Overview Of Housing/Credit Crisis And Why There Is More Pain To Come

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Slide 1: An Overview of the Housing/Credit Crisis And Why There Is More Pain to Come T2 Partners LLC T2 Accredited Fund, LP Tilson Offshore Fund, Ltd. T2 Qualified Fund, LP December 18, 2008 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 This presentation is available at www.valueinvestingcongress.com. We would like to thank Amherst Securities Group L.P. (www.asglp.com) for generously providing data used in this presentation. This document is not a solicitation to invest in any investment product, nor is it intended to provide investment advice. It is intended for information purposes only and should be used by sophisticated investors who are knowledgeable of the risks involved. All data and comments herein are believed to be correct, but there are no guarantees and readers should do their own work. Please refer to the relevant Confidential Private Placement Memorandum for full details on investment products and strategies of T2 Partners LLC. Slide 2: Overview 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. Overview of the Great Mortgage Bubble Page 3 Causes of the Great Mortgage Bubble Page 11 Consequences of the Bursting of the Great Mortgage Bubble Page 18 The Outlook for Home Prices is Grim Page 28 Economic Weakness Creates an Additional Headwind for Home PricesPage 43 There Are Only a Few Bits of Good News Page 51 What Does the Future Hold? Page 57 A Primer on Option ARMs Page 61 A Primer on HELOCs and Closed-End Seconds Page 68 A Closer Look at Mortgage Loans That Were Securitized: Quantity and Quality Page 73 11. A Closer Look at Mortgage Loans That Were Securitized: Defaults Page 86 12. Where Did the Securitized Mortgages End Up? A Primer on ABSs and CDOs Page 106 13. The Opportunity in Distressed Debt Page 115 T2 Partners LLC -2- Slide 3: Overview of the Great Mortgage Bubble Slide 4: Prior to This Decade, Housing Had Been a Stable Investment, Increasing at Less Than ½ of 1% Per Year After Inflation Source: Robert Shiller; http://i.usatoday.net/news/graphics/housing_prices/home_prices.pdf T2 Partners LLC -4- Slide 5: From 2000-2006, the Borrowing Power of a Typical Home Purchaser More Than Tripled $400,000 1. 2. 3. 4. 5. Pre-Tax Income Debt-to-Income Ratio Non-Agency Mortgage Rate Mortgage Type Borrowing Power Equity Required Cash Required Leverage 1/1/95 1/1/00 1/1/04 1/1/05 1/1/06 1/1/07 6/1/07 $ 30,000 $ 33,693 $ 36,966 $ 38,064 $ 39,581 $ 40,403 $ 40,403 33% 33% 40% 45% 55% 55% 60% 10.50% 9.50% 7.50% 6.25% 6.00% 6.50% 6.75% Full Am. Full Am. Full Am. Int Only Int Only Int Only Int Only $ 90,190 $ 110,191 $176,227 $274,060 $ 362,824 $341,873 $359,139 15% 15% 10% 0% 0% 0% 0% $ 15,916 $ 19,445 $ 19,581 $ $ $ $ 3.0 3.3 4.8 7.2 9.2 8.5 8.9 $300,000 $200,000 $100,000 $1/95 1/96 1/97 1/98 1/99 1/00 1/01 1/02 1/03 1/04 1/05 1/06 1/07 Pre-Tax Income Borrowing Power 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 T2 Partners LLC Source: Amherst Securities Group, L.P. -5- Slide 6: 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 90% 80% 70% 60% Mortgage Debt: $18.6 billion 50% 40% 30% 20% 10% 0% 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 Equity: $97.5 billion Q3 2008 Mortgage Debt: $10.6 trillion Equity: $8.5 trillion Source: Federal Reserve Flow of Funds Accounts of the United States; www.federalreserve.gov/releases/z1/Current/z1.pdf T2 Partners LLC -5- Slide 7: There Was a Dramatic Decline in Mortgage Lending Standards from 2001 through 2006 • In 2005, 29% of new mortgages were interest only — or less, in the case of Option ARMs — vs. 1% in 2001 • In 1989, the average down payment all home