 97


CommoditiesGold

1970-1999

0

400

800

1200

1600

2000

70 74 78 82 86 90 94 98

R e a l P r i c e

Crude Oil1962-1999

0

20

40

60

80

62 66 70 74 78 82 86 90 94 98

R e a l P r i c e

Nickel1979-1999

0

50

100

150

200

250

79 81 83 85 87 89 91 93 95 97

R e a l P r i c e

Cocoa1970-1999

0

100

200

300

400

500

600

70 74 78 82 86 90 94 98

R e a l P r i c e

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.

12 Examples

GMO calls this “the greatest sucker’s rally in history”

The Biggest Danger is That Home PricesOvershoot on the Downside, Which Often



69

Overshoot on the Downside, Which OftenHappens When Bubbles Burst

S&P 500 1927-1954

S&P 500 1955-1986

0.00

0.25

0.50

0.75

1.00

1.25

1.50

1.75

2.00

2.25

2.50

1927 1930 1933 1936 1939 1942 1945 1948 1951 1954

D e

t r e n

d e

d R e a

l S

& P 5 0 0 S t o c

k P r i c e

I n d e x

-59%

Overrun: 59%Fair Value to Bottom: 1.5 Years

Fair Value to Fair Value: 23 Years

0.00

0.25

0.50

0.75

1.00

1.25

1.50

1.75

2.00

2.25

1955 1957 1959 1961 1963 1965 1967 1969 1971 1973 1976 1978 1980 1982 1984 1986

D e t r e n d e d R e a l S &

P 5 0 0 S t o c k P r i c e I n d e x

-45%

Overrun: 45%Fair Value to Bottom: 7 Years

Fair Value to Fair Value: 12 Years

Source: GMO LLC, T2 Partners calculations.

Recent Signs of Stabilization Are Likely



70

the Mother of All Head Fakes

Rather than representing a true bottom, recent signs of stabilization are likely due to seven factors that

are (or are likely to be) short-term:1. Ultra-low interest rates2. The homebuyer tax credit

– In November it was extended until April 30th

– $8,000 for first-time homebuyers and $6,500 to homeowners who have lived in their current home for at least five years – Current cost: $1 billion/month

3. More middle- and upper-end homes are being sold (either voluntarily or via foreclosure), which has the effect ofraising the price at which the average home is sold – but more defaults of higher priced homes is very bad newsfor mortgage holders

4. A decline in resets (which will ramp up again over the next few years)

5. A temporary reduction in the inventory of foreclosed homes – There are currently big delays in foreclosures due to four reasons (in descending order of importance): A) Loan modifications via the

HAMP program; B) Political pressure on banks and servicers; C) The system is overwhelmed with the unprecedented volume ofdefaulting homeowners; and D) Some banks, weakened by losses, may be motivated to drag out the process so that losses/write-downs can be delayed, giving them more time to earn their way out of trouble.

– “For now, the delays have led to what is probably a temporary drop in the supply of bank-owned homes in California and other placeswhere investors and first-time home buyers have been competing for bargains. In Orange County, Calif., the number of bank-ownedhomes listed for sale dropped to 322 in early September from 1,404 in November 2008, according to Altera Real Estate. But thenumber of foreclosures is expected to increase in the fourth quarter as mortgage-servicing companies determine who is eligible for aloan modification and who isn't. ‘We are going to see a spike from now to the end of the year in foreclosures as we take people out ofthe running’ for a loan modification or other alternatives, says a Bank of America Corp. spokeswoman. ‘Foreclosure sales had droppedto ‘abnormally low’ levels in response to government efforts to stem foreclosures, she adds.’ – WSJ, 9/23/09

6. The FHA is providing massive support to the housing market – FHA’s market share has risen from 2% in 2005 to 23% of all mortgages, in part because of lax lending standards: only 3.5% down for

people with FICO scores as low as 580 (deep subprime) – Thousands of shady subprime mortgage lenders rebranded themselves and are now doing FHA-backed business. Approved FHA

lenders grew from just over 9,600 at the end of FY07 to nearly 14,000 today, according to HUD – FHA has very poor systems and controls – it only appointed a Chief Risk Officer on Nov. 12, 2009! – It’s no surprise, therefore, that defaults are skyrocketing – 17.9% of all FHA-guaranteed loans are now in some stage of delinquency – FHA’s annual report for FY09 (which ended 9/30/09) showed that the FHA capital ratio declined dramatically from 6.4% in 2007 to

3.0% in 2008 to 0.53% in 2009, falling below its statutory minimum of 2% – FHA will likely need additional funding from Congress in the near future – one analyst estimated $54 billion – and a condition of this

might be a requirement of tighter lending standards, in which case it’s highly unlikely that any other lender would step in to fill the gap;

it’s possible, however, that Congress might decide to continue the subsidy to help stabilize the housing market7. Home sales and prices are seasonally strong in April-July due to tax refunds and the spring selling season

The Average Loan Size of Defaulted Loans is RisingRapidly Reflecting the Spread of Defaults Away From



71

Rapidly, Reflecting the Spread of Defaults Away From

Smaller Subprime Loans Toward Alt-A and Prime LoansThis Has the Effect of Raising the Average Home Price Reported By Many Data Providers

Note: Data is only for loans that were securitized.

Source: LoanPerformance, Amherst Securities.

Another Wave of Resetting Loans Is On the HorizonThe Last Wave Was Driven By Subprime Loans;



72

The Last Wave Was Driven By Subprime Loans;This Time, It Will be Option ARMs

Source: Loan Performance, Amherst Securities.

0

5

10

15

20

T o t a l L o a n

B a l a n c e

( $ B i l )

Option ARM Alt A Prime Subprime

We are

here



One Third of All New Single Family Home

S l A Fi d With FHA VA L



74Source: HUD/FHA, through August 31, 2009, NY Times, 10/8/09; Commerce Department through Q3 09.

Sales Are Financed With FHA or VA Loans

FHA/VA Share of New SF Home Sales

0%

5%

10%

15%

20%

25%

30%

35%

40%

1 9 8 8

Q 1

1 9 8 9

Q 1

1 9 9 0

Q 1

1 9 9 1

Q 1

1 9 9 2

Q 1

1 9 9 3

Q 1

1 9 9 4

Q 1

1 9 9 5

Q 1

1 9 9 6

Q 1

1 9 9 7

Q 1

1 9 9 8

Q 1

1 9 9 9

Q 1

2 0 0 0

Q 1

2 0 0 1

Q 1

2 0 0 2

Q 1

2 0 0 3

Q 1

2 0 0 4

Q 1

2 0 0 5

Q 1

2 0 0 6

Q 1

2 0 0 7

Q 1

2 0 0 8

Q 1

2 0 0 9

Q 1

Number of FHA Loans Insured

FHA’s Loan Book Is a Rapidly Growing Disaster17.9% of Loans Are in Some Stage of Default;



75Source: HUD/FHA, through August 31, 2009, NY Times, 10/8/09.

g ;For 2007 Loans, It’s 32.4%

Existing Home Sales Are Highly Seasonal



76


Source: National Association of Realtors.




77


Source: National Association of Realtors.

HPA Seasonality Coefficient -- Deviation From Mean

Home Prices Increased Every Month From May-

O t b th F ll i N b



78

October, then Fell in November

Source: S&P Case-Shiller 20-city index.

