T2 Partners Presentation On The Mortgage Crisis

An Overview Of The Housing Crisis And Why
There Is More Pain To Come

T2 Accredited Fund, LP
Tilson Offshore Fund, Ltd.
T2 Qualified Fund, LP
T2 Accredited Fund, LP
Tilson Offshore Fund, Ltd.
T2 Qualified Fund, LP
July 26, 2009
T2 Partners Management L.P.
Is a Registered Investment Advisor
145 E. 57th Street, 10th Floor
New York, NY 10022
(212) 386-7160
Info@T2PartnersLLC.com
www.T2PartnersLLC.com
145 E. 57th Street, 10th Floor
New York, NY 10022
(212) 386-7160
Info@T2PartnersLLC.com
www.T2PartnersLLC.com
The collapse of the U.S. housing market,
the worlds largest debt market, is the
defining economic event of our lifetimes.
This presentation explores what happened
and why, where we are today, and what the
future likely holds.
For More Details, See Our New Book:
More Mortgage Meltdown
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Table of Contents
1. What happened Page 9
2. Why did it happen? Page 16
3. Background on the U.S. housing market Page 28
4. Two waves of losses are behind usbut three are loomingPage
41
5. Current economic situation Page 43
6. Interest rates Page 51
7. Underwater homeowners Page 54
8. Outlook for housing prices Page 57
9. Case study: California, with a focus on Sacramento Page 64
10. Recent signs of stabilization are likely the mother of all head
fakes Page 75
11. Total losses Page 77
11. Where we are finding opportunities Page 82
Appendices
More background data on the housing market Page 84
Detailed Information on five types of mortgages: prime Alt A
What Happened?
10
For the Second Half of the 20
th
Century,
Housing Was a Stable Investment
Sources: Robert J . Shiller, Irrational Exuberance, Princeton University Press 2000, Broadway Books 2001, 2nd edition, 2005, also Subprime
Solution, 2008, as updated by the author at http://www.econ.yale.edu/~shiller/data.htm; Lawler Economic & Housing Consulting.
100
125
150
175
200
225
250
275
300
1
9
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0
1
9
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4
1
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2
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9
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6
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0
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1
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1
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I
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x

(
1
8
9
0
=
1
0
0
)
Shiller
Lawler
Trend Line
11
And Then Housing Prices Exploded
Sources: Robert J . Shiller, Irrational Exuberance: Second Edition, as updated by the author; Lawler Economic & Housing Consulting.
100
125
150
175
200
225
250
275
300
1
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1
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1
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R
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x

(
1
8
9
0
=
1
0
0
)
Shi ller
Lawl er
Trend Line
Housing
Bubble
12
Prices Exploded Because the Borrowing
Power of a Typical Home Purchaser More
Than Tripled from 2000-2006
Source: Amherst Securities.
$0
$100,000
$200,000
$300,000
$400,000
Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08
Pre-Tax Income
Borrowing Power
3.3x in J anuary 2000
9.2x in J anuary 2006
Factors contributing to the ability to borrow more and
more were:
1. Lenders were willing to allow much higher
debt-to-income ratios
2. Interest-only mortgages (vs. full amortizing)
3. No money down
4. Low- and no-documentation loans, which led
to widespread fraud
5. Slowly rising income
6. Falling interest rates
13
Americans Have Borrowed Heavily Against Their Homes Such That
the Percentage of Equity Has Fallen Below 50% for the First Time
There still appears to be substantial equity protecting the debt but this is misleading. Given that 1/3 of homes
have no mortgage (i.e., 100% equity), the remaining homes have only 12% equity. A further 10% decline in
home prices would, on average, leave no equity cushion left to support U.S. mortgage debt.
Source: Federal Reserve Flow of Fund Accounts of the United States.
$0
$2,000
$4,000
$6,000
$8,000
$10,000
$12,000
1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
M
o
r
t
g
a
g
e

D
e
b
t

(
B
n
)
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
E
q
u
i
t
y

a
s

a

%

o
f

H
o
m
e

V
a
l
u
e
1945
Mortgage Debt: $18.6 billion
Equity: $97.5 billion
Q109
Mortgage Debt: $10.5 trillion
Equity: $7.4 trillion
14
Housing Became Unaffordable in Many Areas Using
a Typical 30-Year Fixed-Rate Mortgage, Which Led
Many Borrowers to Take Exotic Mortgages
Sources: NAHB/Wells Fargo Housing Opportunity Index, which measures percentage of households that could afford the average home with a standard mortgage.
0
10
20
30
40
50
60
70
80
Q
1

1
9
9
6
Q
1

1
9
9
7
Q
1

1
9
9
8
Q
1

1
9
9
9
Q
1

2
0
0
0
Q
1

2
0
0
1
Q
1

2
0
0
2
Q
3

2
0
0
4
Q
3

2
0
0
5
Q
3

2
0
0
6
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3

2
0
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7
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u
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I
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d
e
x
Riverside, CA
Los Angeles, CA
San Diego, CA
15
There Was a Dramatic Decline in Mortgage
Lending Standards from 2001 through 2006
In 2005, 29% of
new mortgages
were interest only
or less, in the
case of Option
ARMs vs. 1%
in 2001
In 1989, the
average down
payment for first-
time home buyers
was 10%; by
2007, it was 2%
The sale of new
homes costing
$750,000 or more
quadrupled from
2002 to 2006.
The construction
of inexpensive
homes costing
$125,000 or less
fell by two-thirds
74
74
76
81
83
84
81
68
70
72
74
76
78
80
82
84
86
2001 2002 2003 2004 2005 2006 2007
C
o
m
b
i
n
e
d

L
o
a
n

t
o

V
a
l
u
e

(
%
)
1%
1%
3%
9%
14%
17%
8%
0%
2%
4%
6%
8%
10%
12%
14%
16%
18%
2001 2002 2003 2004 2005 2006 2007
P
e
r
c
e
n
t

o
f

O
r
i
g
i
n
a
t
i
o
n
s
33%
39%
45%
49%
56%
63%
65%
0%
10%
20%
30%
40%
50%
60%
70%
2001 2002 2003 2004 2005 2006 2007
P
e
r
c
e
n
t

o
f

O
r
i
g
i
n
a
t
i
o
n
s
0%
0%
1%
4%
8%
11%
5%
0%
2%
4%
6%
8%
10%
12%
2001 2002 2003 2004 2005 2006 2007
P
e
r
c
e
n
t

o
f

O
r
i
g
i
n
a
t
i
o
n
s
Combined Loan to Value
100% Financing
Limited Documentation
100% Financing & Limited Doc
Sources: Amherst Securities, LoanPerformance; USA Today (www.usatoday.com/money/economy/housing/2008-12-12-homeprices_N.htm).
Why Did It Happen?
17
Among the Many Causes of The Great
Housing Bubble, Two Stand Out
1. The lenders making crazy loans didnt care if the homeowner ended up
defaulting for two reasons:
They didnt hold the loan, but instead sold it to someone else. It was eventually
bought by a Wall Street firm, which packaged it with thousands of other mortgages in
a Residential Mortgage-Backed Security (RMBS), which was then sliced into
numerous tranches that were sold to investors around the world. This entire process
was extraordinarily profitable for all involved, especially the Wall Street firms and the
rating agencies;
Or, if they did plan to hold the loan, they assumed home prices would keep rising,
such that homeowners could either refinance before loans reset or, if the homeowner
defaulted, the losses (i.e., severity) would be minimal.
2. The entire system real estate agents, appraisers, mortgage lenders, banks,
Wall St. firms and rating agencies became corrupted by the vast amounts of
quick money to be made
There were many other reasons, of course a bubble of this magnitude requires
what Charlie Munger calls lollapalooza effects
Regulators and politicians were blinded by free market ideology and/or the dream that
all Americans should own their homes, causing them to fall asleep at the switch, not
want to take the punch bowl away and/or get bought off by the industries they were
supposed to be overseeing
Debt became increasingly available and acceptable in our culture
Millions of Americans became greedy speculators and/or took on too much debt
Greenspan kept interest rates too low for too long
Institutional investors stretched for yield, didnt ask many questions and took on too
much leverage
In general, everyone was suffering from irrational exuberance, driven by the money
being made
When Home Price Appreciation Slows,
Loss Severity Skyrockets
Sources: LoanPerformance; OFHEO; Deutsche Bank; Who's Holding the Bag?, Pershing Square presentation, 5/23/07.
The assumption of
perpetually high HPA led
lenders to give virtually
anyone a loan because
even if they defaulted, the
home could simply be
resold with little or no loss.
19
As Long As Home Prices Rise Rapidly, Even Pools
of Bubble-Era Subprime Mortgages Perform Well
But If Home Prices Fall, Look Out Below!
Source: T2 Partners estimates.
0%
10%
20%
30%
40%
50%
60%
20% 15% 10% 5% 0% -5% -10% -15% -20% -25% -30% -35% -40%
Home Price Appreciation
C
u
m
u
l
a
t
i
v
e

L
o
s
s

(
%
)
Cumulative Five-Year Loss Estimates for a Bubble-Era Pool of Subprime Mortgages
The Enormous Amounts of Money to Be
Made Corrupted Our Financial System
The #1 Immutable Law of the Universe
If you offer people a lot of money to do something, no
matter how foolish, unethical or illegal, a large
number of them will do it
Corollary #1: The more money to be made, the more bad
behavior that will occur
Corollary #2: The people engaged in such behavior will
rationalize it such that they genuinely believe that what
theyre doing isnt foolish, unethical or illegal
The #2 Immutable Law of the Universe
Bad behavior leads to bad consequences
21
Deregulation of the Financial Sector Led to a
Surge of Compensation, Leverage and Profits
Source: Ariell Reshef, University of Virginia; Thomas Philippon, NYU; Wall St. J ournal, 5/14/09.
Ratio of Financial Services Wages to Nonfarm Private-Sector Wages, 1910-2006
22
Sources: Federal Reserve, BEA, as of Q2 2007, GMO presentation.
Low Debt Era Rising Debt Era
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
51 54 57 60 63 66 69 72 75 78 81 84 87 90 93 96 99 02 05
F
i
n
a
n
c
i
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l

