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Housing Market Pain to Come

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Housing Market Pain to Come Powered By Docstoc
					An Overview Of The Housing/Credit Crisis And Why There Is More Pain To Come
T2 Accredited Fund, LP Tilson Offshore Fund, Ltd. T2 Qualified Fund, LP May 19, 2009

T2 Partners Management L.P. Is A Registered Investment Advisor
145 E. 57th Street 10th Floor New York, NY 10022 (212) 386-7160 Info@T2PartnersLLC.com www.T2PartnersLLC.com

For more information…

3

More Mortgage Meltdown Is Now Available

4

The Next Value Investing Congress is October 19-20 in New York City

5

Value Investor Insight and SuperInvestor Insight

6

For the Second Half of the 20th Century, Housing Was a Stable Investment
300 Shiller Lawler 275 Real Home Price Index (1890=100) 250 225 200 175

Trend Line
150 125 100

0

4

8

2

6

0

4

8

2

6

0

4 19 9

19 5

19 5

19 5

19 6

19 6

19 7

19 7

19 8

19 7

19 8

19 9

Source: Robert J. Shiller, Irrational Exuberance, Princeton University Press 2000, Broadway Books 2001, 2nd edition, 2005, also Subprime Solution, 2008, as updated by the author at http://www.econ.yale.edu/~shiller/data.htm; Lawler Economic & Housing Consulting 7

19 9

8

…And Then Housing Prices Exploded

300 Shiller Lawler 275 Real Home Price Index (1890=100) 250 225 200 175

Housing Bubble Trend Line

150 125 100
66 74 86 94 02 20 0 8 82 90 8 54 19 62 19 70 19 98 19 5 19 7 19 5 20 0 19 19 19 19 19 19 19 6

SOURCES: Robert J. Shiller, Irrational Exuberance: Second Edition, as updated by the author; Lawler Economic & Housing Consulting. 8

From 2000-2006, the Borrowing Power of a Typical Home Purchaser Nearly Tripled
$400,000 Pre-Tax Income Borrowing Power

$300,000

$200,000

9.2x in January 2006

$100,000

3.3x in January 2000
$0 Jan-95

Jan-96

Jan-97

Jan-98

Jan-99

Jan-00

Jan-01

Jan-02

Jan-03

Jan-04

Jan-05

Jan-06

Jan-07

Jan-08

Factors contributing to the ability to borrow more and more were: 1. Slowly rising income 2. Lenders being willing to allow much higher debt-to-income ratios 3. Falling interest rates 4. Interest-only mortgages (vs. full amortizing) 5. No money down
Source: Amherst Securities 9

Housing Became Unaffordable in Many Areas
80 70 60 50 40 30 20 10 0
20 02 20 0 20 04 20 05 99 97 00 98 96 06 19 19 19 19 20 20 20 Q 3 07 1

Riverside, CA Los Angeles, CA San Diego, CA

Housing Opportunity Index

1

Q 1

Q 1

Q 1

Q 1

Q 1

Q 1

3

Q

3

SOURCES: NAHB/Wells Fargo Housing Opportunity Index, which measures percentage of households that could afford the average home with a standard mortgage

Q

Q

Q

3

10

Americans Have Borrowed Heavily Against Their Homes Such That the Percentage of Equity in Their Homes Has Fallen Below 50% for the First Time on Record Since 1945

$12,000

90% 80%

$10,000 70% Equity as a % of Home Value $8,000 Mortgage Debt (Bn) 1945 Mortgage Debt: $18.6 billion Equity: $97.5 billion 60% 50% 2008 Mortgage Debt: $10.5 trillion Equity: $8.5 trillion 40% 30% 20% $2,000 10% $0 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
SOURCE: Federal Reserve Flow of Fund Accounts of the United States 11

$6,000

$4,000

0%

There Was a Dramatic Decline in Mortgage Lending Standards from 2001 through 2006
Combined Loan to Value
86 84 84 83 82

100% Financing
18% 17% 16%

81

81

14%

14%

Combined Loan to Value (%)

80

12% Percent of Originations

78 76 76 74 74 74

10% 9% 8% 8%

6%

• In 2005, 29% of new mortgages were interest only — or less, in the case of Option ARMs — vs. 1% in 2001 • In 1989, the average down payment for firsttime home buyers was 10%; by 2007, it was 2% • The sale of new homes costing $750,000 or more quadrupled from 2002 to 2006. The construction of inexpensive homes costing $125,000 or less fell by two-thirds
12

72

4%

3%

70

2% 1% 1%

68 2001 2002 2003 2004 2005 2006 2007

0% 2001 2002 2003 2004 2005 2006 2007

Limited Documentation
70% 65% 63% 60% 56%

100% Financing & Limited Doc
12% 11% 10%

50% 45% Percent of Originations

49%

8% Percent of Originations

8%

40% 33% 30%

39%

6% 5% 4% 4%

20%

2%
10%

1%

0%
0% 2001 2002 2003 2004 2005 2006 2007

0%

0% 2001 2002 2003 2004 2005 2006 2007

SOURCES: Amherst Securities, LoanPerformance; USA Today (www.usatoday.com/money/economy/housing/2008-12-12-homeprices_N.htm)

Among the Many Causes of The Great Mortgage Bubble, Two Stand Out
• The companies making crazy loans didn’t care very much if the homeowner ended up defaulting for two reasons:
1. Either they didn’t plan to hold the loan, but instead intended to pass it along to Wall Street, which would bundle, slice-and-dice it and sell it (along with any subsequent losses) to investors around the world; 2. Or, if they did plan to hold the loan, they assumed home prices would keep rising, such that homeowners could either refinance before loans reset or, if the homeowner defaulted, the losses (i.e., severity) would be minimal.