Sequential Home Prices March 2005-November 2009

-3.5%

-3.0%

-2.5%

-2.0%

-1.5%

-1.0%

-0.5%

0.0%

0.5%

1.0%

1.5%

2.0%

M a r

- 0 5

J u n -

0 5

S e p -

0 5

D e c -

0 5

M a r

- 0 6

J u n -

0 6

S e p -

0 6

D e c -

0 6

M a r

- 0 7

J u n -

0 7

S e p -

0 7

D e c -

0 7

M a r

- 0 8

J u n -

0 8

S e p -

0 8

D e c -

0 8

M a r

- 0 9

J u n -

0 9

S e p -

0 9

November 2009: -0.2%

…But They Always Bounce in the Spring

d S !



79

and Summer!

Source: S&P Case-Shiller 20-city index.

Sequential Home Prices February 2000-November 2009

-4.0%

-3.0%

-2.0%

-1.0%

0.0%

1.0%

2.0%

3.0%

F e b -

0 0

J u l - 0

0

D e c -

0 0

M a y

- 0 1

O c t - 0

1

M a r

- 0 2

A u g -

0 2

J a n -

0 3

J u n -

0 3

N o v -

0 3

A p r - 0

4

S e p -

0 4

F e b -

0 5

J u l - 0

5

D e c -

0 5

M a y

- 0 6

O c t - 0

6

M a r

- 0 7

A u g -

0 7

J a n -

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J u n -

0 8

N o v -

0 8

A p r - 0

9

S e p -

0 9

Red circles represent April -June each year

Outlook for Housing Prices



80

O g

• 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 roughlya 10% further decline from where prices were as of the end of Q3 2009• The key question is whether housing prices will go crashing through the trend line

and fall well below fair value. This is possible, though unlikely because ofcontinued massive government subsidies. In the long-term, housing prices willlikely settle around fair value, but in the short-term prices will be driven both bypsychology as well as supply and demand. The recent bounce in home prices

has improved psychology, but the supply-demand trends are very unfavorable – There is a huge mismatch between supply and demand, due largely to the tsunami of

foreclosures. In addition, the “shadow” inventory of foreclosed homes already exceedsone year and there will be millions more foreclosures over the next few years, creating alarge overhang of excess supply that will likely cause prices to overshoot on thedownside, as they did in California

• Therefore, we expect housing prices to decline approximately 40% from the peak,bottoming in late 2010

• We are also quite certain that wherever prices bottom, there will be no quickrebound – There’s too much inventory to work off quickly, especially in light of the millions of

foreclosures over the next few years – We don’t think the economy is likely to provide a tailwind, as we expect tepid economic

growth at best for a number of years

The Timing Indicates That We Are Still inthe Middle Innings of the Bursting of the



81

g gGreat Housing Bubble

• Mortgage lending standards became progressively worse starting in 2000, but really went off a cliffbeginning in early 2005

• The worst loans were subprime ones, which generally had two-year teaser rates and are nowdefaulting at unprecedented rates

• Such loans made in Q1 2005 started to default in high numbers upon reset in Q1 2007, which notsurprisingly was the beginning of the current crises

• The crisis has continued to worsen as even lower quality subprime loans made over theremainder 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 (it’s now taking a few months longer)• 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 startingto default at catastrophic rates, plus unemployment is a very high levels and continues to rise,there are sobering implications for expected defaults, foreclosures and auctions in 2009, 2010 andbeyond, which promise to drive home prices down further and keep losses at high levels for years

In summary, today we are only in the middle innings of an enormouswave of defaults, foreclosures and auctions that is hitting the UnitedStates. We predicted in early 2008 that it would get so bad that it wouldrequire large-scale federal government intervention – which hasoccurred, and we’re not finished yet.

Future Losses Will Be Driven By Three

P i F t



82

Primary Factors

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 surgein 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 andlosing 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…



Current Economic Situation

The Economy Rebounded at the End of 2009



84

y

Source: Bureau of Economic Analysis, 11/24/09; chart from Pershing Square presentation, 12/22/09.

5.7%

Q4’09

Financial Markets Are Stabilizing



85

g

Source: FRB, FDIC, Haver Analytics, Barclay’s Capital, 11/09; charts from Pershing Square presentation, 12/7/09.

The Stock Market Has Rallied DramaticallyThe S&P 500 Rose 68.2% from March 9, 2009



86

,

Through the End of the Year

Source: Bigcharts.com, 1/27/10.

On March 9, 2009, the S&P wasdown 55% from its peak only 17months before, the largest declinesince the Great Depression.

More Than 7 Million Jobs Have Been Lost SoFar in This Recession, Though the Monthly Ratef L H E d i R t M th



87

of Losses Has Eased in Recent Months

Source: Bureau of Labor Statistics.

-1000

-800

-600

-400

-200

0

200

400

600

J a n -

9 0

J a n -

9 1

J a n -

9 2

J a n -

9 3

J a n -

9 4

J a n -

9 5

J a n -

9 6

J a n -

9 7

J a n -

9 8

J a n -

9 9

J a n -

0 0

J a n -

0 1

J a n -

0 2

J a n -

0 3

J a n -

0 4

J a n -

0 5

J a n -

0 6

J a n -

0 7

J a n -

0 8

J a n -

0 9

C h a n g e

i n N o n

f a r m

P a y r o

l l E m

p l o y m e n

t ( 0 0 0 s

)

There have been job

losses every month sinceDecember 2007

125,000-150,000 jobs/month are required toabsorb new entrants to the workforce and

prevent unemployment from rising

The Unemployment Rate Remains High,

Registering 10% in December



88

Registering 10% in December


3%

4%

5%

6%

7%

8%

9%

10%

11%

J a n -

7 0

J a n -

7 3

J a n -

7 6

J a n -

7 9

J a n -

8 2

J a n -

8 5

J a n -

8 8

J a n -

9 1

J a n -

9 4

J a n -

9 7

J a n -

0 0

J a n -

0 3

J a n -

0 6

J a n -

0 9

U n e m p

l o y m e n

t R a

t e

If part-time and discouraged workers are factored in, the unemployment rate would havebeen 17.3% in December. The labor force participation rate was 64.6%, the lowest in 22years. The average work week was 33.2 hours. To return to the average of 33.8 hours

would be the equivalent of nearly three million new jobs not created.

Chronic Unemployment Is Skyrocketing



89Source: Labor Department, 1/8/10; WSJ, 10/3/09.

39.8%

The Average Weeks Unemployed is 29.1



90Source: Labor Department, 1/8/10; WSJ, 10/3/09.

29.1

The Percentage of Unemployed Not onTemporary Layoff Has Risen to 53.4%



91

Temporary Layoff Has Risen to 53.4%

Source: Labor Department, 1/8/10; WSJ, 10/3/09.

53.4%

The Proportion of Unemployed WhoseUnemployment Benefits Have ExpiredH S d



92

Has Soared

Source: Labor Department, http://ows.doleta.gov/unemploy/claimssum.asp.

0%

10%

20%

30%

40%

50%

60%

J u n - 7

2

M a r - 7 3

D e c - 7 3

S e p - 7

4

J u n - 7

5

M a r - 7 6

D e c - 7 6

S e p - 7

7

J u n - 7

8

M a r - 7 9

D e c - 7 9

S e p - 8

0

J u n - 8

1

M a r - 8 2

D e c - 8 2

S e p - 8

3

J u n - 8

4

M a r - 8 5

D e c - 8 5

S e p - 8

6

J u n - 8

7

M a r - 8 8

D e c - 8 8

S e p - 8

9

J u n - 9

0

M a r - 9 1

D e c - 9 1

S e p - 9

2

J u n - 9

3

M a r - 9 4

D e c - 9 4

S e p - 9

5

J u n - 9

6

M a r - 9 7

D e c - 9 7

S e p - 9

8

J u n - 9

9

M a r - 0 0

D e c - 0 0

S e p - 0

1

J u n - 0

2

M a r - 0 3

D e c - 0 3

S e p - 0

4

J u n - 0

5

M a r - 0 6

D e c - 0 6

S e p - 0

7

J u n - 0

8

M a r - 0 9

There Are Now Six Unemployed People forEvery Job Opening



93

Every Job Opening

Source: Bureau of Labor Statistics, NY Times, 9/27/09.