P
r
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f
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t
s

a
s

P
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n
t

o
f

G
D
P
100%
150%
200%
250%
300%
350%
T
o
t
a
l

D
e
b
t

a
s

P
e
r
c
e
n
t

o
f

G
D
P
Dec-
Total Debt
Financial Profits
Over the Past 30 Years, We Have Become
a Nation Gorged in Debt To The Benefit
of Financial Services Firms
Profits and Wages in the Financial Sector
Soared from 1980 Onward
Source: Moodys Economy.com, NY Times, 12/18/08.
24
Wall Street Firms Were Making a Fortune
Securitizing Loans
Among the most profitable areas for Wall Street
firms was producing Asset-Backed Securities
(ABSs) and Collateralized Debt Obligations (CDOs)
To produce ABSs and CDOs, Wall Street needed a
lot of loan product
Mortgages were a quick, easy, big source
It is easy to generate higher and higher volumes of
mortgage loans: simply lend at higher loan-to-value
ratios, with ultra-low teaser rates, to uncreditworthy
borrowers, and dont bother to verify their income
and assets (thereby inviting fraud)
Theres only one problem:
DONT EXPECT TO BE REPAID!
A Case Study of Wall Street
Compensation Run Amok:
Stan ONeal, Dow Kim & the Mortgage Team at Merrill Lynch
Source: On Wall Street, Bonuses, Not Profits, Were Real, NY Times, 12/18/08.
The Rating Agencies Were Making a Fortune
Rating Structured Finance Products
$10.00
$20.00
$30.00
$40.00
$50.00
$60.00
$70.00
2003 2004 2005 2006
Moodys Stock Price Reflected Its Surge in Profits
Source: Yahoo! Finance.
Greenspan Kept Interest Rates Too Low for
Too Long, Which Fueled the Housing Bubble
0
1
2
3
4
5
6
7
J
a
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s
t

R
a
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e

(
%
)
Source: Federal Reserve Bank of St. Louis.
Background on the U.S. Housing Market
29
There Was a Surge of Toxic Mortgages
From 2000 to Mid-2007
Source: Inside Mortgage Finance, published by Inside Mortgage Finance Publications, Inc. Copyright 2009.
$0
$500
$1,000
$1,500
$2,000
$2,500
$3,000
$3,500
$4,000
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
O
r
i
g
i
n
a
t
i
o
n
s

(
B
n
)
Conforming, FHA/VA
J umbo
Alt-A
Subprime
Seconds
30
Private Label Mortgages (Those Securitized by
Wall St.) Are 15% of All Mortgages, But Account
for 51% of Seriously Delinquent Mortgages
Number of Mortgages (million)
Number of Seriously
Delinquent Mortgages (000)
Freddie Mac
13
Ginne Mae/FHA
6
Private Label
8
Fannie Mae
18
Banks & Thrifts
8
15%
Private Label
1734
Banks & Thrifts
397
Freddie Mac
232
Fannie Mae
444
Ginne Mae/FHA
378
51%
Source: Freddie Mac, Q4 2008.
Approximately two-thirds of homes have mortgages and, of these, 56% are owned or
guaranteed by the two government-sponsored enterprises (GSEs), Fannie & Freddie
31
More Than 9% of Mortgages on 1-to-4 Family Homes
Were Delinquent or in Foreclosure as of Q1 2009
Source: National Delinquency Survey, Mortgage Bankers Association; T2 Partners estimates. Note: Delinquencies (60+days) are seasonally adjusted.
0.0%
1.0%
2.0%
3.0%
4.0%
5.0%
6.0%
7.0%
8.0%
9.0%
10.0%
Q
4

1
9
7
9
Q
4

1
9
8
0
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4

1
9
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4

1
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s
32
All Types of Loans Are Seeing a Surge in
Delinquencies, Led by Subprime
0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
Q
1

1
9
9
9
Q
3

1
9
9
9
Q
1

2
0
0
0
Q
3

2
0
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2
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3

2
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3

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N
o
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c
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e
n
t
Alt A
Option ARM
J umbo
Subprime
Prime
Home Equity Lines of Credit
Sources: Amherst Securities, LoanPerformance; National Delinquency Survey, Mortgage Bankers Association; FDIC Quarterly Banking Profile;
T2 Partners estimates. Note: Prime is seasonally adjusted.
33
Foreclosure Filings Have Increased
Dramatically
Foreclosure filings were reported on 336,173 U.S. properties in J une, the fourth straight monthly
total exceeding 300,000
1.19% of all U.S. housing units (one in 84) received at least one foreclosure filing in the first half of
this year.
Note: Foreclosure filings are defined as default notices, auction sale notices and bank repossessions. Source: RealtyTrac.comU.S.
Foreclosure Market Report.
0
50,000
100,000
150,000
200,000
250,000
300,000
350,000
400,000
J
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-
0
5
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-
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u
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e
s
Credit Suisse Predicts More Than 6 Million
Additional Foreclosures by the End of 2012
Sources: Credit Suisse, 9/08; http://calculatedrisk.blogspot.com
35
Weak Existing Homes Sales and Rising Foreclosures
Are Leading to a Surge in Inventories
Source: NATIONAL ASSOCIATION OF REALTORSExisting Home Sales data series.
Months Supply Existing Home Sales
Actual inventory levels are significantly higher due to shadow
inventory, a combination of homes that banks own (REO) but have
no yet listed for sale, as well as homeowners who want to sell but
cant because theyre underwater.
4.0
4.5
5.0
5.5
6.0
6.5
7.0
7.5
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
M
i
l
l
i
o
n
s
4.9 million units as of the
end of J une 2009
3
4
5
6
7
8
9
10
11
12
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
M
o
n
t
h
s
3.8 million units, equal to 9.4 months
as of the end of J une 2009
36
Inventory Levels Are Especially High for
High-End Homes and Condos/Co-Ops
Sources: J P Morgan; CA Assoc. of Realtors (left chart); National Assoc. of Realtors via Moodys Economy.com, WSJ 6/22/09 (right chart).
Months Inventory in CA By Home Price
Another example: based on the rate of sales
over the seven months ending in May 2009,
there is five years of housing inventory in
Greenwich, CT
Nearly Half of Homes Sold Last Month Were
Distressed Sales, Which Pressures Homes Prices
Sources: National Association of Realtors, NY Times, 6/9/09.
38
The Decline in Lending Standards Led to a
Surge in Subprime Mortgage Origination
Source: Reprinted with permission; Inside Mortgage Finance, published by Inside Mortgage
Finance Publications, Inc. Copyright 2009.
10%
9%
9%
10%
9%
10%
10%
7%
7%
8%
18%
20%
20%
8%
$0
$100
$200
$300
$400
$500
$600
$700
1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
Ori gi nati ons
(Bn)
0%
5%
10%
15%
20%
25%
% of
Total
39
$0
$5
$10
$15
$20
$25
$30
$35
J
a
n
-
0
6
A
p
r
-
0
6
J
u
l
-
0
6
O
c
t
-
0
6
J
a
n
-
0
7
A
p
r
-
0
7
J
u
l
-
0
7
O
c
t
-
0
7
J
a
n
-
0
8
A
p
r
-
0
8
J
u
l
-
0
8
O
c
t
-
0
8
J
a
n
-
0
9
A
p
r
-
0
9
J
u
l
-
0
9
O
c
t
-
0
9
J
a
n
-
1
0
A
p
r
-
1
0
J
u
l
-
1
0
O
c
t
-
1
0
L
o
a
n
s

w
i
t
h

P
a
y
m
e
n
t

S
h
o
c
k

(
B
n
)
Sources: LoanPerformance, Deutsche Bank; slide from Pershing Square presentation, How to Save the Bond Insurers, 11/28/07.
The Wave of Resets from Subprime
Loans Is Mostly Behind Us
We are
here
40
The Mortgage Meltdown Has Moved
Beyond Subprime to Five Other Areas
Sources: Federal Reserve Flow of Funds Accounts of the United States, IMF Global Financial Stability Report October 2008, Goldman Sachs Global Economics
Paper No. 177, FDIC Quarterly Banking Profile, OFHEO, S&P Leverage Commentary & Data, T2 Partners estimates.
$0.0 $0.5 $1.0 $1.5 $2.0 $2.5 $3.0 $3.5 $4.0 $4.5 $5.0
CDO/ CLO
Other Consumer
Construction & Development
Option ARM
Auto
Credit Card
Home Equity
J umbo Prime
High-Yield / Leveraged Loans
Subprime
Commercial & Industrial
Other Corporate
Alt-A
Commercial Real Estate
Prime Mortgage
Amount Outstanding (Trillions)
41
Two Waves of Losses Are Behind Us
But Three Are Looming
Losses Mostly Behind Us
Wave #1: Borrowers committing (or the victim of) fraud, as well as
speculators, who defaulted quickly. Timing: beginning in late 2006 (as
soon as home prices started to fall) into 2008. Mostly behind us.
Wave #2: Mostly subprime borrowers who defaulted when their
mortgages reset due to payment shock. Timing: early 2007 (as two-
year teaser subprime loans written in early 2005 started to reset) to the
present. Now tapering off as low interest rates mitigate payment shock.
Losses Mostly Ahead of Us
Wave #3: Prime loans (most of which are owned or guaranteed by the
GSEs) defaulting due to job loss and home price declines (i.e.,
underwater homeowners). Timing: started to surge in early 2008 to the
present.
Wave #4: J umbo prime, second lien and HELOCs (most of which are
on banks books) defaulting due to job loss and home price declines/
underwater homeowners. Timing: started to surge in early 2008 to the
present.
Wave #5: Losses among loans outside of the housing sector, the
largest of which will be in the $3.5 trillion area of commercial real estate.
Timing: started to surge in early 2008 to the present.
42
Future Losses Will Be Driven By Three
Primary Factors
1. The economy
Especially unemployment
2. Interest rates
Ultra-low rates have helped mitigate some of the damage
But if the recent spike in rates continues, it could lead to an even greater surge
in defaults and losses
3. Behavior of homeowners who are underwater
Roughly one-fourth of homeowners with mortgages are currently underwater,
some deeply so
For many, it is economically rational for them to walk leading to so-called
jingle mail but how many will actually do so?
There is little historical precedent we are in uncharted waters
As home prices continue to fall and more and more homeowners become
deeper and deeper underwater, they are obviously more likely to default,
thereby creating a vicious cycle, but what exactly will the relationship be?
Have millions of foreclosures led to a diminution of the stigma of defaulting and
losing ones home?
Our best guess is that there will be rough symmetry: for homeowners 5%
underwater, an additional 5% will default due to being underwater; 10%
underwater will lead to 10% more defaults, and so forth
Current Economic Situation
44
There Have Been 6.5 Million Jobs Lost So Far in This
Recession, More Than 3 Million in the Past 6 Months
Source: Bureau of Labor Statistics.
-1000
-800
-600
-400
-200
0
200
400
600
J
a
n
-
9
0
J
a
n
-
9
1
J
a
n
-
9
2
J
a
n
-
9
3
J
a
n
-
9
4
J
a
n
-
9
5
J
a
n
-
9
6
J
a
n
-
9
7
J
a
n
-
9
8
J
a
n
-
9
9
J
a
n
-
0
0
J
a
n
-
0
1
J
a
n
-
0
2
J
a
n
-
0
3
J
a
n
-
0
4
J
a
n
-
0
5
J
a
n
-
0
6
J
a
n
-
0
7
J
a
n
-
0
8
J
a
n
-
0
9
C
h
a
n
g
e