•

There were many other reasons, of course – a bubble of this magnitude requires what Charlie Munger calls “Lollapalooza Effects”
– – The entire system – real estate agents, appraisers, mortgage lenders, banks, Wall St. firms and ratings agencies – became corrupted by the vast amounts of quick money to be made Regulators and politicians were blinded by free market ideology or the dream that all Americans should own their homes, causing them to fall asleep at the switch, not want to take the punch bowl away and/or get bought off by the industries they were supposed to be overseeing Debt became increasingly available and acceptable in our culture Millions of Americans became greedy speculators and/or took on too much debt Greenspan kept interest rates too low for too long Institutional investors stretched for yield, didn’t ask many questions and took on too much leverage In general, everyone was suffering from irrational exuberance

– – – – –

13

As Long As Home Prices Rise Rapidly, Even Subprime Mortgages Perform Well – But If Home Prices Fall, Look Out Below!
60%

Cumulative Five-Year Loss Estimates for a Bubble-Era Pool of Subprime Mortgages

50%

40% Cumulative Loss (%)

30%

20%

10%

0% 20% 15% 10% 5% 0% -5% -10% -15% -20% -25% -30% -35% -40% Home Price Appreciation

Source: T2 Partners estimates 14

Deregulation of the Financial Sector Led to a Surge of Leverage, Profits and Compensation
Ratio of Financial Services Wages to Nonfarm Private-Sector Wages, 1910-2006

• Among the most profitable areas for Wall Street firms was producing Asset-Backed Securities (ABSs) and Collateralized Debt Obligations (CDOs) • To produce ABSs and CDOs, Wall Street needed a lot of loan “product” • Mortgages were a quick, easy, big source • It is easy to generate higher and higher volumes of mortgage loans: simply lend at higher loan-to-value ratios, with ultra-low teaser rates, to uncreditworthy borrowers, and don’t bother to verify their income and assets (thereby inviting fraud) • There’s only one problem: DON’T EXPECT TO BE REPAID!
Source: Ariell Reshef, University of Virginia; Thomas Philippon, NYU; Wall St. Journal, 5/14/09 15

Over the Past 30 Years, We Have Become a Nation Gorged in Debt – To The Benefit of Financial Services Firms
3.0%
Financial Profits as Percent of GDP

Low Debt Era

Rising Debt Era

350%

2.5% 2.0%

Total Debt as Percent of GDP

300%

250% 1.5%

Total Debt Financial Profits
200%

1.0% 0.5% 0.0% Dec- 51 54 57 60 63 66 69 72 75 78 81 84 87 90 93 96 99 02 05 150%

100%

Sources: Federal Reserve, BEA, as of Q2 2007, GMO presentation 16

There Was a Surge of Toxic Mortgages Over the Past 10 Years
$4,000 Conforming, FHA/VA Jumbo Alt-A Subprime Seconds

$3,500

$3,000

Originations (Bn)

$2,500

$2,000

$1,500

$1,000

$500

$0 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

SOURCE: Inside Mortgage Finance, published by Inside Mortgage Finance Publications, Inc. Copyright 2009. 17

Private Label Mortgages (Those Securitized by Wall St.) Are 15% of All Mortgages, But Are 51% of Seriously Delinquent Mortgages
Number of Seriously Delinquent Mortgages (000)
Banks & Thrifts 397 Fannie Mae 444 Freddie Mac 232

Number of Mortgages (million)
Banks & Thrifts 8 Fannie Mae 18

15%

Private Label 8

Ginne Mae/FHA 378

Ginne Mae/FHA 6 Freddie Mac 13

Private Label 1734

51%
Approximately two-thirds of homes have mortgages and of these, 56% are owned or guaranteed by the two government-sponsored enterprises (GSEs), Fannie & Freddie
SOURCE: Freddie Mac, Q4 2008. 18

Percentage of Home Loans 0.0% 1.0% 2.0% 3.0% 4.0% 5.0% 6.0% 7.0% 8.0%
Q 4 Q 19 4 79 Q 198 4 0 Q 198 4 1 Q 19 4 82 Q 19 4 83 Q 198 4 4 Q 198 4 5 Q 198 4 6 Q 19 4 87 Q 198 4 8 Q 198 4 9 Q 19 4 90 Q 19 4 91 Q 199 4 2 Q 199 4 3 Q 19 4 94 Q 19 4 95 Q 199 4 6 Q 199 4 7 Q 19 4 98 Q 19 4 99 Q 200 4 0 Q 200 4 1 Q 200 4 2 Q 20 4 03 Q 200 4 4 Q 200 4 5 Q 200 4 6 Q 20 4 07 20 08

Nearly 8% of Mortgages on 1-to-4-Family Homes Were Delinquent or in Foreclosure as of Q4 2008

SOURCE: National Delinquency Survey, Mortgage Bankers Association. Note: Delinquencies (60+ days) are seasonally adjusted. 19

All Types of Loans, Led by Subprime, Are Seeing a Surge in Delinquencies
45% 40% 35% 30% 25% 20% 15% 10% 5% 0%
19 Q 99 3 19 Q 99 1 20 Q 00 3 20 Q 00 1 20 Q 01 3 20 Q 01 1 20 Q 02 3 20 Q 02 1 20 Q 03 3 20 Q 03 1 20 Q 04 3 20 Q 04 1 20 Q 05 3 20 Q 05 1 20 Q 06 3 20 Q 06 1 20 Q 07 3 20 Q 07 1 20 Q 08 3 20 08

Alt A Option ARM Jumbo Subprime Prime Home Equity Lines of Credit

Percent Noncurrent

SOURCES: Amherst Securities, LoanPerformance; National Delinquency Survey, Mortgage Bankers Association; FDIC Quarterly Banking Profile; T2 Partners estimates. Note: Prime is seasonally adjusted.

Q 1

20

The Decline in Lending Standards Led to a Surge in Subprime Mortgage Origination
$700 25%

$600 20% 20% 18% $500 Origina tions (Bn) 15% $400 20% % of T ota l

$300 10% 10% 9% 9% 9% 10% 10% 8% $200 7% 7% 8% 10%

5% $100

$0 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

0%

Source: Reprinted with permission; Inside Mortgage Finance, published by Inside Mortgage Finance Publications, Inc. Copyright 2009.

