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Demystifying the Mortgage Meltdown:
     What It Means for Main Street,
Wall Street and the U.S. Financial System

    James R. Barth                  Glenn Yago
     Senior Fellow           Director of Capital Studies
                     Milken Institute
                     October 2, 2008


                                                           1
“I have great, great confidence in our capital markets and in
our financial institutions. Our financial institutions, banks
and investment banks are strong.”

                               Treasury Secretary Henry Paulson
                                                 March 16, 2008
                                                           CNN




                                                                  2
… but just six months later…


“The financial security of all Americans … depends on our
ability to restore our financial institutions to a sound footing.”

                                  Treasury Secretary Henry Paulson
                                               September 19, 2008
                                                      Press release



                                                                      3
“Any real estate investment is a good investment … ”




                                                       4
“Any real estate investment is a good investment … ”




                  … Really?!
                                                       5
Subprime mortgage meltdown timeline
                                                    December 2006–September 2008
   Dow Jones U.S. Financial Index
                                                                                                                                                                             Aug. 1,
                                                   Aug. 16, 2007:       Sept. 30, 2007:   Oct. 24, 2007:         Mar. 11, 2008: Fed   Mar. 16, 2008:     Mar. 18, 2008:
                                                                                                                                                                             2008: First
                                                   Countrywide gets     NetBank goes      Merrill announces      offers troubled      JP Morgan          Fed cuts
  650                                                                                                                                                                        Priority
           Feburary–March 2007: More than 25       emergency loan of    bankrupt.         $7.9 billion in        banks as much as     Chase offers to    discount rate
                                                                                                                                                                             Bank
           subprime lenders declare                $11 billion from a                     subprime write-        $200 billion in      buy Bear           to 2.4%; Fed
                                                                                                                                                                             closes.
           bankruptcy.                             group of banks.                        downs, surpassing      loans; Fed           Stearns; Fed       funds rate to
                                                                                          Citi’s $6.5 billion.   introduces Term      introduces         2.25%.
                                                                                                                                                                                Sept. 14, 2008:
                                                                                                                 Securities           Primary Dealer
                                                                                                                                                                                Lehman files for
                                                                                                                 Lending Facility.    Credit Facility.
  550                                                                                                                                                                           bankruptcy.
                                                                                                                                                    July 30, 2008:
                                                                                                                                                                                  Sept. 16, 2008:
           Dec. 2006:                        Apr. 2007: New
                               Feb. 2007:
                                                                                                                                                    President
                                                                                                                                                                                  Fed loans AIG
           Ownit Mortgage,                   Century, a
                               HSBC sets
                                                                                                                                                    Bush signs a
                                                                                                                                                                                    $85 billion.
           a subprime                        mortgage
                               aside $10.6                                       Dec. 12, 2007:                                                     housing
           lender, files for                 broker, files
                               billion for                                       Fed introduces                                                     rescue law.
  450      bankruptcy.                       for
                               bad loans,                      Aug. 6, 2007:                                                                                                               Sept. 23, 2008:
                                                                                 Term Auction
                                             bankruptcy.
                               including                       American Home                                                                                                               Washington
                                                                                 Facility.
                               subprime.                       Mortgage files                                                                                                              Mutual is seized
                                                                                          Jan. 11, 2008:
                                                               for bankruptcy.                                                                                                             by FDIC.
                                             July 31, 2007:
                                                                                          Bank of
                                             Two Bear
                                                                                          America agrees                              June 9, 2008:
                                             Stearns                                                             Feb. 13, 2008:
  350                                                                                     to buy                                                                                           Sept. 29, 2008:
                                                                                                                                      Lehman
                                             hedge funds                                                         President Bush
                                                                                          Countrywide.
                                                              Aug. 17, 2007: Fed cuts                                                                                                      Citigroup
                                                                                                                                      announces a $2.8
                                             file for                                                            introduces tax
                                                              discount rate to 5.75%;                                                                                                      agrees to buy
                                                                                                                                      billion loss.
                                             bankruptcy.                                                                                                             Sept. 7, 2008: U.S.
                                                                                                                 rebate stimulus
                                                                                           Jan. 30, 2008: Fed
                                                              Fed introduces Term                                                                                                          Wachovia bank.
                                                                                                                                                                     seizes Fannie Mae
                                                                                                                 program of $168
                                                                                           cuts discount rate
                                                              Discount Window                                                          July 11, 2008: IndyMac
                                                                                                                                                                     and Freddie Mac.
                                                                                                                 billion.
                                                                                           to 3.5%.
                                                              Program.                                                                 is seized by FDIC.
  250

Sources: BusinessWeek, S&P, Global Insight, Milken Institute.                                                                                                                                            6
Overview




           7
Home mortgages: Who borrows, how much has been
              borrowed, and who funds them?
                                          Total value of housing stock = $19.3 trillion

                                    Subprime
                                                                              Securitized
                                    8.4%
                                                                                                        Government-
                                                                                 58%
          Mortgage debt                                                                                  controlled
          $10.6 trillion                                                                                   46%
                                     Prime
                                     91.6%
                                                                                      Non-securitized    Private
                                                                                                         sector-
                                                                                           42%
                                                                                                        controlled
                                                                                                          54%
            Equity in housing stock
            $8.7 trillion



      Note: total residential and commercial mortgages = $14.7 trillion; 5 percent = $700 billion
Sources: Federal Reserve, Milken Institute.                                                                           8
The mortgage problem in perspective

            80 million houses
               27 million are paid off

            53 million have mortgages
             48 million are paying on time

                                                            This compares to
                                                            50% seriously
                                                            delinquent in the
                                                            1930s.
                  5 million are behind
            (9.2% of 53 million with 2.8% in foreclosure)

Sources: U.S. Treasury, Milken Institute.                                       9
I. Low interest rates
and a lending boom




                        10
Did the Fed lower interest rates too much and for too long?
                              Federal funds rate vs. rates on FRMs and ARMs
       Percent
       8
                                                30-year FRM rate
       7
       6
       5
       4                                                                                                Target federal
                                                                                                          funds rate
       3
                                           1-year ARM rate
       2
                                                                           Record low from June 25,
       1
                                                                           2003, to June 30, 2004: 1%
       0
        2001             2002              2003             2004             2005                2006      2007          2008


Sources: Federal Reserve, Mortgage Bankers Association, Moody’s Economy.com, Milken Institute.                                  11
Home price bubble
               Low interest rates
                                                                                    and credit boom
                and credit boom
                                                                                                             Index, January 2000 = 100
         US$ trillions                                         Percent       US$ trillions
         4.5                                                        6.0      4.0                                                    250
         4.0                                                                 3.5
                                                                    5.5
                                                                                                                                    200
         3.5
                                                                             3.0
         3.0                                                        5.0
                                                                             2.5                                                    150
         2.5
                                                                                                                        Home
                                                                    4.5      2.0
                                                  Home                                                                mortgage
         2.0
                                                mortgage                                                                            100
                                                                                                                     originations
                                                                             1.5      S&P/Case-Shiller
         1.5                                                        4.0
                                               originations                                                           (left axis)
                                                                                       National Home
                                                (left axis)                  1.0
         1.0
                                                                                        Price Index
                  1-Year ARM rate                                                                                                   50
                                                                    3.5
                                                                                        (right axis)
                    (right axis)
         0.5                                                                 0.5
         0.0                                                        3.0      0.0                                                    0
               2001           2003          2005           2007
                                                                                    2001           2003           2005       2007

Sources: Inside Mortgage Finance, Mortgage Bankers Association, Moody’s Economy.com, S&P/Case-Shiller, Milken Institute.                  12
II. Homeownership, prices,
  starts and sales take off




                              13
Credit boom pushes                             Home price bubble                     California and national
     homeownership rate                               peaks in 2006                        home prices reach
       to historic high                                                                        record highs
                                                Index, January 1987 = 100
Percent                                                                                  US$ thousands
70                                              380
                         Q2 2008: 68.1%
                                                                                         700
                                                         S&P/
                                                                                               California m e dian
                                                         Cas e -Shille r
        Q2 2004: 69.2%
                                                330
69                                                                                       600   hom e price
                                                        National Hom e
                                                         Price Inde x                          California
                                                                                         500
                                                280
68
                                                                                               ave rage
                                                                                         400   1987-2008        U.S. m e dian
                                                230
67
                                                                                                                hom e price
                                                                                               $229,748
                                                                                         300
                                                180
66
                                                                                         200
                                                130           OFHEO Hom e Price Inde x
65                                                                                       100
      Ave rage , 1965–Q2 2008: 65.2%                                                           U.S. ave rage , 1987-2008: $121,280
                                                  80
64                                                                                         0
                                                    1998 2000 2002 2004 2006 2008
  1998 2000 2002 2004 2006 2008                                                             1998 2000 2002 2004 2006 2008