i
n

N
o
n
f
a
r
m

P
a
y
r
o
l
l

E
m
p
l
o
y
m
e
n
t

(
0
0
0
s
)
There have been job
losses every month since
December 2007
45
The Unemployment Rate Jumped to 9.5%
in June, the Highest Level Since 1983
Source: Bureau of Labor Statistics.
If part-time and discouraged workers are factored in, the unemployment
rate would have been 16.5% in June. In addition, the average work week
was 33 hours, a record low.
3%
4%
5%
6%
7%
8%
9%
10%
11%
J
a
n
-
7
0
J
a
n
-
7
3
J
a
n
-
7
6
J
a
n
-
7
9
J
a
n
-
8
2
J
a
n
-
8
5
J
a
n
-
8
8
J
a
n
-
9
1
J
a
n
-
9
4
J
a
n
-
9
7
J
a
n
-
0
0
J
a
n
-
0
3
J
a
n
-
0
6
J
a
n
-
0
9
U
n
e
m
p
l
o
y
m
e
n
t

R
a
t
e
46
The Decline from Peak Employment Now
Far Exceeds the Past Five Recessions
Source: Bureau of Labor Statistics
-5.0%
-4.5%
-4.0%
-3.5%
-3.0%
-2.5%
-2.0%
-1.5%
-1.0%
-0.5%
0.0%
0 6 12 18 24 30 36 42 48
Months after pre-recession peak
1980
2001 - 05
1990 - 93
1974 - 76
2007- present
1981 - 83
47
Consumer Confidence Rebounded in April
and May, but Retreated in June
Note: 1985=100. Source: The Conference Board (www.pollingreport.com/consumer.htm)
0
20
40
60
80
100
120
140
160
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
C
o
n
s
u
m
e
r

C
o
n
f
i
d
e
n
c
e

I
n
d
e
x
Mortgage Equity Withdrawals of Roughly $400
Billion Annually During the Peak Bubble Years
Fueled Unsustainable Consumer Spending
Source: www.calculatedriskblog.com/2009/05/mew-consumption-and-personal-saving.html.
49
Banks are Tightening Consumer Credit and
New Household Borrowing Has Plunged
Source: Federal Reserve Board.
Househol d Borrowing 1990-2008
(Seasonally-Adjusted Annual Rate)
$0
$200
$400
$600
$800
$1,000
$1,200
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
($ billions)
Percent of US Banks Tightening Consumer Credit
-20%
-10%
0%
10%
20%
30%
40%
50%
60%
70%
J
a
n
-
0
0
S
e
p
-
0
0
M
a
y
-
0
1
J
a
n
-
0
2
S
e
p
-
0
2
M
a
y
-
0
3
J
a
n
-
0
4
S
e
p
-
0
4
M
a
y
-
0
5
J
a
n
-
0
6
S
e
p
-
0
6
M
a
y
-
0
7
J
a
n
-
0
8
S
e
p
-
0
8
Credi t Cards Other Consumer Loans
The U.S. Savings Rate Has Spiked Upward in
Recent Months to a 15-Year High
This is good news in the long run, but could be a severe economic headwind in
the short run, given that consumer spending is 2/3 of GDP
Source: Paul Kedroskys blog, 6/26/09; http://paul.kedrosky.com/archives/2009/06/the_black_swan.html.
Interest Rates
52
The Interest Rate on Conforming 30-Year Fixed-
Rate Mortgages Fell to All-Time Lows in Early 2009
2
3
4
5
6
7
8
9
10
F
e
b
-
0
4
M
a
y
-
0
4
A
u
g
-
0
4
N
o
v
-
0
4
F
e
b
-
0
5
M
a
y
-
0
5
A
u
g
-
0
5
N
o
v
-
0
5
F
e
b
-
0
6
M
a
y
-
0
6
A
u
g
-
0
6
N
o
v
-
0
6
F
e
b
-
0
7
M
a
y
-
0
7
A
u
g
-
0
7
N
o
v
-
0
7
F
e
b
-
0
8
M
a
y
-
0
8
A
u
g
-
0
8
N
o
v
-
0
8
F
e
b
-
0
9
M
a
y
-
0
9
R
a
t
e

(
%
)
J umbo 30 Yr FRM
J umbo 5/1 Hybrid ARM
Conforming 30 Yr FRM
Conforming 5/1 Hybrid ARM
10-Year Treasury
Sources: HSH ASSOCIATES, Freddie Mac PMMS, Yahoo! Finance.
53
The Recent Spike in Treasury Yields Has Pushed
Mortgages Rates Up, Which Crushes Refis and Threatens
Any Hope of Stabilization of the Housing Market
Sources: HSHAssociates.com; Ryan ALM via WSJ Market Data Group; Mortgage Bankers Association via
Thomson Reuters; in the Wall St. J ournal, 6/11/09.
(Conventional or nonconforming)
Roughly speaking, every 1% increase in mortgage rates reduces borrowing power by 10%
Underwater Homeowners
55
24% of Homeowners With a Mortgage Owe
More Than the Home Is Worth, Making
Them Much More Likely to Default
There Has Been a Dramatic Rise in
Homeowners Who Are Underwater
In Bubble Markets, Far More
Homeowners Are Underwater
Source: Zillow.comQ4 08 Real Estate Market Report; Moody's Economy.com, First American CoreLogic, T2 Partners estimates
Among people who bought homes in the past five years, 30%+ are underwater*
4%
6%
16%
20%
24%
0%
5%
10%
15%
20%
25%
Dec-06 Dec-07 Sep-08 Dec-08 Mar-09
P
e
r
c
e
n
t

U
n
d
e
r
w
a
t
e
r
Pr ice Index Is % of Last 5 Yrs
at Lowest Price Drop Purchasers Who
Met ro Area Level Since Since Peak Are Under Water
New York 2004-Q3 -15.2% 23.0%
Los Angeles 2003-Q4 -32.0% 56.4%
Bost on 2002-Q2 -21.8% 27.8%
Washington 2004-Q1 -24.8% 50.3%
Miami 2004-Q1 -36.6% 65.1%
San Francisco 2003-Q3 -27.8% 51.2%
Atlanta
2004-Q4
-10.4% 23.2%
San Diego
2002-Q4
-34.4% 63.9%
Phoenix 2004-Q3 -37.7% 36.4%
Las Vegas 2003-Q4 -41.8% 61.4%
* The actual figures are likely even worse,
as this data doesnt capture people who
bought since 2003 and subsequently did a
cash-out refi or after-the-fact second
mortgage. 50% of all subprime and Alt-A
loans in existence when the collapse
happened were cash-out refis that carried a
higher loan balance than the original
purchase loan amount.
*
56
Certain Types of Loans Are Severely
Underwater
Sources: Amherst Securities (J anuary 2009), LoanPerformance, Standard & Poors.
73%
50%
45%
25%
0%
10%
20%
30%
40%
50%
60%
70%
80%
Prime Alt A Subprime Option ARM
P
e
r
c
e
n
t

U
n
d
e
r
w
a
t
e
r
Outlook for Housing Prices
58
Home Prices Are in an Unprecedented
Freefall
Sources: Standard & Poors, OFHEO Purchase-Only Index, NATIONAL ASSOCIATION OF REALTORSExisting Home Sales data series.
100
120
140
160
180
200
220
Q
1

2
0
0
0
Q
3

2
0
0
0
Q
1

2
0
0
1
Q
3

2
0
0
1
Q
1

2
0
0
2
Q
3

2
0
0
2
Q
1

2
0
0
3
Q
3

2
0
0
3
Q
1

2
0
0
4
Q
3

2
0
0
4
Q
1

2
0
0
5
Q
3

2
0
0
5
Q
1

2
0
0
6
Q
3

2
0
0
6
Q
1

2
0
0
7
Q
3

2
0
0
7
Q
1

2
0
0
8
Q
3

2
0
0
8
Q
1

2
0
0
9
S&P/Case-Shiller U.S. National Home Price Index
S&P/Case-Shiller 20-City Composite
OFHEO Purchase-Only Index
NAR Median Sales Price of Existing Homes
59
Home Prices Need to Fall Another 5-10%
to Reach Trend Line
Sources: Robert J . Shiller, Irrational Exuberance: Second Edition, as updated by the author; Lawler Economic & Housing Consulting.
100
125
150
175
200
225
250
275
300
1
9
5
0
1
9
5
4
1
9
5
8
1
9
6
2
1
9
6
6
1
9
7
0
1
9
7
4
1
9
7
8
1
9
8
2
1
9
8
6
1
9
9
0
1
9
9
4
1
9
9
8
2
0
0
2
2
0
0
6
R
e
a
l

H
o
m
e

P
r
i
c
e

I
n
d
e
x

(
1
8
9
0
=
1
0
0
)
Shi ller
Lawl er
Trend Line
Housing
Bubble
60
A Study of Bubbles Shows That All of
Them Eventually Return to Trend Line
Stocks
S&P 500
1920-1932
0.3
0.8
1.3
1.8
2.3
202122 232425262728 293031
D
e
t
r
e
n
d
e
d

