Leverage and Risk of Financial Institutionswebhome.auburn.edu/~barthjr/papers/Barth_Amsterdam_Final Slides_Feb 2009.pdfNational FICO scores display wide distribution What goes into

11

Leverage and Risk of Leverage and Risk of Financial InstitutionsFinancial Institutions

James R. BarthAuburn University and Milken Institute

[email protected]

Conference on Procyclicality in the Financial SystemAmsterdam, Netherlands

February 9-10, 2009

22

“Any real estate investment is a good investment … ”

33

“Any real estate investment is a good investment … ”

… Really?!

44

Subprime mortgage meltdown timelineDecember 2006–October 2008

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

Oct. 12, 2008: Finance leaders endorse G7 plan to calm markets.

Oct. 27, 2008: Down Jones U.S. Financial Index=230

Oct. 31, 2008:Dow Jones U.S. Financial Index=269

200

300

400

500

600

700

12/2006 02/2007 04/2007 06/2007 08/2007 10/2007 12/2007 02/2008 04/2008 06/2008 08/2008 10/2008

Dow Jones U.S. Financial Index

June 9, 2008:Lehman announces a $2.8 billion loss.

July 11, 2008: IndyMac is seized by FDIC.

Aug. 1, 2008: First Priority Bank closes.

Mar. 11, 2008: Fed offers troubled banks as much as $200 billion in loans; Fed introduces Term Securities Lending Facility.

Oct. 24, 2007: Merrill announces $7.9 billion in subprime write-downs, surpassing Citi’s $6.5 billion.

Feburary–March 2007: More than 25 subprime lenders declare bankruptcy.

Aug. 6, 2007: American Home Mortgage files for bankruptcy.

Sept. 30, 2007: NetBank goes bankrupt.

July 30, 2008: President Bush signs a housing rescue law.

Sept. 7, 2008: U.S. seizes Fannie Mae and Freddie Mac.

Dec. 2006: Ownit Mortgage, a subprime lender, files for bankruptcy.

Apr. 2007: New Century, a mortgage broker, files for bankruptcy.

Feb. 2007: HSBC sets aside $10.6 billion for bad loans, including subprime.

July 31, 2007: Two Bear Stearns hedge funds file for bankruptcy.

Aug. 17, 2007: Fed cuts discount rate to 5.75%; Fed introduces Term Discount Window Program.

Jan. 11, 2008: Bank of America agrees to buy Countrywide.Jan. 30, 2008: Fed cuts discount rate to 3.5%.

Dec. 12, 2007: Fed introduces Term Auction Facility.

Feb. 13, 2008: President Bush introduces tax rebate stimulus program of $168 billion.

Aug. 16, 2007: Countrywide gets emergency loan of $11 billion from a group of banks.

Sept. 14, 2008: Lehman files for bankruptcy.

Mar. 18, 2008: Fed cuts discount rate to 2.5%; Fed funds rate to 2.25%.

Mar. 16, 2008: JP Morgan Chase offers to buy Bear Stearns; Fed introduces Primary Dealer Credit Facility.

April. 30, 2008: Fed cuts discount rate to 2.25%; Fed funds rate to 2%.

Oct. 3, 2008: President Bush signs Emergency Economic Stabilization Act, authorizing bailout of $700 billion.Also, Citigroup sues after Wachovia agrees tie-up with Wells Fargo.

Sept. 16, 2008: Fed loans AIG $85 billion.

Sept. 23, 2008: Washington Mutual is seized by FDIC.

Sept. 29, 2008: Citigroup agrees to buy Wachovia.

Oct. 8, 2008: Fed cuts discount rate to 1.75%; Fed funds rate to 1.5%.

55

Overview

66

Home mortgages: Who borrows, how much has been borrowed, and who funds them?

Note: total residential and commercial mortgages = $14.7 trillion; 5 percent = $700 billion

Government-controlled

46%

Privatesector-

controlled54%

Total value of housing stock = $19.3 trillion

Equity in housing stock$8.7 trillion

Mortgage debt $10.6 trillion

Prime 91.6%

Subprime8.4% Securitized

58%

Non-securitized42%

Sources: Federal Reserve, Milken Institute.

77

The mortgage problem in perspective

80 million houses27 million are paid off

53 million have mortgages 48 million are paying on time

5 million are behind

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

(10% of 53 million with 3% in foreclosure)

Sources: U.S. Treasury, Milken Institute.

88

I. Low interest rates and a lending boom

99

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

Sources: Federal Reserve, Mortgage Bankers Association, Moody’s Economy.com, Milken Institute.

Target federal funds rate

0

1

2

3

4

5

6

7

8

2001 2002 2003 2004 2005 2006 2007 2008 2009

Percent

Record low from June 25, 2003 to June 30, 2004: 1%

30-year FRM rate

Apr. 30, 2008: 2%Oct. 8, 2008: 1.5%Oct. 29, 2008: 1%Dec. 16, 2008: 0-0.25%

1-year ARM rate

January 30, 200930-year FRM rate: 5.1%1-year ARM rate: 4.9%

1010

Home price bubble and credit boom

Low interest rates and credit boom

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

Index, January 2000 = 100

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

2001 2004 2007 Q3 20080

50

100

150

200

250US$ trillions

Home mortgage

originations (left axis)

S&P/Case-Shiller National Home

Price Index (right axis)

US$ trillions

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

2001 2004 2007 Q3 20083.0

3.5

4.0

4.5

5.0

5.5

6.0

1-Year ARM mortgage rate

(right axis)

Home mortgage

originations (left axis)

Percent

Note: Data for Q1-Q3 2008 are annualized.

1111

II. Homeownership, prices, starts and sales take off

1212

Credit boom pushes homeownership rate

to historic high

Home price bubblepeaks in 2006

California and national home prices reach

record highs

Sources: U.S. Census Bureau, OFHEO, Moody’s Economy.com, S&P/Case-Shiller, California Association of Realtors, Milken Institute.

0

100

200

300

400

500

600

700

1998 2000 2002 2004 2006 2008

US$ thousands

California m edian hom e price

U.S. m edianhom e price

U.S. average, 1987-2008: $121,714

California average1987-2008$230,599

80

130

180

230

280

330

380

1998 2000 2002 2004 2006 2008

Index, January 1987 = 100S&P/

Case-Shiller National Hom e

Price Index

OFHEO Hom e Price Index

64

65

66

67

68

69

70

1998 2000 2002 2004 2006 2008

Percent

Q2 2004: 69.2%

Q4 2008: 67.5%

Average, 1965–Q4 2008: 65.2%

1313

0.0

1.4

2.8

4.2

5.6

7.0

1998 2000 2002 2004 2006 20080.0

0.3

0.6

0.9

1.2

1.5Millions Millions

New hom e sales (right axis )

Exis ting hom e sales (le ft axis)

0

1

2

3

4

1998 2000 2002 2004 2006 20080.0

0.2

0.4

0.6

0.8Millions

Existing homes for sale (left axis)

New homes for sale (right axis)

Millions

Homes for sale Homes sales reach a new high

Housing starts hit a record in 2005

Sources: U.S. Census Bureau, OFHEO, Moody’s Economy.com, Milken Institute.