Sources: U.S. Census Bureau, OFHEO, Moody’s Economy.com, S&P/Case-Shiller,
California Association of Realtors, Milken Institute.                                                                           14
Housing starts hit                                                                      Homes sales reach
                                                      Homes for sale
  a record in 2005                                                                          a new high
                                             Millions                        Millions    Millions                           Millions
Housing units, millions
                                             4                                     0.8   7.0                                     1.5
2.0                                                Existing homes for                          Exis ting hom e
       January 2006: 1.8 m illion
                                                   sale (left axis)                            s ale s (le ft axis )
                                                                                         5.6                                    1.2
                                             3                                    0.6
1.5
                                                                                         4.2                                    0.9
                                             2                                    0.4
1.0
      Ave rage s tarts ,
                                                                                         2.8                                    0.6
      1959–July 2008: 1.1 m illion                                                                     Ne w hom e s ale s
                                                                                                       (right axis )
                                             1                                    0.2
0.5                                                                                      1.4                                    0.3
                                                      New homes for
              July 2008: 641,000
                                                      sale (right axis)
                                                                                         0.0                              0.0
                                             0                              0.0
0.0
                                                                                            1998 2000 2002 2004 2006 2008
                                              1998 2000 2002 2004 2006 2008
   1998 2000 2002 2004 2006 2008



Sources: U.S. Census Bureau, OFHEO, Moody’s Economy.com, Milken Institute.                                                        15
III. Subprime borrowers and
     subprime mortgages




                              16
Who is a subprime borrower?
 National FICO scores display wide distribution                              What goes into a FICO score?
   Percentage of population
  40                                                                                  Types of credit in use
                                           Prime = 79%
                                                                                             10%
                                                                           New credit
  30                                                   27                                                      Payment history
                                                                              10%
                                                                                                                    35%
           Subprime = 21%                       18
  20
                                         15                            Length of
                                                              13
                                   12
                                                                     credit history
                            8
  10
                                                                           15%
                    5
           2
    0
                                                                                              Amounts owed
         up to 500-       550-    600-   650-   700-   750-   800+
          499 549         599     649    699    749    799
                                                                                                    30%

Sources: myFICO.com, Milken Institute.                                                                                       17
Prime and subprime mortgage originations
                            by FICO score reveal substantial overlaps
  Percent of total originations
                                    FICO below 620                                                 FICO above 620
    20
                                      Prime: 6.6%                                                   Prime: 93.4%
                                    Subprime: 45.2%                                                Subprime: 54.8%
    16
                                                                                                                                       Prime
    12
                                 Subprime

     8

     4

     0
         59

               79

                       99

                              19

                                     39

                                              59

                                                    79

                                                            99

                                                                  19

                                                                          39

                                                                                59

                                                                                        79

                                                                                              99

                                                                                                      19

                                                                                                            39

                                                                                                                    59

                                                                                                                          79

                                                                                                                                  99

                                                                                                                                        00
     -4

              -4

                    -4

                            -5

                                   -5

                                          -5

                                                   -5

                                                         -5

                                                                 -6

                                                                       -6

                                                                               -6

                                                                                     -6

                                                                                             -6

                                                                                                   -7

                                                                                                           -7

                                                                                                                 -7

                                                                                                                         -7

                                                                                                                               -7

                                                                                                                                       -9
   0

          0

                   0

                         0

                                 0

                                        0

                                               0

                                                        0

                                                              0

                                                                      0

                                                                            0

                                                                                    0

                                                                                          0

                                                                                                  0

                                                                                                        0

                                                                                                                0

                                                                                                                      0

                                                                                                                              0

                                                                                                                                    0
         46

               48

                       50

                              52

                                      54

                                              56

                                                    58

                                                            60

                                                                  62

                                                                          64

                                                                                66

                                                                                        68

                                                                                              70

                                                                                                      72

                                                                                                            74

                                                                                                                    76

                                                                                                                          78

                                                                                                                                  80
                                                                      FICO score
Sources: LoanPerformance, Milken Institute.                                                                                                    18
ARMs look attractive to many borrowers
    Percent
    8.0

    7.0                                      30-year FRM rate

    6.0

    5.0

    4.0
                                                                           1-year ARM rate
    3.0

    2.0
       2001              2002            2003             2004             2005      2006    2007   2008

Sources: Mortgage Bankers Association, Moody’s Economy.com, Milken Institute.
                                                                                                           19
ARM share grows, following low interest rates
         Percent of all outstanding home mortgages
   25


   20


   15


   10


     5


     0
         2001             2002              2003              2004              2005   2006   2007   2008

Sources: Mortgage Bankers Association, Moody’s Economy.com, Milken Institute.
                                                                                                            20
Largest share of ARMs go to subprime borrowers
        Percent of mortgage type
       60
              FHA ARM Prime ARM                      Subprime ARM
       50

       40


       30

       20


       10

        0
            2001             2002             2003              2004            2005   2006   2007   2008

Sources: Mortgage Bankers Association, Moody’s Economy.com, Milken Institute.
                                                                                                            21
Subprimes take an increasing share
                     of all home mortgage originations
         US$ trillions
                                                      8.4%
          4.0
                                                                                            Subprime
                                                                     21.3%                  Prime
                                      7.4%                                   20.1%
                                                             18.2%
          3.0    Subprime's
                   share:                                                            7.9%
                    7.8%

          2.0



          1.0
                                                                                               0.9%


          0.0
                     2001             2002            2003   2004    2005    2006    2007     Q2 2008


Sources: Inside Mortgage Finance, Milken Institute.                                                     22
Subprime mortgages increase rapidly before big decline
                                                                                              Outstandings
                              Originations                               US$ billions
      US$ billions
                                                                         1,400    Average annual growth rates
     700
                                                                                                                1,240
                                                                                  1995–2006: 14%          1,200
                                              625
                                                      600                         2006–Q1 2008: -23%
                                                                         1,200
     600
                                      540
                                                                                                     973                940
                                                                         1,000                                                895
     500

                                                                          800                  699
     400
                              310                                                       574
                                                                          600
     300                                                                         479
                      200                                   191           400
     200     160

                                                                          200
     100
                                                                   14
                                                                             0
        0
                                                                                 2001 2002 2003 2004 2005 2006 2007            Q1
            2001 2002 2003 2004 2005 2006 2007                     Q2
                                                                   H2
                                                                                                                              2008
                                                                  2008
                                                                  2008
Sources: Inside Mortgage Finance, Milken Institute.                                                                                  23
IV. Mortgage product innovation




                                  24
Subprime and Alt-A shares quadruple between 2001
                    and 2006, then fall in 2007
                                                                                                      Q1 2008, $480 billion
                                             2006, $3.0 trillion          2007, $2.4 trillion
        2001, $2.2 trillion
                                                                                                             9%
                                                                                                  4%
                                                                                      4.9%                           9.6%
                                                          2.7%
                 5%
      2%                                                                  14%
                                              14%
                           7.9%                                                                  2%
                                                            33.2%
   7%
                                                                                                 8%
                                                                    11%
                                      13%
                                                                     8%
 20%                                                                                     47.3%                       67.2%
                                                           16%
                               57.1%                                  14%
                                           20%

                                                                                                            p
                                                                                                      Subprime
                                                 FHA & VA
                                                                                                      Alt-A
                                                 Conventional, conforming prime
                                                                                                      Home equity loans
                                                 Jumbo prime

Sources: Inside Mortgage Finance, Milken Institute.                                                                           25
ARM hybrids dominate subprime originations (2006)

            Prime conventional                           Alt-A
                                                                                         Subprime
            Other
                                                                                                       Other
                                                                                      Fixed
                                                Othe r
            ARM                                                                                        ARM
                                                                                       9%
                                                ARM
             7%                                                                                         4%
                                                 23%
 ARM                                                                             30-year
hybrids                                                                        ARM balloon
                                                                                with 40- to
  23%                                                                            50-year
                                                                               amortization
                                                                                   26%
                                                                 ARM hybrids                        2- and 3-year
                                          Fixed Fixe d
                                                                    46%                             hybrids 61%
                                                 31%
                                          70%




Sources: Freddie Mac, Milken Institute.                                                                         26
V. Securitization




                    27
The mortgage model switches from
            originate-to-hold to originate-to-distribute
                Residential mortgage loans                      Residential mortgage loans
                 1980: Total = $958 billion                     Q2 2008: Total = $11.3 trillion


    Securitized
      15.6%
                                                                                                   Held in
                                                                                                  portfolio
                                                                                                    41%



                                               Held in    Securitized
                                                             59%
                                              portfolio
                                               84.4%

Sources: Federal Reserve, Milken Institute.                                                                   28
Securitization becomes the dominant funding
                  source for subprime mortgages
    Percent of all subprime mortgages securitized since 1994
    80
                                                                                               68    68    68
                                                                                          65
    70
                                                                                     62
                                                                                57
    60
                                                                          50
                                                                     47
    50                                          45              45
                                                      43   42
                                       40
    40                        33
             31       29
    30

    20

    10

      0
           1994 1995 1996 1997 1998 1999 2000                   2001 2002 2003 2004 2005 2006 2007    Q1   Q2
                                                                                                     2008 2008


Sources: Inside Mortgage Finance, Milken Institute.                                                              29
The rise and fall of private-label securitizers
                                                            New securities issuance