R
e
a
l

P
r
i
c
e
Tr end Li ne
S&P 500
1946-1984
0.0
0.5
1.0
1.5
2.0
2.5
46 50 54 58 62 66 70 74 78 82
D
e
t
r
e
n
d
e
d

R
e
a
l

P
r
i
c
e
Tr end Li ne
Japan vs. EAFE ex -Japan
1981-1999
0.0
0.5
1.0
1.5
2.0
2.5
3.0
81 83 85 87 89 91 93 95 97 99
R
e
l
a
t
i
v
e

R
e
t
u
r
n
Tr end Line
S&P 500
1992-October 2008
0.8
1.2
1.6
2.0
2.4
92 94 96 98 00 02 04 06 08
D
e
t
r
e
n
d
e
d

R
e
a
l

P
r
i
c
e
Tr end Line
Currencies
U.S. Dol l ar
1979-1992
0.8
1.0
1.2
1.4
1.6
1.8
2.0
79 81 83 85 87 89 91
C
u
m
u
l
a
t
i
v
e

R
e
t
u
r
n
U.K. Pound
1979-1985
0.8
0.9
1.0
1.1
1.2
1.3
1.4
79 80 81 82 83 84
C
u
m
u
l
a
t
i
v
e

R
e
t
u
r
n
Japanese Yen
1983-1990
0.8
0.9
1.0
1.1
1.2
1.3
1.4
83 84 85 86 87 88 89 90
C
u
m
u
l
a
t
i
v
e

R
e
t
u
r
n
Japanese Yen
1992-1998
0.8
0.9
1.0
1.1
1.2
1.3
1.4
92 93 94 95 96 97
C
u
m
u
l
a
t
i
v
e

R
e
t
u
r
n
Commodities
Gol d
1970-1999
0
400
800
1200
1600
2000
70 74 78 82 86 90 94 98
R
e
a
l

P
r
i
c
e
Crude Oi l
1962-1999
0
20
40
60
80
62 66 70 74 78 82 86 90 94 98
R
e
a
l

P
r
i
c
e
Ni ckel
1979-1999
0
50
100
150
200
250
79 81 83 85 87 89 91 93 95 97
R
e
a
l

P
r
i
c
e
Cocoa
1970-1999
0
100
200
300
400
500
600
70 74 78 82 86 90 94 98
R
e
a
l

P
r
i
c
e
Source: GMO LLC. Note: For S&P charts, trend is 2% real price appreciation per year. Source: GMO. Data through 10//10/08.
* Detrended Real Price is the price index divided by CPI+2%, since the long-term trend increase in the price of the S&P 500 has been on the order of 2% real.
61
The Biggest Danger is That Home Prices
Overshoot on the Downside, Which Often
Happens When Bubbles Burst
S&P 500 1927-1954
S&P 500 1955-1986
0.00
0.25
0.50
0.75
1.00
1.25
1.50
1.75
2.00
2.25
2.50
1927 1930 1933 1936 1939 1942 1945 1948 1951 1954
D
e
t
r
e
n
d
e
d

R
e
a
l

S
&
P

5
0
0

S
t
o
c
k

P
r
i
c
e

I
n
d
e
x
-59%
Overrun: 59%
Fair Value to Bottom: 1.5 Years
Fair Value to Fair Value: 23 Years
0.00
0.25
0.50
0.75
1.00
1.25
1.50
1.75
2.00
2.25
1955 1957 1959 1961 1963 1965 1967 1969 1971 1973 1976 1978 1980 1982 1984 1986
D
e
t
r
e
n
d
e
d

R
e
a
l

S
&
P

5
0
0

S
t
o
c
k

P
r
i
c
e

I
n
d
e
x
-45%
Overrun: 45%
Fair Value to Bottom: 7 Years
Fair Value to Fair Value: 12 Years
Source: GMO LLC, T2 Partners calculations.
62
The Housing Affordability Index Shows
Houses Are Now Affordable
14
16
18
20
22
24
26
1
9
8
9
1
9
9
0
1
9
9
1
1
9
9
2
1
9
9
3
1
9
9
4
1
9
9
5
1
9
9
6
1
9
9
7
1
9
9
8
1
9
9
9
2
0
0
0
2
0
0
1
2
0
0
2
2
0
0
3
2
0
0
4
2
0
0
5
2
0
0
6
2
0
0
7
2
0
0
8
2
0
0
9
M
o
r
t
g
a
g
e

P
a
y
m
e
n
t

o
n

M
e
d
i
a
n

P
r
i
c
e
d
H
o
m
e

a
s

%

o
f

F
a
m
i
l
y

I
n
c
o
m
e
Before concluding that houses are cheap, however, there are three big caveats: first, low rates
are only available to those who qualify for conforming mortgages, which doesnt help millions of
homeowners or potential homeowners who have spotty credit histories or are underwater on their
current mortgages. Second, with low enough interest rates, almost anything looks affordable; if
rates rise, houses wont look so reasonably priced based on these metrics. Finally, in light of the
severe economic downturn, average income may fall for quite some time.
Source: NATIONAL ASSOCIATION OF REALTORSHousing Affordability Index.
63
The Home Price-to-Rent Ratio Has
Returned to Normal Levels
15
17
19
21
23
25
27
1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
M
e
d
i
a
n

H
o
m
e

P
r
i
c
e

t
o

M
e
d
i
a
n

G
r
o
s
s

R
e
n
t
Source NATIONAL ASSOCIATION OF REALTORSExisting Home Sales data series, U.S. Census Bureau, T2 Partners estimates.
Case Study: California,
With a Focus on Sacramento
(California accounts for 10% of U.S. homes, but
33% of foreclosures 43% by value)
65
In California, Prices Are Way Down,
Driven By a Surge in the Number of
Homes Sold Out of Foreclosure
Source: MDA Dataquick. Note: Includes new construction.
California
$0
$100
$200
$300
$400
$500
J
a
n
-
0
6
A
p
r
-
0
6
J
u
l
-
0
6
O
c
t
-
0
6
J
a
n
-
0
7
A
p
r
-
0
7
J
u
l
-
0
7
O
c
t
-
0
7
J
a
n
-
0
8
A
p
r
-
0
8
J
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l
-
0
8
O
c
t
-
0
8
J
a
n
-
0
9
A
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r
-
0
9
M
e
d
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a
n

H
o
m
e

P
r
i
c
e

(
0
0
0
s
)
0%
10%
20%
30%
40%
50%
60%
70%
F
o
r
e
c
l
o
s
u
r
e

R
e
s
a
l
e

%
66
Home Prices Have Crashed Through Trend Line in
California, But Stabilized in March and April
Source: California Association of REALTORS . All rights reserved. www.rebsonline.com, T2 Partners estimates.
$0
$100
$200
$300
$400
$500
$600
J
a
n
-
7
9
J
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-
8
1
J
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-
8
3
J
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5
J
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7
J
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9
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-
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-
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-
9
5
J
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9
7
J
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-
9
9
J
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-
0
1
J
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-
0
3
J
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-
0
5
J
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-
0
7
J
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-
0
9
M
e
d
i
a
n