buyers was 20%; in 2007, it was 10%; for first-time home buyers, the figures were 10% and 2%, respectively (aka “Liar’s Loans”) • 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 T2 Partners LLC Source: LoanPerformance, Paulson presentation; USA Today (www.usatoday.com/money/economy/housing/2008-12-12-homeprices_N.htm) -7- Slide 8: The Decline in Lending Standards Led to a Surge in Subprime Mortgage Origination 13.6% of all mortgages originated during the year $B 0.9% of all mortgages originated during the year Source: Lehman Brothers, Paulson presentation T2 Partners LLC -8- Slide 9: But Subprime Mortgages Are Only a Tiny Part of the Problem CDO Other Consu m er Constru ction & Developm ent $ 0 .4 $ 0.4 $0 .6 $ 0.7 $1 .0 $ 1.0 $ 1.0 $ 1.1 $ 1.1 $2 .1 $ 2.4 $ 2.6 $3 .5 $4 .6 $4 .7 Subprime Com m erical & Indu strial Alt-A Au to High-Yield Corporate Bonds Credit Card Hom e Equ ity Ju m bo Leveraged Loans Com m ercial Real Estate Agency MBS Sources: Flow of funds data and Paulson estimates Prim e Mortgage 0 1 2 3 4 T2 Partners LLC Market Size ($ trillion) 5 -9- Slide 10: The Surge in Borrowing Power and Decline in Lending Standards Led to Home Prices Soaring Far Above Trend Line Sources: OFHEO, Bureau of Economic Analysis, Paulson presentation T2 Partners LLC -10- Slide 11: Causes of the Great Mortgage Bubble Slide 12: 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 interests 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 -12- – – – – – T2 Partners LLC Slide 13: Lenders Cared Little Who They Lent To Because They Assumed Perpetually Rising Home Prices When home price appreciation slows, loss severity skyrockets when mortgages default. What will loss severities look like when home prices are declining more than 10% annually?! No-one knows because there is no precedent for this. The assumption of perpetually high HPA led lenders to give virtually anyone a loan because even if they defaulted, the home could simply be resold with little or no loss. Sources: LoanPerformance; OFHEO; Deutsche Bank; “Who's Holding the Bag?”, Pershing Square presentation, 5/23/07 T2 Partners LLC -13- Slide 14: Losses in Bubble-Era Subprime Mortgage Pools Become Catastrophic if Home Prices Decline Cumulative Loss for Various HPA Scenarios Loss 30.0% (Month 60) 25.0% 20.0% 17.5% 15.0% 10.0% 7.1% 5.0% June '06: 83 bps 0.0% 20.0% 15.0% 10.0% 5.0% 0.0% -5.0% -10.0% Home Price Appreciation ("HPA") T2 Partners LLC Source: Merrill Lynch; Paulson estimates -14- Slide 15: Wall Street’s Demand for Loan “Product” Was a Major Driver of the Decline in Lending Standards • As discussed later in this presentation, the Asset-Backed Securities (ABSs) and Collateralized Debt Obligation (CDO) businesses were enormously profitable for Wall Street firms – Structured finance was a big driver of the surge in profitability of financial firms and their employees: • • • • 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: Moody’s Economy.com, NY Times, 12/18/08 T2 Partners LLC -15- Slide 16: A Case Study of Wall Street Compensation Run Amok: Stan O’Neal, Dow Kim & the Mortgage Team at Merrill Lynch Source: On Wall Street, Bonuses, Not Profits, Were Real, NY Times, 12/18/08 T2 Partners LLC -16- Slide 17: The Housing Bubble Helped Many People Achieve the Dream of Home Ownership – Which is Now Turning Into a Nightmare Percentage of Households Owning Homes Source: Census Bureau; http://i.usatoday.net/news/graphics/housing_prices/home_prices.pdf T2 Partners LLC -17- Slide 18: Consequences of the Bursting of the Great Mortgage Bubble Slide 19: 10% of Mortgages on 1- to 4-Family Homes Are Delinquent or in Foreclosure as of the End of Q3 Total Delinquencies and Foreclosures Mortgage Delinquency