Leverage and Risk of Financial Institutions

James R. Barth Auburn University and Milken Institute [email protected]

Conference on Procyclicality in the Financial System Amsterdam, Netherlands February 9-10, 2009 1 “Any real estate investment is a good investment … ”

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

… Really?!

3 Subprime mortgage meltdown timeline December 2006–October 2008

Oct. 24, 2007: Mar. 16, 2008: Mar. 11, 2008: Oct. 3, 2008: Dow Jones U.S. Financial Index Merrill announces JP Morgan Chase Sept. 29, 2008: Fed offers troubled President Bush Sept. 30, 2007: $7.9 billion in offers to buy Bear Citigroup banks as much as signs Emergency Aug. 6, 2007: NetBank goes subprime write- Stearns; Fed agrees to buy Feburary–March 2007: $200 billion in Economic American Home bankrupt. downs, surpassing introduces Primary W achovia. More than 25 subprime loans; Fed Stabilization Act, 700 Mortgage files for Citi’s $6.5 billion. Dealer Credit Facility. lenders declare introduces Term Sept. 23, 2008: authorizing bankruptcy. bankruptcy. Securities Lending Washington bailout of Fa c ility. Mutual is $700 billion. Mar. 18, 2008: seized by FDIC. Also, Citigroup Fe d c uts sues after discount rate to Wachovia agrees 600 2.5%; Fed funds Sept. 16, 2008: tie-up with Wells rate to 2.25%.April. 30, 2008: Fe d loa ns AIG Fargo. Fe d c uts $85 billion. discount rate to Apr. 2007: Dec. 2006: Dec. 12, 2007: 2.25%; Fed funds New Century, a Oct. 12, 2008: Ownit Fed introduces rate to 2%. mortgage Finance 500 Mortgage, a Term Auction broker, files for Oct. 8, 2008: leaders subprime Fa c ility. bankruptcy. Fed cuts discount endorse G7 lender, files rate to 1.75%; Fed plan to calm for Jan. 11, 2008: funds rate to 1.5%. markets. July 31, 2007: Bank of bankruptcy. Aug. 16, 2007: Two Bear 400 Countrywide gets America agrees Stearns hedge June 9, 2008: Feb. 2007: emergency loan of to buy funds file for Lehman announces HSBC sets aside $11 billion from a Countrywide. bankruptcy. Jan. 30, 2008: Fed $10.6 billion for a $2.8 billion loss. group of banks. cuts discount bad loans, Oct. 27, 2008: rate to 3.5%. July 11, 2008: including Down Jones U.S. Aug. 17, 2007: IndyMac is seized by FDIC. Financial Index=230 300 subprime. Fed cuts discount rate to 5.75%; Fed introducesFeb. 13, 2008: July 30, 2008: Sept. 7, 2008: U.S. Oct. 31, 2008: Term Discount WindowPresident Bush President Bush Aug. 1, 2008: seizes Fannie MaeSept. 14, 2008: Dow Jones U.S. Program. introduces tax rebate signs a housing First Priority and Freddie Mac. Lehman files for Financial Index=269 stimulus program of $168 rescue law. Bank closes. billion. bankruptcy. 200 12/2006 02/2007 04/2007 06/2007 08/2007 10/2007 12/2007 02/2008 04/2008 06/2008 08/2008 10/2008 Sources: BusinessWeek, S&P, Global Insight, Milken Institute. 4 Overview

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

Subprime 8.4% Securitized 58% Government- Mortgage debt controlled $10.6 trillion 46% Prime 91.6% Non-securitized Private 42% sector- 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. 6 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 5 million are behind 1930s. (10% of 53 million with 3% in foreclosure)

Sources: U.S. Treasury, Milken Institute. 7 I. Low interest rates and a lending boom

8 Did the Fed lower interest rates too much and for too long? Federal funds rate vs. rates on FRMs and ARMs

Percent January 30, 2009 8 30-year FRM rate 30-year FRM rate: 5.1% 7 1-year ARM rate: 4.9%

4 Target federal 3 funds rate 1-year ARM rate 2 Apr. 30, 2008: 2% Oct. 8, 2008: 1.5% 1 Record low from June Oct. 29, 2008: 1% Dec. 16, 2008: 0-0.25% 0 25, 2003 to June 30, 2004: 1% 2001 2002 2003 2004 2005 2006 2007 2008 2009

Sources: Federal Reserve, Mortgage Bankers Association, Moody’s Economy.com, Milken Institute. 9 Low interest rates Home price bubble and credit boom and credit boom US$ trillions US$ trillions Index, January 2000 = 100 Percent 4.0 6.0 4.0 250

3.5 3.5 5.5 200 3.0 3.0 5.0 2.5 2.5 150

2.0 4.5 2.0 100 1.5 1.5 S&P/Case-Shiller 4.0 Home National Home 1.0 1.0 mortgage 1-Year ARM Home Price Index 50 3.5 originations 0.5 mortgage rate mortgage 0.5 (right axis) originations (left axis) 0.0 (right axis) (left axis) 3.0 0.0 0 2001 2004 2007 Q3 2008 2001 2004 2007 Q3 2008

Note: Data for Q1-Q3 2008 are annualized. Sources: Inside Mortgage Finance, Mortgage Bankers Association, Moody’s Economy.com, S&P/Case-Shiller, Milken Institute. 10 II. Homeownership, prices, starts and sales take off

11 Credit boom pushes Home price bubble California and national homeownership rate peaks in 2006 home prices reach to historic high record highs

Percent Index, January 1987 = 100 70 S&P/ US$ thousands Q2 2004: 69.2% 380 Case-Shiller 700 California m edian National Hom e 69 330 home price Price Index 600 68 280 500 California average 400 1987-2008 U.S. m e dian 67 230 hom e price $230,599 Q4 2008: 67.5% 300 66 180 200 OFHEO Hom e Pr ice Inde x 65 130 100 Average, 1965–Q4 2008: 65.2% U.S. average, 1987-2008: $121,714 64 80 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. 12 Housing starts hit Homes sales reach Homes for sale a record in 2005 a new high

Millions Millions Millions Millions Housing units, millions 7.0 1.5 4 Existing homes for 0.8 Existing home January 2006: 1.8 m illion sales (left axis) 2.0 sale (left axis) 5.6 1.2 3 0.6 1.5 4.2 0.9

1.0 Average starts, 2 0.4 2.8 0.6 1959–Oct. 2008: 1.1 m illion New home sales (right axis) 0.5 1 New homes for 0.2 Oct. 2008: 536,000 1.4 0.3 sale (right axis)

0.0 0 0.00.0 0.0 1998 2000 2002 2004 2006 2008 1998 2000 2002 2004 2006 2008 199820002002200420062008

Sources: U.S. Census Bureau, OFHEO, Moody’s Economy.com, Milken Institute. 13 III. Subprime borrowers and subprime mortgages

14 Who is a subprime borrower?

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

Sources: myFICO.com, Milken Institute. 15 Prime and subprime mortgage originations by FICO score reveal substantial overlaps Percent of total originations

20 FICO below 620 FICO above 620 Prime: 6.6% Prime: 93.4% 16 Subprime: 45.2% Subprime: 54.8% Prime 12 Subprime

0 9 9 99 7 9 9 99 9 59 6 73 6 - 0 - 9 9 59 - 0 - 759 8 9 5 - 59 - 63 - 20 4 7 800 - 900 80 7 7 760 - 77 - 49 - 40 660 - 676 700 - 719 - 45 0 - 519 80 620 6 0 - 479 40 560 - 5795 600 - 619 0 6 80 0 520 - 535 4 4 5 FICO score

Sources: LoanPerformance, Milken Institute. 16 ARMs look attractive to many borrowers

Percent January 30, 2009 30-year FRM rate 8 30-year FRM rate: 5.1% 1-year ARM rate: 4.9% 7

4 1-year ARM rate 3 2001 2002 2003 2004 2005 2006 2007 2008 2009

Sources: Mortgage Bankers Association, Moody’s Economy.com, Milken Institute. 17 ARM share grows, following low interest rates Percent of all outstanding home mortgages 25

0 2001 2002 2003 2004 2005 2006 2007 2008

Sources: Mortgage Bankers Association, Moody’s Economy.com, Milken Institute. 18 Largest share of ARMs go to subprime borrowers Percent of mortgage type 60 FHA ARM Prime ARM Subprime ARM 50