0.0

0.5

1.0

1.5

2.0

1998 2000 2002 2004 2006 2008

January 2006: 1.8 m illion

Oct. 2008: 536,000

Housing units, millions

Average starts , 1959–Oct. 2008: 1.1 m illion

1414

III. Subprime borrowers and subprime mortgages

1515

National FICO scores display wide distribution What goes into a FICO score?

Who is a subprime borrower?

Sources: myFICO.com, Milken Institute.

25

812

1518

27

13

0

10

20

30

40

up to499

500-549

550-599

600-649

650-699

700-749

750-799

800+

Percentage of population

Subprime = 21%

Prime = 79%

Amounts owed

30%

Payment history

35%

Length of credit history

15%

New credit10%

Types of credit in use

10%

1616

Prime

Subprime

0

4

8

12

16

20

0 - 459

460 - 4

79480

- 499

500 - 5

19520

- 539

540 - 5

59560

- 579

580 - 5

99600

- 619

620 - 6

39640

- 659

660 - 6

79680

- 699

700 - 7

19720

- 739

740 - 7

59760

- 779

780 - 7

99800

- 900

Percent of total originations

FICO score

FICO below 620 Prime: 6.6%

Subprime: 45.2%

FICO above 620 Prime: 93.4%

Subprime: 54.8%

Prime and subprime mortgage originations by FICO score reveal substantial overlaps

Sources: LoanPerformance, Milken Institute.

1717

ARMs look attractive to many borrowers

Sources: Mortgage Bankers Association, Moody’s Economy.com, Milken Institute.

3

4

5

6

7

8

2001 2002 2003 2004 2005 2006 2007 2008 2009

Percent

30-year FRM rate

1-year ARM rate

January 30, 200930-year FRM rate: 5.1%1-year ARM rate: 4.9%

1818

ARM share grows, following low interest rates


0

5

10

15

20

25

2001 2002 2003 2004 2005 2006 2007 2008

Percent of all outstanding home mortgages

1919

0

10

20

30

40

50

60

2001 2002 2003 2004 2005 2006 2007 2008

FHA ARM Prime ARM Subprime ARM

Percent of mortgage type

Largest share of ARMs go to subprime borrowers


2020

Subprimes take an increasing shareof all home mortgage originations

Sources: Inside Mortgage Finance, Milken Institute.

0.0

1.0

2.0

3.0

4.0

2001 2002 2003 2004 2005 2006 2007 Q1-Q3 2008

Subprime

Prime

US$ trillions

Subprime'sshare:7.8%

7.4%

8.4%

18.2%21.3%

20.1%

7.9%

1.3%

2121

160200

310

540

625 600

191

140

100

200

300

400

500

600

700

2001 2002 2003 2004 2005 2006 2007 Q22008

US$ billions US$ billions

479574

699

973

1,200 1,240

940 895

0

200

400

600

800

1,000

1,200

1,400

2001 2002 2003 2004 2005 2006 2007 Q12008

Average annual growth rates1995–2006: 14%2006–Q1 2008: -23%

Subprime mortgages increase rapidly before big declineOriginations Outstandings


H22008

2222

IV. Mortgage product innovation

2323

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

FHA & VAConventional, conforming primeJumbo prime

pSubprimeAlt-A Home equity loans


2001, $2.2 trillion

57.1%

2% 5%7.9%

7%

20%

2006, $3.0 trillion

33.2%

13%

14%2.7%

20% 16%

2007, $2.4 trillion

47.3%

11%

14% 4.9%

8%

14%

Q1 2008, $480 billion

67.2%

4% 9% 9.6%2%

8%

2424

ARM hybrids dominate subprime originations (2006)

Fixed

Other ARM7%

23%

70%

ARM hybrids

Fixed

Other ARM7%

23%

70%

ARM hybrids

Other ARM7%

23%

70%

ARM hybrids

ARM balloon

Other ARM 4%

Fixed 9%

30-year

with 40- to 50-year

amortization26%

2- and 3-year hybrids 61%

ARM balloonARM balloon

Other ARM 4%

Fixed 9%

30-year

with 40- to 50-year

amortization26%


Other ARM 4%

Fixed 9%

30-year

with 40- to 50-year

amortization26%


Sources: Freddie Mac, Milken Institute.

SubprimePrime conventional Alt-A

Fixed 31%

Other ARM23%

ARM hybrids46%

Fixed 31%

Other ARM23%

ARM hybrids46%

2525

V. Securitization

2626

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

Held in portfolio

84.4%

Securitized15.6%

Held in portfolio

41%

Securitized59%

Residential mortgage loans1980: Total = $958 billion

Residential mortgage loansQ3 2008: Total = $11.3 trillion


2727

31 2933

4045 43 42 45 47

5057

6265 68 68 68

0

10

20

30

40

50

60

70

80

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Q12008

Q22008

Percent of all subprime mortgages securitized since 1994

Securitization becomes the dominant funding source for subprime mortgages


2828

The rise and fall of private-label securitizersNew securities issuance


35%

42%2%

21%

1985Total = $110B

38%

20% 13%

29%

2001Total = $1.4T

22%

56%

4%

18%

2006Total = $2.0T

31%

19%

45%

5%

Q1–Q3 2008Total = $1.0T

Ginnie Mae Freddie Mac Fannie Mae Private-label

2929

The rise and fall of private-label securitizersOutstanding securities

Ginnie Mae Freddie Mac Fannie Mae Private-label

13%

6%

55%

26%

1985Total = $390B

39%

14% 18%

29%

2001Total = $3.3T

33%

35%7%

25%

2006Total = $5.9T

37%

30%7%

26%

First half 2008Total = $6.8T


3030

Mortgage-backed securities issued by issuer

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

0

500

1,000

1,500

2,000

2,500

3,000

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

Private label

Ginnie Mae

Freddie Mac

Fannie Mae

US$ billions

3131

VI. Affordability

3232

2.5

3.0

3.5

4.0

4.5

5.0

1998 2001 2004 2007

Median home price/median household income

Average, 1967–2007: 3.38

2005: 4.69

2007: 4.29

Ratio of home price to household

income surges

Home mortgage share of household debts reaches

a new high in 2007

Debt-to-income ratio of households has increased rapidly

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

75

100

125

150

1998 2001 2004 2007

Home mortgage debt/disposable personal income

Q4 2007: 139.5%

Average, 1957–2007: 79.7%

60

65

70

75

1998 2001 2004 2007

Percent Q2 2007: 73.7%

Q2 2008: 73.4%

Average, 1952–2008: 64.2%

3333

VII. Collapse

3434

The recent run-up of home prices was extraordinary

Sources: Robert Shiller, Milken Institute.