21

The Wave of Resets from Subprime Loans Is Mostly Behind Us
$35

$30

We are here

$25 Loans with Payment Shock (Bn)

$20

$15

$10

$5

$0
Ja n07 A pr -0 7 Ja n06 A pr -0 6 Ja n10 A pr -1 0 O ct -0 8 Ja n09 Ap r09 Ju l-0 7 O ct -0 7 Ja n08 Ju l-0 6 O ct -0 6 Ap r-0 8 Ju l-0 8 Ju l-0 9 O ct -0 9 Ju l-1 0 O ct -1 0

Sources: LoanPerformance, Deutsche Bank; slide from Pershing Square presentation, How to Save the Bond Insurers, 11/28/07.

22

Numerous Areas of the Mortgage Market Will Suffer Significant Losses Going Forward

Prime Mortgage Commercial Real Estate Alt-A Other Corporate Commercial & Industrial Subprime High-Yield / Leveraged Loans Jumbo Prime Home Equity Credit Card Auto Option ARM Construction & Development Other Consumer CDO/ CLO

$0.0

$0.5

$1.0

$1.5

$2.0

$2.5

$3.0

$3.5

$4.0

$4.5

$5.0

Amount Outstanding (Trillions)
SOURCES: Federal Reserve Flow of Funds Accounts of the United States, IMF Global Financial Stability Report October 2008, Goldman Sachs Global Economics Paper No. 177, FDIC Quarterly Banking Profile, OFHEO, S&P Leverage Commentary & Data, T2 Partners estimates.

23

There Are $2.4 Trillion of Alt-A Mortgages and Their Resets Are Mostly Ahead of Us
$300 $10

We are here

$9 $250 Estimated Cumulative Reset Amount (Bn) $8 $7

$200

Amount (Bn)

$6 $150 $5 $4 $100 $3 $2 $1 $0 $0

$50

0

2

4

n10

n12

n13

n15 Ja

l- 1 1

l-1 3

Ja n11

n14

l-1

l-1

Ju

l-1

Ju

Ju

Ju

Ju

SOURCES: Credit Suisse, LoanPerformance. NOTE: This chart only shows resets for a small fraction of Alt-A loans, but is representative of all of them. 24

Ja

Ja

Ja

Ja

Ju

l-1 5

Percent Noncurrent (60+ days)
n99 Ju l-9 Ja 9 n0 Ju 0 l-0 Ja 0 n01 Ju l-0 Ja 1 n0 Ju 2 l-0 Ja 2 n03 Ju l-0 Ja 3 n0 Ju 4 l-0 Ja 4 n05 Ju l-0 Ja 5 n0 Ju 6 l-0 Ja 6 n07 Ju l-0 Ja 7 n0 Ju 8 l-0 Ja 8 n09 Ja

10%

15%

20%

25%

0%

5%

Delinquencies of Securitized Alt-A Mortgages Are Soaring

SOURCES: Amherst Securities, LoanPerformance. 25

Alt-A Delinquencies By Vintage Show the Collapse in Lending Standards in 2006 and 2007
30% 2007 25% Percent Noncurrent (60+ days) 2006

20%

15% 2005 10% 2004 5%

2003

0% 0 5 10 15 20 25 30 35 40 45 50 55 60 Months of Seasoning
SOURCES: Amherst Securities, LoanPerformance. 26

A Primer on Option ARMs
• • • An Option ARM is an adjustable rate mortgage typically made to a prime borrower Sold under various names such as “Pick-A-Pay” Banks typically relied on the appraised value of the home and the borrower’s high FICO score, so 83% of Option ARMs written in 2004-2007 were low- or no-doc (liar’s loans) Each month, the borrower can choose to pay: 1) the fully amortizing interest and principal; 2) full interest; or 3) an ultra-low teaser interest-only rate (typically 2-3%), in which case the unpaid interest is added to the balance of the mortgage (meaning it is negatively amortizing) Approximately 80% of Option ARMs are negatively amortizing Lenders, however, booked earnings as if the borrowers were making full interest payments A typical Option ARM is a 30- or 40-year mortgage that resets (“recasts”) after five years, when it becomes fully amortizing If an Option ARM negatively amortizes to 110-125% of the original balance (depending on the terms of the loan), this triggers a reset even if five years have not elapsed Upon reset, the average monthly payment jump 63% from $1,672 to $2,725 ($32,700 annually) ‘My sense is that many option ARM borrowers are in a worse position than subprime borrowers,’ says Kevin Stein, associate director of the California Reinvestment Coalition, which combats predatory lending. ‘They wind up owing more and the resets are more significant.’

•

• • • • • •

27

About $750 Billion of Option ARMs Were Written, Nearly All at the Peak of the Bubble
$300 9% 8% $250 8% 7% $200 Originations (Bn) 5% $150 5% 4% $100 3% 2% $50 1% $0 2004 2005 2006 2007 2008 1% 0% 6% Percent of Total
28

9%

5%

SOURCES: 2008 Mortgage Market Statistical Annual, published by Inside Mortgage Finance Publications, Inc. Copyright 2008. T2 Partners estimates.

Options ARMs Were a Bubble State Phenomenon

Other 25%

Arizona 3% Nevada 3%

California 58%

Florida 10%

SOURCES: Amherst Securities, LoanPerformance. 29

Beginning in March 2005, High-FICO-Score Borrowers Opted for an Above-Market-Rate Option ARM in Exchange for the Low Teaser Rate
8.5 Fannie Mae 30 Year FRM Index Option ARM Index 8.0

7.5

7.0 Interest Rate (%)

Nearly all option ARM borrowers during this period (when nearly all option ARMS were written) can’t afford a fullyamortizing mortgage – otherwise they would have taken one

6.5

6.0

5.5

5.0

4.5

4.0

SOURCE: Amherst Securities, BloombergFinance, L.P. 30

Ja n02 A pr -0 2 Ju l-0 2 O ct -0 2 Ja n03 A pr -0 3 Ju l-0 3 O ct -0 3 Ja n04 Ap r-0 4 Ju l-0 4 O ct -0 4 Ja n05 A pr -0 5 Ju l-0 5 O ct -0 5 Ja n06 A pr -0 6 Ju l-0 6 O ct -0 6 Ja n07 A pr -0 7 Ju l-0 7 O ct -0 7 Ja n08