0 2001 2002 2003 2004 2005 2006 2007 2008

Sources: Mortgage Bankers Association, Moody’s Economy.com, Milken Institute. 19 Subprimes take an increasing share of all home mortgage originations US$ trillions 8.4% Subprime 4.0 Prime 21.3% 18.2% 20.1% Subprime's 7.4% 3.0share: 7.9% 7.8%

2.0 1.3%

1.0

0.0 2001 2002 2003 2004 2005 2006 2007 Q1-Q3 2008 Sources: Inside Mortgage Finance, Milken Institute. 20 Subprime mortgages increase rapidly before big decline

Originations US$ billions Outstandings 1,400 US$ billions Average annual growth rates 1,240 700 1995–2006: 14% 1,200 625 1,200 2006–Q1 2008: -23% 600 600 540 973 940 1,000 895 500 800 699 400 574 310 600 479 300 400 200 191 200 160 200 100 14 0 0 2001 2002 2003 2004 2005 2006 2007 Q1 2001 2002 2003 2004 2005 2006 2007 Q2 H2 2008 20082008

Sources: Inside Mortgage Finance, Milken Institute. 21 IV. Mortgage product innovation

22 Subprime and Alt-A shares quadruple between 2001 and 2006, then fall in 2007

2001, $2.2 trillion 2006, $3.0 trillion 2007, $2.4 trillion Q1 2008, $480 billion 9% 2% 5% 2.7% 4.9% 4% 9.6% 7.9% 14% 14% 2% 7% 33.2% 11% 8% 13% 8% 20% 57.1% 20% 16% 14% 47.3% 67.2% p FHA & VA Subprime Conventional, conforming prime Alt-A Jumbo prime Home equity loans

Sources: Inside Mortgage Finance, Milken Institute. 23 ARM hybrids dominate subprime originations (2006)

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

Sources: Freddie Mac, Milken Institute. 24 V. Securitization

25 The mortgage model switches from originate-to-hold to originate-to-distribute

Residential mortgage loans Residential mortgage loans 1980: Total = $958 billion Q3 2008: Total = $11.3 trillion

Securitized 15.6% Held in portfolio 41%

Held in Securitized portfolio 59% 84.4%

Sources: Federal Reserve, Milken Institute. 26 Securitization becomes the dominant funding source for subprime mortgages Percent of all subprime mortgages securitized since 1994 80 68 68 68 70 65 62 60 57 50 47 50 45 45 43 42 40 40 33 31 29 30

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. 27 The rise and fall of private-label securitizers

New securities issuance

4% 2% 13% 5% 42% 20% 19% 21% 56% 18%

1985 2001 2006 Q1–Q3 2008 Total = $110B Total = $1.4T Total = $2.0T Total = $1.0T

29% 22% 35% 31% 38% 45%

Ginnie Mae Freddie Mac Fannie Mae Private-label

Sources: Inside Mortgage Finance, Milken Institute. 28 The rise and fall of private-label securitizers Outstanding securities

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

1985 2001 2006 First half 2008 Total = $390B Total = $3.3T 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. 29 Mortgage-backed securities issued by issuer

US$ billions

3,000 Private label

2,500 Ginnie Mae

2,000 Freddie Mac Fannie Mae 1,500

1,000

500

0 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007

Sources: Inside Mortgage Finance, Milken Institute. Note: 2008 data are annualized. 30 VI. Affordability

31 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

Percent Median home price/ Q2 2007: 73.7% median household income Home mortgage debt/disposableQ4 2007: 139.5% 75 personal income 5.0 2005: 4.69 150

4.5 70 Q2 2008: 73.4% 4.0 125 Average, 1957–2007: 79.7% 2007: 4.29 3.5 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 20071998 2001 2004 2007

Sources: U.S. Census Bureau, OFHEO, Federal Reserve, Moody’s Economy.com, Milken Institute. 32 VII. Collapse

33 The recent run-up of home prices was extraordinary

Index, 2000 = 100

250Annualized growth rate of nominal home index, 1890–June 2008: 3.3% Current boom Great 200 Depression World World War I 1970’s 1980’s 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. 34 Home prices don’t go up forever Change in home prices in 100-plus years

Percentage change in nominal home price, year ago World Great World 1970’s 1980’s Current 30 War I Depression War II Boom Boom Boom 25

20 Average, 1890–June 2008: 3.6% 15

10 5

-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. 35 2005: The collapse begins

Home price indices, percent change on a year earlier 25 S&P/Case-Shiller 10-city

20 S&P/Case-Shiller national 15 OFHEO 10 5 0

-5 -10

-15 -20 1988 1992 1996 2000 2004 2008

Sources: S&P/Case-Shiller, OFHEO, Moody’s Economy.com, Milken Institute. 36 Forty-six states had falling prices in the fourth quarter 2007 United States: - 9.3% (fourth-quarter annualized growth)

Source: Freddie Mac. 37 If you bought your house… One year ago… Five years ago… Seattle -2.7 Dallas 43.8 -2.8 Charlotte 43.3 Portland -4.7 Boston 24.4 Tampa -5.1 Denver 24.3 New York -6.6 Cleveland 22.8 Washington -6.9 New York 20.7 Charlotte -7.6 Portland 18.3 Miami -8.5 Atlanta 17.9 Phoenix -8.8 Seattle 16.9 Los Angeles -9.8 Chicago 15.0 Composite-10 -13.8 Minneapolis 14.2 Las Vegas -15.4 Washington 13.8 Composite-20 -16.6 Composite-20 12.4 Chicago -17.2 Detroit 6.5 Dallas -17.7 Composite-10 5.6 Atlanta -18.1 Tampa 5.0 Boston -25.8 San Diego 4.7 Denver -26.7 Los Angeles 1.8 San Francisco -27.3 San Francisco -1.8 San Diego -28.1 Miami -2.6 Minneapolis -30.6 Las Vegas -4.3 Cleveland -30.7 Phoenix -21.9 Detroit

% change in price, August 07-08 % change in price, August 03-08 Sources: S&P/Case-Shiller, Milken Institute. 38 Housing starts Homes sit longer … as home sharply decline on the market … appreciation slows

Percent Months Percent change, year ago Number of months that Percentage change from 30 hom e s sit on the m a rke t 20 year ago in median 0 12 home sales price 15 Existing homes (left axis) 2 10 10 0 4 8 -15 0 6 6 -30 8 4 -10 Number of months -45 Sept. 2008: -41.2% homes stay on 10 2 New homes Oct. 2008: -39.4% market (right axis) -20 12 -60 0 1998 2000 2002 2004 2006 2008 1998 2000 2002 2004 2006 2008 1999 2001 2003 2006 2008

Note: Shaded area represents fluctuation within one standard deviation from mean (1.15%) Sources: Mortgage Bankers Association, OFHEO, Moody’s Economy.com, Milken Institute. 39 VIII. Delinquencies and foreclosures

40 Foreclosures are nothing new, but …

Thousands of foreclosures per year

2,150

1,900

1,650

1,400

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

900

650 8 6 400 5 2006 2 200 2005 4 2 2007 4 2007 002 2003 4 2 200 Q Q 4 2004 2 200 Q Q Q 99 4 2 2004 Q Q 2 2002 4 2 Q Q 2 2001 4 2001 Q2 2003Q 4 2000 Q Q Q 2 1999 4 19 Q Q Q Q Q2 2000

Sources: Mortgage Bankers Association, Milken Institute. 41 … their numbers have doubled

Thousands of foreclosures per year

2,400

2,150 Average 1,412,656 annual forclosures from Q3 2006 to Q3 2008 1,900 1,650

1,400 Average 661,362 annual foreclosures from Q2 1999 to Q2 2006 1,150 900 650 7 7 8 5 6 6 400 00 00 3 3 4 200 1 1 200 200 9 0 200 4 200 Q4 2 Q2 9 200 2 2005 Q2 Q4 Q2 2 9 2 200 Q Q 99 4 2002 Q4 Q2 Q4 2004 4 2000 2 200 Q2 2002Q Q Q Q Q4 20 Q2 1 Q4 19 Q2 2000

Sources: Mortgage Bankers Association, Milken Institute. 42 Subprime mortgages accounted for half or more of foreclosures since 2006

Number of home mortgage loan foreclosures started (annualized rate in thousands)

2,500 Subprime Q3 2008 FHA and VA Subprime: 12% of loans serviced 2,000 Prime (includes Alt-A)

1,500

1,000

500

0 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 2003 2003 2004 2004 2005 2005 2006 2006 2007 2007 2008 2008

Sources: Mortgage Bankers Association, Milken Institute. 43 Subprime ARMs have the worst default record