                                                                                       4%
                 2%                                                                                                      15%
                                                                                                               6%
                                                                13%
                                             20%
                              42%
                                                                            56%
 21%                                                                                              18%

                 1985                                     2001                        2006                    First half 2008
             Total = $110B                            Total = $1.3T               Total = $2.0T               Total = $734B



                                                                                                                                33%
                                                                      29%                         22%
     35%
                                                                                                        46%
                                              38%


      Ginnie Mae                              Freddie Mac                         Fannie Mae                   Private-label



Sources: Inside Mortgage Finance, Milken Institute.                                                                               30
The rise and fall of private-label securitizers
                                                          Outstanding securities

                                                                                                                      7%
                                                                                          7%
               6%                             14%                     18%                                30%
                                                                             35%
                                                                                                   25%
13%                               55%                                                                                            26%

                1985                                      2001                         2006                    First half 2008
                                                      Total = $3.3T
            Total = $390B                                                          Total = $5.9T                Total = $6.8T

26%
                                         39%                           29%
                                                                             33%                          37%


      Ginnie Mae                              Freddie Mac                      Fannie Mae                      Private-label


Sources: Inside Mortgage Finance, Milken Institute.                                                                               31
VI. Affordability




                    32
Ratio of home                                Debt-to-income ratio                         Home mortgage share of
  price to household                               of households has                           household debts reaches
    income surges                                   increased rapidly                             a new high in 2007
                                                 Home mortgage debt/disposable                 Percent
 Median home price/                                                                                               Q2 2007: 73.7%
                                                 personal income                               75
 median household income                                             Q4 2007: 139.5%
                                                 150
 5.0                     2005: 4.69

 4.5
                                                                                               70
                                                 125
                                                                                                                      Q2 2008: 73.4%
 4.0

                                  2007: 4.29
 3.5
                                                                   Average, 1957–2007: 79.7%   65
                                                 100
 3.0                                                                                                Average, 1952–2008: 64.2%
        Average, 1967–2007: 3.38
 2.5
                                                  75                                           60
       1998       2001        2004        2007
                                                    1998        2001        2004        2007    1998      2001      2004        2007



Sources: U.S. Census Bureau, OFHEO, Federal Reserve, Moody’s Economy.com, Milken Institute.                                            33
VII. Collapse




                34
The recent run-up of home prices was extraordinary
Index, 2000 = 100
 250
                                                                                                          Current
        Annualized growth rate of nominal home index: 3.4%
                                                                                                           boom
                                                      Great
200
                                                    Depression
                                 World
                                                           World                    1970’s      1980’s
                                 War I
150                                                        War II                   boom        boom


100



  50           Long-term trend line


    0
    1890         1900         1910           1920   1930   1940     1950   1960   1970   1980      1990   2000   2010


Sources: Robert Shiller, Milken Institute.                                                                          35
Home prices don’t go up forever
                                             Change in home prices in 100 plus years
  Percentage change in nominal home price, year ago
  30
                                  Great        World
                    World                                                              1970’s     1980’s    Current
                                Depression     War II
                    War I                                                              Boom       Boom       Boom
  25
  20
                                                                                 Average, 1890–2007: 3.7%
  15
  10
    5
    0
   -5
 -10                                                               +/- one standard deviation
 -15
 -20
   1890           1900        1910           1920   1930   1940   1950    1960    1970     1980      1990   2000      2010

Sources: Robert Shiller, Milken Institute.                                                                              36
2005: The collapse begins
 Home price indices, percent change on a year earlier
                                                      S&P/Case-Shiller
 20
                                                          10 city
 15                                S&P/Case-Shiller
                                                          national
 10
                                               OFHEO
   5

   0

  -5

-10

-15
    1988         1990          1992         1994          1996         1998   2000   2002   2004   2006   2008

Sources: S&P/Case-Shiller, OFHEO, Moody’s Economy.com, Milken Institute.                                     37
Forty-six states had falling prices
                            in the fourth quarter 2007
                       United States: - 9.3% (fourth-quarter annualized growth)




Source: Freddie Mac.                                                              38
If you bought your house…
              One year ago…                                                                          Five years ago…
                                                             -1.0   Charlotte                                            48.4 Seattle
                                                      -3.2          Dallas                                               48.0 Portland
                                                   -4.7             Denver                                        28.2        Washington
                                                  -5.2              Boston                                        27.9        New York
                                                 -5.8               Portland                                                  Phoenix
                                                                                                                 26.8
                                              -7.1                  Seattle                                                   Los Angeles
                                                                                                                 26.3
                                             -7.3                   New York                                     26.3         Tampa
                                             -7.3                   Cleveland                                                 Miami
                                                                                                                 26.0
                                           -8.1                     Atlanta                                                   Las Vegas
                                                                                                                24.4
                                        -9.5                        Chicago                                                   Charlotte
                                                                                                               22.9
                                -13.9                               Minneapolis                              20.5             Composite 10
                             -15.7                                  W ashington                                               Composite 20
                                                                                                            18.6
                            -15.9                                   Composite 20
                                                                                                                              Chicago
                                                                                                          14.3
                           -16.3                                    Detroit
                                                                                                       9.1                    San Francisco
                         -17.0                                      Composite 10
                                                                                                      6.6                     Atlanta
                 -20.1                                              Tampa
                                                                                                                              Dallas
                                                                                                      6.5
         -23.7                                                      San Francisco
                                                                                                                              San Diego
                                                                                                     6.1
        -24.2                                                       San Diego
                                                                                                     5.9                      Boston
      -25.3                                                         Los Angeles
                                                                                                                              Denver
                                                                                                     4.8
  -27.9                                                             Phoenix
                                                                                                                              Minneapolis
                                                                                              -0.7
  -28.3                                                             Miami
                                                                                                                              Cleveland
                                                                                            -3.8
  -28.6                                                             Las Vegas
                                                                                    -21.3                                     Detroit

             % change in price, June 07-08                                          % change in price, June 03-08
Sources: S&P/Case-Shiller, Milken Institute.                                                                                                  39
Housing starts                                     Homes sit longer                          … as home
       sharply decline                                    on the market …                        appreciation slows
                                                                                           Percent                             Months
                                                     Number of months that
Percent change, year ago
30                                                   homes sit on the market                     Pe rce ntage change from
                                                                                           20                                          0
                                                                                                 ye ar ago in m e dian
                                                     12
                                                                    Existing homes
15                                                                                               hom e s ale s price
                                                                                                                                       2
                                                                                                  (le ft axis )
                                                     10
                                                                                           10
 0
                                                                                                                                       4
                                                      8
-15
                                                                                            0                                          6
                                                      6
-30                                                                                                                                    8
                                                      4
                                                                                           -10
       June 2008: -41.9%                                                                             Num be r of m onths
-45                                                                                                                                    10
       July 2008: -39.2%                              2                                                hom e s s tay on
                                                                    New homes
                                                                                                     m ark e t (right axis )
-60                                                                                        -20                                         12
                                                      0
   1998 2000 2002 2004 2006 2008                                                              1999   2001     2003      2006    2008
                                                       1998 2000 2002 2004 2006 2008


Note: Shaded area represents fluctuation within one standard deviation from mean (1.28%)
Sources: Mortgage Bankers Association, OFHEO, Moody’s Economy.com, Milken Institute.                                                   40
VIII. Delinquencies and foreclosures




                                       41
Foreclosures are nothing new, but …
 Thousands of foreclosures per year
 2,150

 1,900

 1,650

 1,400

 1,150        Av erage 661,362 annual foreclosures from Q2 1999 to Q2 2006

   900

   650

   400
       99

              99

                      00

                              00

                                     01

                                             01

                                                    02

                                                               02

                                                                     03

                                                                             03

                                                                                   04

                                                                                           04

                                                                                                 05

                                                                                                         05

                                                                                                               06

                                                                                                                       06

                                                                                                                             07

                                                                                                                                     07

                                                                                                                                           08
     19

             19

                    20

                            20

                                    20

                                           20

                                                   20

                                                           20

                                                                    20

                                                                          20

                                                                                  20

                                                                                        20

                                                                                                20

                                                                                                      20

                                                                                                              20

                                                                                                                    20

                                                                                                                            20

                                                                                                                                  20

                                                                                                                                          20
   2

          4

                  2

                          4

                                 2

                                         4

                                                2

                                                           4

                                                                2

                                                                         4

                                                                               2

                                                                                       4

                                                                                             2

                                                                                                     4

                                                                                                           2

                                                                                                                   4

                                                                                                                         2

                                                                                                                                 4

                                                                                                                                       2
 Q

         Q

                Q

                        Q

                                Q

                                       Q

                                               Q

                                                      Q

                                                               Q

                                                                     Q

                                                                             Q

                                                                                   Q

                                                                                           Q

                                                                                                 Q

                                                                                                         Q

                                                                                                               Q

                                                                                                                       Q

                                                                                                                             Q

                                                                                                                                     Q
Sources: Mortgage Bankers Association, Milken Institute.                                                                                        42
… their numbers have doubled
 Thousands of foreclosures per year
 2,150