Percent Noncurrent (60+ days)
n99 Ju l-9 Ja 9 n0 Ju 0 l-0 Ja 0 n01 Ju l-0 Ja 1 n02 Ju l-0 Ja 2 n03 Ju l-0 Ja 3 n04 Ju l-0 Ja 4 n05 Ju l-0 Ja 5 n06 Ju l-0 Ja 6 n07 Ju l-0 Ja 7 n08 Ju l-0 Ja 8 n09 Ja

10%

15%

20%

25%

30%

35%

0%

5%

Delinquencies of Securitized Option ARMs Are Soaring

SOURCES: Amherst Securities, LoanPerformance, T2 Partners estimates. 31

Option ARM Delinquencies By Vintage Show the Collapse in Lending Standards in 2005-2007

45%

40%

2006

35%

Percent Noncurrent (60+ days)

30%

2007 2005

25%

20%

2004
15% 10%

2003

5%

0% 0 5 10 15 20 25 30 35 40 45 50 55 60 Months of Seasoning

SOURCE: Amherst Securities, LoanPerformance. 32

Percent Noncurrent (60+ days) 0.0% 0.5% 1.0% 1.5% 2.0% 2.5% 3.0% 3.5% 4.0%
n99 Ju l-9 Ja 9 n0 Ju 0 l-0 Ja 0 n01 Ju l-0 Ja 1 n02 Ju l-0 Ja 2 n03 Ju l-0 Ja 3 n04 Ju l-0 Ja 4 n05 Ju l-0 Ja 5 n06 Ju l-0 Ja 6 n07 Ju l-0 Ja 7 n08 Ju l-0 Ja 8 n09 Ja

Delinquencies of Securitized Jumbo Prime Mortgages Are Soaring

SOURCES: Amherst Securities, LoanPerformance. 33

Percent Noncurrent (60+ days)
Q 1

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

4.5%

5.0%

Delinquencies of Prime Mortgages Are Soaring

SOURCE: Mortgage Bankers Association National Delinquency Survey.

19 Q 99 3 19 Q 99 1 20 Q 00 3 20 Q 00 1 20 Q 01 3 20 Q 01 1 20 Q 02 3 20 Q 02 1 20 Q 03 3 20 Q 03 1 20 Q 04 3 20 Q 04 1 20 Q 05 3 20 Q 05 1 20 Q 06 3 20 Q 06 1 20 Q 07 3 20 Q 07 1 20 Q 08 3 20 08

34

HELOCs and Home Equity Loans Soared in Popularity During the Bubble
$1,000 Closed-End Junior Lien Mortgages $900 $800 $700 Amount (Bn) $600 $500 $400 $300 $200 $100 $0
20 03 05 06 20 02 00 01 20 0 07 20 20 20 20 20 20 Q 1 08 4 Q 1 Q 1

Home Equity Lines of Credit

1

Q 1

Q 1

Q 1

Note: Does not include approximately $200 billion of securitized HELOCs and junior liens. SOURCE: FDIC Quarterly Banking Profile. 35

Q 1

Q

Q 1

Many Borrowers Used HELOCs to Buy New Cars
• • As home prices have declined and other funding sources have dried up, millions of consumers have maxed out on home equity debt. In hot markets like California and Florida, a significant percentage of all consumers tapped into the value of their homes to help finance their new cars, according to CNW Marketing Research.

•

Clearly this dynamic does not bode well for HELOC recovery rates or new car sales.
36

SOURCE: New York Times 5/27/2008.

Delinquencies of HELOCs and CESs Are Soaring
3.0% Closed-End Junior Lien Mortgages Home Equity Lines of Credit 2.5% Percent Noncurrent (90+ days)

2.0%

1.5%

1.0%

0.5%

0.0%
20 Q 04 2 20 Q 04 3 20 Q 04 4 20 Q 04 1 20 Q 05 2 20 Q 05 3 20 Q 05 4 20 Q 05 1 20 Q 06 2 20 Q 06 3 20 Q 06 4 20 Q 06 1 20 Q 07 2 20 Q 07 3 20 Q 07 4 20 Q 07 1 20 Q 08 2 20 Q 08 3 20 Q 08 4 20 08

SOURCE: FDIC Quarterly Banking Profile. 37

Q 1

Existing Homes Sales Are Falling and Foreclosures Are Rising, Leading to a Surge in Inventories

Existing Home Sales
7.5 7.0

6.5

Millions

6.0

5.5

Months Supply
12 11

5.0

4.5

4.6 million units as of the end of March 2009
Months
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

10 9

3.8 million units, equal to 9.8 months as of the end of March 2009

4.0

8 7 6 5 4 3 1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

SOURCE: NATIONAL ASSOCIATION OF REALTORS® Existing Home Sales data series. 38

Foreclosure Filings Have Increased Dramatically
• • • Foreclosures in March rose 32% year-over-year and under 1% sequentially April was the highest monthly total since RealtyTrac began issuing its report in January 2005 despite a decrease in bank repossessions (REOs) RealtyTrac estimates that over 1.5 million bank-owned properties are on the market, representing around a third of all properties for sale in the U.S.
400,000 350,000

300,000 Number of Foreclosures

250,000 200,000

150,000

100,000

50,000 0
Ju n Au -05 gO 05 ct De 05 cFe 05 bAp 06 rJu 0 6 nAu 06 gO 06 ct D -06 ec F e 06 bAp 07 rJu 0 7 nA u 07 gO 07 ct D 07 ec Fe 07 bA p 08 rJu 0 8 n Au -08 gO 08 ct De 08 cFe 08 bAp 09 r- 0 9

Note: Foreclosure filings are defined as default notices, auction sale notices and bank repossessions. SOURCE: RealtyTrac.com U.S. Foreclosure Market Report.