Home mortgage loans delinquent or in foreclosure (percent of number) 40 Q3 2008, Subprime ARM: 35.3% 35 Subprime FRM: 13.5% 30 FHA and VA: 6.3% 25

20 Prime: 3.5%

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. 44 Percentage of homes purchased between Q2 2001 and Q2 2006 that now have negative equity United States = 44.8%

< 20% >= 20% and < 35% >= 35% and < 50% >= 50%

Sources: Zillow.com, Milken Institute. 45 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. 46 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. 47 IX. Damages scorecard

48 Losses/write-downs, capital raised, and jobs cut by financial institutions worldwide

US$ billions Number of jobs cut (thousands) 120 480 5 420 Capital raised 10 360 (left axis) 90 300 Jobs cut (right axis) 75 240 60 Losses/write-downs 180 45 (left axis) 120 30 60 15 0 0 Prior Q3 2007 Q4 2007 Q1 2008 Q2 2008 Q3 2008 Q4 2008 Through quarters Feb. 4, 2009

Sources: Bloomberg, Milken Institute. 49 What is the cumulative damage? Cumulative losses/write-downs, capital raised, and jobs cut by financial institutions worldwide

US$ billions Number of jobs cut 1,200 Jobs cut (right axis) 300,000 February 4, 2009: 269.1 thousand 1,000 250,000 Capital raised (left axis) 800 February 4, 2009: $969.2 billion 200,000

600 150,000 Losses/write-downs (left axis) 400 February 4, 2009: $1068.4 billion 100,000

200 50,000

0 0 Prior Q3 2007 Q4 2007 Q1 2008 Q2 2008 Q3 2008 Q4 2008 Through quarters Feb. 4, 2009 Sources: Bloomberg, Milken Institute. 50 Recent losses/write-downs and capital raised by selected financial institutions

US$ billions, through February 4, 2009 Losses /write-downs Capital raised Wachovia, United States 97.9 11 Citigroup, United States 85.4 109.3 AIG, United States 60.9 65.7 Freddie Mac, United States 58.4 20.8 Fannie Mae, United States 56.0 15.6 Merrill Lynch, United States 55.9 29.9 UBS, Switzerland 48.6 32.0 Washington Mutual, United States 45.6 12.1 Bank of America, United States 40.2 78.5 HSBC, United Kingdom 33.1 4.9 Others 486.4 589.4 Grand total (US$ billions) 1,068.40 969.2

Sources: Bloomberg, Milken Institute. 51 Worldwide capital raised by source July 2007–July 2008 July 2007–December 2007 January 2008–July 2008 Total = $56 billion Total = $300 billion

Other institutional Other Sovereign investors institutional wealth funds 28% investors 7% 24%

Sovereign Public wealth funds investors 60% Public 12% investors 69%

Source: International Monetary Fund. 52 Financial stock prices take big hits

Percentage change in stock price, December 2006–January 2009 -99.9 Lehman Brothers -99.9 Washington mutual -99.1 Freddie Mac -99.0 Fannie Mae -98.2 AIG -94.3 Bear Stearns -90.3 Wachovia -90.0 Countrywide -87.7 Bank of America -87.5 Merrill Lynch -77.8 UBS Equity -70.1 Morgan Stanley -59.5 Goldman Sachs -47.2 JP Morgan & Chase -46.9 W ells Fargo

Note: Bear Stearns stock price is to May 2008. Countrywide stock price is to June 2008. Merrill Lynch stock price is to December 2008. Wachovia stock price is to December 2008. Sources: Bloomberg, Milken Institute. 53 Financial market capitalization takes big hit

Total loss in market value: $1,094 billion, December 2006–January 2009 -197.9 Bank of America -169.2 AIG -112.9 UBS Equity -96.6 Wachovia -72.3 JP Morgan & Chase -64.1 Merrill Lynch -63.7 Morgan Stanley -54.7 Fannie Mae -47.9 Goldman Sachs -45.1 Freddie Mac -42.9 Washington mutual -41.4 Lehman Brothers -40.1 W ells Fargo -23.9 Countrywide US$ billions -21.4 Note: Bear Stearns stock price is to May 2008. Countrywide stock price is to June 2008. Bear Stearns Merrill Lynch stock price is to December 2008. Wachovia stock price is to December 2008. 54 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 LTCM Dotcom Subprime 80

-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 Maximum spread: 01/30/2009: 3,647 bps 5,000 4,500 4,000 Merrill Lynch Mortgage-Backed Securities Index 3,500 Average, 2004–Januray 30, 2009: 503 bps 3,000 Merrill Lynch High-Yield Bond Index 2,500 Average, 2004–Januray 30, 2009: 426 bps 2,000 1,500 1,000 500 0 01/2004 07/2004 01/2005 07/2005 01/2006 07/2006 01/2007 07/2007 01/2008 07/2008 01/2009

Sources: Merrill Lynch, Bloomberg, Milken Institute. 57 Liquidity freeze Spread between 3-month LIBOR Spread between 3-month LIBOR and and T-bill rate overnight index swap rate

Basis points Basis points 500 400 October 10, 2008: 463.6 bps 450 350 October 10, 2008: 364 bps 400 300 350 August 20, 2007: 240 bps Average since Average since 250 August 2007: 97 bps 300 August 2007: 250 150 bps 200 200 150 Average since Average since 150 December 2001: 29 bps 1985: 92 bps 100 100 50 50 0 0 2006 2007 2008 2009 2006 2007 2008 2009 Sources: Bloomberg, Milken Institute. 58 Counterparty risk increases

Average CDS spread, basis points October 10, 2008: 607 bps 700 Citigroup agreed to buy Wachovia AIG rescued 600 January 30, 2009: Lehman Brother files for bankruptcy 422 bps 500 and Merrill Lynch acquired

400 Government announces support for Fannie Mae and Freddie Mac 300 Bear Stearns acquired 200

100

0 07/2007 09/2007 11/2007 01/2008 03/2008 05/2008 07/2008 09/2008 11/2008 01/2009 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 Rising risk: The credit default swap market nearly doubled each year from June 2001 through October 2008

Notional amount of credit default swaps outstanding, US$ trillions 70 62.2 Annualized growth rate 60 H1 2001–H2 2007: 102% 54.6 50 H1 2001–H1 2008: 89% 45.5 47.0

40 34.4

30 26.0

20 17.1 12.4 8.4 10 3.8 5.4 0.6 0.9 1.6 2.2 2.7 0 June Dec. June Dec. June Dec. June Dec. June Dec. June Dec. June Dec. June Oct. 2001 2001 2002 2002 2003 2003 2004 2004 2005 2005 2006 2006 2007 2007 2008 2008

Sources: International Swaps and Derivatives Association, Milken Institute. 60 Commercial paper issuance dries up

Quarterly change in outstanding amount, US$ billions 150

100

-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. 61 Federal Reserve responds by cutting Fed funds rate, but mortgage rates remain relatively flat Percent Percent

10 6

30-year FRM rate (left axis) 5 8

4 6 3 4 Spread (right axis) Federal funds rate (left axis) 2

2 1

0 0 01/2007 03/2007 06/2007 09/2007 12/2007 02/2008 05/2008 08/2008 11/2008 01/2009

Sources: Freddie Mac, Federal Reserve, Moody’s Economy.com, Milken Institute. 62 Increasing spreads between corporate bonds, mortgage securities, and target federal funds rate Percent

24 High yield corporate bonds yield 20

Freddie Mac 30-year fixed mortgage rate 8

4 Federal intented funds rateAAA corporate bonds yield 0 01/2007 04/2007 07/2007 10/2007 01/2008 04/2008 07/2008 10/2008 01/2009 Sources: Federal Reserve, Freddie Mac, Merrill Lynch, Bloomberg, Milken Institute. 63 Federal Reserve assets increased but asset quality deteriorated

US$ billions 2,400 Total assets of Federal Reserve banks 11/12/2008: $2.21 trillion 2,000 U.S. Treasury securities held outright 12/17/2008: $2.31 trillion

1,600 1/28/2009: $1.93 trillion

1,200

800

400 1/28/2009: $475 billion 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Sources: Federal Reserve, Milken Institute. 64 Federal Reserve has little maneuvering room

Percent

Target federal funds rate 3 Effective federal funds rate Apr. 30, 2008: 2% Oct. 8, 2008: 1.5% Oct. 29, 2008: 1% Dec. 16, 2008: 0-0.25% 2

0 06/01/08 07/01/08 07/31/08 08/30/08 09/29/08 10/29/08 11/28/08 12/28/08 01/27/09

Sources: Federal Reserve, Milken Institute. 65 Federal Government Comes to the Rescue of Main Street and Wall Street

Federal Reserve 4,549 Congress and White House 1,149 Federal Deposit Insurance Corporation 1,465 Treasury, Federal Deposit Insurance Corporation and Federal Reserve 362 Total amount committed (US$ billions) 7,525

Upper limit to total funds provided/cost under these programs…$7.52 trillion plus ?