 1,900
                                                  Average 1,316,220 annual forclosures from Q3 2006 to Q2 2008
 1,650

 1,400

 1,150
              Average 661,362 annual foreclosures from Q2 1999 to Q2 2006
    900

    650

    400
       99

               99

                       00

                              00

                                      01

                                              01

                                                     02

                                                               02

                                                                     03

                                                                             03

                                                                                   04

                                                                                           04

                                                                                                 05

                                                                                                         05

                                                                                                               06

                                                                                                                       06

                                                                                                                             07

                                                                                                                                     07

                                                                                                                                           08
     19

              19

                     20

                            20

                                    20

                                            20

                                                    20

                                                           20

                                                                    20

                                                                          20

                                                                                  20

                                                                                        20

                                                                                                20

                                                                                                      20

                                                                                                              20

                                                                                                                    20

                                                                                                                            20

                                                                                                                                  20

                                                                                                                                          20
   2

           4

                   2

                          4

                                  2

                                          4

                                                 2

                                                           4

                                                                2

                                                                         4

                                                                               2

                                                                                       4

                                                                                             2

                                                                                                     4

                                                                                                           2

                                                                                                                   4

                                                                                                                         2

                                                                                                                                 4

                                                                                                                                       2
 Q

          Q

                 Q

                        Q

                                Q

                                        Q

                                                Q

                                                       Q

                                                               Q

                                                                     Q

                                                                             Q

                                                                                   Q

                                                                                           Q

                                                                                                 Q

                                                                                                         Q

                                                                                                               Q

                                                                                                                       Q

                                                                                                                             Q

                                                                                                                                     Q
Sources: Mortgage Bankers Association, Milken Institute.                                                                                        43
Subprime mortgages accounted for half
                          or more of foreclosures since 2006
     Number of home mortgage foreclosures started (annualized, in thousands)
     2,000
                                                                 Subprime: 12% of mortgages
                      Subprime
                                                                 serviced (M arch 2008)
                      FHA and VA
     1,600
                                                                                                                 50%
                      Prime (includes Alt-A)
                                                                                                       54%
     1,200

                                                                                              56%
                                                                                                                  8%
                                                                                   55%
        800                                                                                             9%
                   37%                         37%
                                 36%                   44%      47%       52%                                    42%
                                                                                              11%      37%
        400                                                                        13%
                   29%                         29%
                                 29%                   22%      20%       17%
                                                                                              33%
                                                                          31%
                                                                                   32%
                   34%                         34%
                                 35%                   34%      33%
           0
               Dec. 2003        June       Dec. 2004   June   Dec. 2005   June   Dec. 2006    June   Dec. 2007   M arch
                                2004                   2005               2006                2007                2008


Sources: Inside Mortgage Finance, Milken Institute.                                                                       44
Subprime ARMs have the worst default record
  Home mortgages delinquent or in foreclosure (percent of number)
  35
                                                                  Q2 2008, Subprime ARM: 33.4%
  30
                                                                                Subprime FRM: 11.8%
  25
                                                                                FHA and VA: 5.8%
  20
                                                                                Prime FRM: 3.0%
  15

  10

    5

    0
         Q2       Q1        Q4        Q3         Q2         Q1     Q4     Q3      Q2     Q1     Q4     Q3     Q2     Q1
        1998     1999      1999      2000       2001       2002   2002   2003    2004   2005   2005   2006   2007   2008


Sources: Mortgage Bankers Association, Milken Institute.                                                                   45
Percentage of homes purchased in Q2 2008
                   that now have negative equity




      United States = 44.8%
                                 < 20%
                                 >= 20% and < 35%
                                 >= 35% and < 50%
                                 >= 50%


Sources: Zillow.com, Milken Institute.                  46
Percentage of homes sold for a loss (Q2 2008)




      United States = 32.7%
                                  < 15%
                                  >= 15% and < 30%
                                  >= 30% and < 45%
                                  >= 45%


Sources: Zillow.com, Milken Institute.                   47
Percentage of homes sold that were in
                             foreclosure (Q2 2008)




      United States = 18.6%
                                 < 1%
                                 >= 1% and < 25%
                                 >= 25% and < 40%
                                 >= 40%



Sources: Zillow.com, Milken Institute.                       48
IX. Damages scorecard




                        49
Losses/write-downs, capital raised, and jobs cut
              by financial institutions worldwide
 US$ billions                                                                       Number of jobs cut
 200                                                                                              60,000
                                                  Jobs cut (right axis)

 160                                                                                              48,000

                           Capital raised
 120                                                                                              36,000
                             (left axis)
   80                                                                                             24,000
          Losses/write-downs
              (left axis)
   40                                                                                             12,000

    0                                                                                             0
          Prior quarters            Q3 2007     Q4 2007       Q1 2008     Q2 2008    Q3 2008


Note: Q3 data are through September 25, 2008.
Sources: Bloomberg, Milken Institute.                                                                 50
What is the cumulative damage?
   Cumulative losses/write-downs, capital raised, and jobs cut by financial institutions worldwide

US$ billions                                                                      Number of jobs cut
600                                                                                         140,000

                                                                                            120,000
500
                              Jobs cut (right axis)                                         100,000
400
                                                                                            80,000
            Capital raised (left axis)
300
                                                                                            60,000
        Losses/write-downs (left axis)
200
                                                                                            40,000
100                                                                                         20,000

    0                                                                                       0
         Prior quarters            Q3 2007       Q4 2007   Q1 2008   Q2 2008    Q3 2008


Note: Q3 data are through September 25, 2008.
Sources: Bloomberg, Milken Institute.                                                                51
Recent losses/write-downs and capital raised
                     by selected financial institutions
              US$ billions, through September 25, 2008   Losses /write-downs   Capital raised
      Citigroup, United States                                  55.1               49.1
      Merrill Lynch, United States                              52.2               29.9
      UBS, Switzerland                                          44.2               28.2
      HSBC, United Kingdom                                      27.4                5.1
      Wachovia, United States                                   22.7               11.0
      Bank of America, United States                            21.2               20.7
      Morgan Stanley, United States                             15.7                5.6
      IKB Deutsche, Germany                                     15.0               12.3
      Washington Mutual, United States                          14.8               12.1
      Royal Bank of Scotland, United Kingdom                    14.4               23.5
      World total                                               521.9              379.2



Sources: Bloomberg, Milken Institute.                                                           52
Financial stock prices take big hits
     Percentage change in stock price, December 2006–September 2008
           -99.8                                                                                     W ashington Mutual
           -99.7                                                                                     Lehman Brothers
             -97.5                                                                                   Freddie Mac
             -97.4                                                                                   Fannie Mae
              -95.4                                                                                  AIG
               -94.3                                                                                 Bear Stearns*
               -93.9                                                                                 W achov ia
                  -90.0                                                                              Countrywide**
                          -72.8                                                                      Merrill Lynch
                              -66.0                                                                  Morgan Stanley
                              -65.6                                                                  UBS Equity
                                              -35.8                                                  Goldman Sachs
                                               -34.4                                                 Bank of America
                                                               -3.3                                  JP Morgan & Chase
                                                                                               5.5   W ells Fargo

Note: * Bear Stearns stock price is to May 2008. ** Countrywide stock price is to June 2008.
Sources: Bloomberg, Milken Institute.                                                                                53
Financial market capitalization takes big hit
   Total loss in market value: $728 billion, December 2006–September 2008
               -142                                                                                     AIG
                                      -101                                                              W achov ia
                                                   -80                                                  Bank of America
                                                      -74                                               UBS Equity
                                                               -60                                      Morgan Stanley
                                                                     -50                                Fannie Mae
                                                                       -44                              Merrill Lynch
                                                                        -43                             W ashington Mutual
                                                                         -42                            Freddie Mac
                                                                         -41                            Lehman Brothers
                                                                                -28                     Goldman Sachs
                                                                                  -24                   Countrywide**
                                                                                   -21                  Bear Stearns*
                                                                                               4        W ells Fargo
                                                                                                   17   JP Morgan & Chase
                                                                          US$ billions
Note: * Bear Stearns stock price is to May 2008. ** Countrywide stock price is to June 2008.
Sources: Bloomberg, Milken Institute.                                                                                        54
X. Credit crunch and liquidity freeze




                                        55
Tightened standards for real estate loans
  Net percentage of domestic respondents tightening standards for commercial real estate loans
 100
                   The end of S&L crisis
  80
                                                             Dotcom             Subprime
                                               LTCM
  60

  40

  20

    0

  -20

  -40
     1990           1992           1994       1996    1998   2000     2002   2004   2006   2008

Sources: Federal Reserve, Milken Institute.                                                       56
Widening spreads between
                         mortgage-backed and high-yield bonds
      Basis points, spread over 10-year Treasury bond
      1,800
                                              Maximum spread: 08/29/2008: 955.8 bps
      1,600

      1,400                                  Merrill Lynch Mortgage-Backed Securities Index
      1,200