5.2% of All Jobs Have Disappeared, Worse

Than Any Recession Since the Great Depression



94

Than Any Recession Since the Great Depression


-5.5%

-4.5%

-3.5%

-2.5%

-1.5%

-0.5%

0 6 12 18 24 30 36 42 48Months after pre-recession peak

1948 1953 1958 1960 1969 1974 1980 1981 1990 2001 2007

2007-

Assuming Job Losses End Immediately (Unlikely) andJob Gains Average the Rate of the Most RecentExpansion the Lost Jobs Won’t Be Restored Until 2016



95

Expansion, the Lost Jobs Won t Be Restored Until 2016

Source: Labor Department, Wall St. Journal.

Consumer Confidence Has ReboundedSomewhat But Remains Low



96

Somewhat But Remains Low

Note: 1985=100. Source: The Conference Board (www.pollingreport.com/consumer.htm)

0

20

40

60

80

100

120

140

160

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

C o n s u m e r

C o n

f i d e n c e

I n d e x

Mortgage Equity Withdrawals of Roughly $400Billion Annually During the Peak Bubble Years

F l d U i bl C S di



Fueled Unsustainable Consumer Spending

Source: www.calculatedriskblog.com/2009/05/mew-consumption-and-personal-saving.html.97

Many Borrowers Used Cash from Refinancings

(Cash-Out Refis) and HELOCs to Buy New Cars



98

• 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 newcars, according to CNW Marketing Research.

• Clearly this dynamic does not bode well for HELOC recovery rates or newcar sales.

(Cash Out Refis) and HELOCs to Buy New Cars

Source: New York Times 5/27/2008.

Total Consumer Credit Is Falling Sharply



99Source: Federal Reserve Board, WSJ, 10/9/09.

Total Consumer Credit Outstanding(Change From Year Earlier)

Down $119 billion or 4.6% from its peak in 7/08.Down $12 billion in August, a 5.8% seasonally

adjusted annual rate, the seventh straight monthof declines, the longest stretch since 1991.

Total Amount of Revolving and NonrevolvingConsumer Credit Outstanding

Household Credit Market Debt OutstandingHas Declined for the First Time Since ThisWas Measured Beginning in the Early 1950s



100

Was Measured Beginning in the Early 1950s

Source: St. Louis Fed.

The Percentage of Banks Tightening Standards

for Consumer Loans Has Risen Sharply



101

o Co su e oa s as se S a p y

Source: Federal Reserve Board Senior Loan Officer Opinion Survey on Bank Lending Practices, July 2009.

The U.S. Savings Rate Hit a 15-Year High of 6.9%in May, but Fell to 4.7% by November



This is good news in the long run, but could be a severe economic headwind in

the short run, given that consumer spending is 2/3 of GDP

Source: Paul Kedrosky’s blog, 6/26/09; http://paul.kedrosky.com/archives/2009/06/the_black_swan.html; www.bea.gov/newsreleases/national/pi/pinewsrelease.htm. 102

Peaked

Household Liabilities as a Percentage of Disposable Income Remains Very High



Disposable Income Remains Very High

Source: U.S. Federal Reserve, WSJ, 10/13/09. 103

Peaked

1991: 90%

Peak: 138%

2000: 101%

Today: 129%

Private Domestic Investment Has Plunged



Source: WSJ, 10/13/09. 104

Peaked

• “Of the 100 largestbond issues globallythis year, only sevenlisted expansion,investment, capitalexpenditures orresearch anddevelopment as the

purpose of themoney-raising,according toDealogic.”

• “In a recent surveyconducted by theConference Board,51% of chief

executives said theyexpect conditions intheir industries toimprove over the nextsix months, comparedwith 12% in the fourthquarter of 2008.”

Over the Past 30 Years, We Have Becomea Nation Gorged in Debt – To The Benefitof Financial Services Firms



105Sources: Federal Reserve, BEA, as of Q2 2007, GMO presentation.

Low Debt Era Rising Debt Era

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

51 54 57 60 63 66 69 72 75 78 81 84 87 90 93 96 99 02 05

F i n a n c i a l P r o f i t s a s

P e r c e n t o f G D P

100%

150%

200%

250%

300%

350%

T o t al D e b t a

sP er c en t of GD P

Dec-

Total Debt

Financial Profits

of Financial Services Firms



Interest Rates

The Interest Rate on Conforming 30-Year Fixed-Rate Mortgages Fell to All-Time Lows in Early

2009 and Remains at Historically Low Levels



107

2009 and Remains at Historically Low Levels

Sources: HSH ASSOCIATES, Freddie Mac PMMS, Yahoo! Finance.

2

3

4

5

6

7

8

9

10

F e b -

0 4

M a y

- 0 4

A u g -

0 4

N o v -

0 4

F e b -

0 5

M a y

- 0 5

A u g -

0 5

N o v -

0 5

F e b -

0 6

M a y

- 0 6

A u g -

0 6

N o v -

0 6

F e b -

0 7

M a y

- 0 7

A u g -

0 7

N o v -

0 7

F e b -

0 8

M a y

- 0 8

A u g -

0 8

N o v -

0 8

F e b -

0 9

M a y

- 0 9

A u g -

0 9

N o v -

0 9

R a t e ( % )

Jumbo 30 Yr FRM

Jumbo 5/1 Hybrid ARM

Conforming 30 Yr FRM

Conforming 5/1 Hybrid ARM

10-Year Treasury

Low Interest Rates Are Helping Stabilizethe Housing Market



108

g

Sources: HSHAssociates.com; Ryan ALM via WSJ Market Data Group; Mortgage Bankers Association viaThomson Reuters; in the Wall St. Journal, 6/11/09 and 9/21/09.

(Conventional or nonconforming)

Roughly speaking, every 1% increase in mortgage rates reduces borrowing power by 10%



Underwater Homeowners

24% of Homeowners With a Mortgage OweMore Than the Home Is Worth, MakingThem Much More Likely to Default



110

Them Much More Likely to Default

There Has Been a Dramatic Rise inHomeowners Who Are Underwater

In Bubble Markets, Far MoreHomeowners Are Underwater

Source: Zillow.com Q4 08 Real Estate Market Report; Moody's Economy.com, First American CoreLogic, T2 Partners estimates

Among people who bought homes in the past five years, 30%+ are underwater*

4%

6%

16%

20%

24%

0%

5%

10%

15%

20%

25%

Dec-06 Dec-07 Sep-08 Dec-08 Mar-09

PcU

we

Price Index Is % of Last 5 Yrs

at Lowest Price Drop Purchasers Who

Metro Area Level Since Since Peak Are Under Water

New York 2004-Q3 -15.2% 23.0%

Los Angeles 2003-Q4 -32.0% 56.4%

Boston 2002-Q2 -21.8% 27.8%

Washington 2004-Q1 -24.8% 50.3%

Miami 2004-Q1 -36.6% 65.1%

San Francisco 2003-Q3 -27.8% 51.2%

Atlanta 2004-Q4 -10.4% 23.2%

San Diego 2002-Q4 -34.4% 63.9%

Phoenix 2004-Q3 -37.7% 36.4%

Las Vegas 2003-Q4 -41.8% 61.4%

* The actual figures are likely even worse,as this data doesn’t capture people who

bought since 2003 and subsequently did acash-out refi or after-the-fact secondmortgage. 50% of all subprime and Alt-Aloans in existence when the collapsehappened were cash-out refis that carried ahigher loan balance than the originalpurchase loan amount.