66 Federal Reserve programs

Amount committed Program Description (US$ billions) Announced on 10/17/2007. Extends the term of Term Discount Window 62.898 discount window loans from overnight to up to 90 Program (TDWP) days. Announced on 12/12/2007. The Fed auctions off loans under the TAF every Thursday for a term of 28 Term Auction Facility (TAF) 416.031 days. Outstanding TAF credit may potentially be expanded up to $900 billion. Announced on 3/11/2008. Establishes term swaps between the Fed and primary dealers. Collateral can Term Securities Lending 133.1 be Treasury securities, federal agency securities, Facility (TSLF) and other highly rated debt securities. On December 2, 2008, TSLF was extended through April 30, 2009. Announced on 3/14/2008. The Fed acquired $29 billion in mortgage backed securities from Bear Stearns 29 JPMorgan Chase to fund its purchase of Bear Stearns. As of January 21, 2009, the market value of these mortgage-backed securities is $27.2 billion. 67 Federal Reserve programs

Amount Program committed (US$ Description billions) Announced on 3/16/2008. Extends overnight borrowing from the Primary Dealer Credit Federal Reserve to primary dealers. On December 2, 2008, PDCF 58 Facility (PDCF) was extended through April 30, 2009. As of January 21, 2009, credit extended under PDCF was less than $33.3 billion. First announced on 9/16/2008. AIG received an $85 billion, two-year secured loan on September 16, 2008, in exchange for warrants for a 79.9 percent equity stake in the firm. It was given an additional $37.8 billion on October 8, and another $20.9 billion credit line under CPFF on October 30, 2008. On November 10, Treasury purchased $40 billion of newly issued AIG preferred stock under the TARP (potentially reducing the original loan from $85 billion to AIG 173.4 $60 billion), terminated the $37.8 billion lending facility previously established, created a new lending facility to purchase up to $22.5 billion MBS from AIG, and another facility to lend up to $30 billion to purchase CDOs on which AIG had written CDSs. As of January 21, 2009, $79.6 billion of credit was extended to AIG, $19.8 billion was extended to purchase MBSs, and $26.9 billion was extended to purchase CDOs. 68 Federal Reserve programs Amount committed Program Description (US$ billions) Announced on 9/19/2008. Loans to banks so that they can buy asset-backed Asset Backed Commercial commercial paper from money market Paper Money Market Mutual 53 funds. On December 2, 2008, AMLF was Fund Liquidity Facility (AMLF) extended through April 30, 2009. As of January 21, 2009, credit extended under AMLF was $14.8 billion. Announced on 9/29/2008. The Federal Open Market Committee authorized a $330 billion expansion of its swap lines for U.S. dollar liquidity operations by other central banks, raising the total cap to $620 billion Expansion of the Federal Open (up to $30 billion by the Bank of Canada, Market's temporary reciprocal 620 $80 billion by the Bank of England, $120 currency arrangements (swap billion by the Bank of Japan, $15 billion by lines) Danmarks Nationalbank, $240 billion by the ECB, $15 billion by the Norges Bank, $30 billion by the Reserve Bank of Australia, $30 billion by the Sveriges Riksbank, and $60 billion by the Swiss National Bank). 69 Federal Reserve programs Amount committed Program Description (US$ billions) Announced on 10/7/2008. The CPFF is a credit facility to a special purpose vehicle (SPV). The SPV purchases from eligible issuers three-month U.S. dollar-denominated commercial paper through the New York Fed's primary dealers. Eligible issuers are U.S. issuers of commercial paper, including U.S. issuers with a foreign parent company. The SPV only purchases U.S. dollar-denominated commercial paper (including asset-backed commercial paper (ABCP)) that is rated at least A-1/P-1/F1 by a major Commercial Paper nationally recognized statistical rating organization 1777.2 Funding Facility (CPFF) (NRSRO) and, if rated by multiple major NRSROs, is rated at least A-1/P-1/F1 by two or more major NRSROs. The maximum amount of a single issuer's commercial paper the SPV may own at any time is greatest amount of U.S. dollar- denominated commercial paper the issuer had outstanding on any day between January 1 and August 31, 2008. The SPV does not purchase additional commercial paper from an issuer whose total commercial paper outstanding to all investors (including the SPV) equals or exceeds the issuer's limit. As of 1/21/2009, $350 billion was outstanding. 70 Federal Reserve programs

Amount committed Program Description (US$ billions)

Announced on 10/21/2008. The MMIFF provides assurance that money market mutual funds can liquidate their investments if cash is needed to cover withdrawals from customers. On 1/7/2009, the set of eligible institutions was expanded to also include a number of other money market investors, Money Market Investor Funding 540 including U.S. based securities-lending cash- Facility (MMIFF) collateral reinvestment funds, portfolios, and accounts; and U.S. –based investment funds that operate in a manner similar to money market mutual funds such as certain local government investment pools, common trust funds, and collective investment funds. As of 1/21/2009, outstanding amount was zero.

71 Federal Reserve programs Amount committed Program Description (US$ billions) Announced on 11/25/2008. TALF loans will have a one-year term, will be non-recourse to the borrower, and will be fully secured by eligible ABS. Treasury will provide $20 billion of credit protection to the Fed in connection with the TALF. Eligible collateral will include U.S. dollar-denominated cash (that is, not synthetic) ABS that have a long-term credit rating in the highest investment-grade rating category (for example, AAA) from two or more major nationally recognized statistical rating organizations (NRSROs) and do not Term Asset- have a long-term credit rating of below the highest investment-grade Backed rating category from a major NRSRO. The underlying credit 200 Securities Loan exposures of eligible ABS initially must be auto loans, student loans, Facility (TALF) credit card loans, or small business loans guaranteed by the U.S. Small Business Administration. All U.S. persons that own eligible collateral may participate in the TALF. Collateral haircuts will be established by the FRBNY for each class of eligible collateral. Haircuts will be determined based on the price volatility of each class of eligible collateral. On December 19, 2008, it was announced that TALF loan maturity was extended from one to three years, and TALF loans would be provided to all eligible borrowers with eligible collateral rather than distributed through an auction. 72 Federal Reserve programs

Amount committed Program Description (US$ billions)

Announced on 11/25/2008. The Fed will purchase the direct obligations of housing-related government-sponsored enterprises (GSEs)--Fannie Mae, Freddie Mac, and the Federal Home Loan Banks--and mortgage-backed securities (MBS) backed by Fannie Mae, Freddie Mac, and Ginnie Mae. Purchases of up to $100 billion in GSE direct obligations Purchase of GSE under the program will be conducted with the Fed's primary direct obligations 600 dealers through a series of competitive auctions and will and MBS begin in the first week of December. Purchases of up to $500 billion in MBS will be conducted by asset managers selected via a competitive process with a goal of beginning these purchases before year-end 2008. Purchases of both direct obligations and MBS are expected to take place over several quarters. Congress and White House

Amount committed Program Description (US$ billions) FHA Secure 50 Announced on 8/31/2007. Guarantees $50 billion in mortgages. Announced on 2/13/2008. Provided tax rebates in 2008. Most taxpayers below the income limit received rebates of $300-$600. Also gave businesses a one-time depreciation tax deduction on Economic Stimulus 124 specific new investment and raised the limits on the value of new Act productive capital that may be classified as business expenses during 2008. The Congressional Budget Office (CBO) estimates the net cost of the stimulus to be $124 billion. Housing and Announced on 7/30/2008. The CBO estimates that the Act will Economic Recovery 24.9 increase budget deficits by about $24.9 billion over the 2008 to Act of 2008 2018 period. Purchase of GSE Debt Announced on 7/30/2008. Designed to shore up Fannie Mae and 25 and Equity Freddie Mac. Announced on 7/30/2008. This voluntary program encourages lenders to write down the loan balances of borrowers in exchange HOPE for Homeowners 300 for FHA-guaranteed loans up to 90 percent of the newly appraised home value. Program runs through September 2011. 74 Congress and White House Amount committed Program Description (US$ billions) Announced on 9/7/2008. Treasury and FHFA established contractual agreements to ensure that each company maintains a positive net worth. They are indefinite in duration and have a capacity of $100 billion each. Treasury also established a new secured lending credit facility, available to Fannie Mae, Freddie Mac, and the Federal Home Loan Conservatorship of Fannie Banks. Funding is provided directly by Treasury in 200 Mae and Freddie Mac exchange for eligible collateral from the GSEs (guaranteed mortgage backed securities issued by Freddie Mac and Fannie Mae, as well as advances made by the Federal Home Loan Banks). To further support the availability of mortgage financing, Treasury is initiating a temporary program to purchase GSE MBS, with the size and timing subject to the discretion of the Treasury Secretary.