0

50

100

150

200

250

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

WorldWar I World

War II1970’sboom

1980’sboom

Currentboom

Long-term trend line

Annualized growth rate of nominal home index, 1890–June 2008: 3.3%

Index, 2000 = 100

GreatDepression

3535

Home prices don’t go up foreverChange in home prices in 100-plus years

Sources: Robert Shiller, Milken Institute.

-20

-15

-10

-5

0

5

10

15

20

25

30

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

WorldWar I

GreatDepression

WorldWar II

1970’sBoom

1980’sBoom

CurrentBoom

Average, 1890–June 2008: 3.6%

Percentage change in nominal home price, year ago

+/- one standard deviation

3636

2005: The collapse begins

Sources: S&P/Case-Shiller, OFHEO, Moody’s Economy.com, Milken Institute.

-20

-15

-10

-5

0

5

10

15

20

25

1988 1992 1996 2000 2004 2008

Home price indices, percent change on a year earlier

OFHEO

S&P/Case-Shiller national

S&P/Case-Shiller 10-city

3737

Forty-six states had falling prices in the fourth quarter 2007

United States: - 9.3% (fourth-quarter annualized growth)

Source: Freddie Mac.

3838

One year ago… Five years ago…If you bought your house…

% change in price, August 07-08 % change in price, August 03-08Sources: S&P/Case-Shiller, Milken Institute.

-2.7-2.8

-4.7-5.1

-6.6-6.9

-7.6-8.5-8.8

-9.8-13.8

-15.4-16.6

-17.2-17.7

-18.1-25.8

-26.7-27.3

-28.1-30.6-30.7

DallasCharlotteBostonDenverClevelandNew YorkPortlandAtlantaSeattleChicagoMinneapolisWashingtonComposite-20 DetroitComposite-10TampaSan DiegoLos AngelesSan FranciscoMiamiLas VegasPhoenix

43.843.3

24.424.3

22.820.7

18.317.916.9

15.014.213.8

12.46.55.65.04.7

1.8-1.8-2.6

-4.3-21.9

SeattlePortlandTampaNew YorkWashingtonCharlotteMiamiPhoenixLos AngelesComposite-10Las VegasComposite-20 ChicagoDallasAtlantaBostonDenverSan FranciscoSan DiegoMinneapolisClevelandDetroit

3939

Housing startssharply decline

Homes sit longeron the market …

… as home appreciation slows

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

0

2

4

6

8

10

12

1998 2000 2002 2004 2006 2008

Number of months that homes sit on the market

Existing homes

New homes-20

-10

0

10

20

1999 2001 2003 2006 2008

0

2

4

6

8

10

12

Percentage change from year ago in median home sales price (left axis)

Number of months homes stay on

market (right axis)

Percent Months

-60

-45

-30

-15

0

15

30

1998 2000 2002 2004 2006 2008

Sept. 2008: -41.2%Oct. 2008: -39.4%

Percent change, year ago

4040

VIII. Delinquencies and foreclosures

4141

400

650

900

1,150

1,400

1,650

1,900

2,150

Q2 1999

Q4 1999

Q2 2000

Q4 2000

Q2 2001

Q4 2001

Q2 2002

Q4 2002

Q2 2003

Q4 2003

Q2 2004

Q4 2004

Q2 2005

Q4 2005

Q2 2006

Q4 2006

Q2 2007

Q4 2007

Q2 2008

Thousands of foreclosures per year

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

Foreclosures are nothing new, but …

Sources: Mortgage Bankers Association, Milken Institute.

4242

… their numbers have doubled


400

650

900

1,150

1,400

1,650

1,900

2,150

2,400

Q2 1999

Q4 1999

Q2 2000

Q4 2000

Q2 2001

Q4 2001

Q2 2002

Q4 2002

Q2 2003

Q4 2003

Q2 2004

Q4 2004

Q2 2005

Q4 2005

Q2 2006

Q4 2006

Q2 2007

Q4 2007

Q2 2008

Thousands of foreclosures per year

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

Average 1,412,656 annual forclosures from Q3 2006 to Q3 2008

4343

Subprime mortgages accounted for half or more of foreclosures since 2006


0

500

1,000

1,500

2,000

2,500

Q12003

Q32003

Q12004

Q32004

Q12005

Q32005

Q12006

Q32006

Q12007

Q32007

Q12008

Q32008

SubprimeFHA and VAPrime (includes Alt-A)

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

Q3 2008Subprime: 12% of loans serviced

4444

Subprime ARMs have the worst default record


Home mortgage loans delinquent or in foreclosure (percent of number)

0

5

10

15

20

25

30

35

40

Q21998

Q11999

Q41999

Q32000

Q22001

Q12002

Q42002

Q32003

Q22004

Q12005

Q42005

Q32006

Q22007

Q12008

Q3 2008, Subprime ARM: 35.3%

Subprime FRM: 13.5%

Prime: 3.5%

FHA and VA: 6.3%

4545

Percentage of homes purchased between Q2 2001 and Q2 2006 that now have negative equity

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

Sources: Zillow.com, Milken Institute.

United States = 44.8%

4646

Percentage of homes sold for a loss (Q2 2008)

< 15%>= 15% and < 30%>= 30% and < 45%>= 45%



4747

Percentage of homes sold that were in foreclosure (Q2 2008)

< 1%>= 1% and < 25%>= 25% and < 40%>= 40%



4848

IX. Damages scorecard

4949

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

Sources: Bloomberg, Milken Institute.

060

120180240300360420480

Priorquarters

Q3 2007 Q4 2007 Q1 2008 Q2 2008 Q3 2008 Q4 2008 ThroughFeb. 4,2009

0153045607590105120

Number of jobs cut (thousands) US$ billions

Losses/write-downs(left axis)

Capital raised(left axis)

Jobs cut (right axis)

5050

What is the cumulative damage?


Cumulative losses/write-downs, capital raised, and jobs cut by financial institutions worldwide

0

200

400

600

800

1,000

1,200

Priorquarters

Q3 2007 Q4 2007 Q1 2008 Q2 2008 Q3 2008 Q4 2008 ThroughFeb. 4,2009

0

50,000

100,000

150,000

200,000

250,000

300,000Number of jobs cut US$ billions

Losses/write-downs (left axis)February 4, 2009: $1068.4 billion

Capital raised (left axis)February 4, 2009: $969.2 billion

Jobs cut (right axis)February 4, 2009: 269.1 thousand

5151

Recent losses/write-downs and capital raised by selected financial institutions


US$ billions, through February 4, 2009 Losses /write-downs Capital raisedWachovia, 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

5252

Worldwide capital raised by sourceJuly 2007–July 2008

Sovereign wealth funds

60%Public

investors12%

Other institutional

investors28%

July 2007–December 2007Total = $56 billion

Public investors

69%

Other institutional

investors24%

Sovereign wealth funds

7%

January 2008–July 2008Total = $300 billion

Source: International Monetary Fund.