*

Certain Types of Loans Are SeverelyUnderwater



111Sources: Amherst Securities (January 2009), LoanPerformance, Standard & Poor’s.

73%

50%

45%

25%

0%

10%

20%

30%

40%

50%

60%

70%

80%

Prime Alt A Subprime Option ARM

P e r c e n t U n d e r w a t e r



Investment Outlook

We Think We’re Likely in the Midst of a Secular Bear Market– And With Interest Rates Low and P/E Multiples High, It’sHard to See How a Sustained Bull Market Could Occur



113Source: Ned Davis Research; WSJ Market Data Group; appeared in WSJ 6/16/09; GNP andinterest rate data: “Warren Buffett on the Stock Market”, Fortune, 12/10/01

Gain inGNP373%

Gain inGNP177%

Interest Rates on Long-Term Govt. Bonds12/31/64: 4.20% 12/31/81: 13.65% 12/31/98: 5.09%

Based on Inflation-Adjusted 10-Year TrailingEarnings, the S&P 500 at 20.8x Is TradingAbove Its 130-Year Average of 16.3x



114

g

Source: Stock Market Data Used in "Irrational Exuberance" Princeton University Press, 2000, 2005, updated, Robert J. Shiller.

History Indicates That the Current Rally WillLikely Run Out of Steam in the Near Future



115Source: Ned Davis Research; appeared in WSJ 9/21/09.

Where We Are Finding Opportunities10 Months Ago, We Were Playing Offense; Now We’re Playing

Defense, As We Trim Our Longs, Add to Our Shorts and Shift



116

e e se, s We Ou o gs, dd to Ou S o ts a d S t

Our Longs Toward Large, Dominant, Cash-Rich Companies

• 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 marketdecline and weak economic conditions rather than any company-specific issues. In this category, we’dput Wal-Mart (which we own), Coca-Cola, McDonald’s, Altria, ExxonMobil, and Johnson & Johnson.

• Out of favor blue-chips. For somewhat more adventurous investors looking to buy great companies in themost out-of-favor sectors such as financials, retailers and healthcare, we own Berkshire Hathaway, WellsFargo, American Express, Target and Pfizer. We also own Microsoft and Yahoo!. All are greatbusinesses, but their stocks have suffered mightily thanks to the economic downturn. We think they’regood 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 retailerdELiA*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 andare reporting dismal results – with stock prices to match. Investors in those that survive and return toanything 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, aspecialty chemical maker, Crosstex, a pipeline company, and Resource America, a specialty financecompany.

• Special situations. This is somewhat of a catch-all category that, for us, includes Contango Oil & Gas, astock that’s declined due to an aborted attempt to sell the company and the sharp drop in the price ofnatural gas.

• Mispriced options. Every once in a while we take a tiny position in a highly speculative situation – oftenwhere the stock price is below $1 – in which there’s a real chance that the outcome is zero, but also adecent 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 a number of stocks andwarrants of Special Purpose Acquisition Companies (SPACs), General Growth Properties, TravelCentersof America, Ambassadors International, Borders Group and PhotoChannel Networks.



Appendix(Many of these slides are out of date)



Distressed Sales Have Fallen DueMainly to Seasonal Factors



Sources: National Association of Realtors, NY Times, 6/9/09. 119

31% in June andJuly due to

seasonally strongorganic sales.

This percentageis almost certainto rise in the off-

season

The Home Price-to-Rent Ratio HasReturned to Normal Levels



120

15

17

19

21

23

25

27

1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

MaHmPcoMaGoR

Source NATIONAL ASSOCIATION OF REALTORS® Existing Home Sales data series, U.S. Census Bureau, T2 Partners estimates.

The Housing Bubble Helped Many PeopleAchieve the Dream of Home Ownership –Which is Now Turning Into a Nightmare



g g

Source: Census Bureau.

60

61

62

63

64

65

66

67

68

69

70

1 9 6 5

1 9 6 7

1 9 6 9

1 9 7 1

1 9 7 3

1 9 7 5

1 9 7 7

1 9 7 9

1 9 8 1

1 9 8 3

1 9 8 5

1 9 8 7

1 9 8 9

1 9 9 1

1 9 9 3

1 9 9 5

1 9 9 7

1 9 9 9

2 0 0 1

2 0 0 3

2 0 0 5

2 0 0 7

Percentage of Households Owning Homes

%

121

The Percentage of Homes Listed for SalesRemains Near an All-Time High(Note that many more homes are vacant but not listed for sale)



Source: Census Bureau.122

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

Q 1 1 9 5

6

Q 4 1 9 5

9

Q 3 1 9 6

3

Q 2 1 9 6

7

Q 1 1 9 7

1

Q 4 1 9 7

4

Q 3 1 9 7

8

Q 2 1 9 8

2

Q 1 1 9 8

6

Q 4 1 9 8

9

Q 3 1 9 9

3

Q 2 1 9 9

7

Q 1 2 0 0

1

Q 4 2 0 0

4

Q 3 2 0 0

8

H o m e V a c a n c y

R a t e

Home Vacancy Rate 1965-Q2 09

Housing Starts, Completions and SalesAre At or Near All-Time Lows



Source: Commerce Department, data through 9/09.123

A slightrebound instarts andsales inrecentmonths

200

400

600

800

1000

1200

1400

1600

1800

2000

1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009

S e a s o n a

l l y A d j u s

t e d A n n u a

l R a

t e ( 0 0 0 s

)

Starts

Completions

New Homes Sold

There Is an Enormous Inventory Glut of New HomesThe Average New Home Has Been on the Market for 12.9 Months



Source: Census Bureau, through 8/09.124

2

4

6

8

10

12

14

J a n -

9 0

J a n -

9 1

J a n -

9 2

J a n -

9 3

J a n -

9 4

J a n -

9 5

J a n -

9 6

J a n -

9 7

J a n -

9 8

J a n -

9 9

J a n -

0 0

J a n -

0 1

J a n -

0 2

J a n -

0 3

J a n -

0 4

J a n -

0 5

J a n -

0 6

J a n -

0 7

J a n -

0 8

J a n -

0 9

M e d i a n A g e ( m

o n t h s

Vacant Housing Stock Creates anEnormous Inventory Overhang



Source: Census Bureau

Source: Census Bureau, Moody’s Economy.com.125

1.1-1.5 million excess units, equal to2-3 years of existing home sales

Nearly 6% of Homes Built This DecadeAre Vacant




Source: Census Bureau, through Q4 2008126

5.9%

2.0%

April 2000 to presentMarch 2000 or earlier

Vacancy Rate By Date of Construction

Unlike Past Housing Downturns, New Home SalesHave Fallen Far More Than Existing Home Sales



Source: National Assoc. of Realtors (existing sales) and Census Bureau (new sales), both via Haver Analytics; chart from the New York Times, 6/27/09;manually updated through 8/09. 127

A slightreboundfrom March-

August

New homessales fell 76%from the peak;still down 69%through August

So Far, Few Loan ModificationsAre Working



Source: Office of the Comptroller of the Currency and the Office of Thrift Supervision Mortgage Metrics

28.2%

52.1%

23.2%

36.7%

45.7%44.0%

49.8%

31.8%

46.1%

29.1%

0%

10%

20%

30%

40%

50%

60%

3 6 9 12

Months Since Modification

P e r

c e n t o f M o d i f i e d L o a n s 6 0

+ D a y s D e l i n q u e n t

Q1 2008

Q2 2008

Q3 2008

Q408

128

Banks Are Starting to Do LoanModifications With Principal Reductions,Increasing the Chance of Success



Source: WSJ, 10/1/09.129

Most Loan Modifications Fail Because theHomeowner Is So Deep Underwater



Among foreclosuresin California in May,the average amountowed was $412,000,yet the home wasworth only $235,000.