P
r
i
c
e

(
$
0
0
0
s
)
Median Sales Price
4% Trend
67
Are We Seeing the Beginnings of a Bottom
in Hard-Hit Markets Like Sacramento?
Source: NY Times, 5/4/09.
68
Home Prices in Sacramento More Than Tripled
in Six Years And Have Now Fallen 47%
Source: Zillow.com.
69
The Vast Majority of Sacramento Homeowners Who
Purchased During the Bubble Years Are Now Underwater
Source: Zillow.com.
70
In Sacramento County, Home Sales Have
Rebounded But Are Still Outweighed by Defaults
Sources: MDA Dataquick; The Field Check Group -- data provided by ForeclosureRadar.com. Note:
Includes new construction.
Monthly Notices-of-Default in Sacramento
71
Home Prices Are Stabilizing in Sacramento Country,
In Part Due to More Higher End Homes Being Sold Off
Source: The Field Check Group -- data provided by ForeclosureRadar.com.
Sacramento House Prices at the
Time of Foreclosure/REO
Sacramento Mix of Houses at
the Time of Foreclosure/REO
Comments From Mark Hanson (1)
The Field Check Group, May 5, 2009
California housing at the low end is 'bottoming' mostly because: a) median prices
are down 55% from their peak over the past two years, thereby making the low end
affordable; b) foreclosures have temporarily been cut by 66% through moratoriums
reducing supply; and c) demand is picking up going into the busy season.
But the moratoriums are ending and the number of foreclosures in the pipeline is
massive they will start showing themselves as REO over the near to mid-term. The
Obama plan held the foreclosure wave back, creating a huge backlog and now the
servicers are testing hundreds of thousands of defaults against the new loss mitigation
initiatives. We presently see the Notice of Defaults at record highs and Notice of Trustee
Sales back up to nine-month highs there is no reason for a loan to go to the Notice of
Trustee Sale stage if indeed it wasn't a foreclosure. However, the new 'batch' are not only
from the low end but a wide mix all the way up to several million dollars in present value.
Because the majority of buyers are in ultra low and low-mid prices ranges, the supply-
demand imbalance from foreclosures and organic supply will crush the mid-to-upper
priced properties in 2009. We already have early seasonal hard data proving this. As the
mid-to-upper end go through their respective implosions this year and the volume of
sales in these bands increase as prices tumble, the mix shift will raise median and
average house prices creating the ultimate in false bottoms. We also have data proving
this phenomenon.
Comments From Mark Hanson (2)
The Field Check Group, May 5, 2009
After a year or so the real pain will occur when the mid to upper bands are down 40% from where
they are now, and the price compression has made the low to low-mid bands much less attractive the
very same bands that are so hot right now. Rents are tumbling and those that bought these properties
for investment will be at risk of default (investors have been buying all the way down). Investors have
just started to get taken to the woodshed from all of the supply and this will get much worse. Mid-to-
upper end rental supply is also flooding on the market making it much better to rent a beautiful million
dollar house than putting $300,000 down and buying.
After investors are punished -- and with move-up buyers gone for years it will leave first-time
homeowners to fix the housing market on their own. Good luck and good night. Five years from now
when things look to be stabilizing, all of these terrible kick-the-can-down-the-road modifications that
leave borrowers in 5-year-teaser, ultra-high-leverage, 150% LTV, balloon loans will start adjusting
upward and it will be Mortgage Implosion 2.0. These loan mods will turn millions of homeowners into
over-levered, underwater, renters and ensure housing is a dead asset class for years to come.
Due to a confluence of events including a national foreclosure moratorium and near-zero sales in the
mid to upper end during the off season, the broader housing data show signs of stabilization. Taken in
context, it is a blip. There are no silver linings or green shoots in housing whatsoever other than by these
first-time homeowners former renters who now find it cheaper to own than rent. This is a very good
thing, but it only applies to a small segment of the population and will not be able to support the market.
In addition, the first-time buyers who come out of the rental market put continuous pressure on rents.
Our data shows that the mid-to-upper end housing market is on the precipice of the exact cliff that the
market fell off of in 2007, led by new loan defaults. What happens to the economy when you hit the mid-
to-upper end earners the same way the low-to-mid end was hit with the subprime implosion? We will find
out soon enough. When we look back on housing at the end of 2009, anyone that made positive
housing predictions this year will not believe how far off they were.
74
Outlook for Housing Prices
We think housing prices will reach fair value/trend line, down 40% from the peak based on the
S&P/Case-Shiller national (not 20-city) index, which implies a 5-10% further decline from where
prices where as of the end of Q1 2009. Its almost certain that prices will reach these levels
The key question is whether housing prices will go crashing through the trend line and fall well
below fair value. Unfortunately, this is very likely. In the long-term, housing prices will likely settle
around fair value, but in the short-term prices will be driven both by psychology as well as supply
and demand. The trends in both are very unfavorable
Regarding the former, national home prices have declined for 33 consecutive months since their peak in J uly
2006 through April 2009 and theres no end in sight, so this makes buyers reluctant even when the price
appears cheap and sellers desperate.
Regarding the latter, there is a huge mismatch between supply and demand, due largely to the tsunami of
foreclosures. In March 2009, distressed sales accounted for just over 50% of all existing home sales
nationwide and more than 57% in California. In addition, the shadowinventory of foreclosed homes
already likely exceeds one year and there will be millions more foreclosures over the next few years,
creating a large overhang of excess supply that will likely cause prices to overshoot on the downside, as
they are already doing in California.
Therefore, we expect housing prices to decline 45-50% from the peak, bottoming in mid-2010
We are also quite certain that wherever prices bottom, there will be no quick rebound
Theres too much inventory to work off quickly, especially in light of the millions of foreclosures
over the next few years
While foreclosure sales are booming in many areas, regular sales by homeowners have plunged,
in part because people usually cant sell when theyre underwater on their mortgage and in part
due to human psychology: people naturally anchor on the price they paid or what something was
worth in the past and are reluctant to sell below this level. We suspect that there are millions of
homeowners like this who will emerge as sellers at the first sign of a rebound in home prices
Finally, we dont think the economy is likely to provide a tailwind, as we expect it to contract the
rest of 2009, stagnate in 2010, and only then grow tepidly for some time thereafter
75
Conclusion: Recent Signs of Stabilization
Are Likely the Mother of All Head Fakes
Rather than representing a true bottom, recent signs of stabilization are likely
due to five factors that are (or are likely to be) short-term:
1. Ultra-low interest rates
2. A shift from low-end to middle- and upper-end homes defaulting, which has the
effect of raising average home prices but its very bad news
3. Home sales and prices are seasonally strong in April, May and J une due to tax
refunds and the spring selling season
4. The new $8,000 tax credit for first-time homebuyers
But this expires on November 30
th
5. A temporary reduction in the inventory of foreclosed homes
Shortly after Obama was elected, his administration promised a new, more robust plan
to stem the wave of foreclosures so the GSEs and many other lenders imposed a
foreclosure moratorium
Early this year, the Obama administration unveiled its plan, the Homeowner
Affordability and Stabilization Plan, which is a step in the right direction but even if it is
hugely successful, we estimate that it might only save 20% of homeowners who would
otherwise lose their homes
The GSEs and other lenders are now quickly moving to save the homeowners who can
be saved and foreclose on those who cant
This is necessary to work our way through the aftermath of the bubble, but will lead to a
surge of housing inventory later this year, which will further pressure home prices
76
The Timing Indicates That We Are Still in the
Middle Innings of the Bursting of the Great
Housing Bubble
Mortgage lending standards became progressively worse starting in 2000, but really went off a cliff
beginning in early 2005
The worst loans were subprime ones, which generally had two-year teaser rates and are now
defaulting at unprecedented rates
Such loans made in Q1 2005 started to default in high numbers upon reset in Q1 2007, which not
surprisingly was the beginning of the current crises
The crisis has continued to worsen as even lower quality subprime loans made over the
remainder of 2005 reset over the course of 2007, triggering more and more defaults
It takes an average of 15 months from the date of the first missed payment by a homeowner to a
liquidation (generally a sale via auction) of the home
Thus, the Q1 2005 subprime loans that defaulted in Q1 2007 led to foreclosures and auctions in
early 2008
Given that lending standards got much worse in late 2005 through 2006 and into the first half of
2007, and the many other types of loans that are now with longer reset dates that are now starting
to default at catastrophic rates, plus unemployment is a very high levels and continues to rise,
there are sobering implications for expected defaults, foreclosures and auctions in 2009 and
beyond, which promise to drive home prices down further
In summary, today we are only in the middle innings of an enormous
wave of defaults, foreclosures and auctions that is hitting the United
States. We predicted in early 2008 that it would get so bad that it would
require large-scale federal government intervention which has
occurred, and were not finished yet.
Total Losses
78
Total Losses Are Now Estimated at $2.1-$3.8 Trillion
And Only $1.5 Trillion Has Been Realized To Date
Sources: Goldman Sachs, International Monetary Fund, RGE Monitor, Bloomberg Finance L.P., T2 Partners estimates.
Banks/
Brokers
Insurers
GSEs
$0
$500
$1,000
$1,500
$2,000
$2,500
$3,000
$3,500
$4,000
Goldman
Sachs J an
2009
Roubini J an
2009
T2 Partners
Mar 2009
IMF Apr 2009 Writedowns to
Date
Capital Raised
A
m
o
u
n
t

(
B
n
)
Corporate
Consumer
Commercial
Real Estate
Residential
Mortgages
$2,083
$2,632
$3,552
$3,778
$1,525
$1,281
A Breakdown of Our Financial Sector
Loss Estimates
$0 $100 $200 $300 $400 $500 $600 $700 $800
CDO/ CLO
Other Consumer
Construction & Development
Option ARM
Auto
Credit Card
Home Equity
J umbo Prime
High-Yield / Leveraged Loans
Subprime
Commercial & Industrial
Other Corporate
Alt-A
Commercial Real Estate
Prime Mortgage
Amount (Bn)
Total Estimated
Financial Sector
Losses = $3.8 trillion
Source: T2 Partners estimates.
80
Institutions Have Been Able to Raise Capital to
Mostly Keep Up With Writedowns, But This Will
Likely Not Continue
$0
$250
$500
$750
$1,000
$1,250
$1,500
Prior Q3 2007 Q4 2007 Q1 2008 Q2 2008 Q3 2008 Q4 2008 Q1 2009 Q2 2009
A
m
o
u
n
t

(
B
n
)
Losses & Writedowns
Capital Raised
Source: Bloomberg Finance L.P.
81
We Think Were Likely in the Midst
of a Secular Bear Market
Source: Ned Davis Research; WSJ Market Data Group; appeared in WSJ 6/16/09
82
Where We Are Finding Opportunities
Blue-chips. The stocks of some of the greatest businesses, with strong balance sheets and dominant
competitive positions, are trading at their cheapest levels in years due primarily to the overall market
decline and weak economic conditions rather than any company-specific issues. In this category, wed
put Wal-Mart (which we own), Coca-Cola, McDonalds, Altria, ExxonMobil, and J ohnson & J ohnson.
Out of favor blue-chips. For somewhat more adventurous investors looking to buy great companies in the
most out-of-favor sectors such as financials, retailers and healthcare, we own Berkshire Hathaway, Wells
Fargo, American Express, Target and Pfizer. We also own Microsoft. All are great businesses, but their
stocks have suffered mightily thanks to the economic downturn. We think theyre good bets to rebound
when things stabilize.
Balance sheet plays. For investors who are comfortable with lower-quality businesses but want downside
protection, there are many companies trading near or even below net cash on the balance sheet.
Examples in our portfolio include digital media equipment company EchoStar Corp. and clothing retailer
dELiA*s. Berkshire is the best of both worlds: a premier company but also a balance sheet play.
Turnarounds. There are countless companies that have gotten clobbered by the economic downturn and
are reporting dismal results with stock prices to match. Investors in those that survive and return to
anything close to former levels of profitability will be well rewarded but picking these stocks isnt easy.
Among our holdings in this category are Wendys restaurants, Winn-Dixie supermarkets, Huntsman, a
specialty chemical maker, Crosstex, a pipeline company, and Resource America, a specialty finance
company.
Special situations. This is somewhat of a catch-all category that, for us, includes Contango Oil & Gas, a
stock thats declined due to an aborted attempt to sell the company and the sharp drop in the price of
natural gas.
Mispriced options. Every once in a while we take a tiny position in a highly speculative situation often
where the stock price is below $1 in which theres a real chance that the outcome is zero, but also a
decent chance, in our opinion, of making many multiples of our money. On an expected value basis,
therefore, a small portfolio of such investments is attractive. Our holdings include General Growth
Properties, TravelCenters of America, Ambassadors International, Borders Group and PhotoChannel
Networks.
Appendix
More Background Data on
the Housing Market
The Housing Bubble Helped Many People
Achieve the Dream of Home Ownership
Which is Now Turning Into a Nightmare
Source: Census Bureau.
60
61
62
63
64
65
66
67
68
69
70
1
9
6
5
1
9
6
7
1
9
6
9
1
9
7
1
1
9
7
3
1
9
7
5
1
9
7
7
1
9
7
9
1
9
8
1
1
9
8
3
1
9
8
5
1
9
8
7
1
9
8
9
1
9
9
1
1
9
9
3
1
9
9
5
1
9
9
7
1
9
9
9
2
0
0
1
2
0
0
3
2
0
0
5
2
0
0
7
Percentage of Households Owning Homes
%
Home Vacancies Are at an All-Time High
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
1
9
5
6
-
1
1
9
5
7
-
4
1
9
5
9
-
3
1
9
6
1
-
2
1
9
6
3
-
1
1
9
6
4
-
4
1
9
6
6
-
3
1
9
6
8
-
2
1
9
7
0
-
1
1
9
7
1
-
4
1
9
7
3
-
3
1
9
7
5
-
2
1
9
7
7
-
1
1
9
7
8
-
4
1
9
8
0
-
3
1
9
8
2
-
2
1
9
8
4
-
1
1
9
8
5
-
4
1
9
8
7
-
3
1
9
8
9
-
2
1
9
9
1
-
1
1
9
9
2
-
4
1
9
9
4
-
3
1
9
9
6
-
2
1
9
9
8
-
1
1
9
9
9
-
4
2
0
0
1
-
3
2
0
0
3
-
2
2
0
0
5
-
1
2
0
0
6
-
4
2
0
0
8
-
3
Home Vacancy Rate 1965-2008
Nearly 10% of Homes Built This Decade
Are Vacant
Source: Census Bureau
Vacancy Rate By Date of Construction
9.5%
2.2%
April 2000 to present March 2000 or earlier
Housing Starts, Completions and Sales
Have Plunged to All-Time Lows
Source: Commerce Department.
200
400
600
800
1000
1200
1400
1600
1800
2000
1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009
Starts
Completions
New Homes Sold
Unlike Past Housing Downturns, New Home Sales
Have Fallen Far More Than Existing Home Sales,
Leading to an Enormous Inventory Glut
Source: New York Times, 6/27/09.
So Far, Few Loan Modifications
Are Working
Source: Office of the Comptroller of the Currency and the Office of Thrift Supervision Mortgage Metrics
28.2%
52.1%
23.2%
36.7%
45.7%
44.0%
49.8%
31.8%
46.1%
29.1%
0%
10%
20%
30%
40%
50%
60%
3 6 9 12
Months Since Modification
P
e
r
c
e
n
t