Percentage change in stock price, December 2006–January 2009

-99.1-99.0-98.2

-94.3-90.3-90.0

-87.7

-77.8-70.1

-59.5-47.2-46.9

-99.9

-87.5

-99.9Lehman BrothersWashington mutualFreddie MacFannie MaeAIGBear StearnsWachoviaCountrywideBank of AmericaMerrill LynchUBS EquityMorgan StanleyGoldman SachsJP Morgan & ChaseWells Fargo

5353

Financial stock prices take big hits

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.

-21.4-23.9

-40.1-41.4-42.9

-45.1-47.9

-54.7-63.7-64.1

-72.3-96.6

-112.9-169.2

-197.9

Bear StearnsCountrywideWells FargoLehman BrothersWashington mutualFreddie MacGoldman SachsFannie MaeMorgan StanleyMerrill LynchJP Morgan & ChaseWachoviaUBS EquityAIGBank of America

US$ billions

Total loss in market value: $1,094 billion, December 2006–January 2009

5454

Financial market capitalization takes big hit

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.

5555

X. Credit crunch and liquidity freeze

5656

Tightened standards for real estate loans


-40

-20

0

20

40

60

80

100

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

Net percentage of domestic respondents tightening standards for commercial real estate loans

LTCM Dotcom SubprimeThe end of S&L crisis

5757

Widening spreads betweenmortgage-backed and high-yield bonds

Sources: Merrill Lynch, Bloomberg, Milken Institute.

0

5001,000

1,500

2,0002,500

3,000

3,500

4,0004,500

5,000

01/2004 07/2004 01/2005 07/2005 01/2006 07/2006 01/2007 07/2007 01/2008 07/2008 01/2009

Basis points, spread over 10-year Treasury bond

Merrill Lynch Mortgage-Backed Securities IndexAverage, 2004–Januray 30, 2009: 503 bps

Merrill Lynch High-Yield Bond IndexAverage, 2004–Januray 30, 2009: 426 bps

Maximum spread: 01/30/2009: 3,647 bps

5858

Liquidity freezeSpread between 3-month LIBOR and

overnight index swap rate


Spread between 3-month LIBOR and T-bill rate

0

50

100

150

200

250

300

350

400

2006 2007 2008 2009

Average since December 2001: 29 bps

October 10, 2008: 364 bps

Basis points

Average since August 2007: 97 bps

050

100150200250300350400450500

2006 2007 2008 2009

August 20, 2007: 240 bps

Average since 1985: 92 bps

Average since August 2007: 150 bps

Basis points

October 10, 2008: 463.6 bps

5959

Counterparty risk increases

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.

0

100

200

300

400

500

600

700

07/2007 09/2007 11/2007 01/2008 03/2008 05/2008 07/2008 09/2008 11/2008 01/2009

Average CDS spread, basis points

Bear Stearns acquired

Government announces support for Fannie Mae and Freddie Mac

Lehman Brother files for bankruptcy and Merrill Lynch acquired

AIG rescuedCitigroup agreed to buy Wachovia

October 10, 2008: 607 bps

January 30, 2009: 422 bps

6060

Rising risk: The credit default swap market nearly doubled each year from June 2001 through October 2008

Sources: International Swaps and Derivatives Association, Milken Institute.

0.6 0.9 1.6 2.2 2.7 3.8 5.4 8.412.4

17.1

26.0

34.4

45.5

62.254.6

47.0

0

10

20

30

40

50

60

70

June2001

Dec.2001

June2002

Dec.2002

June2003

Dec.2003

June2004

Dec.2004

June2005

Dec.2005

June2006

Dec.2006

June2007

Dec.2007

June2008

Oct.2008

Notional amount of credit default swaps outstanding, US$ trillions

Annualized growth rateH1 2001–H2 2007: 102%H1 2001–H1 2008: 89%

6161

Commercial paper issuance dries up


-200

-150

-100

-50

0

50

100

150

Q1 2006 Q2 2006 Q3 2006 Q4 2006 Q1 2007 Q2 2007 Q3 2007 Q4 2007 Q1 2008 Q2 2008

Issuers of asset-backed securities

Other issuers

Quarterly change in outstanding amount, US$ billions

6262

Federal Reserve responds by cutting Fed funds rate, but mortgage rates remain relatively flat

Sources: Freddie Mac, Federal Reserve, Moody’s Economy.com, Milken Institute.

0

2

4

6

8

10

01/2007 03/2007 06/2007 09/2007 12/2007 02/2008 05/2008 08/2008 11/2008 01/20090

1

2

3

4

5

6

30-year FRM rate (left axis)

Federal funds rate (left axis)

Percent Percent

Spread (right axis)

6363

Increasing spreads between corporate bonds, mortgage securities, and target federal funds rate

Sources: Federal Reserve, Freddie Mac, Merrill Lynch, Bloomberg, Milken Institute.

0

4

8

12

16

20

24

01/2007 04/2007 07/2007 10/2007 01/2008 04/2008 07/2008 10/2008 01/2009

Freddie Mac 30-year fixed mortgage rate

Federal intented funds rate

High yield corporate bonds yield

AAA corporate bonds yield

Percent

6464

Federal Reserve assets increased but asset quality deteriorated


0

400

800

1,200

1,600

2,000

2,400

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

US$ billions

Total assets of Federal Reserve banks

U.S. Treasury securities held outright11/12/2008: $2.21 trillion

12/17/2008: $2.31 trillion

1/28/2009: $1.93 trillion

1/28/2009: $475 billion

6565

Federal Reserve has little maneuvering room


0

1

2

3

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

Effective federal funds rate

Percent

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

6666

Federal Government Comes to the Rescue of Main Street and Wall Street

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

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

6767

Federal Reserve programsProgram Amount committed

(US$ billions) Description

Term Discount Window Program (TDWP) 62.898

Announced on 10/17/2007. Extends the term of discount window loans from overnight to up to 90 days.

Term Auction Facility (TAF) 416.031

Announced on 12/12/2007. The Fed auctions off loans under the TAF every Thursday for a term of 28 days. Outstanding TAF credit may potentially be expanded up to $900 billion.

Term Securities Lending Facility (TSLF) 133.1

Announced on 3/11/2008. Establishes term swaps between the Fed and primary dealers. Collateral can be Treasury securities, federal agency securities, and other highly rated debt securities. On December 2, 2008, TSLF was extended through April 30, 2009.

Bear Stearns 29

Announced on 3/14/2008. The Fed acquired $29 billion in mortgage backed securities from 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.

