1

The Rise and Fall of the U.S. Mortgage and Credit Markets

Glenn YagoOctober 2009

2

Overview Factors that contributed to credit boom and bust• Lax monetary policy and global imbalances led to low interest rates• Reach for yield, reliance on short-term wholesale funding for relatively illiquid assets,

small cash buffers, and risky/substantial leverage• Financial innovation, such as securitization that weakened lending standards (e.g.,

mortgage originators) and credit default swaps that increased inter-connectivity (e.g., AIG), transferred risk broadly to others

• Opacity due to complexity of financial instruments (e.g., CDOs), riskier collateral for securities (e.g., subprime mortgages), heavy reliance on credit rating agencies, and over-the-counter trading of credit default swaps

• Procyclicality of regulation (capital requirements) and mark-to-market accounting, which contributed to forced asset sales and deleveraging

• Lack of a procedure to deal with deeply troubled big banks and non-bank financial institutions (too big to fail or too strategically important or too inter-connected)

• Incentive/compensation system that encouraged excessive risk taking, and poor corporate governance

• Public policy: gaps in regulatory structure and inconsistent asset management strategy• Flight to safety due to uncertainty of asset values and solvency of financial institutions

(hoarding of liquidity and/or calls for more collateral)

3

Overview of the housing market

Total value of housing stock = $18.3 trillion

Note: total residential and commercial mortgages = $14.6 trillion at year-end 2008.

Sources: Federal Reserve, Milken Institute.

Equity in housing stock$7.8 trillion

Mortgage debt $10.5 trillion Prime

92.7%

Subprime7.3%

Securitized60%

Non-Securitized

40%

Government-controlled

48%

Privatesector-

controlled52%

4

The mortgage problem in perspective

Note: The data is at year-end 2008.Sources: U.S. Census, Freddie Mac, Mortgage Bankers Association, Milken Institute.

25 million or 31% are paid off80 million houses

55 million have mortgages 49 million or 89% are paying on time

6 million are behind11% of 55 million with 3% in foreclosure

This compares to 50% seriously delinquent in the 1930s.

5

Home price bubble, credit boom and bust

Low interest rates, credit boom and bust

Sources: Inside Mortgage Finance, Mortgage Bankers Association, Moody’s Economy.com, S&P/Case-Shiller, Milken Institute.

US$ trillions

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

2001 2002 2003 2004 2005 2006 2007 2008

2.5

3.0

3.5

4.0

4.5

5.0

5.5

6.0

1-Year ARM mortgage rate

(right axis)

Home mortgage

originations (left axis)

Percent Index, January 2000 = 100

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

2001 2002 2003 2004 2005 2006 2007 2008

50

75

100

125

150

175

200

US$ trillions

Home mortgage

originations (left axis)

S&P/Case-Shiller National Home

Price Index (right axis)

6

All states had home price increases From 4Q 2001 to 4Q 2006

Sources: Moody’s Economy.com, Milken Institute.

United States = 43%

7

Forty-seven states had home price declines From 4Q 2006 to 4Q 2008

Sources: Moody’s Economy.com, Milken Institute.

United States = -19%

8

One year ago… Six years ago…

If you bought your house…

% change in price, January 2008-2009 % change in price, January 2003-2009Sources: S&P/Case-Shiller, Milken Institute.

-4.9-5.1-5.2

-7.3

-8.2-9.6

-14.0-14.3

-15.0-16.4

-19.0

-19.3-19.4

-20.4-22.6

-23.3-24.9

-25.8-29.4

-32.4-32.5

-35.0

DallasDenverClevelandBoston

CharlotteNew YorkPortlandAtlantaSeattleChicagoComposite-20

WashingtonComposite-10MinneapolisDetroitTampaSan DiegoLos Angeles

MiamiSan FranciscoLas VegasPhoenix

35.3

33.3

23.7

18.4

15.4

12.3

12.0

10.6

10.6

7.9

3.2

3.0

2.7

0.0

-1.0

-2.0

-4.6

-4.9

-6.6

-12.4

-13.3

-32.9

Portland

Seattle

New York

Washington

Los Angeles

Charlotte

Tampa

Composite-10

Miami

Composite-20

Chicago

Las Vegas

Boston

Phoenix

Dallas

Denver

San Diego

Atlanta

Cleveland

San Francisco

Minneapolis

Detroit

9

Las Vegas housing market

Source: James Barth and Harris Hollans.