This means thehomeowner was 43%underwater and thehome price wouldhave to rise 75% toequal the amount ofthe debt.

Source: The Field Check Group -- data provided by ForeclosureRadar.com.130

Case Study: San Diego County Resales



Source: San Diego Union-Tribune, MDA Dataquick. Note: Excludes new construction.

378

1,254

1,312

1,154

0

500

1,000

1,500

2,000

2,500

3,000

1/1/2007 1/1/2008

R e s a l e H o m e s

Normal

Foreclosure

+42%

-12%

+232%

More than half of homes and condos sold inNovember in San Diego had been in foreclosure,contributing to an increase in home sales - - whileprices fell 35%.

November 2007 November 2008

(52%

Foreclosure)

(22%

Foreclosure)

131



Data on the Major Public Homebuilders

Debt-to-Equity Ratio of Major Homebuilders




Source: Company filings.

133

0.00 0.00

0.17

0.26

0.480.53 0.55

0.590.64

0.99

1.40

1.97

-0.5

0.0

0.5

1.0

1.5

2.0

NVR M DC TOL RYL M TH DHI LEN M HO PHM BHS KBH SPF BZH HOV

6.76

-11.98

Inventory-to-Equity Ratio of Major Homebuilders





134

0.30

0.50

1.33

1.50 1.56 1.551.80

1.46

1.71

2.10

3.12

3.37

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0


8.74

-12.89

Price-to-Book Ratio of Major Homebuilders





135

2.69

1.76

1.21

1.62

1.41

1.55

1.08

0.70

1.27

0.39

1.97

2.43

1.37

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0


-3.09



Case Study: California,

With a Focus on Sacramento

(California accounts for 10% of U.S. homes, but33% of foreclosures – 43% by value)

Does the Recent Rise in Prices and Decline inthe Percentage of Homes Sold Out of Foreclosure Mean California Has Bottomed?



137

Source: MDA Dataquick. Note: Includes new construction.

California

$0

$100

$200

$300

$400

$500

J a n -

0 6

A p r - 0

6

J u l - 0

6

O c t - 0

6

J a n -

0 7

A p r - 0

7

J u l - 0

7

O c t - 0

7

J a n -

0 8

A p r - 0

8

J u l - 0

8

O c t - 0

8

J a n -

0 9

A p r - 0

9

J u l - 0

9

M e d i a n H o m e P r i c e

( 0 0 0 s )

0%

10%

20%

30%

40%

50%

60%

70%

F or e

c l o s ur eR e s al e %

Home Prices Crashed Through Trend Linein California, But Have Rebounded



138

Source: California Association of REALTORS ® . All rights reserved. www.rebsonline.com, T2 Partners estimates.

$0

$100

$200

$300

$400

$500

$600

J a n -

7 9

J a n -

8 1

J a n -

8 3

J a n -

8 5

J a n -

8 7

J a n -

8 9

J a n -

9 1

J a n -

9 3

J a n -

9 5

J a n -

9 7

J a n -

9 9

J a n -

0 1

J a n -

0 3

J a n -

0 5

J a n -

0 7

J a n -

0 9

M e d i a n P r i c e ( $ 0 0 0 s )

Median Sales Price

4% Trend



Home Prices in Sacramento More Than Tripledin Six Years – And Have Now Fallen 47%



140

Source: Zillow.com.

The Vast Majority of Sacramento Homeowners WhoPurchased During the Bubble Years Are Now Underwater



141

Source: Zillow.com.

In Sacramento County, Home Sales HaveRebounded – But Are Still Outweighed by Defaults



142

Sources: MDA Dataquick; The Field Check Group -- data provided by ForeclosureRadar.com. Note:

Includes new construction.

Monthly Notices-of-Default in Sacramento

Home Prices Are Stabilizing in Sacramento Country,In Part Due to More Higher End Homes Being Sold Off



143

Source: The Field Check Group -- data provided by ForeclosureRadar.com.

Sacramento House Prices at theTime of Foreclosure/REO

Sacramento Mix of Houses atthe Time of Foreclosure/REO

Comments From Mark Hanson (1)The Field Check Group, May 5, 2009



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 endaffordable; b) foreclosures have temporarily been cut by 66% through moratoriumsreducing 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 ismassive – they will start showing themselves as REO over the near to mid-term. TheObama 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 mitigationinitiatives. We presently see the Notice of Defaults at record highs and Notice of TrusteeSales back up to nine-month highs – there is no reason for a loan to go to the Notice ofTrustee Sale stage if indeed it wasn't a foreclosure. However, the new 'batch' are not onlyfrom 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-upperpriced properties in 2009. We already have early seasonal hard data proving this. As themid-to-upper end go through their respective implosions this year and the volume ofsales in these bands increase as prices tumble, the mix shift will raise median andaverage house prices creating the ultimate in false bottoms. We also have data provingthis phenomenon.

144

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 – thevery same bands that are so hot right now. Rents are tumbling and those that bought these propertiesfor 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 milliondollar house than putting $300,000 down and buying.

After investors are punished -- and with move-up buyers gone for years – it will leave first-timehomeowners 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 thatleave borrowers in 5-year-teaser, ultra-high-leverage, 150% LTV, balloon loans will start adjustingupward and it will be Mortgage Implosion 2.0. These loan mods will turn millions of homeowners intoover-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 themid to upper end during the off season, the broader housing data show signs of stabilization. Taken incontext, it is a blip. There are no silver linings or green shoots in housing whatsoever other than by thesefirst-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 themarket 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 findout soon enough. When we look back on housing at the end of 2009, anyone that made positivehousing predictions this year will not believe how far off they were.

145



Detailed Information onThree Types of Mortgages:

Jumbo Prime, CES/HELOCs and Option ARMs

Delinquencies of Securitized Jumbo PrimeMortgages Are Soaring



147


0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

J a n -

9 9

J u l - 9

9

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0

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P e r c e n

t N o n c u r r e n

t ( 6 0 +

d a y s

)

As the Credit Crisis Worsened, the Spread BetweenJumbo and Conforming Loans Widened Dramatically



148

Sources: Mortgage Bankers Association via Thomson Reuters; HSHAssociates.com, in the WSJ 6/11/09.

Interest Rates on Jumbo Loans Remain High



149

Source: Freddie Mac investor presentation, 9/09, www.freddiemac.com/investors/pdffiles/investor-presentation.pdf.

HELOCs and Home Equity Loans Soaredin Popularity During the Bubble



150

Note: Does not include approximately $200 billion of securitized HELOCs and junior liens. Source: FDIC Quarterly Banking Profile.

$0

$100

$200

$300

$400

$500

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$700

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Q 1 2 0 0

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1

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7

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8

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9

A m o u n t ( B n )

Closed-End Junior Lien Mortgages

Home Equity Lines of Credit

Delinquencies of HELOCs and CESs AreSoaring, Though Q2 Showed Improvement



151

Source: FDIC Quarterly Banking Profile.