      1,000                  Merrill Lynch High-Yield Bond Index
         800
         600
         400
         200
            0
           01/2004 07/2004 01/2005 07/2005 01/2006 07/2006 01/2007 07/2007 01/2008 07/2008

Sources: Merrill Lynch, Bloomberg, Milken Institute.                                          57
Liquidity freeze
                                                            Spread between 3-month LIBOR and
          Spread between 3-month LIBOR
                                                                 overnight index swap rate
                  and T-bill rate
      Basis points                                          Basis points
      350                                                   140
                          Se pte m be r 18, 2008: 313 bps
                                                                                Se pte m be r 19, 2008:
       300                                                                      127.5 bps
                                                             120
                      Augus t 20, 2007: 240 bps
       250                                                   100
                                                                     Ave rage s ince
                                                                     Augus t 2007: 69.8 bps
                                                              80
       200
                  Ave rage s ince
                                                              60
       150        Augus t 2007: 130 bps
                                                              40 Ave rage s ince
                Ave rage s ince
       100                                                         De ce m be r 2001: 21.1 bps
                1985: 76 bps
                                                              20
        50
                                                               0
          0
                                                               2006             2007             2008
           2006                 2007          2008
Sources: Bloomberg, Milken Institute.                                                                     58
Counterparty risk increases
    Basis points spread, basis points
    Average CDS
    500
                                                                                                                 AIG rescued

    400
                                                                Lehman Brother files for bankruptcy
                                                                    and Merrill Lynch acquired
    300
                                           Government announces support for
                                              Fannie Mae and Freddie Mac
    200
                                         Bear Stearns acquired

    100


       0
      07/2007            09/2007           11/2007            01/2008           03/2008            05/2008        07/2008      09/2008
Note: Counterparty Risk index averages the market spreads of the credit default swaps (CDS) of fifteen major
credit derivatives dealers, including ABN Amro, Bank of America, BNP Paribas, Barclays Bank, Citigroup, Credit
Suisse, Deutsche Bank, Goldman Sachs Group, HSBC, Lehman Brothers, JPMorgan Chase, Merrill Lynch,
Morgan Stanley, UBS, and Wachovia.
Sources: Datastream, Milken Institute.                                                                                                   59
Commercial paper issuance dries up
  Quarterly change in outstanding amount, US$ billions
  150

   100

     50

      0

    -50

  -100
                      Issuers of asset-backed securities
  -150
                      Other issuers
  -200
            Q1 2006 Q2 2006 Q3 2006 Q4 2006 Q1 2007 Q2 2007 Q3 2007 Q4 2007 Q1 2008 Q2 2008

Sources: Federal Reserve, Milken Institute.                                                   60
Federal Reserve responds by cutting Fed funds rate,
             but mortgage rates remain relatively flat
  Percent                                                                                                   Percent
  10                                                                                                             5.0
   9                                                                                                             4.5
            Freddie Mac 30-year FRM rate (left axis) (left axis)
                        30-year fixed mortgage rate
   8                                                                                                             4.0
   7                                                                                                             3.5
   6                                                                                                             3.0
   5                                                                                                             2.5
   4                                                                                                             2.0
          Federal funds rate (left axis)
   3                                                                                                             1.5
   2                                                                                                             1.0
                                                                 Spread (right axis)
   1                                                                                                             0.5
   0                                                                                                             0.0
   01/2007          03/2007           06/2007          09/2007          12/2007   02/2008   05/2008   08/2008


Sources: Freddie Mac, Federal Reserve, Moody’s Economy.com, Milken Institute.                                          61
Congress and White House responses
 HOPE NOW
 The Economic Stimulus Act of 2008
 Housing and Economic Recovery Act of 2008
 Conservatorship of Fannie Mae and Freddie Mac
 Temporary guaranty program for money market funds
 Temporary ban on short selling in selected
 companies
 Bailout package?


                                                     62
XI. When will we hit bottom?




                               63
Looking for a bottom?
                     Economists say the economy isn’t at its low point yet,
                     and house prices likely won’t get there until 2009
           Does this feel like the bottom           When will home prices hit bottom?
                 to a downturn?
                                               1st half
                                    Yes                       6%
                                                2010
                                    27%
                                               2nd half
                                                                                  29%
                                                2009
                                               1st half
                                                                                        38%
                                                2009
                                               2nd half
                                                                       17%
                                                2008
          No
          73%                                  1st half
                                                            4%
                                                2008
Source: Wall Street Journal.                                                              64
How far do home prices have to fall?
   Annual rents as percent of home prices
   6.5       Q2 1971: 6.08%
    6.0

    5.5

    5.0
                                                                                                      Q1 2008:
    4.5
                                                                                                       3.93%
               Average, 1960–Q1 2008: 5.04%
    4.0
                                                               Average, 2000–Q1 2008: 4.06%
    3.5
                                                                                            Q4 2006: 3.48%
    3.0
       1960           1965          1970           1975       1980   1985    1990    1995      2000    2005      2010


Sources: Davisa, Lehnertb, Martin (2007), Milken Institute.                                                         65
Combinations of rental price growth rates and rent-to-price
  ratios to get home prices back to their Q4 2006 value

                                                          Annual home price price decline
                                                             Annual home decline required
                                                       -2.0%      -5.0%    -10.0%    -15.0%    -20.0%

                                           3.80%     2010 Q3     2008 Q4   2008 Q2   2008 Q2   2008 Q2
                     Rent-to-price ratio




                                           4.00%     2013 Q1     2009 Q4   2008 Q3   2008 Q2   2008 Q2

                                           5.00%     2024 Q1     2014 Q1   2010 Q4   2009 Q3   2009 Q1
                                            5.04%
                                                     2024 Q3     2014 Q2   2010 Q4   2009 Q3   2009 Q1
                                           average
                                           6.00%     2026 Q4     2017 Q3   2012 Q3   2010 Q4   2009 Q4


Sources: Davisa, Lehnertb, Martin (2007), Milken Institute.                                              66
Alternative measures of the affordability of
                      mortgage debt for California
  US$/month
  4,000                                                            Payment with 100% LT V
                                                                   Payment with 90% LT V
  3,500
                                                                   Payment with 80% LT V
  3,000       M ortgage payment assumptions: Every month, a home is purchased at
              median price, buyer takes out a 30-year conforming, fixed-rate loan with 80%
  2,500       LT V. Payment also includes 1% property tax per year, 0.1% property
              insurance.
  2,000

  1,500

  1,000
                                                            Maximum affortablility limit is
    500
                                                             38% of median household
        0
         1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007

Sources: Moody’s Economy.com, Milken Institute.                                               67
XII. What went wrong




                       68
Milken Institute - Mortgage Crisis Overview
Milken Institute - Mortgage Crisis Overview
Milken Institute - Mortgage Crisis Overview
Milken Institute - Mortgage Crisis Overview
Milken Institute - Mortgage Crisis Overview
Milken Institute - Mortgage Crisis Overview
Milken Institute - Mortgage Crisis Overview
Milken Institute - Mortgage Crisis Overview
Milken Institute - Mortgage Crisis Overview
Milken Institute - Mortgage Crisis Overview
Milken Institute - Mortgage Crisis Overview
Milken Institute - Mortgage Crisis Overview
Milken Institute - Mortgage Crisis Overview
Milken Institute - Mortgage Crisis Overview
Milken Institute - Mortgage Crisis Overview
Milken Institute - Mortgage Crisis Overview

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Milken Institute - Mortgage Crisis Overview