6868

Federal Reserve programs

ProgramAmount

committed (US$ billions)

Description

Primary Dealer Credit Facility (PDCF) 58

Announced on 3/16/2008. Extends overnight borrowing from the Federal Reserve to primary dealers. On December 2, 2008, PDCF was extended through April 30, 2009. As of January 21, 2009, credit extended under PDCF was less than $33.3 billion.

AIG 173.4

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 $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.

6969



Asset Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF)

53

Announced on 9/19/2008. Loans to banks so that they can buy asset-backed commercial paper from money market funds. On December 2, 2008, AMLF was extended through April 30, 2009. As of January 21, 2009, credit extended under AMLF was $14.8 billion.

Expansion of the Federal Open Market's temporary reciprocal currency arrangements (swap lines)

620

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 (up to $30 billion by the Bank of Canada, $80 billion by the Bank of England, $120 billion by the Bank of Japan, $15 billion by 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).

7070



Commercial Paper Funding Facility (CPFF) 1777.2

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 nationally recognized statistical rating organization (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.

7171



Money Market Investor Funding Facility (MMIFF) 540

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, including U.S. based securities-lending cash-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.

7272



Term Asset-Backed Securities Loan Facility (TALF)

200

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 have a long-term credit rating of below the highest investment-grade rating category from a major NRSRO. The underlying credit exposures of eligible ABS initially must be auto loans, student loans, 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.

Federal Reserve programs

Program Amount committed(US$ billions) Description

Purchase of GSE direct obligations and MBS

600

Announced on 11/25/2008. The Fed will purchase the directobligations 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 under the program will be conducted with the Fed's primary dealers through a series of competitive auctions and will 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.

7474

Congress and White HouseProgram Amount committed


FHA Secure 50 Announced on 8/31/2007. Guarantees $50 billion in mortgages.

Economic Stimulus Act 124

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 specific new investment and raised the limits on the value of new 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 Economic Recovery Act of 2008

24.9Announced on 7/30/2008. The CBO estimates that the Act will increase budget deficits by about $24.9 billion over the 2008 to2018 period.

Purchase of GSE Debt and Equity 25 Announced on 7/30/2008. Designed to shore up Fannie Mae and

Freddie Mac.

HOPE for Homeowners 300

Announced on 7/30/2008. This voluntary program encourages lenders to write down the loan balances of borrowers in exchangefor FHA-guaranteed loans up to 90 percent of the newly appraised home value. Program runs through September 2011.

7575



Conservatorship of Fannie Mae and Freddie Mac 200

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 Banks. Funding is provided directly by Treasury in 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.

Guaranty Program for Money Market Funds 50

Announced on 9/19/2008. To restore confidence in money market funds, Treasury made available up to $50 billion from the Exchange Stabilization Fund.

7676



IRS Notice 2008-83 ?

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 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.

Emergency Economic Stabilization Act

700

Announced on 10/3/2008. Empowers Treasury to use up to $700 billion to inject capital into financial institutions, to purchase or insure mortgage assets, and to purchase any other troubled assets necessary to promote financial market stability.

Troubled Assets Relief Program (TARP)

272.9

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: Capital Purchase Program (CPP), Automobile Industry Financing Program (AIFP), Targeted Investment Program (TIP), and Asset Guarantee Program (AGP). TARP also includes on initiative: providing $20 billion to support the Fed's Term Asset-Backed Securities Loan Facility



Capital Purchase Program (CPP)

192

Under CPP, Treasury was allowed to purchase up to $250 billion of senior preferred shares in selected banks. The first $125 billion was allocated to nine of the nation's largest financial institutions on October 28, 2008. As of January 23, 2009, $192 billion has been distributed to 296 institutions.

Automotive Industry Financing Program (AIFP)

20.9

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 also purchased $5 billion of senior preferred equity from GMAC. Additionally, Treasury agreed to lend up to $1 billion of TARP funds to GM so that GM can participate in a rights offering by GMAC in support of GMAC’s reorganization as a bank holding company. On 1/2/2009, Treasury 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.



Targeted Investment Program (TIP)

20

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 program are required to provide Treasury with warrants or alternative consideration as necessary. They also need to 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.

Asset Guarantee Program (AGP)

?

On 12/31/ 2008, Treasury transmitted to Congress a report that describes the Asset Guarantee Program (AGP). This program provides guarantees for assets held by systemically significant financial institutions that face a risk of losing market confidence due in large part to a portfolio of distressed or illiquid assets.

7979

Federal Deposit Insurance CorporationProgram Amount committed


Increase FDIC insurance coverage

? Announced on 10/3/2008. A provision of EESA temporarily raised the basic limit on federal deposit insurance coverage from $100,000 to $250,000 per depositor. Limits are scheduled to return to $100,000 after December 31, 2009.

Temporary Liquidity Guarantee Program (TLGP)

1465

Announced on 10/14/2008. Temporarily guarantees the senior debt of all FDIC-insured institutions and their holding companies, as well as deposits in non-interest 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 files for bankruptcy. This includes promissory notes, commercial paper, interbank funding, and any unsecured portion of secured debt. Coverage would be limited to June 30, 2012. On November 21, 2008, FDIC strengthened TLGP. Chief among the changes is that the debt guarantee will be triggered by 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)

8080

Treasury, Federal Deposit Insurance Corporation and Federal Reserve

Program Amount committed (US$ billions) Description

Guarantee a portion of an asset pool of loans and securities backed by residential and commercial real estate and other such assets on Citigroup's balance sheet

249.3

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 (90%) and Citigroup (10%). Treasury (via TARP) takes the second loss up to $5 billion, while FDIC takes the third loss up to $10 billion. The Federal Reserve funds 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.

Treasury, Federal Deposit Insurance Corporation and Federal Reserve

Program Amount committed (US$ billions) Description

Provide a package of guarantees, liquidity access, and capital to the Bank of America

138

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 assumed by BOA as a result of its acquisition of Merrill Lynch. The assets will remain on BOA’s balance sheet. As a fee for this arrangement, BOA will issue preferred shares to the Treasury and FDIC. In addition and 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 (US$ billions)

7524.929 The final tab for taxpayers will only become known once the crisis is over.

8282

XI. When will we hit bottom?

8383

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 to a downturn?

Yes 27%

No 73%

When will home prices hit bottom?

4%

17%

38%

29%

6%

1st half2008

2nd half2008

1st half2009

2nd half2009

1st half2010

Source: Wall Street Journal.

8484

How far do home prices have to fall?

Sources: Davisa, Lehnertb, Martin (2007), Milken Institute.

3.0

3.5

4.0

4.5

5.0

5.5

6.0

6.5

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

Q2 1971: 6.08%Annual rents as percent of home prices

Q4 2006: 3.48%

Q1 2008: 3.93%Average, 1960–Q1 2008: 5.04%

Average, 2000–Q1 2008: 4.06%

8585

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) Annual home price decline

-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% average 2024 Q3 2014 Q2 2010 Q4 2009 Q3 2009 Q1

Ren

t-to-

pric

e ra

tio

6.00% 2026 Q4 2017 Q3 2012 Q3 2010 Q4 2009 Q4

Annual home price decline required

Sources: Davisa, Lehnertb, Martin (2007), Milken Institute.