0.0%

0.5%

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4

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6

Q 1 2 0 0

7

Q 2 2 0 0

7

Q 3 2 0 0

7

Q 4 2 0 0

7

Q 1 2 0 0

8

Q 2 2 0 0

8

Q 3 2 0 0

8

Q 4 2 0 0

8

Q 1 2 0 0

9

Q 2 2 0 0

9


Closed-End Junior Lien MortgagesHome Equity Lines of Credit

Pools of HELOCs and CESs Can SufferAstronomical Losses Due to 100%+ Severities



0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

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

M o n t h l y L o s s R a t e ( 3 m

a v e

r a g e )

Ambac Projection April 2008

Actual

Sources: Ambac Q1 08 presentation, Amherst Securities; funds managed by T2 Partners are short Ambac.

On one second lien deal, Ambac expected losses of 10-12% when it guaranteed the seniortranche. 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.

From Ambac slide, April 2008:

• Second lien deal that closed in April 2007• Loss to date 9.9%; projected loss: 81.8%

• Projected collateral loss as a % of currentcollateral: 86%

• A reasonable estimate of projected collateralloss for the above transaction might havebeen 10-12%, with the transaction having anA+ rating at inception and being structured towithstand 28-30% collateral loss

152

A Primer on Option ARMs



153

• An Option ARM is an adjustable rate mortgage typically made to a prime

borrower• Sold under various names such as “Pick-A-Pay”• Banks typically relied on the appraised value of the home and the borrower’s

high FICO score, so 83% of Option ARMs written in 2004-2007 were low- orno-doc (liar’s loans)

• Each month, the borrower can choose to pay: 1) the fully amortizing interestand principal; 2) full interest; or 3) an ultra-low teaser interest-only rate(typically 2-3%), in which case the unpaid interest is added to the balance ofthe mortgage (meaning it is negatively amortizing)

• Approximately 80% of Option ARMs are negatively amortizing• Lenders, however, booked earnings as if the borrowers were making full

interest payments• A typical Option ARM is a 30- or 40-year mortgage that resets (“recasts”)

after five or ten years, when it becomes fully amortizing• If an Option ARM negatively amortizes to 110-125% of the original balance

(depending on the terms of the loan), this triggers a reset even if 5 or 10years have not elapsed

• Upon reset, the average monthly payment can jump significantly, though thepayment shock is currently mitigated by today’s low interest rates

Further Details on Option ARMs



“The Option ARM home loan product is an adjustable-rate mortgage loan that provides the borrowerwith the option each month to make a fully-amortizing, interest-only, or minimum payment. As describedin greater detail below, the minimum payment is typically insufficient to cover interest accrued in the prior month and any unpaid interest is deferred and added to the principal balance of the loan .

The minimum payment on an Option ARM loan is based on the interest rate charged during theintroductory period. This introductory rate has usually been significantly below the fully-indexed rate. Thefully-indexed rate is calculated using an index rate plus a margin. Once the introductory period ends, thecontractual interest rate charged on the loan increases to the fully-indexed rate and adjusts monthly toreflect movements in the index.

If the borrower continues to make the minimum monthly payment after the introductory period ends,the payment may not be sufficient to cover interest accrued in the previous month. In this case, the loan will "negatively amortize" as unpaid interest is deferred and added to the principal balance of the loan.The minimum payment on an Option ARM loan is adjusted on each anniversary date of the loan but eachincrease or decrease is limited to a maximum of 7.5% of the minimum payment amount on such date untila "recasting event" occurs.

A recasting event occurs every 60 months or sooner upon reaching a negative amortization cap.When a recasting event occurs, a new minimum monthly payment is calculated without regard to any limits on the increase or decrease in amount that would otherwise apply under the annual 7.5% payment cap. This new minimum monthly payment is calculated to be sufficient to fully repay the principal balance

of the loan, including any theretofore deferred interest, over the remainder of the loan term using the fully- indexed rate then in effect.

A recasting event occurs immediately whenever the unpaid principal balance reaches the negativeamortization cap, which is expressed as a percent of the original loan balance. Prior to 2006, the negativeamortization cap was 125% of the original loan balance... For all Option ARM loans originated in 2006,the negative amortization cap was 110% of the original loan balance. For Option ARM loans originated in2007, the negative amortization cap was raised to 115%...

In the first month that follows a recasting event, the minimum payment will equal the fully-amortizingpayment.

From Washington Mutual’s 2007 10K (emphasis added):

154

About $750 Billion of Option ARMs WereWritten, Nearly All at the Peak of the Bubble



155

Sources: 2008 Mortgage Market Statistical Annual, published by Inside Mortgage Finance Publications, Inc. Copyright 2008. T2 Partners estimates.

5%

9%

1%

8%

5%

$0

$50

$100

$150

$200

$250

$300

2004 2005 2006 2007 2008

O r i g i n a t i o n s ( B

n )

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

P

er c en t of T o t al

Options ARMs Were a Bubble StatePhenomenon



156


California58%

Florida10%

Nevada3%

Arizona3%

Other25%

Beginning in March 2005, High-FICO-ScoreBorrowers Opted for an Above-Market-Rate

Option ARM in Exchange for the Low Teaser Rate



Source: Amherst Securities, BloombergFinance, L.P.

4.0

4.5

5.0

5.5

6.0

6.5

7.0

7.5

8.0

8.5

Jan-02

Apr-02

Jul-0

2

Oct-02

Jan-03

Apr-03

Jul-0

3

Oct-03

Jan-04

Apr-04

Jul-0

4

Oct-04

Jan-05

Apr-05

Jul-0

5

Oct-05

Jan-06

Apr-06

Jul-0

6

Oct-06

Jan-07

Apr-07

Jul-0

7

Oct-07

Jan-08

IneeRe%)

Fannie Mae 30 Year FRM Index

Option ARM Index

Nearly all Option ARM borrowers duringthis period (when nearly all OptionARMs were written) can’t afford a fully-amortizing mortgage – otherwise theywould have taken one

157

Option ARMs are Recasting Much Faster ThanExpected Due to Negative Amortization



$-

$2

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$6

$8

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$12

$14

$16

$18

A p r - 0

8

J u n - 0 8

A u g - 0 8

O c t - 0

8

D e c - 0 8

F e b - 0

9

A p r - 0

9

J u n - 0 9

A u g - 0 9

O c t - 0

9

D e c - 0 9

F e b - 1

0

A p r - 1

0

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0

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1

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1

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1

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F e b - 1

2

A p r - 1

2

J u n - 1 2

A u g - 1 2

Original recast schedule (5 yrs from origination)

Recast schedule based on current neg am

Source: Credit Suisse for BusinessWeek.

158

Delinquencies of Securitized Option ARMsAre Soaring



159

Sources: Amherst Securities, LoanPerformance, T2 Partners estimates.

0%

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“My sense is that many Option ARMborrowers are in a worse position thansubprime borrowers. They wind up owingmore and the resets are more significant.”

-- Kevin Stein, associate director of the

California Reinvestment Coalition

Comments From a FederalSenior Bank Examiner (3/08)



“The next problem is with the Option ARM product.

Approximately 80-90% are paying the minimum credit cardpayment and most loans are negatively amortizing.