Announced on 9/19/2008. To restore confidence in Guaranty Program for Money 50 money market funds, Treasury made available up to Market Funds $50 billion from the Exchange Stabilization Fund. 75 Congress and White House Amount committed Program Description (US$ billions) Announced on 9/30/2008. Allows banks to offset their profits with losses from the loan portfolio of banks they acquire. Initial media reports indicate that Wells Fargo alone may be able to claim more IRS Notice 2008-83 ? than $70 billion in losses from its acquisition of Wachovia, obtaining tax savings that exceed the market value of Wachovia as of November 7, 2008. Announced on 10/3/2008. Empowers Treasury to use up to $700 Emergency billion to inject capital into financial institutions, to purchase or Economic 700 insure mortgage assets, and to purchase any other troubled assets Stabilization Act necessary to promote financial market stability. Announced on 10/14/2008 as part of the EESA. On November 25, Treasury purchased $40 billion of preferred shares from AIG. As of December 31, 2008, there are four programs under the TARP: Troubled Assets Capital Purchase Program (CPP), Automobile Industry Financing Relief Program 272.9 Program (AIFP), Targeted Investment Program (TIP), and Asset (TARP) Guarantee Program (AGP). TARP also includes on initiative: providing $20 billion to support the Fed's Term Asset-Backed Securities Loan Facility 76 Congress and White House Amount committed Program Description (US$ billions) Under CPP, Treasury was allowed to purchase up to $250 billion of senior Capital preferred shares in selected banks. The first $125 billion was allocated to Purchase 192 nine of the nation's largest financial institutions on October 28, 2008. As Program (CPP) of January 23, 2009, $192 billion has been distributed to 296 institutions. On 12/19/2008,Treasury announced a plan to make emergency loans available to General Motors and Chrysler. GM was provided with up to a total of $13.4 billion in short-term financing. Treasury funded $4 billion of this loan immediately, and an additional $5.4 billon on 1/16/2009. Treasury will provide an additional $4 billion on 2/17/2009. On 12/29/2008, Treasury Automotive also purchased $5 billion of senior preferred equity from GMAC. Industry Additionally, Treasury agreed to lend up to $1 billion of TARP funds to GM Financing 20.9 so that GM can participate in a rights offering by GMAC in support of Program GMAC’s reorganization as a bank holding company. On 1/2/2009, Treasury (AIFP) provided a 3-year $4 billion loan to Chrysler, secured by various collateral, including parts inventory, real estate, and certain equity interests. On 1/19/2008, Treasury announced that a $1.5 billion loan to a SPV created by Chrysler Financial to finance the extension of new consumer auto loans as part of a broader program to assist the domestic automotive industry in becoming financially viable. Congress and White House

Amount committed Program Description (US$ billions)

Treasury may invest in any financial instrument, including debt, equity, or warrants, that the Secretary of the Treasury determines to be a troubled asset, after consultation with the Chairman of the Board of Governors of the Federal Reserve System and notice to Congress. Institutions participating in this Targeted program are required to provide Treasury with warrants or Investment 20 alternative consideration as necessary. They also need to Program (TIP) adhere to rigorous executive compensation standards. In addition, Treasury will consider other measures, including limitations on the institution's expenditures, or other corporate governance requirements. The $20 billion investment in Citigroup that was announced on Nov. 23 was made under the TIP. On 12/31/ 2008, Treasury transmitted to Congress a report that Asset describes the Asset Guarantee Program (AGP). This program Guarantee ? provides guarantees for assets held by systemically significant Program (AGP) financial institutions that face a risk of losing market confidence due in large part to a portfolio of distressed or illiquid assets. Federal Deposit Insurance Corporation Amount committed Program Description (US$ billions) Increase FDIC Announced on 10/3/2008. A provision of EESA temporarily raised the basic ? insurance limit on federal deposit insurance coverage from $100,000 to $250,000 per coverage depositor. Limits are scheduled to return to $100,000 after December 31, 2009. Announced on 10/14/2008. Temporarily guarantees the senior debt of all FDIC- insured institutions and their holding companies, as well as deposits in noninterest bearing deposit transaction accounts. Certain newly issued senior unsecured debt issued on or before June 30, 2009, would be fully protected in the event the issuing institution subsequently fails, or its holding company Temporary files for bankruptcy. This includes promissory notes, commercial paper, Liquidity interbank funding, and any unsecured portion of secured debt. Coverage Guarantee 1465 would be limited to June 30, 2012. On November 21, 2008, FDIC strengthened Program TLGP. Chief among the changes is that the debt guarantee will be triggered by (TLGP) payment default rather than bankruptcy or receivership. Another change is that short-term debt issued for one month or less will not be included in the TLGP. Eligible entities will have until December 5, 2008 to opt out of TLGP. The other part of the program provides for a temporary unlimited guarantee of funds in noninterest-bearing transactions accounts (the Transaction Account Guarantee Program, or TAG) 79 Treasury, Federal Deposit Insurance Corporation and Federal Reserve

Amount committed Program Description (US$ billions)

Announced on 11/23/2008. Up to $306 billion of Citigroup's assets are guaranteed. Citigroup takes the first loss up to $29 billion, and any loss in excess of that amount is shared by the government Guarantee a portion of an asset (90%) and Citigroup (10%). Treasury (via pool of loans and securities backed TARP) takes the second loss up to $5 by residential and commercial real 249.3 billion, while FDIC takes the third loss up estate and other such assets on to $10 billion. The Federal Reserve funds Citigroup's balance sheet the remaining pool of assets with a non- recourse loan, subject to Citigroup's 10 percent loss sharing, at a floating rate of overnight interest swap plus 300 basis points.

80 Treasury, Federal Deposit Insurance Corporation and Federal Reserve

Amount committed Program Description (US$ billions)

Announced on 1/16/2009. Treasury and FDIC will provide protection against the possibility of unusually large losses on an asset pool of approximately $118 billion of loans, securities backed by residential and commercial real estate loans, and other such assets, all of which have been marked to market value. The large majority of these assets were Provide a package of assumed by BOA as a result of its acquisition of Merrill Lynch. The guarantees, liquidity assets will remain on BOA’s balance sheet. As a fee for this arrangement, 138 access, and capital to BOA will issue preferred shares to the Treasury and FDIC. In addition and the Bank of America if necessary, The Federal Reserve stands ready to backstop residual risk in the asset pool through a non-recourse loan. In addition, Treasury will invest $20 billion in BOA from the TARP program in exchange for preferred stock with an 8 percent dividend to the Treasury. The investment was made under the Targeted Investment Program.

Loans, guarantees and investments committed 7524.929 The final tab for taxpayers will only become known once the crisis is (US$ billions) over. XI. When will we hit bottom?

82 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% 27% 2010 2nd half 29% 2009 1st half 38% 2009 2nd half 17% No 2008 73% 1st half 4% 2008

Source: Wall Street Journal. 83 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

4.5 Q1 2008: 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. 84 Declines in home prices and the time it takes to get the rent-to-price ratio to a targeted value (5.04 is the longer-run average ratio)

AnnualAnnual home homeprice declineprice decline required -2.0% -5.0% -10.0% -15.0% -20.0%

3.80% 2010 Q3 2008 Q4 2008 Q2 2008 Q2 2008 Q2

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

5.00% 2024 Q1 2014 Q1 2010 Q4 2009 Q3 2009 Q1 5.04% 2024 Q3 2014 Q2 2010 Q4 2009 Q3 2009 Q1 average

Rent-to-price ratio ratio Rent-to-price 6.00% 2026 Q4 2017 Q3 2012 Q3 2010 Q4 2009 Q4

Sources: Davisa, Lehnertb, Martin (2007), Milken Institute. 85 Alternative measures of the affordability of mortgage debt for California

US$/month Payment with 100% LTV 4,000 Payment with 90% LTV 3,500 Payment with 80% LTV Mortgage payment assumptions: Every month, a home is purchased at 3,000 median price, buyer takes out a 30-year conforming, fixed-rate loan with 80% 2,500 LTV. 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. 86 XII. What went wrong

87 The importance of Fannie Mae and Freddie Mac

US$ billions 3,000 2,443 2,500 2,067 2,000 1,410 1,500 886 879 944 1,000

500 0 Fannie Mae: Fannie Mae: Freddie Mac: Freddie Mac: Commercial Savings total assets total MBS total assets total MBS banks: total institutions: outstanding outstanding residential real total estate assets residential real estate assets

Sources: Freddie Mac, Fannie Mae, FDIC, Milken Institute. 88 Fannie Mae and Freddie Mac: Too big with too little capital?