  • 1. Demystifying the Mortgage Meltdown: What It Means for Main Street, Wall Street and the U.S. Financial System James R. Barth Glenn Yago Senior Fellow Director of Capital Studies Milken Institute October 2, 2008 1
  • 2. “I have great, great confidence in our capital markets and in our financial institutions. Our financial institutions, banks and investment banks are strong.” Treasury Secretary Henry Paulson March 16, 2008 CNN 2
  • 3. … but just six months later… “The financial security of all Americans … depends on our ability to restore our financial institutions to a sound footing.” Treasury Secretary Henry Paulson September 19, 2008 Press release 3
  • 4. “Any real estate investment is a good investment … ” 4
  • 5. “Any real estate investment is a good investment … ” … Really?! 5
  • 6. Subprime mortgage meltdown timeline December 2006–September 2008 Dow Jones U.S. Financial Index Aug. 1, Aug. 16, 2007: Sept. 30, 2007: Oct. 24, 2007: Mar. 11, 2008: Fed Mar. 16, 2008: Mar. 18, 2008: 2008: First Countrywide gets NetBank goes Merrill announces offers troubled JP Morgan Fed cuts 650 Priority Feburary–March 2007: More than 25 emergency loan of bankrupt. $7.9 billion in banks as much as Chase offers to discount rate Bank subprime lenders declare $11 billion from a subprime write- $200 billion in buy Bear to 2.4%; Fed closes. bankruptcy. group of banks. downs, surpassing loans; Fed Stearns; Fed funds rate to Citi’s $6.5 billion. introduces Term introduces 2.25%. Sept. 14, 2008: Securities Primary Dealer Lehman files for Lending Facility. Credit Facility. 550 bankruptcy. July 30, 2008: Sept. 16, 2008: Dec. 2006: Apr. 2007: New Feb. 2007: President Fed loans AIG Ownit Mortgage, Century, a HSBC sets Bush signs a $85 billion. a subprime mortgage aside $10.6 Dec. 12, 2007: housing lender, files for broker, files billion for Fed introduces rescue law. 450 bankruptcy. for bad loans, Aug. 6, 2007: Sept. 23, 2008: Term Auction bankruptcy. including American Home Washington Facility. subprime. Mortgage files Mutual is seized Jan. 11, 2008: for bankruptcy. by FDIC. July 31, 2007: Bank of Two Bear America agrees June 9, 2008: Stearns Feb. 13, 2008: 350 to buy Sept. 29, 2008: Lehman hedge funds President Bush Countrywide. Aug. 17, 2007: Fed cuts Citigroup announces a $2.8 file for introduces tax discount rate to 5.75%; agrees to buy billion loss. bankruptcy. Sept. 7, 2008: U.S. rebate stimulus Jan. 30, 2008: Fed Fed introduces Term Wachovia bank. seizes Fannie Mae program of $168 cuts discount rate Discount Window July 11, 2008: IndyMac and Freddie Mac. billion. to 3.5%. Program. is seized by FDIC. 250 Sources: BusinessWeek, S&P, Global Insight, Milken Institute. 6
  • 8. Home mortgages: Who borrows, how much has been borrowed, and who funds them? Total value of housing stock = $19.3 trillion Subprime Securitized 8.4% Government- 58% Mortgage debt controlled $10.6 trillion 46% Prime 91.6% Non-securitized Private sector- 42% controlled 54% Equity in housing stock $8.7 trillion Note: total residential and commercial mortgages = $14.7 trillion; 5 percent = $700 billion Sources: Federal Reserve, Milken Institute. 8
  • 9. The mortgage problem in perspective 80 million houses 27 million are paid off 53 million have mortgages 48 million are paying on time This compares to 50% seriously delinquent in the 1930s. 5 million are behind (9.2% of 53 million with 2.8% in foreclosure) Sources: U.S. Treasury, Milken Institute. 9
  • 10. I. Low interest rates and a lending boom 10
  • 11. Did the Fed lower interest rates too much and for too long? Federal funds rate vs. rates on FRMs and ARMs Percent 8 30-year FRM rate 7 6 5 4 Target federal funds rate 3 1-year ARM rate 2 Record low from June 25, 1 2003, to June 30, 2004: 1% 0 2001 2002 2003 2004 2005 2006 2007 2008 Sources: Federal Reserve, Mortgage Bankers Association, Moody’s Economy.com, Milken Institute. 11
  • 12. Home price bubble Low interest rates and credit boom and credit boom Index, January 2000 = 100 US$ trillions Percent US$ trillions 4.5 6.0 4.0 250 4.0 3.5 5.5 200 3.5 3.0 3.0 5.0 2.5 150 2.5 Home 4.5 2.0 Home mortgage 2.0 mortgage 100 originations 1.5 S&P/Case-Shiller 1.5 4.0 originations (left axis) National Home (left axis) 1.0 1.0 Price Index 1-Year ARM rate 50 3.5 (right axis) (right axis) 0.5 0.5 0.0 3.0 0.0 0 2001 2003 2005 2007 2001 2003 2005 2007 Sources: Inside Mortgage Finance, Mortgage Bankers Association, Moody’s Economy.com, S&P/Case-Shiller, Milken Institute. 12
  • 13. II. Homeownership, prices, starts and sales take off 13
  • 14. Credit boom pushes Home price bubble California and national homeownership rate peaks in 2006 home prices reach to historic high record highs Index, January 1987 = 100 Percent US$ thousands 70 380 Q2 2008: 68.1% 700 S&P/ California m e dian Cas e -Shille r Q2 2004: 69.2% 330 69 600 hom e price National Hom e Price Inde x California 500 280 68 ave rage 400 1987-2008 U.S. m e dian 230 67 hom e price $229,748 300 180 66 200 130 OFHEO Hom e Price Inde x 65 100 Ave rage , 1965–Q2 2008: 65.2% U.S. ave rage , 1987-2008: $121,280 80 64 0 1998 2000 2002 2004 2006 2008 1998 2000 2002 2004 2006 2008 1998 2000 2002 2004 2006 2008 Sources: U.S. Census Bureau, OFHEO, Moody’s Economy.com, S&P/Case-Shiller, California Association of Realtors, Milken Institute. 14
  • 15. Housing starts hit Homes sales reach Homes for sale a record in 2005 a new high Millions Millions Millions Millions Housing units, millions 4 0.8 7.0 1.5 2.0 Existing homes for Exis ting hom e January 2006: 1.8 m illion sale (left axis) s ale s (le ft axis ) 5.6 1.2 3 0.6 1.5 4.2 0.9 2 0.4 1.0 Ave rage s tarts , 2.8 0.6 1959–July 2008: 1.1 m illion Ne w hom e s ale s (right axis ) 1 0.2 0.5 1.4 0.3 New homes for July 2008: 641,000 sale (right axis) 0.0 0.0 0 0.0 0.0 1998 2000 2002 2004 2006 2008 1998 2000 2002 2004 2006 2008 1998 2000 2002 2004 2006 2008 Sources: U.S. Census Bureau, OFHEO, Moody’s Economy.com, Milken Institute. 15
  • 16. III. Subprime borrowers and subprime mortgages 16
  • 17. Who is a subprime borrower? National FICO scores display wide distribution What goes into a FICO score? Percentage of population 40 Types of credit in use Prime = 79% 10% New credit 30 27 Payment history 10% 35% Subprime = 21% 18 20 15 Length of 13 12 credit history 8 10 15% 5 2 0 Amounts owed up to 500- 550- 600- 650- 700- 750- 800+ 499 549 599 649 699 749 799 30% Sources: myFICO.com, Milken Institute. 17
  • 18. Prime and subprime mortgage originations by FICO score reveal substantial overlaps Percent of total originations FICO below 620 FICO above 620 20 Prime: 6.6% Prime: 93.4% Subprime: 45.2% Subprime: 54.8% 16 Prime 12 Subprime 8 4 0 59 79 99 19 39 59 79 99 19 39 59 79 99 19 39 59 79 99 00 -4 -4 -4 -5 -5 -5 -5 -5 -6 -6 -6 -6 -6 -7 -7 -7 -7 -7 -9 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 46 48 50 52 54 56 58 60 62 64 66 68 70 72 74 76 78 80 FICO score Sources: LoanPerformance, Milken Institute. 18
  • 19. ARMs look attractive to many borrowers Percent 8.0 7.0 30-year FRM rate 6.0 5.0 4.0 1-year ARM rate 3.0 2.0 2001 2002 2003 2004 2005 2006 2007 2008 Sources: Mortgage Bankers Association, Moody’s Economy.com, Milken Institute. 19
  • 20. ARM share grows, following low interest rates Percent of all outstanding home mortgages 25 20 15 10 5 0 2001 2002 2003 2004 2005 2006 2007 2008 Sources: Mortgage Bankers Association, Moody’s Economy.com, Milken Institute. 20
  • 21. Largest share of ARMs go to subprime borrowers Percent of mortgage type 60 FHA ARM Prime ARM Subprime ARM 50 40 30 20 10 0 2001 2002 2003 2004 2005 2006 2007 2008 Sources: Mortgage Bankers Association, Moody’s Economy.com, Milken Institute. 21
  • 22. Subprimes take an increasing share of all home mortgage originations US$ trillions 8.4% 4.0 Subprime 21.3% Prime 7.4% 20.1% 18.2% 3.0 Subprime's share: 7.9% 7.8% 2.0 1.0 0.9% 0.0 2001 2002 2003 2004 2005 2006 2007 Q2 2008 Sources: Inside Mortgage Finance, Milken Institute. 22