o
f

M
o
d
i
f
i
e
d

L
o
a
n
s

6
0
+

D
a
y
s

D
e
l
i
n
q
u
e
n
t
Q1 2008
Q2 2008
Q3 2008
Q408
Most Loan Modifications Fail Because the
Homeowner Is So Deep Underwater
Among foreclosures
in California in May,
the average amount
owed was $412,000,
yet the home was
worth only $235,000.
This means the
homeowner was 43%
underwater and the
home price would
have to rise 75% to
equal the amount of
the debt.
Source: The Field Check Group -- data provided by ForeclosureRadar.com.
Case Study: San Diego County Resales
Source: San Diego Union-Tribune, MDA Dataquick. Note: Excludes new construction.
378
1,254
1,312
1,154
0
500
1,000
1,500
2,000
2,500
3,000
1/1/2007 1/1/2008
R
e
s
a
l
e

H
o
m
e
s
Normal
Foreclosure
+42%
-12%
+232%
More than half of homes and condos sold in
November in San Diego had been in foreclosure,
contributing to an increase in home sales - - while
prices fell 35%.
November 2007 November 2008
(52%
Foreclosure)
(22%
Foreclosure)
92
Detailed Information on
Five Types of Mortgages:
Prime, Alt-A, Jumbo Prime,
CES/HELOCs and Option ARMs
94
Delinquencies of Prime Mortgages
Are Soaring
Source: Mortgage Bankers Association National Delinquency Survey.
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
3.5%
4.0%
4.5%
5.0%
Q
1

1
9
9
9
Q
3

1
9
9
9
Q
1

2
0
0
0
Q
3

2
0
0
0
Q
1

2
0
0
1
Q
3

2
0
0
1
Q
1

2
0
0
2
Q
3

2
0
0
2
Q
1

2
0
0
3
Q
3

2
0
0
3
Q
1

2
0
0
4
Q
3

2
0
0
4
Q
1

2
0
0
5
Q
3

2
0
0
5
Q
1

2
0
0
6
Q
3

2
0
0
6
Q
1

2
0
0
7
Q
3

2
0
0
7
Q
1

2
0
0
8
Q
3

2
0
0
8
P
e
r
c
e
n
t

N
o
n
c
u
r
r
e
n
t

(
6
0
+

d
a
y
s
)
95
There Is a Surge of Notices of Default and
Foreclosures Among the GSEs
Prime Notices of Default
Subprime Notices of Default
Prime Foreclosures
Subprime Foreclosures
Source: The Field Check Group.
96
15 States With the Highest Prime
Mortgage Foreclosure Rates
97
Delinquencies of Prime and Alt-A
Mortgages Are Soaring
98
There Are $2.4 Trillion of Alt-A Mortgages
and Their Resets Are Mostly Ahead of Us
$0
$1
$2
$3
$4
$5
$6
$7
$8
$9
$10
J
a
n
-
1
0
J
u
l
-
1
0
J
a
n
-
1
1
J
u
l
-
1
1
J
a
n
-
1
2
J
u
l
-
1
2
J
a
n
-
1
3
J
u
l
-
1
3
J
a
n
-
1
4
J
u
l
-
1
4
J
a
n
-
1
5
J
u
l
-
1
5
A
m
o
u
n
t