US$ billions 3,000 Fannie Mae Freddie Mac 2,500 2,278

2,000 1,778 1,459 1,500 1,301 1,022 1,123 897 1,000 844 803752 805 804

500 288 316 133 41 0 1990 2003 2006 Q3 2008 1990 2003 2006 Q3 2008 Total assets Total MBS outstanding

Sources: Freddie Mac, Fannie Mae, Milken Institute. 89 Fannie Mae and Freddie Mac are highly leveraged

Mortgage book of business over capital measures 300 Freddie Mac 250 Fannie Mae 203x 185x 200 167x 150 81x 100 64x 60x 60x 56x 58x 48x 52x 56x 55x 57x 50 0 -50 Core capital Fair value Core capital Fair value -52x -100 -66x

2005 2006 2007 Q3 2008

Sources: Freddie Mac, Fannie Mae, FDIC, Milken Institute. 90 Freddie Mac’s and Fannie Mae's retained private-label portfolios Subprime Alt-A All others

Fannie Mae, Q3 2008 $85.7 billion 30.3% 33.4% 36.4% Fannie Mae, 2007 $94.8 billion 33.8% 34.3% 32.0% Fannie Mae, 2006 $97.3 billion 46.4% 36.1% 17.5% Fannie Mae, 2005 $86.9 billion 32.1% 37.4% 30.5% Freddie Mac, Q3 2008 $191.5 billion 41.7% 24.0% 34.3% Freddie Mac, 2007 $218.9 billion 46.3% 23.4% 30.3% Freddie Mac, 2006 $224.6 billion 54.4% 25.0% 20.6%

Sources: Freddie Mac, Fannie Mae, FDIC, Milken Institute. 91 Leverage ratios of different types of financial firms (June 2008)

Leverage ratio, total assets/common equtity

Freddie Mac 67.9

Fannie Mae 21.5

Federal Home Loan Banks 23.7

Brokers/hedge funds 31.6

Savings institutions 9.4

Commercial banks 9.8

Credit unions 9.1

Sources: Federal Deposit Insurance Corporation, Office of Federal Housing Enterprise Oversight, National Credit Union Administration, Bloomberg, Google Finance, Milken Institute. 92 Too much dependence on debt? Leverage ratios at biggest investment banks Total assets/total shareholder equity 2000 2005 2007 Sept. 2008 40 34 33 35 32 31 31 30 28 28 27 26 24 24 23 25 22 23 22 22 19 19 20 18

10 June 2008 5 n.a 0 Bear Stearns Merrill Lynch Morgan Stanley Lehman Brothers Goldman Sachs

Sources: Bloomberg, Milken Institute. 93 Debt dependence Leverage ratios at bank holding companies

Total assets/total shareholder equity 25 2000 2005 2007 Sept. 2008

20 19 16 17 15 15 13 13 13 13 13 12 11 11 10

0 Citigroup Bank of America JP Morgan Chase

Sources: Bloomberg, Milken Institute. 94 Leverage vs. issuer rating

Fitch long term issuer default rating AAA 24 Merrill Lynch ● 2000 ● 2005 ● 2007 AA+ 23 Morgan Stanley Morgan Stanley AA Citigroup 22 Bank of America AA- Merrill Lynch 21 A+ Merrill Lynch 20 A JP Morgan Goldman Sachs 19 A- Bear Stearns Lehman Brothers 18 10 15 20 25 30 35 Total assets/total equity capital Sources: Bloomberg, Milken Institute. 95 Leverage vs. issuer rating

Total assets/ Fitch long term issuer total shareholder equity default rating 2000 2005 2007 2000 2005 2007 Bear Stearns 27.8 26.6 33.5 A+ A+ A+ Merrill Lynch 19.4 19.1 31.9 AA AA- A+ Morgan Stanley 21.6 30.7 33.4 AA AA- AA- Lehman Brothers 26.0 24.4 30.7 A A+ AA- Goldman Sachs 17.5 22.7 22.4 AA- AA- AA- Citigroup 12.7 13.3 19.3 AA AA+ AA Bank of America 13.5 12.7 11.7 AA- AA- AA JP Morgan Chase 16.7 11.2 12.7 AA- A+ AA-

Sources: Bloomberg, Milken Institute. 96 CDS premiums vs. issuer rating

AAAFitch long term issuer default rating ● 2004 ● 2005 ● 2007 AA+

Citigroup Morgan Stanley AA Bank of America Merrill Lynch Lehman Brothers

AA- JPMorgan Goldman Sachs A+ Merrill Lynch

Bear Stearns A Lehman Brothers

A- 0 102030405060708090 Average CDS premium, basis points

Sources: Datastream, Milken Institute. 97 Credit default swap premiums basis points

2004 2005 2006 2007 2008

Bear Stearns 35.97 29.65 23.48 79.62 155.64

Merrill Lynch 33.37 27.19 20.34 57.62 231.03

Morgan Stanley 33.39 27.81 22.42 52.20 289.61

Lehman Brothers 35.91 29.88 23.53 68.95 936.23

Goldman Sachs 34.04 27.53 22.58 46.25 189.79

Citigroup 22.17 17.01 10.69 30.05 165.20

Bank of America 22.52 17.27 11.06 26.11 113.09

JP Morgan Chase 31.23 27.30 16.83 31.11 105.75

Sources:Datastream, Milken Institute. 98 Leverage vs. CDS premiums

Average CDS premium, basis points 100 ● 2004 ● 2005 ● 2007 Bear Stearns 80 Lehman Brothers Merrill Lynch Goldman Sachs 60 JP Morgan Morgan Stanley

40 Morgan Stanley

Merrill Lynch 20 Bear Stearns Citigroup Lehman Brothers Bank of America 0 10 15 20 25 30 35 Total assets/total equity capital Sources: Datastream, Bloomberg, Milken Institute. Leverage vs. CDS premium

Total assets/ Average CDS premium total shareholder equity basis points

2004 2005 2007 2004 2005 2007

Bear Stearns 28.4678 26.6 33.5 35.97 29.65 79.62 Merrill Lynch 20.0223 19.1 31.9 33.37 27.19 57.62 Morgan Stanley 26.4337 30.7 33.4 33.39 27.81 52.2 Lehman Brothers 23.9389 24.4 30.7 35.91 29.88 68.95 Goldman Sachs 19.7627 22.7 22.4 34.04 27.53 46.25 Citigroup 13.5794 13.3 19.3 22.17 17.01 30.05 Bank of America 11.0783 12.7 11.7 22.52 17.27 26.11 JP Morgan Chase 10.9533 11.2 12.7 31.23 27.3 31.11

Sources: Datastream, Bloomberg, Milken Institute. Credit default swap premiums for large banks

Credit default swap premium, basis points

500 JP Morgan Chase Wells Fargo 400 Bank of America Citigroup 300

200

100

0 12/2005 04/2006 08/2006 12/2006 04/2007 08/2007 12/2007 04/2008 08/2008 12/2008

Sources: Datastream, Milken Institute. 101 Standard & Poor’s ratings New issues: 1/1/2000 to 9/30/2008

Investment-grade securities Non-investment-grade securities AAA 16,907 BB+ 238 AA+ 240 BB 313 BB- 331 AA 2,098 B+ 339 AA- 3,414 B330 A+ 2,623 B- 1,189 A2,602CCC+ 293 A- 2,027 CCC 214 BBB+ 903 CCC- 104 BBB 1,371 CC 36 C11 BBB- 1,359 D303 Sources: Bloomberg, Milken Institute. 102 56 percent of MBS issued from 2005 to 2007 were eventually downgraded

Downgraded as S&P Total Downgraded a percentage of total AAA 1,032 156 15.1% AA(+/-) 3,495 1,330 38.1% A(+/-) 2,983 1,886 63.2% BBB(+/-) 2,954 2,248 76.1% BB(+/-) 789 683 86.6% B(+/-) 8 7 87.5% Total 11,261 6,310 56.0%