0

50

100

150

200

250

300

350

1994 1996 1998 2000 2002 2004 2006 2008 Q3

US$ thousands

0

10

20

30

40

50

60

70

80

Median home sales price (left axis)

Flips/total transactions (right axis)

Foreclosures/total transactions (right axis)

Percent

10

Percentage of homes purchased between 2004 and 2008 that now have negative equity

Sources: Zillow.com, Milken Institute.

United States = 41%

11

Leverage ratios of selected financial firms December 2008

9.3

10.6

11.1

31.6

26.2

21.5

67.9

0 10 20 30 40 50 60 70 80

Credit unions

Commercial banks

Saving institutions

Brokers/hedge funds

Federal Home Loan Banks

Fannie Mae

Freddie Mac

Leverage ratio, total assets/common equity

Note: Leverage ratios for Freddie Mac and Fannie Mae are as of June 2008. The two institutions have negative common equities as of December 2008.Sources: FDIC, FHL Banks Office of Finance, National Credit Union Administration, Freddie Mac, Fannie Mae, Milken Institute.

(June 2008)

(June 2008)(June 2008)

12

Too much dependence on debt? Leverage ratios at biggest investment banks

2219

2826

18

31

19

2724

23

33 32 3431

13

33 34

2422

13

0

5

10

15

20

25

30

35

40

Morgan Stanley Merrill Lynch Bear Stearns Lehman Brothers Goldman Sachs

2000 2005 2007 2008

Total assets/total shareholder equity

March 2008

June 2008

Sources: Bloomberg, Milken Institute.

13

Too much dependence on debt? Leverage ratios at bank holding companies

Sources: Bloomberg, Milken Institute.

13

17

1311

19

14 13 1312 13

10

13

0

5

10

15

20

25

Citigroup Bank of America JPMorgan Chase

2000 2005 2007 2008

Total assets/total shareholder equity

14

Balance sheet information on FDIC-insured institutions

Sources: FDIC, Milken Institute.

0

5

10

15

20

25

1992 1994 1996 1998 2000 2002 2004 2006 2008

0

10

20

30

40

50

60

70

80

90Percent Percent

Equity capital-to-asset ratio (right axis)

Cash-to-asset ratio(left axis)

Deposits-to-asset ratio (right axis)

Insured deposits-to-asset ratio (right axis)

Borrowed funds-to-asset ratio (left axis)

15

Reserve coverage ratio of all FDIC-insured institutions

Sources: Quarterly Banking Profile, FDIC, Milken Institute .

0

50

100

150

200

250

2005 2006 2007 2008

020406080100120140160180200

US$ billions Percent

Noncurrent loans (left axis)

Loan-loss reserves (left axis)

Coverage ratio (right axis)

16

The mortgage model switches fromoriginate-to-hold to originate-to-distribute

Sources: Federal Reserve, Milken Institute.

Household mortgage debt

2008=$10.5 trillion

Held in portfolio40%

Securitized60%

Household mortgage debt

1980=$958 billion

Held in portfolio89%

Securitized11%

17

The rise and fall of private-label securitizers Outstanding securities

Sources: Inside Mortgage Finance, Milken Institute.

26%

55%

6%

13%

1985Total = $390B

39%

14% 18%

29%

2001Total = $3.3T

33%

35%7%

25%

2006Total = $5.9T

37%

27%9%

27%

2008Total = $6.8T

Ginnie Mae Freddie Mac Fannie Mae Private-label

26%

55%

6%

13%

1985Total = $390B

39%

14% 18%

29%

2001Total = $3.3T

33%

35%7%

25%

2006Total = $5.9T

37%

27%9%

27%

2008Total = $6.8T

Ginnie Mae Freddie Mac Fannie Mae Private-label

18

S&P Total Downgraded Downgraded/ Total

AAA 1,032 156 15.1%

AA(+/-) 3,495 1,330 38.1%

A(+/-) 2,983 1,886 63.2%

BBB(+/-) 2,954 2,248 76.1%

BB(+/-) 789 683 86.6%

B(+/-) 8 7 87.5%

Total 11,261 6,310 56.0%

56 percent of MBS issued from 2005 to 2007 were eventually downgraded

Sources: Inside Mortgage Finance, Milken Institute.

Note: A bond is considered investment grade if its credit rating is BBB- or higher by S&P. The data is downgraded through October 2008.

19

When is a AAA not a AAA? Multilayered mortgage products

Sources: International Monetary Fund, Milken Institute.