39

Home Prices Are in an Unprecedented Freefall
220 S&P/Case-Shiller U.S. National Home Price Index S&P/Case-Shiller 20-City Composite OFHEO Purchase-Only Index NAR Median Sales Price of Existing Homes

200

180

160

140

120

100
20 Q 00 3 20 Q 00 1 20 Q 01 3 20 Q 01 1 20 Q 02 3 20 Q 02 1 20 Q 03 3 20 Q 03 1 20 Q 04 3 20 Q 04 1 20 Q 05 3 20 Q 05 1 20 Q 06 3 20 Q 06 1 20 Q 07 3 20 Q 07 1 20 Q 08 3 20 Q 08 1 20 09

SOURCES: Standard & Poor’s, OFHEO Purchase-Only Index, NATIONAL ASSOCIATION OF REALTORS® Existing Home Sales data series. 40

Q 1

24% of Homeowners With a Mortgage Owe More Than the Home Is Worth, Making Them Far More Likely to Default
Among people who bought homes in the past five years, 30%+ are under water
In Bubble Markets, Far More Homeowners Are Under Water
Metro Area New York Los Angeles Boston Washington Miami San Francisco Atlanta San Diego Phoenix Las Vegas Price Index Is at Lowest Level Since 2004-Q3 2003-Q4 2002-Q2 2004-Q1 2004-Q1 2003-Q3 2004-Q4 2002-Q4 2004-Q3 2003-Q4 Price Drop Since Peak -15.2% -32.0% -21.8% -24.8% -36.6% -27.8% -10.4% -34.4% -37.7% -41.8% % of Last 5 Yrs Purchasers Who Are Under Water 23.0% 56.4% 27.8% 50.3% 25% 65.1% 51.2% 23.2% 20% 63.9% 36.4% 61.4%
Percent Underwater 15%

There Has Been a Dramatic Rise in Homeowners Who Are Under Water
24%

20%

16%

10%

6% 5% 4%

0% Dec-06 Dec-07 Sep-08 Dec-08 Mar-09

Source: Zillow.com Q4 08 Real Estate Market Report; Moody's Economy.com, First American CoreLogic, T2 Partners estimates

41

Certain Types of Loans Are Severely Under Water
80% 73% 70%

60% Percent Underwater 50% 45% 40%

50%

30% 25% 20%

10%

0% Prime Alt A Subprime Option ARM

SOURCES: Amherst Securities, LoanPerformance, Standard & Poor’s. 42

Home Prices Need to Fall Another 5-10% to Reach Trend Line
300 Shiller Lawler 275 Real Home Price Index (1890=100) 250 225 200 175

Housing Bubble Trend Line

150 125 100
66 74 86 94 02 20 0 8 82 90 8 54 19 62 19 70 19 98 19 5 19 7 19 5 20 0 19 19 19 19 19 19 19 6

SOURCES: Robert J. Shiller, Irrational Exuberance: Second Edition, as updated by the author; Lawler Economic & Housing Consulting. 43

A Study of Bubbles Shows That All of Them Eventually Return to Trend Line
S&P 500
Detrended Real Price

S&P 500
Detrended Real Price

1.8 1.3 0.8 0.3 20 21 22 23 24 25 26 27 28 29 30 31
Tre nd Line

Relative Return

2.0 1.5 1.0 0.5 0.0 46 50 54 58 62 66 70 74 78 82
Tre nd Line

Detrended Real Price

2.3

1920-1932

2.5

1946-1984

Stocks
3.0 2.5 2.0 1.5 1.0 0.5 0.0

Japan vs. EAFE ex-Japan
1981-1999

S&P 500
2.4 2.0 1.6 1.2 0.8 92 94 96 98 00 02 04 06 08
Trend Line

1992-October 2008

Tre nd Line

81 83 85 87 89 91 93 95 97 99

U.S. Dollar
Cumulative Return Cumulative Return

U.K. Pound
1.4 1.3 1.2 1.1 1.0 0.9 0.8 79 80 81 82 83 1979-1985

Cumulative Return

1.6 1.4 1.2 1.0 0.8 79 81 83 85 87 89 91

1.2 1.1 1.0 0.9 0.8 83 84 85 86 87 88 89 90

Cumulative Return

2.0 1.8

1979-1992

Currencies
1.4 1.3

Japanese Yen
1983-1990
1.4 1.3 1.2 1.1 1.0 0.9 0.8 92 93

Japanese Yen
1992-1998

84

94

95

96

97

Gold
2000 1600
Real Price
Real Price

Crude Oil
80 60 40 20 0 1962-1999

Commodities
250 200 Real Price 150 100 50 0

Nickel
1979-1999

Cocoa
600 500 400 300 200 100 0 70 74 78 82 86 90 94 98
Real Price

1970-1999

1970-1999

1200 800 400 0 70 74 78 82 86 90 94 98

62 66 70 74 78 82 86 90 94 98

79 81 83 85 87 89 91 93 95 97

SOURCE: GMO LLC. Note: For S&P charts, trend is 2% real price appreciation per year. Source: GMO. Data through 10//10/08. * Detrended Real Price is the price index divided by CPI+2%, since the long-term trend increase in the price of the S&P 500 has been on the order of 2% real.