Sources: Inside Mortgage Finance, Milken Institute. Note: A bond is considered investment grade if its credit rating is BBB- or higher by S&P. 103 Subprime mortgage-backed Investment grade S&P 500 securities downgrades companies’ credit ratings and 2005–2007 issuance associated CDS spreads Percent downgraded S&P Number of CDS spread Rating companies 100 S&P 94 Highest Lowest Average 90 87 Moody’s 84 AAA 3 56 15 41 80 76 Fitch 71 AA+ 1 95 95 95 66 70 63 AA 5 86 49 74 60 AA- 9 265 54 118 50 50 A+ 17 2,999 12 346 38 40 A 36 1,040 38 151 A- 34 2,557 51 427 30 24 BBB+ 43 1,114 38 222 20 1517 BBB 41 1,210 61 271 10 BBB- 17 1,235 89 359 0 AAA AA(+/-) A(+/-) BBB(+/-) Note: As of October 17, 2008. Sources: S&P, Datastream, Milken Institute. 104 Credit ratings of selected S&P 500 companies and associated CDS spreads as of October 17, 2008 Investment grade Speculative grade

Number of CDS spreads (basis points) Number of CDS spreads (basis points) S&P's S&P's companies Highest Lowest Averagecompanies Highest Lowest Average AAA 3 56 15 41 BB+ 12 795 130 419 AA+ 1 95 95 95 BB 14 938 168 522 AA 5 86 49 74 BB- 8 1,352 337 713 AA- 9 265 54 118 B+ 4 3,925 418 1,612 A+ 17 2,999 12 346 B 3 2,686 894 1,523 A 36 1,040 38 151 B- 2 4,718 3,701 4,209 A- 34 2,557 51 427 BBB+ 43 1,114 38 222 BBB 41 1,210 61 271 BBB- 17 1,235 89 359

Sources: S&P, Bloomberg, Datastream, Milken Institute. Note: Credit ratings of S&P 500 companies and the associated CDS spreads for those firms for which both ratings and CDS spreads are available. 105 When is a AAA not a AAA? Multilayered mortgage products Origination of mortgage loans High-grade CDO

Senior AAA 88% Junior AAA 5% Pool of mortgage AA 3% loans: prime or subprime A 2% BBB 1% Unrated 1%

Mortgage bonds

AAA 80% AA 11% A 4% Mezzanine CDO BBB 3% CDO-squared BB-unrated 2% Senior AAA 62% Junior AAA 14% Senior AAA 60% AA 8% Junior AAA 27% A6%AA4%CDO-cubed… BBB 6% A 3% Unrated 4% BBB 3% Unrated 2% Sources: International Monetary Fund, Milken Institute. 106 Dollar losses in reported Mortgage loan fraud surges cases of mortgage fraud US$ millions

Number of cases reported, thousands 1,200 60 1,014 52.91,000 946 50 813 800 40 37.3 600 30 26.0 429 400 293 20 18.4 225 200 9.5 10 5.4 2.9 3.5 4.7 1. 2.3 0 0 7 2002 2003 2004 2005 2006 2007 1997 1999 2001 2003 2005 2007

Sources: Financial Crimes Enforcement Network, Federal Bureau of Investigation, Milken Institute. 107 Is adequate information disclosed to consumers?

Percent of respondents who could not correctly identify various loan costs using current disclosure forms

Prepayment penalty amount 95 Total up-front cost amount 87 Property tax and homeowner’s insurance cost amount 84 Reason why the interest rate and APR sometimes differ 79 Presence of charges for optional credit insurance 74 Presence of prepayment penalty for refinance in two years 68 Loan amount 51 Which loan was less expensive 37 Whether loan amount included finances settlement charges 33 Interest rate amount 32 Balloon payment (presence and amount) 30 Settlement charges amount 23 Monthly payment (including whether it includes taxes and insurance) 21 Cash due at closing amount 20 APR amount 20

Sources: Federal Trade Commission, Milken Institute. 108 Drivers of foreclosures: Strong appreciation or weak economies? Foreclosures per 1,000 homes 25 Weak economies Housing bubbles Stockton 20 Detroit Las Vegas Riverside 15 Cleveland Toledo Sacramento Fort Lauderdale Dayton Bakersfield 10 Akron Denver Miami Atlanta Phoenix Oakland Fresno Warren Memphis Tampa Orlando 5 San Diego Columbus Palm Beach National average Indianapolis 0 -20 0 20 40 60 80 100 120 140 Five-year price gain, Q3 2002–Q3 2007 (percent)

Sources: U.S. Treasury Department, RealtyTrac, Office of Federal Housing Enterprise Oversight, Milken Institute. 109 After housing bubble burst in 2007: Foreclosures highest for areas with biggest price declines

Foreclosures per 1,000 homes 45 Collaping housing bubbles National average Weak 40 economies Stockton strengthen 35 Riverside Las Vegas 30 Fort Lauderdale Bakersfield Denver 25 Oakland Sacramento Phoenix Toledo 20 Atlanta Fresno Miami Akron Detroit 15 Memphis Orlando San Diego Tampa 10 Palm Beach Warren Cleveland 5 Dayton Columbus Indianapolis 0 -30 -25 -20 -15 -10 -5 0 5 Price change, 2007–June 2008 (percent, annualized)

Sources: RealtyTrac, Office of Federal Housing Enterprise Oversight, Milken Institute. 110 XIII. Policy lessons from the current crisis and proposals for reform in regulatory oversight

111 Balance sheet information on FDIC-insured institutions Percent Percent 20 90 Borrowed funds-to- 18 asset ratio 80 (left axis) 16 70 14 60 Insured deposits-to- 12 Deposits-to-asset ratio (right axis) asset ratio (right axis) 50 10 40 8 30 6 Equity capital-to- 4 asset ratio Cash-to-asset ratio 20 (right axis) (left axis) 2 10 0 0 1992 1994 1996 1998 2000 2002 2004 2006 Q3 2008

Sources: FDIC, Milken Institute. 112 U.S. regulatory capital requirements and prompt corrective action categories Tier 1 Tier 1 risk- Total risk-based leverage based Well capitalized >= 5% and >= 6% and >= 10%

Adequately capitalized >= 4% and >= 4% and >= 8%

Undercapitalized < 4% or < 4% or < 8% Significantly < 3% or < 3% or < 6% undercapitalized Critically Tangible equity capital ratio that is <= 2% undercapitalized

Source: FDIC. 113 Selected information for U.S. banks December 31, 2008

$US billions Percent

Market Long-term Deposits Short-term Total Total capitalization borrowing Cash/total Name to total borrowing to assets equity (Jan. 30, to total assets assets total assets 2009) assets JP Morgan Chase 2,175 167 95 46.4 12.9 18.8 1.2 Citigroup 1,945 151 21 39.8 18.5 29.3 1.5 Bank of America 1,818 177 43 48.6 14.8 23.2 1.8 Wells Fargo 1,310 99 79 59.7 20.4 8.3 1.8 US Bancorp 266 26 26 59.9 14.4 12.8 2.6 SunTrust Banks 189 22 5 59.9 14.2 5.0 3.0 BB&T Corp 152 16 11 64.9 11.9 7.1 1.1 Regions Financial 146 17 3 62.2 13.1 10.8 1.8 Fifth Third Bancorp 120 12 2 65.6 11.3 8.6 2.3 KeyCorp 105 10 4 62.4 14.3 9.6 1.2

Sources: Bloomberg, Milken Institute. 114 Selected information for U.S. banks December 31, 2008 Regulatory capital ratios Alternative capital adequacy assessment Total risk- Tangible Equity to Tangible Credit rating based Tier 1 risk- equity total common capital based capital assets equity Moody's S&P Name ratio capital ratio ratio ratio ratio issuer issuer JP Morgan Chase 14.7 10.8 6.9 7.7 3.4 Aa3 A+ Citigroup 15.6 11.8 6.0 7.8 1.5 N.A. A Bank of America 13.0 9.2 6.4 9.7 2.8 A1 A+ Wells Fargo 11.9 7.9 n.a. 7.6 3.5 Aa3 AA US Bancorp 14.3 10.6 9.8 9.9 2.7 Aa2 AA SunTrust Banks 14.0 10.9 10.4 11.8 5.0 A1 A BB&T Corp 17.1 12.0 9.7 10.5 6.9 Aa3 A+ Regions Financial n.a. n.a. n.a. 11.5 5.2 A2 A Fifth Third Bancorp 14.8 10.6 10.3 10.1 7.9 A2 A- KeyCorp 14.7 10.8 11.0 10.0 5.9 A2 A- 115 Sources: Bloomberg, Milken Institute. 115 Equity capital-asset ratio for commercial banks