8686

0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007

US$/month

Payment with 100% LTVPayment with 90% LTVPayment with 80% LTV

Maximum affortablility limit is 38% of median household

Mortgage payment assumptions: Every month, a home is purchased at median price, buyer takes out a 30-year conforming, fixed-rate loan with 80% LTV. Payment also includes 1% property tax per year, 0.1% property insurance.

Alternative measures of the affordability of mortgage debt for California

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

8787

XII. What went wrong

8888

2,443

879

1,410

2,067

944886

0

500

1,000

1,500

2,000

2,500

3,000

Fannie Mae:total assets

Fannie Mae:total MBS

outstanding

Freddie Mac:total assets

Freddie Mac:total MBS

outstanding

Commercialbanks: total

residential realestate assets

Savingsinstitutions:

totalresidential realestate assets

US$ billions

The importance of Fannie Mae and Freddie Mac

Sources: Freddie Mac, Fannie Mae, FDIC, Milken Institute.

8989

Fannie Mae and Freddie Mac: Too big with too little capital?

Sources: Freddie Mac, Fannie Mae, Milken Institute.

133

1,022844 897

41

803 805 804

288

1,301

1,778

2,278

316

752

1,459

1,123

0

500

1,000

1,500

2,000

2,500

3,000

1990 2003 2006 Q3 2008 1990 2003 2006 Q3 2008

US$ billions

Total assets Total MBS outstanding

Fannie Mae Freddie Mac

9090

Fannie Mae and Freddie Mac are highly leveraged


60x 56x 48x 55x60x 58x 52x 57x64x 81x56x

167x185x

-66x

203x

-52x-100

-50

0

50

100

150

200

250

300

Core capital Fair value Core capital Fair value

2005 2006 2007 Q3 2008

Mortgage book of business over capital measures

Fannie Mae Freddie Mac

9191

Freddie Mac’s and Fannie Mae's retained private-label portfolios


Fannie Mae, Q3 2008

Fannie Mae, 2007

Fannie Mae, 2006

Fannie Mae, 2005

Freddie Mac, Q3 2008

Freddie Mac, 2007

Freddie Mac, 2006

Subprime Alt-A All others

46.3% 23.4% 30.3%

33.8% 34.3% 32.0%

46.4% 36.1% 17.5%

32.1% 37.4% 30.5%

41.7% 24.0% 34.3%

54.4% 25.0% 20.6%$224.6 billion

$218.9 billion

$86.9 billion

$97.3 billion

$94.8 billion

$191.5 billion

30.3% 33.4% 36.4%$85.7 billion

9292

9.1

9.8

9.4

31.6

23.7

21.5

67.9

Credit unions

Commercial banks

Savings institutions

Brokers/hedge funds

Federal Home Loan Banks

Fannie Mae

Freddie Mac

Leverage ratio, total assets/common equtity

Leverage ratios of different types of financial firms (June 2008)

Sources: Federal Deposit Insurance Corporation, Office of Federal Housing Enterprise Oversight, National Credit Union Administration, Bloomberg, Google Finance, Milken Institute.

9393

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


28

1922

26

18

27

19

31

2423

34 32 3331

2223

2824

22

0

5

10

15

20

25

30

35

40

Bear Stearns Merrill Lynch Morgan Stanley Lehman Brothers Goldman Sachs

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

n.a

June 2008

9494

Debt dependenceLeverage ratios at bank holding companies


13 13

17

13 1311

19

12 1311

1516

0

5

10

15

20

25

Citigroup Bank of America JP Morgan Chase

2000 2005 2007 Sept. 2008

Total assets/total shareholder equity

9595

Leverage vs. issuer rating


18

19

20

21

22

23

24

10 15 20 25 30 35Total assets/total equity capital

Fitch long term issuer default rating

Citigroup

JP Morgan

Bank of America

Lehman Brothers

Morgan Stanley

Bear Stearns

Merrill Lynch

Morgan Stanley

Goldman Sachs

Merrill Lynch

Merrill Lynch

● 2000 ● 2005 ● 2007AAA

AA+

AA

AA-

A+

A

A-

9696

Leverage vs. issuer 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-

9797

AAA

AA+

AA

AA-

A+

A

A-

CDS premiums vs. issuer rating

Sources: Datastream, Milken Institute.

0 10 20 30 40 50 60 70 80 90Average CDS premium, basis points


Citigroup

JPMorgan

Bank of America

Lehman BrothersBear Stearns

Morgan Stanley

Goldman Sachs

Merrill Lynch

● 2004 ● 2005 ● 2007

Lehman Brothers

Merrill Lynch

9898

Credit default swap premiumsbasis points

Sources:Datastream, Milken Institute.

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

Leverage vs. CDS premiums

Sources: Datastream, Bloomberg, Milken Institute.

0

20

40

60

80

100

10 15 20 25 30 35Total assets/total equity capital

Average CDS premium, basis points

JP Morgan

Bank of America

Morgan Stanley

Bear Stearns

Merrill LynchGoldman Sachs

● 2004 ● 2005 ● 2007

Lehman Brothers

Bear StearnsLehman Brothers

Merrill LynchCitigroup

Morgan Stanley

Leverage vs. CDS premium

Sources: Datastream, Bloomberg, Milken Institute.


Average CDS premiumbasis 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

101101

Credit default swap premiums for large banks

Sources: Datastream, Milken Institute.

0

100

200

300

400

500

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

JP Morgan ChaseWells FargoBank of AmericaCitigroup

Credit default swap premium, basis points

102102

Standard & Poor’s ratingsNew issues: 1/1/2000 to 9/30/2008


Investment-grade securities

AAA 16,907

AA+ 240

AA 2,098

AA- 3,414

A+ 2,623

A 2,602

A- 2,027

BBB+ 903

BBB 1,371

BBB- 1,359

Non-investment-grade securitiesBB+ 238BB 313BB- 331B+ 339B 330B- 1,189CCC+ 293CCC 214CCC- 104CC 36C 11D 303

103103

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

S&P Total Downgraded Downgraded as 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.

104104

15

38

63

76

17

50

71

84

24

66

8794

0

10

20

30

40

50

60

70

80

90

100

AAA AA(+/-) A(+/-) BBB(+/-)

S&PMoody’sFitch

Percent downgraded

Subprime mortgage-backed securities downgrades

2005–2007 issuance

S&P Rating

Number of companies

CDS spread

Highest Lowest Average

AAA 3 56 15 41

AA+ 1 95 95 95AA 5 86 49 74AA- 9 265 54 118A+ 17 2,999 12 346A 36 1,040 38 151A- 34 2,557 51 427

BBB+ 43 1,114 38 222

BBB 41 1,210 61 271BBB- 17 1,235 89 359

Investment grade S&P 500 companies’ credit ratings and

associated CDS spreads

Note: As of October 17, 2008.Sources: S&P, Datastream, Milken Institute.