44

The Biggest Danger is That Home Prices Overshoot on the Downside, Which Often Happens When Bubbles Burst
S&P 500 1927-1954
2.50 2.25 Detrended Real S&P 500 Stock Price Index 2.00 1.75 1.50 1.25 1.00 0.75 0.50 0.25 0.00 1927
2.25 2.00

Overrun: 59% Fair Value to Bottom: 1.5 Years Fair Value to Fair Value: 23 Years

S&P 500 1955-1986
Overrun: 45% Fair Value to Bottom: 7 Years Fair Value to Fair Value: 12 Years

-59%

Detrended Real S&P 500 Stock Price Index

1.75 1.50 1.25 1.00 0.75 0.50

1930

1933

1936

1939

1942

1945

1948

1951

1954

-45%
0.25 0.00 1955 1957 1959 1961 1963 1965 1967 1969 1971 1973 1976 1978 1980 1982 1984 1986

SOURCE: GMO LLC, T2 Partners calculations. 45

In Bubble Markets, Prices Are Way Down, Driven By a Surge in the Number of Homes Sold Out of Foreclosure
California

$500

70%

60% $400 Median Home Price (000s) 50% Foreclosure Resale % $300

40%

$200

30%

20% $100 10%

$0
-0 6 ct -0 6 7 ct -0 7 8 8 -0 7 -0 8 -0 8 Ja n06 Ap r-0 Ap r-0 Ju l-0 Ju l-0 l-0 Ja n Ja n O ct Ap r Ja n Ju -0 9 6 7

0%

O

SOURCE: MDA Dataquick. Note: Includes new construction 46

O

Home Prices Have Crashed Through the Trend Line in California, But Stabilized in March

$600 Median Sales Price 4% Trend $500

Median Price ($000s)

$400

$300

$200

$100

$0
Ja n79 Ja n81 Ja n83 Ja n85 Ja n87 Ja n89 Ja n91 Ja n93 Ja n95 Ja n97 Ja n99 Ja n01 Ja n03 Ja n05 Ja n07 Ja n09
SOURCE: California Association of REALTORS ® . All rights reserved. www.rebsonline.com, T2 Partners estimates. 47

The Housing Affordability Index Shows Houses Are Now Affordable
Before concluding that houses are cheap, however, there are three big caveats: first, low rates are only available to those who qualify for conforming mortgages, which doesn’t help millions of homeowners or potential homeowners who have spotty credit histories or are underwater on their current mortgages. Second, with low enough interest rates, almost anything looks affordable; if rates rise, houses won’t look so reasonably priced based on these metrics. Finally, in light of the severe economic downturn, average income may fall for quite some time.
26

24 Mortgage Payment on Median Priced Home as % of Family Income

22

20

18

16

14
19 91 19 92 19 93 19 94 19 95 19 96 19 97 19 98 19 99 20 00 20 01 20 02 20 03 20 04 20 05 20 06 20 07 20 08 20 09 89 19 19 90

SOURCE: NATIONAL ASSOCIATION OF REALTORS® Housing Affordability Index

48

Mortgage Rates Have Fallen Recently
8 Jumbo 30 Yr FRM Jumbo 5/1 Hybrid ARM Conforming 30 Yr FRM Conforming 5/1 Hybrid ARM 10-Year Treasury

7

6

Rate (%)

5

4

3

2
Fe b05 M ay -0 5 A ug -0 5 N ov -0 5 Fe b06 M ay -0 6 Au g06 No v06 Fe b04 M ay -0 4 A ug -0 4 N ov -0 4 Fe b07 M ay -0 7 Au g07 No v07 Fe b08 M ay -0 8 A ug -0 8 No v08 Fe b09

49

The Home Price-to-Rent Ratio Has Returned to Normal Levels
27

25

Median Home Price to Median Gross Rent

23

21

19

17

15 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

SOURCE NATIONAL ASSOCIATION OF REALTORS® Existing Home Sales data series, U.S. Census Bureau, T2 Partners estimates 50

Are We Seeing the Beginnings of a Bottom in Hard-Hit Markets?

SOURCE: NY Times, 5/4/09. 51

Home Prices in Sacramento More Than Tripled in Six Years – And Have Now Fallen 47%

SOURCE: Zillow.com. 52

The Vast Majority of Sacramento Homeowners Who Purchased During the Bubble Years Are Now Underwater

SOURCE: Zillow.com. 53

In Sacramento Country, Home Sales Have Rebounded – But Are Still Outweighed by Defaults

Monthly Notices-of-Default in Sacramento

SOURCES: MDA Dataquick; The Field Check Group -- data provided by ForeclosureRadar.com. Note: Includes new construction.

54

Home Prices Are Stabilizing in Sacramento Country, In Part Due to More Higher End Homes Being Sold Off

Sacramento House Prices at the Time of Foreclosure/REO

Sacramento Mix of Houses at the Time of Foreclosure/REO

SOURCE: The Field Check Group -- data provided by ForeclosureRadar.com. 55

There Have Been 5.7 Million Jobs Lost So Far in This Recession, More Than 3 Million in the Past Five Months
600 400

Change in Nonfarm Payroll Employment (000s)

200

0 -200

-400

-600

-800 -1000

There have been job losses every month since December 2007
n9 Ja 1 n9 Ja 2 n9 Ja 3 n9 Ja 4 n9 Ja 5 n9 Ja 6 n9 Ja 7 n9 Ja 8 n9 Ja 9 n0 Ja 0 n0 Ja 1 n0 Ja 2 n0 Ja 3 n0 Ja 4 n0 Ja 5 n0 Ja 6 n0 Ja 7 n0 Ja 8 n09

Ja

SOURCE: Bureau of Labor Statistics. 56

Ja

n90

The Unemployment Rate Jumped to 8.9% in April, the Highest Level Since 1983
If part-time and discouraged workers are factored in, the unemployment rate 12% would have been 15.8% in April. In addition, the average work week in April was 33.2 hours, a record low.
11% 10% 9% 8% 7% 6% 5% 4% 3%

Unemployment Rate

n06 Ja

n91

n73

n76

n79

n94

Ja n88

Ja n70

n82

n97

Ja n-

Ja n-

n03

Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja

n09

85

00

SOURCE: Bureau of Labor Statistics.