Rate, By Product Type Foreclosure Inventory, By Product Type T2 Partners LLC Note: Delinquencies (defined as at least 30 days past due) are seasonally adjusted; foreclosures are not. • Issued by federally qualified lenders and insured by the Federal Housing Administration; 2. A mortgage guaranteed by the U.S. Department of Veterans Affairs. Source: Mortgage Bankers Association, WSJ, 12/6/08; http://i.usatoday.net/news/graphics/housing_prices/home_prices.pdf -19- Slide 20: Sales of Existing Homes Are Falling and Foreclosures Are Rising, Leading to a Surge in Inventories Monthly Supply of Homes for Sale (Seasonally adjusted annual rate, millions) 4.23 million units, equal to 10.2 months as of the end of 10/08 5.0 million units as of the end of 10/08 The recent stabilization in home sales is driven by a surge of foreclosed homes, which now account for 35-40% of all sales. This puts tremendous pressure on home prices. Source: National Association of Realtors, Paulson presentation; http://i.usatoday.net/news/graphics/housing_prices/home_prices.pdf T2 Partners LLC -20- Slide 21: Home Vacancies Are at an All-Time High More than 10% of all homes built this decade are vacant today T2 Partners LLC Note: In Q2, the overall rate dropped slightly to 2.8% and stayed at that level in Q3 -21- Slide 22: 16% of Homeowners Owe More on Their Mortgage Than the Home Is Worth, Making Them Far More Likely to Default Among people who bought homes in the past five years, 29% are under water. There Has Been a Dramatic Rise in Homeowners Who Are Under Water 18% 16% 14% 12% 10% 8% 6% 4% 2% 0% 2006 2007 Sept '08 In Bubble Markets, Far More Homeowners Are Under Water Source: WSJ, 10/8/08, http://online.wsj.com/article/SB122341352084512611.html. T2 Partners LLC -22- Slide 23: Certain Types of Loans are Severely Under Water Percentage of Borrowers Who Had Negative Equity (as of Sept. 2008) 70% 60% 50% 40% 30% 20% 10% 0% Prime Jumbo Alt-A Subprime Option ARM Source: Credit Suisse, WSJ 12/8/08 T2 Partners LLC -23- Slide 24: Foreclosure Filings Have Increased Dramatically • Foreclosures in November rose 28% year-over-year, but declined 7% sequentially – “Foreclosure activity in November hit the lowest level we’ve seen since June thanks in part to recently enacted laws that have extended the foreclosure process in some states, along with more aggressive loan modification programs and self-imposed holiday foreclosure moratoriums introduced by some lenders,” said James J. Saccacio, chief executive officer of RealtyTrac. “There are several indications, however, that this lower activity is simply a temporary lull before another foreclosure storm hits in the coming months.” • By the end of the year, RealtyTrac expects more than a million bank-owned properties on the market, representing around a third of all properties for sale in the U.S. 350,000 300,000 250,000 200,000 150,000 100,000 50,000 0 Ju n06 A ug -0 6 O ct -0 6 D ec -0 6 Fe b07 A pr -0 7 Ju n05 A ug -0 5 O ct -0 5 D ec -0 5 Fe b06 A pr -0 6 Ju n07 A ug -0 7 O ct -0 7 D ec -0 7 Fe b08 A pr -0 8 Note: Foreclosure filings are defined as default notices, auction sale notices and bank repossessions Sources: RealtyTrac T2 Partners LLC Ju n08 A ug -0 8 O ct -0 8 -24- Slide 25: Credit Suisse Predicts More Than Six Million Foreclosures by the End of 2012 Sources: Credit Suisse; http://calculatedrisk.blogspot.com T2 Partners LLC -25- Slide 26: So Far, Few Loan Modifications Are Working % In Default Sources: Office of the Comptroller of the Currency and the Office of Thrift Supervision Mortgage Metrics; http://calculatedrisk.blogspot.com T2 Partners LLC -26- Slide 27: In Bubble Markets, Sales and Prices Are Way Down, While the Number of Homes Sold