105105

Credit ratings of selected S&P 500 companies and associated CDS spreads as of October 17, 2008

S&P's Number of companies

CDS spreads (basis points)S&P's Number of

companiesCDS spreads (basis points)

Highest Lowest Average Highest Lowest AverageAAA 3 56 15 41 BB+ 12 795 130 419AA+ 1 95 95 95 BB 14 938 168 522AA 5 86 49 74 BB- 8 1,352 337 713AA- 9 265 54 118 B+ 4 3,925 418 1,612A+ 17 2,999 12 346 B 3 2,686 894 1,523A 36 1,040 38 151 B- 2 4,718 3,701 4,209A- 34 2,557 51 427

BBB+ 43 1,114 38 222BBB 41 1,210 61 271BBB- 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.

Speculative gradeInvestment grade

106106

When is a AAA not a AAA?Multilayered mortgage products

Sources: International Monetary Fund, Milken Institute.

Origination ofmortgage loans High-grade CDO

Senior AAA 88%Junior AAA 5%

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

BBB 1%Unrated 1%

Mortgage bonds

AAA 80%AA 11%A 4% Mezzanine CDO

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

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

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

Unrated 2%

107107

Dollar losses in reported cases of mortgage fraud

US$ millions

293225

429

1,014946

813

0

200

400

600

800

1,000

1,200

2002 2003 2004 2005 2006 2007

Mortgage loan fraud surges

Sources: Financial Crimes Enforcement Network, Federal Bureau of Investigation, Milken Institute.

1.7

2.3 2.9 3.5 4.7 5.49.5

18.4

26.0

37.3

52.9

0

10

20

30

40

50

60

1997 1999 2001 2003 2005 2007

Number of cases reported, thousands

1.7

2.3 2.9 3.5 4.7 5.49.5

18.4

26.0

37.3

52.9

0

10

20

30

40

50

60

1997 1999 2001 2003 2005 2007

Number of cases reported, thousands

108108

Is adequate information disclosed to consumers?

Sources: Federal Trade Commission, Milken Institute.

20202123

303233

3751

6874

7984

8795

APR amountCash due at closing amount

Monthly payment (including whether it includes taxes and insurance)Settlement charges amount

Balloon payment (presence and amount)Interest rate amount

Whether loan amount included finances settlement chargesWhich loan was less expensive

Loan amountPresence of prepayment penalty for refinance in two years

Presence of charges for optional credit insuranceReason why the interest rate and APR sometimes differProperty tax and homeowner’s insurance cost amount

Total up-front cost amountPrepayment penalty amount

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

109109

Drivers of foreclosures:Strong appreciation or weak economies?

Sources: U.S. Treasury Department, RealtyTrac, Office of Federal Housing Enterprise Oversight, Milken Institute.

0

5

10

15

20

25

-20 0 20 40 60 80 100 120 140

Five-year price gain, Q3 2002–Q3 2007 (percent)

Detroit

MiamiBakersfield

Riverside

Fresno

Fort Lauderdale

Orlando

Phoenix

Las Vegas

Palm Beach

Tampa

Stockton

San Diego

Oakland

Sacramento

Atlanta

MemphisColumbus

Indianapolis

ToledoDaytonDenver

Cleveland

Akron

Warren

Weak economies Housing bubbles

Foreclosures per 1,000 homes

National average

110110

After housing bubble burst in 2007: Foreclosures highest for areas with biggest price declines

Sources: RealtyTrac, Office of Federal Housing Enterprise Oversight, Milken Institute.

0

5

10

15

20

25

30

35

40

45

-30 -25 -20 -15 -10 -5 0 5

Price change, 2007–June 2008 (percent, annualized)

Weak economies strengthenStockton

Miami

Orlando

Bakersfield

Phoenix

RiversideLas Vegas

Fort Lauderdale

Fresno

SacramentoOakland

San DiegoDetroit

Warren ClevelandDayton

Columbus Indianapolis

Palm BeachTampa

ToledoAkron

Denver

Atlanta

Memphis

Foreclosures per 1,000 homes

National average

Collaping housing bubbles

111111

XIII. Policy lessons from the current crisis and proposals for reform in

regulatory oversight

112112

Balance sheet information on FDIC-insured institutions

Sources: FDIC, Milken Institute.

Cash-to-asset ratio (left axis)

Borrowed funds-to-asset ratio (left axis)

Deposits-to-asset ratio (right axis)

Equity capital-to-asset ratio (right axis)

Insured deposits-to-asset ratio (right axis)

0

2

4

6

8

10

12

14

16

18

20

1992 1994 1996 1998 2000 2002 2004 2006 Q3 20080

10

20

30

40

50

60

70

80

90Percent Percent

113113

U.S. regulatory capital requirements and prompt corrective action categories

Tier 1leverage

Tier 1 risk-based Total risk-based

Well capitalized >= 5% and >= 6% and >= 10%

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

Undercapitalized < 4% or < 4% or < 8%

Significantly undercapitalized < 3% or < 3% or < 6%

Critically undercapitalized Tangible equity capital ratio that is <= 2%

Source: FDIC.

114114

Selected information for U.S. banks December 31, 2008

$US billions Percent

Name Total assets

Total equity

Market capitalization

(Jan. 30, 2009)

Deposits to total assets

Long-term borrowing

to total assets

Short-term borrowing to total assets

Cash/total 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


115115

Selected information for U.S. banksDecember 31, 2008

Regulatory capital ratios Alternative capital adequacy assessment

Name

Total risk-based capital ratio

Tier 1 risk-based

capital ratio

Tangible equity capital ratio

Equity to total

assets ratio

Tangible common

equity ratio

Credit rating

Moody's issuer

S&P 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-Sources: Bloomberg, Milken Institute.

116116

Equity capital-asset ratio for commercial banks

Sources: Historical Statistics of the United States, FDIC, Milken Institute.

0

5

10

15

20

25

30

1896 1905 1914 1923 1932 1941 1950 1959 1968 1977 1986 1995 2004

Equity capital/asset ratio, percent

Average, 1896 - Q3 2008: 10.9%

1945: 5.5% 1979: 5.8%

1932: 16.2% Q3 2008: 9.7%

1896: 28.1%

117117

Leverage ratio for commercial banks

Sources: Historical Statistics of the United States, FDIC, Milken Institute.Note: The leverage ratio is the reciprocal of the capital-asset ratio.