57

The Decline from Peak Employment Now Exceeds the Past Five Recessions
0.0% 1980 -0.5% -1.0% -1.5% -2.0% -2.5% -3.0% -3.5% -4.0% 2007-4.5% 0 6 12 18 24 30 36 42 48 Months after pre-recession peak
SOURCE: Bureau of Labor Statistics 58

1981 - 83 1974 - 76

1990 - 93 2001 - 05

Consumer Confidence is Near an All-Time Low – Though It Rebounded in April
160

140

120 Consumer Confidence Index

100

80

60

40

20

0 1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

Note: 1985=100. SOURCE: The Conference Board (www.pollingreport.com/consumer.htm) 59

Banks are Tightening Consumer Credit and New Household Borrowing Has Plunged

Percent of US Banks Tightening Consumer Credit
70% 60% 50% 40% 30% 20% 10% 0% -10%
$1,200

Household Borrowing 1990-2008
(Seasonally-Adjusted Annual Rate)

-20%
Ja n02 Se p00 Se p04 Ja n06 M ay -0 1 M ay -0 3 M ay -0 5 M ay -0 7 Se p08 Ja n00 Ja n04 Se p02 Se p06 Ja n08

($ billions)

$1,000

Credit Cards

Other Consumer Loans
$800

$600

$400

$200

$0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

SOURCE: Federal Reserve Board. 60

Pools of HELOCs and CESs Can Suffer Astronomical Losses Due to 100%+ Severities
On one second lien deal, Ambac expected losses of 10-12% when it guaranteed the senior tranche. A year ago, Ambac admitted that the pool would likely lose 81.8% of its value – and based on the pool’s performance since then, this will almost certainly prove to be conservative.
3.0% Ambac Projection April 2008 Actual 2.5% Monthly Loss Rate (3m average)

From Ambac slide, 4/08: • Second lien deal that closed in April 2007 • Loss to date 9.9%; projected loss: 81.8% • Projected collateral loss as a % of current collateral: 86% • A reasonable estimate of projected collateral loss for the above transaction might have been 10-12%, with the transaction having an A+ rating at inception and being structured to withstand 28-30% collateral loss

2.0%

1.5%

1.0%

0.5%

0.0% 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 45 47 49 51 53 55 57 59 Months Since Close
SOURCES: Ambac Q1 08 presentation, Amherst Securities; funds managed by T2 Partners are short Ambac. 61

Comments From Mark Hanson (1) The Field Check Group, May 5, 2009
California housing -- at the low end -- is 'bottoming' mostly because: a) median prices are down 55% from their peak over the past two years, thereby making the low end affordable; b) foreclosures have temporarily been cut by 66% through moratoriums reducing supply; and c) demand is picking up going into the busy season. But the moratoriums are ending and the number of foreclosures in the pipeline is massive -- they will start showing themselves as REO over the near to mid-term. The Obama plan held the foreclosure wave back, creating a huge backlog and now the servicers are testing hundreds of thousands of defaults against the new loss mitigation initiatives. We presently see the Notice of Defaults at record highs and Notice of Trustee Sales back up to 9 month highs -- there is no reason for a loan to go to the Notice of Trustee Sale stage if indeed it wasn't a foreclosure. However, the new 'batch' are not only from the low end but a wide mix all the way up to several million dollars in present value. Because the majority of buyers are in ultra low and low-mid prices ranges, the supply-demand imbalance from foreclosures and organic supply will crush the mid-to-upper priced properties in 2009. We already have early seasonal hard data proving this. As the mid-to-upper end go through their respective implosions this year and the volume of sales in these bands increase as prices tumble, the mix shift will raise median and average house prices creating the ultimate in false bottoms. We also have data proving this phenomenon.
62

Comments From Mark Hanson (2) The Field Check Group, May 5, 2009
After a year or so the real pain will occur when the mid to upper bands are down 40% from where they are now, and the price compression has made the low to low-mid bands much less attractive -- the very same bands that are so hot right now. Rents are tumbling and those that bought these properties for investment will be at risk of default (investors have been buying all the way down). Investors have just started to get taken to the woodshed from all of the supply and this will get much worse. Mid-to-upper end rental supply is also flooding on the market making it much better to rent a beautiful million dollar house than putting $300,000 down and buying. After investors are punished -- and with move-up buyers gone for years -- it will leave first-time homeowners to fix the housing market on their own. Good luck and good night. Five years from now when things look to be stabilizing, all of these terrible kick-the-can-down-the-road modifications that leave borrowers in 5-year-teaser, ultra-high-leverage, 150% LTV, balloon loans will start adjusting upward and it will be Mortgage Implosion 2.0. These loan mods will turn millions of homeowners into over-levered, underwater, renters and ensure housing is a dead asset class for years to come. Due to a confluence of events including a national foreclosure moratorium and near-zero sales in the mid to upper end during the off season, the broader housing data show signs of stabilization. Taken in context, it is a blip. There are no silver linings or green shoots in housing whatsoever other than by these first-time homeowners -- former renters -- who now find it cheaper to own than rent. This is a very good thing, but it only applies to a small segment of the population and will not be able to support the market. In addition, the first-time buyers who come out of the rental market put continuous pressure on rents. Our data shows that the mid-to-upper end housing market is on the precipice of the exact cliff that the market fell off of in 2007, led by new loan defaults. What happens to the economy when you hit the mid-to-upper end earners the same way the low-to-mid end was hit with the subprime implosion? We will find out soon enough. When we look back on housing at the end of 2009, anyone that made positive housing predictions this year will not believe how far off they were.
63

Outlook for Housing Prices
• • We think housing prices will reach fair value/trend line, down 40% from the peak based on the S&P/Case-Shiller national (not 20-city) index, which implies a 10-15% further decline from where prices where as of the end of 2008. It’s almost certain that prices will reach these levels The key question is whether housing prices will go crashing through the trend line and fall well below fair value. Unfortunately, this is very likely. In the long-term, housing prices will likely settle around fair value, but in the short-term prices will be driven both by psychology as well as supply and demand. The trends in both are very unfavorable
– – Regarding the former, national home prices have declined for 31 consecutive months since their peak in July 2006 through February 2009 and there’s no end in sight, so this makes buyers reluctant – even when the price appears cheap – and sellers desperate. Regarding the latter, there is a huge mismatch between supply and demand, due largely to the tsunami of foreclosures. In March 2009, distressed sales accounted for just over 50% of all existing home sales nationwide – and more than 57% in California. In addition, the “shadow” inventory of foreclosed homes already likely exceeds one year and there will be millions more foreclosures over the next few years, creating a large overhang of excess supply that will likely cause prices to overshoot on the downside, as they are already doing in California.