  • 23. Subprime mortgages increase rapidly before big decline Outstandings Originations US$ billions US$ billions 1,400 Average annual growth rates 700 1,240 1995–2006: 14% 1,200 625 600 2006–Q1 2008: -23% 1,200 600 540 973 940 1,000 895 500 800 699 400 310 574 600 300 479 200 191 400 200 160 200 100 14 0 0 2001 2002 2003 2004 2005 2006 2007 Q1 2001 2002 2003 2004 2005 2006 2007 Q2 H2 2008 2008 2008 Sources: Inside Mortgage Finance, Milken Institute. 23
  • 24. IV. Mortgage product innovation 24
  • 25. Subprime and Alt-A shares quadruple between 2001 and 2006, then fall in 2007 Q1 2008, $480 billion 2006, $3.0 trillion 2007, $2.4 trillion 2001, $2.2 trillion 9% 4% 4.9% 9.6% 2.7% 5% 2% 14% 14% 7.9% 2% 33.2% 7% 8% 11% 13% 8% 20% 47.3% 67.2% 16% 57.1% 14% 20% p Subprime FHA & VA Alt-A Conventional, conforming prime Home equity loans Jumbo prime Sources: Inside Mortgage Finance, Milken Institute. 25
  • 26. ARM hybrids dominate subprime originations (2006) Prime conventional Alt-A Subprime Other Other Fixed Othe r ARM ARM 9% ARM 7% 4% 23% ARM 30-year hybrids ARM balloon with 40- to 23% 50-year amortization 26% ARM hybrids 2- and 3-year Fixed Fixe d 46% hybrids 61% 31% 70% Sources: Freddie Mac, Milken Institute. 26
  • 28. The mortgage model switches from originate-to-hold to originate-to-distribute Residential mortgage loans Residential mortgage loans 1980: Total = $958 billion Q2 2008: Total = $11.3 trillion Securitized 15.6% Held in portfolio 41% Held in Securitized 59% portfolio 84.4% Sources: Federal Reserve, Milken Institute. 28
  • 29. Securitization becomes the dominant funding source for subprime mortgages Percent of all subprime mortgages securitized since 1994 80 68 68 68 65 70 62 57 60 50 47 50 45 45 43 42 40 40 33 31 29 30 20 10 0 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Q1 Q2 2008 2008 Sources: Inside Mortgage Finance, Milken Institute. 29
  • 30. The rise and fall of private-label securitizers New securities issuance 4% 2% 15% 6% 13% 20% 42% 56% 21% 18% 1985 2001 2006 First half 2008 Total = $110B Total = $1.3T Total = $2.0T Total = $734B 33% 29% 22% 35% 46% 38% Ginnie Mae Freddie Mac Fannie Mae Private-label Sources: Inside Mortgage Finance, Milken Institute. 30
  • 31. The rise and fall of private-label securitizers Outstanding securities 7% 7% 6% 14% 18% 30% 35% 25% 13% 55% 26% 1985 2001 2006 First half 2008 Total = $3.3T Total = $390B Total = $5.9T Total = $6.8T 26% 39% 29% 33% 37% Ginnie Mae Freddie Mac Fannie Mae Private-label Sources: Inside Mortgage Finance, Milken Institute. 31
  • 33. Ratio of home Debt-to-income ratio Home mortgage share of price to household of households has household debts reaches income surges increased rapidly a new high in 2007 Home mortgage debt/disposable Percent Median home price/ Q2 2007: 73.7% personal income 75 median household income Q4 2007: 139.5% 150 5.0 2005: 4.69 4.5 70 125 Q2 2008: 73.4% 4.0 2007: 4.29 3.5 Average, 1957–2007: 79.7% 65 100 3.0 Average, 1952–2008: 64.2% Average, 1967–2007: 3.38 2.5 75 60 1998 2001 2004 2007 1998 2001 2004 2007 1998 2001 2004 2007 Sources: U.S. Census Bureau, OFHEO, Federal Reserve, Moody’s Economy.com, Milken Institute. 33
  • 35. The recent run-up of home prices was extraordinary Index, 2000 = 100 250 Current Annualized growth rate of nominal home index: 3.4% boom Great 200 Depression World World 1970’s 1980’s War I 150 War II boom boom 100 50 Long-term trend line 0 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 Sources: Robert Shiller, Milken Institute. 35
  • 36. Home prices don’t go up forever Change in home prices in 100 plus years Percentage change in nominal home price, year ago 30 Great World World 1970’s 1980’s Current Depression War II War I Boom Boom Boom 25 20 Average, 1890–2007: 3.7% 15 10 5 0 -5 -10 +/- one standard deviation -15 -20 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 Sources: Robert Shiller, Milken Institute. 36
  • 37. 2005: The collapse begins Home price indices, percent change on a year earlier S&P/Case-Shiller 20 10 city 15 S&P/Case-Shiller national 10 OFHEO 5 0 -5 -10 -15 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 Sources: S&P/Case-Shiller, OFHEO, Moody’s Economy.com, Milken Institute. 37
  • 38. Forty-six states had falling prices in the fourth quarter 2007 United States: - 9.3% (fourth-quarter annualized growth) Source: Freddie Mac. 38
  • 39. If you bought your house… One year ago… Five years ago… -1.0 Charlotte 48.4 Seattle -3.2 Dallas 48.0 Portland -4.7 Denver 28.2 Washington -5.2 Boston 27.9 New York -5.8 Portland Phoenix 26.8 -7.1 Seattle Los Angeles 26.3 -7.3 New York 26.3 Tampa -7.3 Cleveland Miami 26.0 -8.1 Atlanta Las Vegas 24.4 -9.5 Chicago Charlotte 22.9 -13.9 Minneapolis 20.5 Composite 10 -15.7 W ashington Composite 20 18.6 -15.9 Composite 20 Chicago 14.3 -16.3 Detroit 9.1 San Francisco -17.0 Composite 10 6.6 Atlanta -20.1 Tampa Dallas 6.5 -23.7 San Francisco San Diego 6.1 -24.2 San Diego 5.9 Boston -25.3 Los Angeles Denver 4.8 -27.9 Phoenix Minneapolis -0.7 -28.3 Miami Cleveland -3.8 -28.6 Las Vegas -21.3 Detroit % change in price, June 07-08 % change in price, June 03-08 Sources: S&P/Case-Shiller, Milken Institute. 39
  • 40. Housing starts Homes sit longer … as home sharply decline on the market … appreciation slows Percent Months Number of months that Percent change, year ago 30 homes sit on the market Pe rce ntage change from 20 0 ye ar ago in m e dian 12 Existing homes 15 hom e s ale s price 2 (le ft axis ) 10 10 0 4 8 -15 0 6 6 -30 8 4 -10 June 2008: -41.9% Num be r of m onths -45 10 July 2008: -39.2% 2 hom e s s tay on New homes m ark e t (right axis ) -60 -20 12 0 1998 2000 2002 2004 2006 2008 1999 2001 2003 2006 2008 1998 2000 2002 2004 2006 2008 Note: Shaded area represents fluctuation within one standard deviation from mean (1.28%) Sources: Mortgage Bankers Association, OFHEO, Moody’s Economy.com, Milken Institute. 40
  • 41. VIII. Delinquencies and foreclosures 41
  • 42. Foreclosures are nothing new, but … Thousands of foreclosures per year 2,150 1,900 1,650 1,400 1,150 Av erage 661,362 annual foreclosures from Q2 1999 to Q2 2006 900 650 400 99 99 00 00 01 01 02 02 03 03 04 04 05 05 06 06 07 07 08 19 19 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 2 4 2 4 2 4 2 4 2 4 2 4 2 4 2 4 2 4 2 Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Sources: Mortgage Bankers Association, Milken Institute. 42
  • 43. … their numbers have doubled Thousands of foreclosures per year 2,150 1,900 Average 1,316,220 annual forclosures from Q3 2006 to Q2 2008 1,650 1,400 1,150 Average 661,362 annual foreclosures from Q2 1999 to Q2 2006 900 650 400 99 99 00 00 01 01 02 02 03 03 04 04 05 05 06 06 07 07 08 19 19 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 2 4 2 4 2 4 2 4 2 4 2 4 2 4 2 4 2 4 2 Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Sources: Mortgage Bankers Association, Milken Institute. 43
  • 44. Subprime mortgages accounted for half or more of foreclosures since 2006 Number of home mortgage foreclosures started (annualized, in thousands) 2,000 Subprime: 12% of mortgages Subprime serviced (M arch 2008) FHA and VA 1,600 50% Prime (includes Alt-A) 54% 1,200 56% 8% 55% 800 9% 37% 37% 36% 44% 47% 52% 42% 11% 37% 400 13% 29% 29% 29% 22% 20% 17% 33% 31% 32% 34% 34% 35% 34% 33% 0 Dec. 2003 June Dec. 2004 June Dec. 2005 June Dec. 2006 June Dec. 2007 M arch 2004 2005 2006 2007 2008 Sources: Inside Mortgage Finance, Milken Institute. 44
  • 45. Subprime ARMs have the worst default record Home mortgages delinquent or in foreclosure (percent of number) 35 Q2 2008, Subprime ARM: 33.4% 30 Subprime FRM: 11.8% 25 FHA and VA: 5.8% 20 Prime FRM: 3.0% 15 10 5 0 Q2 Q1 Q4 Q3 Q2 Q1 Q4 Q3 Q2 Q1 Q4 Q3 Q2 Q1 1998 1999 1999 2000 2001 2002 2002 2003 2004 2005 2005 2006 2007 2008 Sources: Mortgage Bankers Association, Milken Institute. 45