0

2

4

6

810

12

14

16

18

20

1896 1905 1914 1923 1932 1941 1950 1959 1968 1977 1986 1995 2004

Asset/equity capital ratio

Average, 1896 - Q3 2008: 11.0x

1945: 18.2x 1979: 17.4x

1932: 6.2xQ3 2008: 10.3x

1896: 3.6x

Reserve coverage ratio ofall FDIC-insured institutions

Sources: Quarterly Banking Profile, FDIC, Milken Institute .

020406080

100120140160180200

03/2005 09/2005 03/2006 09/2006 03/2007 09/2007 03/2008 09/2008020406080100120140160180200

US$ billions Percent

Noncurrent loans (left axis)

Loan-loss reserves (left axis)

Coverage ratio (right axis)

119119

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

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

National banks State commercial and savings banks

Federal savings banks

Insurance companies

Securities brokers/dealers

Other financial companies, including mortgage

companies and brokers

• Fed• OTS

• OCC• FDIC

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

• OTS• FDIC

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

• FINRA• SEC• CFTC• State securities regulators

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

• OCC• Host county regulator

• Fed• Host county regulator

• OTS• Host county regulator

Federal branch

Foreign branch

Limited foreign branch

Fed is the umbrella or consolidated regulator

Primary/secondaryfunctionalregulator

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

• Federal Housing Finance Agency

Fannie Mae, Freddie Mac, and Federal Home Loan Banks

Financial, bank and thrift holding companies

Justice Department• Assesses effects of mergers and acquisitions on competition

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

120120

Countries with the Central Bank as a supervisory authority Income

level Central bank only

(75 countries)

Central bank among multiple

supervisors (7 countries)

Central bank not a supervisory authority

(52 countries)

Anguilla Estonia Israel Montserrat Slovenia Netherlands South Korea Australia Denmark Isle of Man Norway

Antigua and

Barbuda Germany Italy New

Zealand Spain Saudi Arabia United States Bahrain Finland Japan Sweden

Austria Greece Kuwait Portugal Taiwan, China Belgium France Luxembourg Switzerland

Cyprus Hong Kong, China Liechtenstein Singapore Trinidad &

Tobago Canada Iceland Macau, China United Kingdom

High income

Czech Republic Cayman

Islands Ireland Malta

Argentina Bulgaria Lithuania Russia St. Kitts and Nevis Malaysia Chile Gabon Latvia Panama

Belize Croatia Mauritius Seychelles St. Lucia Costa Rica Hungary Lebanon Poland

Botswana Dominica Oman Slovak Republic

St. Vincent and the

Grenadines Equatorial

Guinea Kazakhstan Mexico

Brazil Grenada Romania South Africa Uruguay

Upper middle income

Algeria

Angola Egypt Jamaica Maldives Sri Lanka Bolivia China Dominican Republic Honduras

Armenia Fiji Jordan Moldova Suriname Bosnia and Herzegovina Colombia El Salvador Nicaragua

Belarus Guyana Lesotho Morocco Syrian Cameroon Congo Guatemala Peru

Lower middle income

Bhutan Indonesia Macedonia, FYR Philippines Thailand

Bangladesh Ghana Kyrgyz Republic Tajikistan Pakistan Nigeria Zimbabwe Benin Chad Mali Senegal

Burundi India Malawi Tanzania Uganda Burkina Faso Côte d'Ivoire Niger Togo Low income

Ethiopia Kenya Mozambique Central African Republic

Guinea-Bissau

121121

Countries with single vs. multiple supervisory authorities Income

level Single supervisor

(127 countries) Multiple supervisors

(7 countries) Anguilla Cyprus Hong Kong,

China Liechtenstein Singapore Netherlands Saudi Arabia

Antigua and Barbuda Czech Republic Iceland Luxembourg Slovenia South Korea United States Australia Denmark Ireland Macau, China Spain Austria Estonia Isle of Man Malta Switzerland Bahrain Finland Israel Montserrat Taiwan, China Belgium France Italy New Zealand Trinidad & Tobago Canada Germany Japan Norway United Kingdom

High income

Cayman Islands Greece Kuwait Portugal Sweden Argentina Costa Rica Grenada Lithuania Seychelles Malaysia

Belize Croatia Hungary Mauritius Slovak Republic Botswana Dominica Kazakhstan Mexico St. Kitts and Nevis

Brazil Equatorial Guinea Latvia Oman St. Lucia Bulgaria Romania Lebanon Poland St. Vincent and the Grenadines

Chile Gabon South Africa Russia Uruguay

Upper middle income

Panama

Guatemala Bosnia and Herzegovina Egypt Lesotho Peru

Algeria Cameroon El Salvador Macedonia, FYR Philippines

Angola China Fiji Maldives Sri Lanka Armenia Colombia Guyana Moldova Suriname Belarus Jordan Honduras Morocco Syrian Bhutan Congo Indonesia Nicaragua Thailand

Lower middle income

Bolivia Dominican Republic Jamaica

Bangladesh Chad India Pakistan Togo Nigeria Zimbabwe Benin Côte d'Ivoire Kenya Senegal Uganda

Burkina Faso Ethiopia Kyrgyz Republic Tajikistan Mali Burundi Ghana Malawi Tanzania Niger

Low income

Central African Republic Guinea-Bissau Mozambique

122122

Scope of supervisory authority for countries Income

level Only banks

(96 countries) All of the main financial institutions

(38 countries) Anguilla Greece Luxembourg Slovenia Australia Denmark Japan Singapore

Antigua and Barbuda Hong Kong, China Montserrat South Korea Austria Estonia Liechtenstein Sweden

Canada Isle of Man Netherlands Spain Bahrain Germany Macau, China Taiwan, China

Cyprus Israel New Zealand Switzerland Belgium Iceland Malta Trinidad & Tobago

Finland Italy Portugal United States Cayman Islands Ireland Norway United Kingdom

High income

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

Brazil Gabon Panama St. Kitts and Nevis Bulgaria Grenada Poland St. Lucia

Chile Lebanon Romania St. Vincent and the Grenadines

Upper middle income

Costa Rica Lithuania Russia Algeria Congo Jamaica Sri Lanka Armenia Colombia Honduras Nicaragua

Angola Dominican Republic Jordan Suriname Bhutan Fiji Lesotho Peru

Belarus Egypt Macedonia, FYR Syrian Bosnia and

Herzegovina Guatemala Maldives

Bolivia El Salvador Moldova Thailand Cameroon Guyana Morocco

Lower middle income

China Indonesia Philippines

Bangladesh Côte d'Ivoire Kyrgyz Republic Senegal Malawi

Benin Ethiopia Mali Tajikistan Burkina Faso Ghana Mozambique Tanzania

Burundi Guinea-Bissau Niger Togo Central African

Republic India Nigeria Uganda

Low income

Chad Kenya Pakistan Zimbabwe

Documents

Leverage and Risk of Financial Institutionswebhome.auburn.edu/~barthjr/papers/Barth_Amsterdam_Final Slides_Feb 2009.pdfNational FICO scores display wide distribution What goes into