Origination ofmortgage loans High-grade CDO

Senior AAA 88%Junior AAA 5%

Pool of mortgage AA 3%loans: prime or subprime A 2%

BBB 1%Unrated 1%

Mortgage bonds

AAA 80%AA 11%A 4% Mezzanine CDO

BBB 3% CDO-squaredBB-unrated 2% Senior AAA 62%

Junior AAA 14% Senior AAA 60%AA 8% Junior AAA 27%A 6% AA 4% CDO-cubed…

BBB 6% A 3%Unrated 4% BBB 3%

Unrated 2%

20

National banks State commercial and savings banks

Federal savings banks

Insurance companies

Securities brokers/dealers

Other financial companies, including mortgage

companies and brokers

• Fed• OTS

• OCC• FDIC

• State bank regulators• FDIC• Fed--state member commerical banks

• OTS• FDIC

• 50 State insurance regulators plus District of Columbia and Puerto Rico

• FINRA• SEC• CFTC• State securities regulators

• Fed• State licensing (if needed)• U.S. Treasury for some products

• OCC• Host county regulator

• Fed• Host county regulator

• OTS• Host county regulator

Federal branch

Foreign branch

Limited foreign branch

Fed is the umbrella or consolidated regulator

Primary/secondaryfunctionalregulator

Notes:Justice Department: Assesses effects of mergers and acquisitions on competitionFederal Courts: Ultimate decider of banking, securities, and insurance productsCFTC: Commodity Futures Trading CommissionFDIC: Federal Deposit Insurance CorporationFed: Federal ReserveFINRA: Financial Industry Regulatory Authority GSEs: Government Sponsored Enterprises OCC: Comptroller of the CurrencyOTS: Office of Thrift SupervisionSEC: Securities and Exchange Commission

• Federal Housing Finance Agency

Fannie Mae, Freddie Mac, and Federal Home Loan Banks

Financial, bank and thrift holding companies

Justice Department• Assesses effects of mergers and acquisitions on competition

Federal courts• Ultimate decider of banking, securities, and insurance products

Sources: Financial Services Roundtable (2007), Milken Institute.

The U.S. regulatory regime: In need of reform?

commercial banks

21

How far do home prices have to fall? Average = 100

Sources: Moody’s Economy.com, Milken Institute.

60

80

100

120

140

160

1981 1988 1995 2002 2009

OFHEO

Case-Shiller: 20-metro

Case-Shiller: 10-metro

Case-Shiller National

Price/rent

60

80

100

120

140

160

1981 1988 1995 2002 2009

OFHEO

Case-Shiller: 20-metro

Case-Shiller: 10-metro

Case-Shiller National

Price/disposable income per capita

22

Alternative measures for the affordability ofmortgage debt for California

Mortgage payment assumptions:

* Home is purchased at median price

* Buyer takes out a 30-year

conforming, fixed-rate loan

* Payment also includes 1% property

tax per year, 0.1% property

insurance

Sources: Moody’s Economy.com, Milken Institute.

20%

30%

40%

50%

60%

70%

80%

2000 2002 2004 2006 2008

Estimated monthly payment / monthly household income

100% LTV

Maximum affordablility limit is 38% of median household income

90% LTV

80% LTV

23

Overview Government responses to liquidity freeze and credit crunch

• Government/private sector purchases of toxic assets• Guarantees for selected assets and liabilities • Capital injections into financial institutions• Subsidization of loan modifications by financial institutions • Debt for equity swaps• Easier monetary policies, including lowering interest rates and quantitative/

credit easing• Coordinated responses by countries (e.g., central bank currency swaps)• Establish an RTC-like agency (?)• Create good banks, bad banks (?)• Nationalize deeply troubled financial institutions (?)

24

Federal government comes to the rescue of Main Street and Wall Street

Upper limit to total funds under these programsUpper limit to total funds under these programs

……$9.8 trillion plus ?$9.8 trillion plus ?

Federal Reserve 6,048

Congress and White House 2,466

Federal Deposit Insurance Corporation 926

Treasury, Federal Deposit Insurance Corporation and Federal Reserve 362

Total amount dispersed/committed (US$ billions) 9,802

Source: Milken Institute.