(
B
n
)
$
0
$
5
0
$
1
0
0
$
1
5
0
$
2
0
0
$
2
5
0
$
3
0
0
E
s
t
i
m
a
t
e
d

C
u
m
u
l
a
t
i
v
e

R
e
s
e
t

A
m
o
u
n
t

(
B
n
)
We are
here
Sources: Credit Suisse, LoanPerformance.
NOTE: This chart only shows resets for a small fraction of Alt-A loans, but is representative of all of them.
99
Delinquencies of Securitized Alt-A
Sources: Amherst Securities, LoanPerformance.
0%
5%
10%
15%
20%
25%
J
a
n
-
9
9
J
u
l
-
9
9
J
a
n
-
0
0
J
u
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100
Alt-A Delinquencies By Vintage Show the
Collapse in Lending Standards in 2006 and 2007
0%
5%
10%
15%
20%
25%
30%
0 5 10 15 20 25 30 35 40 45 50 55 60
Months of Seasoning
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2007 2006
2005
2004
2003
101
Delinquencies of Securitized Jumbo Prime
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
3.5%
4.0%
J
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102
As the Credit Crisis Worsened, the Spread Between
Jumbo and Conforming Loans Widened Dramatically
Sources: Mortgage Bankers Association via Thomson Reuters; HSHAssociates.com, in the WSJ 6/11/09.
103
HELOCs and Home Equity Loans Soared
in Popularity During the Bubble
Note: Does not include approximately $200 billion of securitized HELOCs and junior liens. Source: FDIC Quarterly Banking Profile.
$0
$100
$200
$300
$400
$500
$600
$700
$800
$900
$1,000
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Closed-End J unior Lien Mortgages
104
As home prices have declined and other funding sources have dried up,
millions of consumers have maxed out on home equity debt.
In hot markets like California and Florida, a significant percentage of all
consumers tapped into the value of their homes to help finance their new
cars, according to CNW Marketing Research.
Clearly this dynamic does not bode well for HELOC recovery rates or new
car sales.
Many Borrowers Used HELOCs to Buy
New Cars
Source: New York Times 5/27/2008.
105
Delinquencies of HELOCs and CESs
Are Soaring
Source: FDIC Quarterly Banking Profile.
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
3.5%
4.0%
4.5%
Q
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Closed-End J unior Lien Mortgages
Pools of HELOCs and CESs Can Suffer
Astronomical Losses Due to 100%+ Severities
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
1 3 5 7 9 11 13 15 17 1921 23 25 27 2931 33 35 37 3941 43 45 47 49 51 5355 57 59
Months Since Close
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Ambac Projection April 2008
Actual
Sources: Ambac Q1 08 presentation, Amherst Securities; funds managed by T2 Partners are short Ambac.
On one second lien deal, Ambac expected losses of 10-12% when it guaranteed the senior
tranche. A year ago, Ambac admitted that the pool would likely lose 81.8% of its value and
based on the pools performance since then, this will almost certainly prove to be conservative.
From Ambac slide, April 2008:
Second lien deal that closed in April 2007
Loss to date 9.9%; projected loss: 81.8%
Projected collateral loss as a % of current
collateral: 86%
A reasonable estimate of projected collateral
loss for the above transaction might have
been 10-12%, with the transaction having an
A+rating at inception and being structured to
withstand 28-30% collateral loss
107
A Primer on Option ARMs
An Option ARM is an adjustable rate mortgage typically made to a prime
borrower
Sold under various names such as Pick-A-Pay
Banks typically relied on the appraised value of the home and the borrowers
high FICO score, so 83% of Option ARMs written in 2004-2007 were low- or
no-doc (liars loans)
Each month, the borrower can choose to pay: 1) the fully amortizing interest
and principal; 2) full interest; or 3) an ultra-low teaser interest-only rate
(typically 2-3%), in which case the unpaid interest is added to the balance of
the mortgage (meaning it is negatively amortizing)
Approximately 80% of Option ARMs are negatively amortizing
Lenders, however, booked earnings as if the borrowers were making full
interest payments
A typical Option ARM is a 30- or 40-year mortgage that resets (recasts)
after five years, when it becomes fully amortizing
If an Option ARM negatively amortizes to 110-125% of the original balance
(depending on the terms of the loan), this triggers a reset even if five years
have not elapsed
Upon reset, the average monthly payment can jump significantly, though the
payment shock is currently mitigated by todays low interest rates
Further Details on Option ARMs
The Option ARM home loan product is an adjustable-rate mortgage loan that provides the borrower
with the option each month to make a fully-amortizing, interest-only, or minimum payment. As described
in greater detail below, the minimum payment is typically insufficient to cover interest accrued in the prior
month and any unpaid interest is deferred and added to the principal balance of the loan.
The minimum payment on an Option ARM loan is based on the interest rate charged during the
introductory period. This introductory rate has usually been significantly below the fully-indexed rate. The
fully-indexed rate is calculated using an index rate plus a margin. Once the introductory period ends, the
contractual interest rate charged on the loan increases to the fully-indexed rate and adjusts monthly to
reflect movements in the index.
If the borrower continues to make the minimum monthly payment after the introductory period ends,
the payment may not be sufficient to cover interest accrued in the previous month. In this case, the loan
will "negatively amortize" as unpaid interest is deferred and added to the principal balance of the loan.
The minimum payment on an Option ARM loan is adjusted on each anniversary date of the loan but each
increase or decrease is limited to a maximum of 7.5% of the minimum payment amount on such date until
a "recasting event" occurs.
A recasting event occurs every 60 months or sooner upon reaching a negative amortization cap. When
a recasting event occurs, a new minimum monthly payment is calculated without regard to any limits on
the increase or decrease in amount that would otherwise apply under the annual 7.5% payment cap. This
new minimum monthly payment is calculated to be sufficient to fully repay the principal balance of the
loan, including any theretofore deferred interest, over the remainder of the loan term using the fully-
indexed rate then in effect.
A recasting event occurs immediately whenever the unpaid principal balance reaches the negative
amortization cap, which is expressed as a percent of the original loan balance. Prior to 2006, the negative
amortization cap was 125% of the original loan balance... For all Option ARM loans originated in 2006,
the negative amortization cap was 110% of the original loan balance. For Option ARM loans originated in
2007, the negative amortization cap was raised to 115%...
In the first month that follows a recasting event, the minimum payment will equal the fully-amortizing
payment.
From Washington Mutuals 2007 10K (emphasis added):
109
About $750 Billion of Option ARMs Were
Written, Nearly All at the Peak of the Bubble
Sources: 2008 Mortgage Market Statistical Annual, published by Inside Mortgage Finance Publications, Inc. Copyright 2008. T2 Partners estimates.
5%
9%
1%
8%
5%
$0
$50
$100
$150
$200
$250
$300
2004 2005 2006 2007 2008
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110
Options ARMs Were a Bubble State
Phenomenon
California
58%
Florida
10%
Nevada
3%
Arizona
3%
Other
25%
Beginning in March 2005, High-FICO-Score
Borrowers Opted for an Above-Market-Rate
Option ARM in Exchange for the Low Teaser Rate
Source: Amherst Securities, BloombergFinance, L.P.
4.0
4.5
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(
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Fannie Mae 30 Year FRM Index
Opt ion ARM Index
Nearly all Option ARM borrowers during
this period (when nearly all Option
ARMs were written) cant afford a fully-
amortizing mortgage otherwise they
would have taken one
Option ARMs are Recasting Much Faster Than
Expected Due to Negative Amortization
$-
$2
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2
Original recast schedule (5 yrs fromorigination)
Recast schedule based on current neg am
Source: Credit Suisse for BusinessWeek.
113
Delinquencies of Securitized Option ARMs
Are Soaring
Sources: Amherst Securities, LoanPerformance, T2 Partners estimates.
0%
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My sense is that many Option ARM
borrowers are in a worse position than
subprime borrowers. They wind up owing
more and the resets are more significant.
-- Kevin Stein, associate director of the
California Reinvestment Coalition
Comments From a Federal
Senior Bank Examiner (3/08)
The next problem is with the Option ARM product.
Approximately 80-90% are paying the minimum credit card
payment and most loans are negatively amortizing.
Here the payment shock is two-fold rate and principal and the
increase in payments can be astronomical: 200% or higher, not the
10 to 100% that subprime has experienced. Also, the dollars
exposed in Alt-A [many analysts group Option ARMs with Alt-A] are
nearly 50% higher than subprime: the Alt-A average balance is
$299,000 versus $181,000 for subprime.
Also, 73% were underwritten with Low or No Doc. The Option
ARM books of many lenders are already showing significant
deterioration and they have not even recast yet.
This is the next tsunami to hit the housing market. This will hit
much higher price points $600,000 and above as this was the
affordability product used by higher income/higher FICO score
households to buy that dream home.
A Closer Look at Mortgages That
Were Securitized: Quantity and Quality
Hundreds of Billions of Dollars of Mortgages
Were Securitized, Many On Terms With No
Historical Precedent
Green: Loans with historical precedent
Yellow: Loans with limited historical precedent
Red: Loans with no historical precedent
Securitized First Liens Origination Volume
Source: Amherst Securities Group, L.P.
These are the worst
loans: $828 billion worth
Tens of Billions of Dollars of 2
nd
Lien
Mortgages Were Also Securitized, Many
On Terms With No Historical Precedent
Green: Loans with historical precedent
Yellow: Loans with limited historical precedent
Securitized Second Liens Origination Volume
Another $56 billion of
even bigger problems
Volume of June 2005 Fixed Rate and 2/28
*
Full Doc Securitized Mortgage Loans
2/28 Full Doc June 2005 Production
Total Volume: $16.4 billion
Green: 39.9%; Yellow: 25.2%; Red: 26.1%
Fixed Full Doc June 2005 Production
Total Volume: $ 8.1 billion
Green: 70.0%; Yellow: 9.3%; Red: 5.4%
Note: Green: Loans with historical precedent; Yellow: Loans with limited historical precedent;
* 2-28 loans are those with two-year teaser interest rates that then reset, often to higher rates, causing payment
shock and a surge in defaults. Because they offer the lowest monthly payments (for the first two years), they
are generally the lowest-quality loans, preferred by speculators and the most over-stretched borrowers.
Loan-to-Value Loan-to-Value
F
I
C
O
Volume of June 2005 Fixed Rate and 2/28
Low Doc Securitized Mortgage Loans
2/28 Low Doc June 2005 Production
Green: 17.0%; Yellow: 33.4%; Red: 31.1%
Fixed Low Doc June 2005 Production
Green: 49.2%; Yellow: 25.8%; Red: 8.0%
Origination Volume of Fixed Rate, Full Doc
Securitized Mortgage Loans, January 2005
In the best category of loans (full doc, fixed
rate), in J anuary 2005, just before
mortgage lending standards collapsed,
nearly all securitized mortgages were
green, meaning they had FICO and LTV
characteristics with historical precedent.
Subprime
Alt-A
Prime
Securitized Mortgage Loans, June 2005
Mortgage lending standards began to
worsen by J une 2005.
By J anuary 2006, mortgage lending
standards had deteriorated substantially,
even more the best loans, with large
percentages yellow and red, meaning they
had FICO and LTV characteristics with little
or no historical precedent.
By J une 2006, mortgage lending standards
had collapsed, even for the best loans, with
large percentages yellow and red, meaning
they had FICO and LTV characteristics with
little or no historical precedent.
Origination Volume of 2/28, Low Doc
For the worst category of loans (low/no doc
with two-year teaser rates), mortgage
lending standards were abysmal as early
as J anuary 2005 and got worse from
there.
A very high percentage of these loans will
never be repaid.
A Closer Look at Mortgages
That Were Securitized: Defaults
Default Rates of June 2005 Fixed Rate and
2/28 Full Doc Securitized Mortgage Loans
2/28 Full Doc June 2005 Production
Green: 39.9%; Yellow: 25.2%; Red: 26.1%
Fixed Full Doc June 2005 Production
Green: 70.0%; Yellow: 9.3%; Red: 5.4%
F
I
C
O
Unprecedented default rates and lending standards
got much worse subsequent to J une 2005!
Source: Amherst Securities, May 25
th
reports, reflecting payments through 4/30/09.
Default Rates of June 2005 Fixed Rate and
2/28 Low Doc Securitized Mortgage Loans
2/28 Low Doc June 2005 Production
Green: 17.0%; Yellow: 33.4%; Red: 31.1%
Fixed Low Doc June 2005 Production
Green: 49.2%; Yellow: 25.8%; Red: 8.0%
Default rates are much higher for no/low doc liarsloans
F
I
C
O
th
Monthly Default Rate for Fixed Rate
Securitized Mortgage Loans (Green)
Defaults are defined as loans that are 90 days or more
delinquent. sTr measures the percentage of loans that
become 90 days or more delinquent during the month, as a
percentage of non-delinquent loans at the beginning of the
month.
This chart shows the performance of the very best (fixed
rate, green) mortgages. Note that late 2004 and early 2005
vintage loans have sTrs of approximately 70 basis points,