in Foreclosure Has Skyrocketed Case Study: Resale House Sales in San Diego 1,600 1,400 1,200 Resale Homes Sold Home prices in San Diego fell 16.7% year over year in January – and this accelerated to -26.3% in Sept. -34% 1,000 800 600 400 200 0 1,417 -54% 657 Normal Foreclosure +328% 338 79 (5% of total) January '07 (34% of total) January '08 More than half of homes sold in September in CA had been in foreclosure. This contributed to home sales jumping 65% year over year, but the statewide median home price fell 34% (MDA DataQuick). T2 Partners LLC Note: Excludes condos and new construction. Source: San Diego Union-Tribune article, 2/13/08. -27- Slide 28: The Outlook for Home Prices is Grim We Estimate That Home Prices Are Only a Little More Than Half Way Finished Declining Slide 29: Home Prices Are in an Unprecedented Freefall Through September, home prices had fallen an average of 21.8% from their peak in 20 major metropolitan areas 220 200 S&P/ CaseShiller Home Price Index (20 city) -21.8% 180 160 140 120 100 Feb-00 Feb-01 Feb-02 Feb-03 Feb-04 Feb-05 Feb-06 Feb-07 Feb-08 Source: S&P/Case-Shiller index T2 Partners LLC -29- Slide 30: Home Prices Have Fallen, But Are Still Well Above Levels at the Start of the Decade in Almost All Cities 200% Jan. 2000-July 2006 Jan. 2000-Sept. 2008 150% 100% 50% 0% sA ng ele W s as hi ng to n, D .C . ap ol is ieg o tle Po rtl an d, O re . Fr an ci sc o N ew Y or k Ch ar lo tte oe ni x en ve r ica go eg as Bo sto n Ta m pa M ia Se at Cl ev el etr oi tla n all La sV av e D D ra ge an d ta m i as t D 20 -c ity M in ne Ch Ph Lo Sa n -50% Source: S&P/Case-Shiller index T2 Partners LLC Sa n D A -30- Slide 31: The Surge in Borrowing Power and Decline in Lending Standards Led to Home Prices Soaring Far Above Trend Line A 34% decline to return to trend line Sources: OFHEO, Bureau of Economic Analysis. T2 Partners LLC -31- Slide 32: Borrowing Power of a Typical Home Purchaser Has Tumbled By Approximately 32% $400,000 1. 2. 3. 4. 5. Pre-Tax Income Debt-to-Income Ratio Non-Agency Mortgage Rate Mortgage Type Borrowing Power Equity Required Cash Required Leverage 1/1/1995 1/1/2000 1/1/2004 1/1/2005 1/1/2006 1/1/2007 6/1/2007 1/1/2008 12/1/2008 $ 30,000 $ 33,693 $ 36,966 $ 38,064 $ 39,581 $ 40,403 $ 40,403 $ 41,963 42,173 33% 33% 40% 45% 55% 55% 60% 35% 35% 10.50% 9.50% 7.50% 6.25% 6.00% 6.50% 6.75% 6.75% 6.00% Full Am. Full Am. Full Am. Int Only Int Only Int Only Int Only Int Only Int Only $ 90,190 $110,191 $176,227 $274,060 $362,824 $341,873 $359,139 $217,585 246,008 15% 15% 10% 0% 0% 0% 0% 0% 0% $ 15,916 $ 19,445 $ 19,581 3.0 3.3 4.8 7.2 9.2 8.5 8.9 5.2 5.8 $300,000 $200,000 $100,000 Even with average homeowners able to borrow nearly 6x their income, nearly double historical averages, borrowing power is still down 32% from its peak $1/95 1/96 1/97 1/98 1/99 1/00 1/01 1/02 1/03 1/04 1/05 1/06 1/07 1/08 Pre-Tax Income Borrowing Power Source: Amherst Securities Group, L.P. T2 Partners LLC -32- Slide 33: Home Prices Would Have to Fall 41.6% to Return to 2002 Levels A 17.8% decline plus a 29.0% decline equals a total decline of a 41.6% Note: Based on the S&P/Case-Shiller Index thru April 2008 Source: Wall St. Journal, 7/14/08; Mark Zandi, chief economist at Moody's Economy.com and author of "Financial Shock" T2 Partners LLC -33- Slide 34: Sequential (month-to-month) Home Price Declines Improved Dramatically in April, May and June of This Year March 2005 – September 2008 2.0% 1.5% 1.0% 0.5% 0.0% M a r05 Apr05 M a y05 J un05 J ul05 Aug05 S e p05 Oc t05 No v- De c 05 05 J a n06 F e b06 M a r06 Apr06 M a y06 J un06 J ul06 Aug06 S e p06 Oc t06 No v- De c 06 06 J a n07 F e b07 M a r07 Apr- M a y07 07 J un07 J ul07 Aug07 S e p07 Oc t07 No