Equity capital/asset ratio, percent 30 1896: 28.1%

20 1932: 16.2% Q3 2008: 9.7% 15 Average, 1896 - Q3 2008: 10.9% 10

5 1945: 5.5% 1979: 5.8% 0 1896 1905 1914 1923 1932 1941 1950 1959 1968 1977 1986 1995 2004

Sources: Historical Statistics of the United States, FDIC, Milken Institute. 116 Leverage ratio for commercial banks

Asset/equity capital ratio 20 1979: 17.4x 18 1945: 18.2x 16 14 12 10 Average, 1896 - Q3 2008: 11.0x 8 6 Q3 2008: 10.3x 1932: 6.2x 4 2 1896: 3.6x 0 1896 1905 1914 1923 1932 1941 1950 1959 1968 1977 1986 1995 2004

Sources: Historical Statistics of the United States, FDIC, Milken Institute. Note: The leverage ratio is the reciprocal of the capital-asset ratio. 117 Reserve coverage ratio of all FDIC-insured institutions

US$ billions Percent 200 200 180 180 Coverage ratio (right axis) 160 160 140 Loan-loss reserves (left axis) 140 120 120 100 100 80 80 60 60 40 40 20 Noncurrent loans (left axis) 20 0 0 03/2005 09/2005 03/2006 09/2006 03/2007 09/2007 03/2008 09/2008

Sources: Quarterly Banking Profile, FDIC, Milken Institute . The U.S. regulatory regime: In need of reform?

Financial, bank and thrift Fannie Mae, Freddie Mac, and Justice Department Federal courts • Assesses effects of holding companies Federal Home Loan Banks • Ultimate decider of banking, securities, and mergers and acquisitions on • Fed • Federal Housing Finance insurance products competition • OTS Agency

Fed is the umbrella or consolidated regulator

National banks State commercial Federal savings Insurance Securities Other financial companies, and savings banks banks companies brokers/dealers including mortgage companies and brokers Primary/ • OCC • State bank • OTS • 50 State insurance • FINRA • Fed secondary • FDIC regulators • FDIC regulators plus • SEC • State licensing functional • FDIC District of Columbia • CFTC (if needed) regulator • Fed--state member and Puerto Rico • State securities • U.S. Treasury commerical banks regulators for some products

Notes: Federal Foreign Limited foreign Justice Department: Assesses effects of mergers and acquisitions on competition Federal Courts: Ultimate decider of banking, securities, and insurance products branch branch branch CFTC: Commodity Futures Trading Commission FDIC: Federal Deposit Insurance Corporation • OCC • Fed • OTS Fed: Federal Reserve • Host county • Host county • Host county FINRA: Financial Industry Regulatory Authority regulator regulator regulator GSEs: Government Sponsored Enterprises OCC: Comptroller of the Currency OTS: Office of Thrift Supervision SEC: Securities and Exchange Commission Sources: Financial Services Roundtable (2007), Milken Institute. 119 Countries with the Central Bank as a supervisory authority

Central bank Central bank not a supervisory Income Central bank only among multiple authority level (75 countries) supervisors (52 countries) (7 countries) South Anguilla Estonia Israel Montserrat Slovenia Netherlands Australia Denmark Isle of Man Norway Korea Antigua New United and Germany Italy Spain Saudi Arabia Bahrain Finland Japan Sweden Zealand States Barbuda High income Austria Greece Kuwait Portugal Taiwan, China Belgium France Luxembourg Switzerland Hong Kong, Trinidad & United Cyprus Liechtenstein Singapore Canada Iceland Macau, China China Tobago Kingdom Czech Cayman Ireland Malta Republic Islands St. Kitts and Argentina Bulgaria Lithuania Russia Malaysia Chile Gabon Latvia Panama Nevis Belize Croatia Mauritius Seychelles St. Lucia Costa Rica Hungary Lebanon Poland St. Vincent Upper middle Slovak Equatorial Botswana Dominica Oman and the Kazakhstan Mexico income Republic Guinea Grenadines South Brazil Grenada Romania Uruguay Africa Algeria Dominican Angola Egypt Jamaica Maldives Sri Lanka Bolivia China Honduras Republic Bosnia and Lower middle Armenia Fiji Jordan Moldova Suriname Colombia El Salvador Nicaragua Herzegovina income Belarus Guyana Lesotho Morocco Syrian Cameroon Congo Guatemala Peru Macedonia, Bhutan Indonesia Philippines Thailand FYR Kyrgyz Bangladesh Ghana Tajikistan Pakistan Nigeria Zimbabwe Benin Chad Mali Senegal Republic Côte Low income Burundi India Malawi Tanzania Uganda Burkina Faso Niger Togo d'Ivoire Central African Guinea- Ethiopia Kenya Mozambique Republic Bissau

120 Countries with single vs. multiple supervisory authorities

Income Single supervisor Multiple supervisors level (127 countries) (7 countries) Hong Kong, Anguilla Cyprus Liechtenstein Singapore Netherlands Saudi Arabia China Antigua and Barbuda Czech Republic Iceland Luxembourg Slovenia South Korea United States Australia Denmark Ireland Macau, China Spain High Austria Estonia Isle of Man Malta Switzerland income Bahrain Finland Israel Montserrat Taiwan, China Belgium France Italy New Zealand Trinidad & Tobago Canada Germany Japan Norway United Kingdom Cayman Islands Greece Kuwait Portugal Sweden Argentina Costa Rica Grenada Lithuania Seychelles Malaysia Belize Croatia Hungary Mauritius Slovak Republic Upper Botswana Dominica Kazakhstan Mexico St. Kitts and Nevis middle Brazil Equatorial Guinea Latvia Oman St. Lucia income Bulgaria Romania Lebanon Poland St. Vincent and the Grenadines Chile Gabon South Africa Russia Uruguay Panama Bosnia and Guatemala Egypt Lesotho Peru Herzegovina Macedonia, Algeria Cameroon El Salvador Philippines FYR Lower Angola China Fiji Maldives Sri Lanka middle Armenia Colombia Guyana Moldova Suriname income Belarus Jordan Honduras Morocco Syrian Bhutan Congo Indonesia Nicaragua Thailand Dominican Bolivia Jamaica Republic Bangladesh Chad India Pakistan Togo Nigeria Zimbabwe Benin Côte d'Ivoire Kenya Senegal Uganda Low income Burkina Faso Ethiopia Kyrgyz Republic Tajikistan Mali Burundi Ghana Malawi Tanzania Niger Central African Republic Guinea-Bissau Mozambique 121 Scope of supervisory authority for countries Income Only banks All of the main financial institutions level (96 countries) (38 countries) Anguilla Greece Luxembourg Slovenia Australia Denmark Japan Singapore Hong Kong, Antigua and Barbuda Montserrat South Korea Austria Estonia Liechtenstein Sweden China High Canada Isle of Man Netherlands Spain Bahrain Germany Macau, China Taiwan, China income Trinidad & Cyprus Israel New Zealand Switzerland Belgium Iceland Malta Tobago Finland Italy Portugal United States Cayman Islands Ireland Norway United Kingdom France Kuwait Saudi Arabia Czech Republic Argentina Croatia Mauritius Seychelles Hungary Kazakhstan Latvia Malaysia Belize Dominica Mexico Slovak Republic Uruguay Botswana Equatorial Guinea Oman South Africa Upper Brazil Gabon Panama St. Kitts and Nevis middle income Bulgaria Grenada Poland St. Lucia St. Vincent and the Chile Lebanon Romania Grenadines Costa Rica Lithuania Russia Algeria Congo Jamaica Sri Lanka Armenia Colombia Honduras Nicaragua Dominican Angola Jordan Suriname Bhutan Fiji Lesotho Peru Republic Lower Macedonia, Bosnia and middle Belarus Egypt Syrian Guatemala Maldives FYR Herzegovina income Bolivia El Salvador Moldova Thailand Cameroon Guyana Morocco China Indonesia Philippines Kyrgyz Bangladesh Côte d'Ivoire Senegal Malawi Republic Benin Ethiopia Mali Tajikistan Burkina Faso Ghana Mozambique Tanzania Low income Burundi Guinea-Bissau Niger Togo Central African India Nigeria Uganda Republic Chad Kenya Pakistan Zimbabwe 122