  • 46. Percentage of homes purchased in Q2 2008 that now have negative equity United States = 44.8% < 20% >= 20% and < 35% >= 35% and < 50% >= 50% Sources: Zillow.com, Milken Institute. 46
  • 47. Percentage of homes sold for a loss (Q2 2008) United States = 32.7% < 15% >= 15% and < 30% >= 30% and < 45% >= 45% Sources: Zillow.com, Milken Institute. 47
  • 48. Percentage of homes sold that were in foreclosure (Q2 2008) United States = 18.6% < 1% >= 1% and < 25% >= 25% and < 40% >= 40% Sources: Zillow.com, Milken Institute. 48
  • 50. Losses/write-downs, capital raised, and jobs cut by financial institutions worldwide US$ billions Number of jobs cut 200 60,000 Jobs cut (right axis) 160 48,000 Capital raised 120 36,000 (left axis) 80 24,000 Losses/write-downs (left axis) 40 12,000 0 0 Prior quarters Q3 2007 Q4 2007 Q1 2008 Q2 2008 Q3 2008 Note: Q3 data are through September 25, 2008. Sources: Bloomberg, Milken Institute. 50
  • 51. What is the cumulative damage? Cumulative losses/write-downs, capital raised, and jobs cut by financial institutions worldwide US$ billions Number of jobs cut 600 140,000 120,000 500 Jobs cut (right axis) 100,000 400 80,000 Capital raised (left axis) 300 60,000 Losses/write-downs (left axis) 200 40,000 100 20,000 0 0 Prior quarters Q3 2007 Q4 2007 Q1 2008 Q2 2008 Q3 2008 Note: Q3 data are through September 25, 2008. Sources: Bloomberg, Milken Institute. 51
  • 52. Recent losses/write-downs and capital raised by selected financial institutions US$ billions, through September 25, 2008 Losses /write-downs Capital raised Citigroup, United States 55.1 49.1 Merrill Lynch, United States 52.2 29.9 UBS, Switzerland 44.2 28.2 HSBC, United Kingdom 27.4 5.1 Wachovia, United States 22.7 11.0 Bank of America, United States 21.2 20.7 Morgan Stanley, United States 15.7 5.6 IKB Deutsche, Germany 15.0 12.3 Washington Mutual, United States 14.8 12.1 Royal Bank of Scotland, United Kingdom 14.4 23.5 World total 521.9 379.2 Sources: Bloomberg, Milken Institute. 52
  • 53. Financial stock prices take big hits Percentage change in stock price, December 2006–September 2008 -99.8 W ashington Mutual -99.7 Lehman Brothers -97.5 Freddie Mac -97.4 Fannie Mae -95.4 AIG -94.3 Bear Stearns* -93.9 W achov ia -90.0 Countrywide** -72.8 Merrill Lynch -66.0 Morgan Stanley -65.6 UBS Equity -35.8 Goldman Sachs -34.4 Bank of America -3.3 JP Morgan & Chase 5.5 W ells Fargo Note: * Bear Stearns stock price is to May 2008. ** Countrywide stock price is to June 2008. Sources: Bloomberg, Milken Institute. 53
  • 54. Financial market capitalization takes big hit Total loss in market value: $728 billion, December 2006–September 2008 -142 AIG -101 W achov ia -80 Bank of America -74 UBS Equity -60 Morgan Stanley -50 Fannie Mae -44 Merrill Lynch -43 W ashington Mutual -42 Freddie Mac -41 Lehman Brothers -28 Goldman Sachs -24 Countrywide** -21 Bear Stearns* 4 W ells Fargo 17 JP Morgan & Chase US$ billions Note: * Bear Stearns stock price is to May 2008. ** Countrywide stock price is to June 2008. Sources: Bloomberg, Milken Institute. 54
  • 55. X. Credit crunch and liquidity freeze 55
  • 56. Tightened standards for real estate loans Net percentage of domestic respondents tightening standards for commercial real estate loans 100 The end of S&L crisis 80 Dotcom Subprime LTCM 60 40 20 0 -20 -40 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 Sources: Federal Reserve, Milken Institute. 56
  • 57. Widening spreads between mortgage-backed and high-yield bonds Basis points, spread over 10-year Treasury bond 1,800 Maximum spread: 08/29/2008: 955.8 bps 1,600 1,400 Merrill Lynch Mortgage-Backed Securities Index 1,200 1,000 Merrill Lynch High-Yield Bond Index 800 600 400 200 0 01/2004 07/2004 01/2005 07/2005 01/2006 07/2006 01/2007 07/2007 01/2008 07/2008 Sources: Merrill Lynch, Bloomberg, Milken Institute. 57
  • 58. Liquidity freeze Spread between 3-month LIBOR and Spread between 3-month LIBOR overnight index swap rate and T-bill rate Basis points Basis points 350 140 Se pte m be r 18, 2008: 313 bps Se pte m be r 19, 2008: 300 127.5 bps 120 Augus t 20, 2007: 240 bps 250 100 Ave rage s ince Augus t 2007: 69.8 bps 80 200 Ave rage s ince 60 150 Augus t 2007: 130 bps 40 Ave rage s ince Ave rage s ince 100 De ce m be r 2001: 21.1 bps 1985: 76 bps 20 50 0 0 2006 2007 2008 2006 2007 2008 Sources: Bloomberg, Milken Institute. 58
  • 59. Counterparty risk increases Basis points spread, basis points Average CDS 500 AIG rescued 400 Lehman Brother files for bankruptcy and Merrill Lynch acquired 300 Government announces support for Fannie Mae and Freddie Mac 200 Bear Stearns acquired 100 0 07/2007 09/2007 11/2007 01/2008 03/2008 05/2008 07/2008 09/2008 Note: Counterparty Risk index averages the market spreads of the credit default swaps (CDS) of fifteen major credit derivatives dealers, including ABN Amro, Bank of America, BNP Paribas, Barclays Bank, Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs Group, HSBC, Lehman Brothers, JPMorgan Chase, Merrill Lynch, Morgan Stanley, UBS, and Wachovia. Sources: Datastream, Milken Institute. 59
  • 60. Commercial paper issuance dries up Quarterly change in outstanding amount, US$ billions 150 100 50 0 -50 -100 Issuers of asset-backed securities -150 Other issuers -200 Q1 2006 Q2 2006 Q3 2006 Q4 2006 Q1 2007 Q2 2007 Q3 2007 Q4 2007 Q1 2008 Q2 2008 Sources: Federal Reserve, Milken Institute. 60
  • 61. Federal Reserve responds by cutting Fed funds rate, but mortgage rates remain relatively flat Percent Percent 10 5.0 9 4.5 Freddie Mac 30-year FRM rate (left axis) (left axis) 30-year fixed mortgage rate 8 4.0 7 3.5 6 3.0 5 2.5 4 2.0 Federal funds rate (left axis) 3 1.5 2 1.0 Spread (right axis) 1 0.5 0 0.0 01/2007 03/2007 06/2007 09/2007 12/2007 02/2008 05/2008 08/2008 Sources: Freddie Mac, Federal Reserve, Moody’s Economy.com, Milken Institute. 61
  • 62. Congress and White House responses HOPE NOW The Economic Stimulus Act of 2008 Housing and Economic Recovery Act of 2008 Conservatorship of Fannie Mae and Freddie Mac Temporary guaranty program for money market funds Temporary ban on short selling in selected companies Bailout package? 62
  • 63. XI. When will we hit bottom? 63
  • 64. Looking for a bottom? Economists say the economy isn’t at its low point yet, and house prices likely won’t get there until 2009 Does this feel like the bottom When will home prices hit bottom? to a downturn? 1st half Yes 6% 2010 27% 2nd half 29% 2009 1st half 38% 2009 2nd half 17% 2008 No 73% 1st half 4% 2008 Source: Wall Street Journal. 64
  • 65. How far do home prices have to fall? Annual rents as percent of home prices 6.5 Q2 1971: 6.08% 6.0 5.5 5.0 Q1 2008: 4.5 3.93% Average, 1960–Q1 2008: 5.04% 4.0 Average, 2000–Q1 2008: 4.06% 3.5 Q4 2006: 3.48% 3.0 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 Sources: Davisa, Lehnertb, Martin (2007), Milken Institute. 65
  • 66. Combinations of rental price growth rates and rent-to-price ratios to get home prices back to their Q4 2006 value Annual home price price decline Annual home decline required -2.0% -5.0% -10.0% -15.0% -20.0% 3.80% 2010 Q3 2008 Q4 2008 Q2 2008 Q2 2008 Q2 Rent-to-price ratio 4.00% 2013 Q1 2009 Q4 2008 Q3 2008 Q2 2008 Q2 5.00% 2024 Q1 2014 Q1 2010 Q4 2009 Q3 2009 Q1 5.04% 2024 Q3 2014 Q2 2010 Q4 2009 Q3 2009 Q1 average 6.00% 2026 Q4 2017 Q3 2012 Q3 2010 Q4 2009 Q4 Sources: Davisa, Lehnertb, Martin (2007), Milken Institute. 66
  • 67. Alternative measures of the affordability of mortgage debt for California US$/month 4,000 Payment with 100% LT V Payment with 90% LT V 3,500 Payment with 80% LT V 3,000 M ortgage payment assumptions: Every month, a home is purchased at median price, buyer takes out a 30-year conforming, fixed-rate loan with 80% 2,500 LT V. Payment also includes 1% property tax per year, 0.1% property insurance. 2,000 1,500 1,000 Maximum affortablility limit is 500 38% of median household 0 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 Sources: Moody’s Economy.com, Milken Institute. 67
  • 68. XII. What went wrong 68