Here the payment shock is two-fold – rate and principal – and the increase in payments can be astronomical: 200% or higher, not the 10 to 100% that subprime has experienced . Also, the dollars

exposed in Alt-A [many analysts group Option ARMs with Alt-A] arenearly 50% higher than subprime: the Alt-A average balance is$299,000 versus $181,000 for subprime.

Also, 73% were underwritten with Low or No Doc . The OptionARM books of many lenders are already showing significant

deterioration and they have not even recast yet.This is the next tsunami to hit the housing market. This will hit

much higher price points $600,000 and above as this was theaffordability product used by higher income/higher FICO scorehouseholds to buy that dream home.”

160



What’s Happening at the Micro Level

Among Securitized Loans

Among Securitized Loans, There Are Signs of Stabilization – New Defaults Are Slowing,

Though They Remain Very High



162

Sources: LoanPerformance, Amherst Securities.

The Pool of Defaulted Loans Is No Longer GrowingBecause Defaults Are Now Matched by Liquidations



163


All Types of Securitized Loans Are ShowingLower Defaults in Recent Months – But It’sUnclear If This Is Sustainable



164


The Foreclosure Process Has SlowedDramatically



165


What Happened In August Among AllSecuritized Loans1.7% of Performing Loans Defaulted, 3.1% of Defaulted LoansWere Modified and 10.9% of Modified Loans Re-Defaulted



166




A Closer Look at Mortgages That

Were Securitized: Quantity and Quality

Hundreds of Billions of Dollars of MortgagesWere Securitized, Many On Terms With NoHistorical Precedent

S iti d Fi t Li O i i ti V l



Green: Loans with historical precedentYellow: Loans with limited historical precedentRed: Loans with no historical precedent

Securitized First Liens – Origination Volume

Source: Amherst Securities Group, L.P.

These are the worstloans: $828 billion worth

168

Tens of Billions of Dollars of 2

nd

LienMortgages Were Also Securitized, ManyOn Terms With No Historical Precedent

S i i d S d Li O i i i V l



Green: Loans with historical precedentYellow: Loans with limited historical precedentRed: Loans with no historical precedent

Securitized Second Liens – Origination Volume


Another $56 billion ofeven bigger problems

169

Volume of June 2005 Fixed Rate and 2/28*

Full Doc Securitized Mortgage Loans

2/28 Full Doc June 2005 ProductionFixed Full Doc June 2005 Production



2/28 Full Doc – June 2005 ProductionTotal Volume: $16.4 billion

Green: 39.9%; Yellow: 25.2%; Red: 26.1%

Fixed Full Doc – June 2005 ProductionTotal Volume: $ 8.1 billion

Green: 70.0%; Yellow: 9.3%; Red: 5.4%

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 paymentshock and a surge in defaults. Because they offer the lowest monthly payments (for the first two years), theyare generally the lowest-quality loans, preferred by speculators and the most over-stretched borrowers.


Loan-to-Value Loan-to-Value

F I C

O

170

Volume of June 2005 Fixed Rate and 2/28 Low Doc Securitized Mortgage Loans



2/28 Low Doc – June 2005 Production

Total Volume: $14.1 billionGreen: 17.0%; Yellow: 33.4%; Red: 31.1%

Fixed Low Doc – June 2005 Production

Total Volume: $ 7.7 billionGreen: 49.2%; Yellow: 25.8%; Red: 8.0%


171

Origination Volume of Fixed Rate, Full DocSecuritized Mortgage Loans, January 2005



In the best category of loans (full doc, fixedrate), in January 2005, just beforemortgage lending standards collapsed,nearly all securitized mortgages weregreen, meaning they had FICO and LTVcharacteristics with historical precedent.

Subprime

Alt-APrime

172

Origination Volume of Fixed Rate, Full DocSecuritized Mortgage Loans, June 2005



Mortgage lending standards began to worsen

by June 2005.

173

Origination Volume of Fixed Rate, Full DocSecuritized Mortgage Loans, January 2006

By January 2006 mortgage lending



By January 2006, mortgage lendingstandards had deteriorated substantially,

even more the best loans, with largepercentages yellow and red, meaning theyhad FICO and LTV characteristics with littleor no historical precedent.

174

Origination Volume of Fixed Rate, Full DocSecuritized Mortgage Loans, June 2006

B J 2006 t l di t d d



By June 2006, mortgage lending standardshad collapsed, even for the best loans, with

large percentages yellow and red, meaningthey had FICO and LTV characteristics withlittle or no historical precedent.

175

Origination Volume of 2/28, Low DocSecuritized Mortgage Loans, January 2005

F th t t f l (l / d



For the worst category of loans (low/no docwith two-year teaser rates), mortgagelending standards were abysmal as earlyas January 2005 – and got worse fromthere.

176

Origination Volume of 2/28, Low DocSecuritized Mortgage Loans, June 2005



177

Origination Volume of 2/28, Low DocSecuritized Mortgage Loans, January 2006



178

Origination Volume of 2/28, Low DocSecuritized Mortgage Loans, June 2006

A very high percentage of these loans will



never be repaid.

179



A Closer Look at Mortgages

That Were Securitized: Defaults

Default Rates of June 2005 Fixed Rate and2/28 Full Doc Securitized Mortgage Loans

2/28 Full Doc – June 2005 ProductionFixed Full Doc – June 2005 Production



Total Volume: $16.4 billion

Green: 39.9%; Yellow: 25.2%; Red: 26.1%

Total Volume: $ 8.1 billion

Green: 70.0%; Yellow: 9.3%; Red: 5.4%Loan-to-Value Loan-to-Value

F I C

O

Unprecedented default rates – and lending standardsgot much worse subsequent to June 2005!

Source: Amherst Securities, May 25th reports, reflecting payments through 4/30/09.

181

Default Rates of June 2005 Fixed Rate and2/28 Low Doc Securitized Mortgage Loans

2/28 Low Doc – June 2005 ProductionFixed Low Doc – June 2005 Production



2/28 Low Doc June 2005 ProductionTotal Volume: $14.1 billion

Green: 17.0%; Yellow: 33.4%; Red: 31.1%

Fixed Low Doc June 2005 ProductionTotal Volume: $ 7.7 billion

Green: 49.2%; Yellow: 25.8%; Red: 8.0%

Default rates are much higher for no/low doc “liars” loans

Loan-to-Value Loan-to-Value

F I C O


182

Monthly Default Rate for Fixed RateSecuritized Mortgage Loans (Green)

D f lt d fi d l th t 90 d



Defaults are defined as loans that are 90 days or more

delinquent. sTr measures the percentage of loans thatbecome 90 days or more delinquent during the month, as apercentage of non-delinquent loans at the beginning of themonth.

This chart shows the performance of the very best (fixedrate, green) mortgages. Note that late 2004 and early 2005

vintage loans have sTrs of approximately 70 basis points,which translates into roughly an 8% cumulative default rate inone year, whereas more recent vintage loans are quickly

spiking up to a 2% sTr, which translates into an 21.5%

cumulative default rate in one year.

12/04

9/06

Source: Amherst Securities Group, L.P. 183



Monthly Default Rate for Fixed RateSecuritized Mortgage Loans (Red)

I thi h t l t 2004 d l 2005 i t l h T



In this chart, late 2004 and early 2005 vintage loans have sTrs

of approximately 2%, which translates into a 21.5% cumulativedefault rate in one year, whereas more recent vintage loansare quickly spiking up to a 4-5% sTr, which translates into a38-46% cumulative default rate in one year.