25

Overview Reforms to prevent/mitigate credit booms and busts

• Macro-prudential regulation (i.e., establish a systemic risk regulator or market stability regulator)• A liquidity regulation to take into account maturity mismatches due to short-term funding of longer-

term, illiquid assets• Countercyclical regulation (e.g., dynamic capital and/or provisioning regulations)• A regulation that internalizes (taxes) a financial institution’s contribution to systemic risk (to address

too-big-to-fail issue)• Greater transparency by requiring clearing and settling of credit default swaps to be conducted

through clearing houses or on exchanges, which provides for greater monitoring of exposures and posting of necessary collateral

• Change fee structure for credit rating agencies, eliminate the Nationally Recognized Statistical Rating Organization (NRSRO) designation, and decrease use of ratings in regulatory system

• Consider eliminating treatment of residential mortgages as non-recourse loans (i.e., secured only by the underlying property), merging Freddie Mac and Fannie Mae, and requiring mortgage originators to have “skin in the game”

• Consider modifying incentive/compensation systems to discourage excessive risk taking• Reform structure of regulatory system • Consider establishing greater co-operation among regulators in countries or establish centralized

supervision or deposit insurer in some regions

26

• Barry Eichengreen’s slides

27

And not only here: It is a global slump in industrial production

60

65

70

75

80

85

90

95

5 10 15 20 25 30 35 40 45 50

Ju ne 1929= 100 A pril 2008=100

100

28

Not only here:Trade is collapsing faster than in 1929

60

70

80

90

100

110

5 10 15 20 25 30 35 40 45 50

Ju ne 1929=100 A pril 2008=100

29

Not only here:It is a global stock market crash

30

40

50

60

70

80

90

100

110

5 10 15 20 25 30 35 40 45 50

Ju ne 1929=100 A pril 2008=100

30

Grading the policy response

• Monetary policy: A-• Fiscal policy: B+• Housing policy: B+• Banking policy: Incomplete

31

Even then there is no instantaneous fix

• Vertical line in figure at left is date of major bank recapitalization.

• It still takes two years after that for lending to recover even in the Swedish case that is the benchmark of how to do it.

• It took a long time to get into this mess. Alas it will take a long time to get out.

32

We will become more heavily indebted, but we have no choice

CBO forecasts now suggest that the US debt ratio will rise from 40 to 80 percent of GDP.

33

This is roughly what happened in Finland and Sweden

• In resolving their banking crises, their debt ratios similarly rose by 40% of GDP.

• Of course, you can make progress later, bringing this ratio back down, through surpluses and growth (if you fix the banking system and then show political resolve)

34

This is not to deny that there will be medium term consequences

• There will be crowding out of capital investment, not now but once the economy is firing on all cylinders again.

• But my point is that there is little choice.

• We have dug ourselves a deep hole. The cost of preventing growth from collapsing now will be somewhat slower growth for several years going forward (until we normalize the budget balance).

35

• Alan Boyce’s slides

36

U.S. Non-Agency MBS market died

Note: 2000-2005 assumed straight-line for quarterly comparison

$0

$20,000

$40,000

$60,000

$80,000

$100,000

$120,000

$140,000

1Q00

3Q00

1Q01

3Q01

1Q02

3Q02

1Q03

3Q03

1Q04

3Q04

1Q05

3Q05

1Q06

3Q06

1Q07

3Q07

1Q08

3Q08

MB

S Is

suan

ce (

$ m

illio

ns)

0%

10%

20%

30%

40%

50%

60%

No

n-A

gen

cy Is

suan

ce /

To

tal I

ssu

ance

Prime

Subprime

Alt-A

Non-Agency / Total

37

Which reduces risk of negative equityTypical homeowner scenario:

–Borrower pays $100,000 for a house with an 80% LTV, loan originated at par–Agency Loan, housing prices have fallen 10% and FN 5% mortgage bond prices have fallen to 94

–Non-Agency Loan, housing prices have fallen 30% and mortgage bond prices have fallen to 75

At Origination

House 100

Loan 80

Equity 20

Agency Loan:

Housing Prices Down 10%

Non-Agency Loan:

Housing Prices Down 30%

Principleof Balance

House 70

Loan 60

Equity10

Change in Equity: -50%

Existing System

House 90

Loan 80

Equity10

Change in Equity: -50%

Existing System

House 70

Loan 80

Equity -10

Negative Equity

Principleof Balance

House 90

Loan 75

Equity15

Change in Equity: -25%

38

First lossLoan Originator

10%

Down payment 20%

Guaranty from GSE

90%Value

of the

loan

Value of

the house

Credit enhancement structure for shared platform

Provided by Originator and/or MI industry Expected Capital reserves of 20% Backup capital and industry skill to be provided

by MI Reinsurance Industry

AAA rating flows from GSE guarantee The value of the house will serve as collateral Bond holder looks to GSE for full faith and credit

guaranty GSE looks to Originator remove bad loans from

the pool Originator purchases parri passu amount of bonds

from pool at lower of market or par If originator fails to perform, GSE can seize servicing

rights and margin and reassign to another servicer