which translates into roughly an 8% cumulative default rate
in one year, whereas more recent vintage loans are quickly
spiking up to a 2% sTr, which translates into an 21.5%
cumulative default rate in one year.
12/04
9/06
Securitized Mortgage Loans (Yellow)
In this chart, late 2004 and early 2005 vintage loans have
sTrs of approximately 1.5%, which translates into a 16.6%
cumulative default rate in one year, whereas more recent
vintage loans are quickly spiking up to a 3% sTr, which
translates into a 30.6% cumulative default rate in one year.
Securitized Mortgage Loans (Red)
In this chart, late 2004 and early 2005 vintage loans have sTrs
of approximately 2%, which translates into a 21.5% cumulative
default rate in one year, whereas more recent vintage loans
are quickly spiking up to a 4-5% sTr, which translates into a
38-46% cumulative default rate in one year.
Monthly Default Rate for 2-28
Securitized Mortgage Loans (Green)
2-28 loans are those with two-
year teaser interest rates that
then reset, sometimes to higher
rates, which triggers payment
shock and a surge in defaults.
In this chart, note the surge in
sTr shortly after the two-year
reset, as well as the rapidly rising
sTr even before the reset in more
recent vintage loans compare
12/04, 12/05 and 9/06 loans, for
example.
12/05
(pre-reset)
9/06
(pre-reset)
12/04-6/05
(pre-reset)
Securitized Mortgage Loans (Yellow)
2006 and 2007 loans are
defaulting at 5-6% per month
even before the reset
Securitized Mortgage Loans (Red)
For recent vintage 2-28 red loans,
sTrs are jumping to 6-8% long
before the reset
Current Trends Are Quickly Leading
to Unprecedented Default Levels
Historical levels
Late 2005 and thereafter,
Green, fixed
Green, 2/28
Red, 2/28
2004 green,
fixed
Three-Year Cumulative Defaults
Notes: MDR =sTr =monthly default rate. CDR =cumulative default rate, which represents the amount of loans in default
after 36 months as a percentage of the original balance when keeping MDR and VPR constant for that time period.
Source: Amherst Securities Group.
(1 yr):
V
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Bubble-Era Pools of Subprime Mortgages
Are Performing Catastrophically
th
Cumulative defaults
Monthly default rate
Annualized default rate
Monthly
prepay rate
Annualized
prepay rate
An average of 47.6% of the
loans have already defaulted
On average, 5.1% of the
performing loans in the pools
defaulted during the month
The monthly prepay
rate only averaged 0.5%
The 20 RMBS Pools That Comprise the ABX 06-2
Total:
Where Did the Securitized Mortgages End Up?
A Primer on ABSs and CDOs
Wall Street Firms Bought Loans and Securitized
Them, First Into Asset-Backed Securities Called
Residential Mortgage Backed Securities (RMBSs)
Quick Review: What is a Securitization?
Source: Deutsche Bank Securitization Research; How to Save the Bond Insurers, Pershing Square presentation, 11/28/07.
Mortgages Were Pooled into RMBSs,
Tranches of Which Were Pooled into CDOs
This is an example of a
Mezzanine CDO. A
High-Grade CDOwould
select collateral primarily
from the A and AA
tranches mixed with
~25% senior tranches
from other, often
mezzanine, CDOs
Note: Asset-based securities backed by home mortgages are called Residential Mortgage-Backed Securities (RMBS), those backed by commercial real estate loans
are called Commercial Mortgage-Backed Securities (CMBS), etc. Source: Citigroup, All Clogged Up: Whats Ailing the Financial System, 2/13/08.
Loss rates of, say, 20%,
in the underlying
RMBSs can lead to
catastrophic losses for a
CDO
Equity
BBB
BBB
BBB
BBB
BBB
BBB
BBB
BBB
BBB
BBB
BBB
BBB
BBB
Equity
BBB
Equity
A
BBB- A
BBB
A
A
A
AA
AA
AA
AAA
AAA
AAA
Super
Senior
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
RMBS CDO Composition CDO Rating
Trillions of Dollars of ABSs and CDOs
Were Created and Distributed
Throughout the Financial System
Note: This is all ABSs and CDOs, not just those related to mortgages
Source: Lehman Brothers, 4/08; Carlyle presentation 10/15/08.
What Should the Government Do in the
Case of Distressed Financial Institutions?
Answer: The problem isnt lack of capital, but lack of the right kind of
capital. They have too much debt and not enough equity.
Therefore the solution is to convert some of the debt to equity.
First, One Must Understand the Capital
Structure of Financial Institutions And
How Highly Leveraged They Are
Taxpayers will
suffer all losses
above preferred
stock
Freddie Mac
Taxpayers will
suffer all losses
above preferred
stock
Lehman Brothers
Had the preferred stock,
junior debt and a small
fraction of the senior
debt been converted to
equity, Lehman could
have become one of the
best-capitalized financial
institutions in the world
and everyone would
have benefitted.
Overview of Fannie, Freddie and Lehman
Source: Amherst Securities
The $1 Trillion Dollar Mistake
The U.S. financial system likely faces losses of at least $1 trillion, most of which is likely
to be realized within the next 2-3 years
There is almost no equity cushion left to cover these losses, so somebody is going to
have to come up with $1 trillion to save the system
THE QUESTION IS: WHO?
Current government policy (in the cases of Fannie, Freddie, AIG, Citigroup and Bank of
America) is to invest (or guarantee assets) senior to the equity, but junior to all debt,
even junior/unsecured/subordinated debt
Absent the government, debt holders would bear the $1 trillion cost (as they did with
Lehman), but under current policy, taxpayers will bear this entire cost
This is unfair and unwise
Fairness: Debt holders were paid higher interest than, for example, buying Treasuries in
exchange for knowingly taking more risk. These investors made bad decisions, lending to highly
leveraged companies that made bad decisions, so why should they be protected?
Moral Hazard: The reckless behavior of debt investors was a major contributor to the bubble. It
was low-cost debt with virtually no strings attached that allowed borrowers, especially the world's
major financial institutions, to become massively overleveraged, fueling the greatest asset
bubble in history. This was not an equity bubble unlike the internet bubble, for example, stock
market valuations never got crazy it was a debt bubble, so it would be particularly perverse
and ironic if government bailouts allowed equity holders to take a beating, yet fully protected
debt holders.
The solution: debt should be converted into equity
But What About Systemic Risk?
What about the lessons from Lehman? Unless we protect the debt holders, wont
the financial system shut down again, as it nearly did in the wake of the Lehman
bankruptcy? No. The lessons from Lehman have been misunderstood.
The mistake wasn't the failure to protect the debt, but rather allowing Lehman to go
bankrupt, which not only impacted Lehman's equity and debt holders, but also stiffed
Lehman's countless clients and counterparties. It's the latter that caused the true chaos.
Lehman should have been seized and put into conservatorship, so that all of Lehman's
clients and counterparties could have relied on Lehman (as was done with AIG) - but debt
holders would have taken losses as they were realized (which is not being done with AIG).
If debt holders take a hit, might other financial institutions who own the debt might
become insolvent, creating a domino effect? And might debt markets freeze up
such that even currently healthy banks might not be able to access debt and
collapse?
Regarding the former, the debt is owned by a wide range of institutions all over the world:
sovereign wealth funds, pension funds, endowments, insurance companies and, to be sure,
other banks. Some of them would no doubt be hurt if they take losses on the debt they hold
in troubled financial institutions - but that's no reason to protect all of them 100% with
taxpayer money.
As for the latter concern that debt markets might freeze up, causing even healthy banks to
collapse, it's important to understand that right now there is no junior debt available to any
financial institution with even a hint of weakness - there's very high cost equity and
government-guaranteed debt. Neither of these will be affected if legacy debt holders are
forced to bear some of the cost of the failure of certain institutions.
Case Study: Bank of America
As of the end of 2008 (not including Merrill Lynch), BofA had $1.82 trillion in assets
($1.72 trillion excluding goodwill and intangibles), supported by a mere $86.6 billion
in tangible equity 5.0% of tangible assets or 20:1 leverage and $48.9 billion of
tangible common equity 2.8% of tangible assets or 35:1 leverage
Among the company's loans are many in areas of great stress including:
$342.8 billion of commercial loans ($6.5 billion of which is nonperforming, up from $2.2 billion
a year earlier)
$253.5 billion of residential mortgages ($7.0 billion of which is nonperforming, up from $2.0
billion a year earlier)
$152.5 billion of home equity loans (HELOCs; about $33 billion of which were Countrywide's)
$18.2 billion of Option ARMs (all Countrywides)
BofA is acknowledging a significant increase in losses, but its reserving has actually
become more aggressive over the past year. From the end of 2007 to the end of
2008, nonperforming assets more than tripled from $5.9 billion to $18.2 billion, yet
the allowance for credit losses didn't even double, from $12.1 billion to $23.5 billion.
As a result, the allowance for loan and lease losses as a percentage of total
nonperforming loans and leases declined from 207% to 141%
BofA has $268.3 billion of long-term debt, $158.1 of commercial paper and other
short-term borrowings
In addition, Merrill Lynch at the time of acquisition had $5.3 billion of junior subordinated
notes, $31.2 billion of short-term debt and $206.6 billion of long-term debt
What the Government Should Do If a
Company Blows Up and Cant Find a Buyer?
1. Seize it and put it into conservatorship
2. The Conservator would replace board and management and suspend
the voting rights and other decision rights of the shareholders
3. No dividends, share repurchases or other transfers of resources to the
old shareholders could take place while the Conservatorship is in effect
4. The Conservator should be able to haircut all unsecured debt holders
and other unsecured creditors, regardless of seniority
5. The Conservator would also be able to impose mandatory debt-to-
equity conversions on all unsecured creditors and debt holders, with or
without first extinguishing the equity of the old shareholders
6. The Conservator would have full authority to sell assets and to
restructure the balance sheet and the activities of the business in any
way deemed appropriate and lawful
7. The Conservator would have the power to liquidate the company
Source: Time to Pull the Plug on AIG?, Willem Buiter, http://blogs.ft.com/maverecon/2008/11/time-to-pull-the-plug-on-aig
It Is Premature to Allow Banks to Repay
TARP Money
We agree with this Financial Times editorial:
An escape too soon for US banks
J une 10 2009
The US Treasurys decision to release 10 of its wards from the straitjacket of the troubled asset relief
programme was presented and widely taken as good news. But in fact, it sacrificed sound financial policy
for political need.
Letting J PMorgan Chase, Goldman Sachs, Morgan Stanley and others repay $68bn to the US taxpayer
helps placate the combustible public fury at bank bail-outs that almost escaped Barack Obamas control this
winter. The president even makes a point of noting that the government made a profit on the returned funds.
The 10 financial groups escape from Tarps heavy-handed restrictions also weakens accusations of socialism
by some Republicans, to which Mr Obamas administration has been surprisingly thin-skinned.
But letting the banks out of Tarp at this point was premature. Supposedly weaned off public support, the
10 had to demonstrate they could raise funds without government guarantees. The temporary liquidity
guarantee programme, however, remains available to them. In effect subsidised by the government, but freed
from Tarp rules on compensation and hiring, they can poach both staff and business from competitors still in
Tarp. This is more regulatory discrimination than it is restitution of market discipline.
Even worse is that, for these 10, Tarp has been terminated without addressing the problem that it was
supposed to stave off. That problem or so many thought in the chaos that followed Lehman Brothers
collapse was that some banks are too big to be allowed to fail, lest they drag the whole financial system
down with them.
This fundamental situation has not changed. The stress tests of the largest banks now looking rather
lenient and the demand that some of them raise additional capital were designed to make failure less likely;
they did nothing to make failure less intolerable to the public interest. A bank that was too large to fail in
October is still too large to fail now, should another market freeze-up occur. These walking systemic dangers
have every reason to restart their risky hunt for yield.
There is much to criticise about the governments use of Tarp to influence the banks. But returning to the
status quo ante is no remedy. Tim Geithner, Treasury secretary, should first have secured the promised
special resolution regime for bank holding companies. Only then would exits from Tarp have sent the right
signal to the market: that the released banks were now free to fail.

T2 Partners Presentation On The Mortgage Crisis

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An Overview Of The Housing Crisis And Why

There Is More Pain To Come

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