Source: Amherst Securities Group, L.P.185

Monthly Default Rate for 2-28Securitized Mortgage Loans (Green)

2-28 loans are those with two-year teaser interest rates that



year teaser interest rates thatthen reset, sometimes to higher

rates, which triggers paymentshock and a surge in defaults.In this chart, note the surge insTr shortly after the two-yearreset, as well as the rapidly risingsTr even before the reset in morerecent vintage loans – compare12/04, 12/05 and 9/06 loans, for

example.

12/05(pre-reset)


9/06(pre-reset)

12/04-6/05(pre-reset)

186

Monthly Default Rate for 2-28Securitized Mortgage Loans (Yellow)



2006 and 2007 loans are

defaulting at 5-6% per montheven before the reset

Source: Amherst Securities Group, L.P. 187

Monthly Default Rate for 2-28Securitized Mortgage Loans (Red)



For recent vintage 2-28 red loans,sTrs are jumping to 6-8% longbefore the reset

Source: Amherst Securities Group, L.P.188

Current Trends Are Quickly Leadingto Unprecedented Default Levels

Three-Year Cumulative Defaults



Historical levels

Late 2005 and thereafter,Green, fixed

Late 2005 and thereafter,

Green, 2/28

Late 2005 and thereafter,Red, 2/28

2004 green,

fixed

Notes: MDR = sTr = monthly default rate. CDR = cumulative default rate, which represents the amount of loans in defaultafter 36 months as a percentage of the original balance when keeping MDR and VPR constant for that time period.

Source: Amherst Securities Group.

(1 yr):

V o l u n t a r y P r e p a y m e n t

R

a t e ( V P R )

189

Bubble-Era Pools of Subprime MortgagesAre Performing Catastrophically

Annualized default rate

The 20 RMBS Pools That Comprise the ABX 06-2




Cumulative defaultsMonthly default rate Monthly

prepay rate

Annualized

prepay rate

An average of 47.6% of theloans have already defaulted

On average, 5.1% of theperforming loans in the pools

defaulted during the month

The monthly prepayrate only averaged 0.5%

Total:

190



Where Did the Securitized Mortgages End Up?

A Primer on ABSs and CDOs

Wall Street Firms Bought Loans and SecuritizedThem, First Into Asset-Backed Securities CalledResidential 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. 192

Trillions of Dollars of ABSs and CDOsWere Created and DistributedThroughout the Financial System



Note: This is all ABSs and CDOs, not just those related to mortgagesSource: Lehman Brothers, 4/08; Carlyle presentation 10/15/08. 193

What Should the Government Do in theCase 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 CapitalStructure of Financial Institutions – AndHow Highly Leveraged They Are



Taxpayers willsuffer all lossesabove preferredstock

Source: Amherst Securities. 195

Freddie Mac



Taxpayers willsuffer all lossesabove preferredstock

Source: Amherst Securities. 196

Lehman Brothers



Source: Amherst Securities.

Had the preferred stock, junior debt and a smallfraction of the seniordebt been converted toequity, Lehman couldhave become one of thebest-capitalized financialinstitutions in the worldand everyone wouldhave benefitted.

197

Overview of Fannie, Freddie and Lehman



Source: Amherst Securities 198

The $1 Trillion Dollar Mistake

• The U S financial system likely faces losses of at least $1 trillion most of which is likely



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 tohave 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 ofAmerica) 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 withLehman), 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 highlyleveraged 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'smajor financial institutions, to become massively overleveraged, fueling the greatest assetbubble in history. This was not an equity bubble – unlike the internet bubble, for example, stockmarket valuations never got crazy – it was a debt bubble, so it would be particularly perverseand ironic if government bailouts allowed equity holders to take a beating, yet fully protecteddebt holders.

• The solution: debt should be converted into equity199

But What About Systemic Risk?

• What about the lessons from Lehman? Unless we protect the debt holders won’t



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 Lehmanbankruptcy? 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 stiffedLehman'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'sclients and counterparties could have relied on Lehman (as was done with AIG) - but debtholders 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 mightbecome insolvent, creating a domino effect? And might debt markets freeze upsuch that even currently healthy banks might not be able to access debt andcollapse? – 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 holdin troubled financial institutions - but that's no reason to protect all of them 100% withtaxpayer money.

– As for the latter concern that debt markets might freeze up, causing even healthy banks tocollapse, it's important to understand that right now there is no junior debt available to anyfinancial institution with even a hint of weakness - there's very high cost equity andgovernment-guaranteed debt. Neither of these will be affected if legacy debt holders areforced to bear some of the cost of the failure of certain institutions.

200

Case Study: Bank of America

• As of the end of 2008 (not including Merrill Lynch), BofA had $1.82 trillion in assets



s ( g y ), a $ ass s($1.72 trillion excluding goodwill and intangibles), supported by a mere $86.6 billionin tangible equity – 5.0% of tangible assets or 20:1 leverage – and $48.9 billion oftangible 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 $2.0billion 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 actuallybecome more aggressive over the past year. From the end of 2007 to the end of2008, nonperforming assets more than tripled from $5.9 billion to $18.2 billion, yetthe 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

201

What the Government Should Do If aCompany Blows Up and Can’t Find a Buyer?

1 S i it d t it i t t hi



1. Seize it and put it into conservatorship

2. The Conservator would replace board and management and suspendthe voting rights and other decision rights of the shareholders

3. No dividends, share repurchases or other transfers of resources to theold shareholders could take place while the Conservatorship is in effect

4. The Conservator should be able to haircut all unsecured debt holders

and other unsecured creditors, regardless of seniority5. The Conservator would also be able to impose mandatory debt-to-

equity conversions on all unsecured creditors and debt holders, with orwithout first extinguishing the equity of the old shareholders

6. The Conservator would have full authority to sell assets and torestructure the balance sheet and the activities of the business in anyway deemed appropriate and lawful

7. The Conservator would have the power to liquidate the company

Source: Time to Pull the Plug on AIG? , Willem Buiter, http://blogs.ft.com/maverecon/2008/11/time-to-pull-the-plug-on-aig

202

It Is Premature to Allow Banks to RepayTARP Money

We agree with this Financial Times editorial:

An escape too soon for US banks



pJune 10 2009

The US Treasury’s decision to release 10 of its wards from the straitjacket of the troubled asset reliefprogramme was presented – and widely taken – as good news. But in fact, it sacrificed sound financial policyfor political need.

Letting JPMorgan Chase, Goldman Sachs, Morgan Stanley and others repay $68bn to the US taxpayerhelps placate the combustible public fury at bank bail-outs that almost escaped Barack Obama’s control thiswinter. The president even makes a point of noting that the government made a profit on the returned funds.The 10 financial groups’ escape from Tarp’s heavy-handed restrictions also weakens accusations of socialismby some Republicans, to which Mr Obama’s administration has been surprisingly thin-skinned.

But letting the banks out of Tarp at this point was premature. Supposedly weaned off public support, the

10 had to demonstrate they could raise funds without government guarantees. The temporary liquidityguarantee programme, however, remains available to them. In effect subsidised by the government, but freedfrom Tarp rules on compensation and hiring, they can poach both staff and business from competitors still inTarp. This is more regulatory discrimination than it is restitution of market discipline.

Even worse is that, for these 10, Tarp has been terminated without addressing the problem that it wassupposed to stave off. That problem – or so many thought in the chaos that followed Lehman Brothers’collapse – was that some banks are too big to be allowed to fail, lest they drag the whole financial systemdown with them.

This fundamental situation has not changed. The stress tests of the largest banks – now looking ratherlenient – and the demand that some of them raise additional capital were designed to make failure less likely;

fascinating report on the housing and economic crisis and why there is more pain to come

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