• • • •

•

Therefore, we expect housing prices to decline 45-50% from the peak, bottoming in mid-2010 We are also quite certain that wherever prices bottom, there will be no quick rebound There’s too much inventory to work off quickly, especially in light of the millions of foreclosures over the next few years While foreclosure sales are booming in many areas, regular sales by homeowners have plunged, in part because people usually can’t sell when they’re under water on their mortgage and in part due to human psychology: people naturally anchor on the price they paid or what something was worth in the past and are reluctant to sell below this level. We suspect that there are millions of homeowners like this who will emerge as sellers at the first sign of a rebound in home prices Finally, we don’t think the economy is likely to provide a tailwind, as we expect it to contract the rest of 2009, stagnate in 2010, and only then grow tepidly for some time thereafter
64

The Timing Indicates That We Are Still in the Middle Innings of the Bursting of the Great Housing Bubble
• • • • • • • Mortgage lending standards became progressively worse starting in 2000, but really went off a cliff beginning in early 2005 The worst loans were subprime ones, which generally had two-year teaser rates and are now defaulting at unprecedented rates Such loans made in Q1 2005 started to default in high numbers upon reset in Q1 2007, which not surprisingly was the beginning of the current crises The crisis has continued to worsen as even lower quality subprime loans made over the remainder of 2005 reset over the course of 2007, triggering more and more defaults It takes an average of 15 months from the date of the first missed payment by a homeowner to a liquidation (generally a sale via auction) of the home Thus, the Q1 2005 subprime loans that defaulted in Q1 2007 led to foreclosures and auctions in early 2008 Given that lending standards got much worse in late 2005 through 2006 and into the first half of 2007, and the many other types of loans that are now with longer reset dates that are now starting to default at catastrophic rates, there are sobering implications for expected defaults, foreclosures and auctions in 2009 and beyond, which promise to drive home prices down further

In summary, today we are only in the middle innings of an enormous wave of defaults, foreclosures and auctions that is hitting the United States. We predicted in early 2008 that it would get so bad that it would require large-scale federal government intervention – which has occurred, and we’re likely not finished yet.
65

Total Losses Are Now Estimated at $2.1-$3.8 Trillion – And Less Than Half of This Has Been Realized To Date
$4,000 $3,552 $3,500 $3,000 $2,632 Amount (Bn) $2,500 $2,083 $2,000 $1,500 $1,000 $500 $0 Goldman Sachs Jan 2009 Roubini Jan 2009 T2 Partners Mar 2009 IMF Apr 2009 Writedowns to Capital Raised Date $1,288 $1,103
GSEs Insurers Banks/ Brokers

$3,778

Corporate Consumer Commercial Real Estate Residential Mortgages

SOURCES: Goldman Sachs, International Monetary Fund, RGE Monitor, Bloomberg Finance L.P., T2 Partners estimates. 66

A Breakdown of Our Financial Sector Loss Estimates
Amount (Bn) $0
CDO/ CLO Other Consumer Construction & Development Option ARM Auto Credit Card Home Equity Jumbo Prime High-Yield / Leveraged Loans Subprime Commercial & Industrial Other Corporate Alt-A Commercial Real Estate Prime Mortgage

$100

$200

$300

$400

$500

$600

$700

$800

Total Estimated Financial Sector Losses = $3.8 trillion

SOURCE: T2 Partners estimates. 67

Institutions Have Been Able to Raise Capital to Mostly Keep Up With Writedowns, But This Will Likely Not Continue
$1,500 Losses & Writedowns Capital Raised $1,250

$1,000 Amount (Bn)

$750

$500

$250

$0 Prior
SOURCE: Bloomberg Finance L.P. 68

Q3 2007 Q4 2007 Q1 2008 Q2 2008 Q3 2008 Q4 2008 Q1 2009 Q2 2009

Where We Are Finding Opportunities

•

•

•

•

• •

Blue-chips. The stocks of some of the greatest businesses, with strong balance sheets and dominant competitive positions, are trading at their cheapest levels in years – due primarily to the overall market decline and weak economic conditions rather than any company-specific issues. In this category, we’d put Coca-Cola, McDonald’s, Wal-Mart, Altria, ExxonMobil, Johnson & Johnson, and Microsoft. Out of favor blue-chips. For somewhat more adventurous investors looking to buy great companies in the most out-of-favor sectors such as financials and retailers, we own Berkshire Hathaway, Wells Fargo, American Express and Target. All are great businesses, but their stocks have suffered mightily thanks to the economic downturn. We think they’re good bets to rebound when things stabilize. Balance sheet plays. For investors who are comfortable with lower-quality businesses but want downside protection, there are many companies trading near or even below net cash on the balance sheet. Examples in our portfolio include digital media equipment company EchoStar Corp. and clothing retailer dELiA*s. Berkshire is the best of both worlds: a premier company but also a balance sheet play. Turnarounds. There are countless companies that have gotten clobbered by the economic downturn and are reporting dismal results – with stock prices to match. Investors in those that survive and return to anything close to former levels of profitability will be well rewarded – but picking these stocks isn’t easy. Among our holdings in this category are Wendy’s restaurants, Winn-Dixie supermarkets, Huntsman, a specialty chemical maker, Crosstex, a pipeline company, and Resource America, a specialty finance company. Special situations. This is somewhat of a catch-all category that, for us, includes Contango Oil & Gas, a stock that’s declined due to an aborted attempt to sell the company and the sharp drop in the price of natural gas. Mispriced options. Every once in a while we take a tiny position in a highly speculative situation – often where the stock price is below $1 – in which there’s a real chance that the outcome is zero, but also a decent chance, in our opinion, of making many multiples of our money. On an expected value basis, therefore, a small portfolio of such investments is attractive. Our holdings include General Growth Properties, TravelCenters of America, Ambassadors International, Borders Group and PhotoChannel Networks.
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Description: Phenomenal overview of the housing market trends in the US and the pain still to come.