v- De c 07 07 J a n08 F e b- M a r08 08 Apr08 M a y08 J un08 J ul08 Aug08 S e p08 -0.5% -1.0% -1.5% -2.0% -2.5% -3.0% Source: S&P/Case-Shiller Home Price Index, 20-city data T2 Partners LLC -34- Slide 35: 0.0% 0.5% 1.0% 1.5% 2.0% -3.0% Fe b A -2.5% -2.0% -1.5% -1.0% -0.5% T2 Partners LLC Source: S&P/Case-Shiller Home Price Index, 20-city data But Home Prices Are Always Strong in April, May and June February 2000 – September 2008 -0 0 pr -0 0 Ju n0 A0 ug -0 O0 ct -0 D0 ec -0 0 Fe b01 A pr -0 1 Ju n01 A ug -0 1 O ct -0 D1 ec -0 1 Fe b02 A pr -0 2 Ju n02 A ug -0 O2 ct -0 2 D ec -0 2 Fe b03 A pr -0 3 Ju n03 A ug -0 O3 ct -0 D3 ec -0 3 Fe b04 A pr -0 4 Ju n04 A ug -0 4 O ct -0 4 D ec -0 4 Fe b05 A pr -0 5 Ju n05 A ug -0 O5 ct -0 D5 ec -0 5 Fe b06 A pr -0 6 Ju n06 A ug -0 O6 ct -0 D6 ec -0 6 Fe b07 A pr -0 7 Ju n07 A ug -0 O7 ct -0 7 D ec -0 7 Fe b08 A pr -0 8 Ju n08 A ug -0 8 -35- Slide 36: Estimates from John Burns Real Estate Consulting Also Indicate That We Are About Half Way to a Bottom Peak Current Projected trough T2 Partners LLC -36- Slide 37: A Comparison to the Last Cycle Indicates a 30-40% Decline in Home Prices from the Peak Sources: Zellman and Associates, 9/08; Carlyle presentation, 10/15/08 T2 Partners LLC -37- Slide 38: The Home Price-to-Income and Price-to-Rent Ratios Show That Home Prices Have Further to Fall Price-to-Income Ratio Price-to-Rent Ratio Sources: Census Bureau; S&P/Case-Shiller index; economist Morris Davis, Univ. of Wisconsin; http://i.usatoday.net/news/graphics/housing_prices/home_prices.pdf T2 Partners LLC -38- Slide 39: Another Look at the Home Price to Income Ratio Median House Price / Median Family Income 4.4 4.2 4.0 3.8 3.6 3.4 1 std dev 3.2 3.0 2.8 2.6 2.4 1976 2 std dev 3 std dev GMO: Home prices need to fall 8% to reach fair value… GMO: Home prices need to fall 8% to reach fair value… but likely will fall 20% to reach a bottom but likely will fall 20% to reach a bottom 1980 1984 1988 1992 1996 2000 2004 Source: National Association of Realtors, U.S. Census Bureau, GMO As of 8/31/08 T2 Partners LLC -39- Slide 40: In Summary, Home Prices Need to Decline Another 17-24% to Reach Fair Value Sources: USA Today analysis; http://i.usatoday.net/news/graphics/housing_prices/home_prices.pdf T2 Partners LLC -40- Slide 41: A Study of Bubbles Shows That All of Them Eventually Return to Trend Line Stocks S&P 500 Detrended Real Price Detrended Real Price * S&P 500 2.5 2.0 1.5 1.0 0.5 0.0 46 50 54 58 62 66 70 74 78 82 Tre nd Line Japan vs. EAFE ex-Japan Detrended Real Price S&P 500 2.4 2.0 1.6 1.2 0.8 92 94 96 98 00 02 04 06 08 Trend Line 2.3 1.8 1.3 0.8 0.3 1920-1932 1946-1984 Relative Return 3.0 2.5 2.0 1.5 1.0 0.5 0.0 1981-1999 1992-October 2008 Tre nd Line Tre nd Line 20 21 22 23 24 25 26 27 28 29 30 31 81 83 85 87 89 91 93 95 97 99 Currencies U.S. Dollar Cumulative Return Cumulative Return U.K. Pound Cumulative Return Japanese Yen Cumulative Return Japanese Yen 1.4 1.3 1.2 1.1 1.0 0.9 0.8 92 93 94 95 96 97 1992-1998 2.0 1.8 1.6 1.4 1.2 1.0 0.8 79 81 1979-1992 1.4 1.3 1.2 1.1 1.0 0.9 0.8 79 80 1979-1985 1.4 1.3 1.2 1.1 1.0 0.9 0.8 1983-1990 83 85 87 89 91 81 82 83 84 83 84 85 86 87 88 89 90 Commodities Gold 2000 1600 Real Price Real Price Crude Oil 80 60 40 20 0 1962-1999 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 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. T2 Partners LLC -41- Slide 42: The Biggest Danger is That Home Prices Overshoot on the Downside, Which Often Happens When Bubbles Burst S&P 500 1926-1954 2.5 2.3 Detrended Real Price S&P 500 1954-1986 2.00 1.75 Detrended Real Price 2.0 1.8 1.5 1.3 1.0 0.8 0.5 0.3 Overrun: 63% Fair Value to Bottom: 1.5 Years Fair Value to Fair Value: 23 Years 1.50 1.25 1.00 0.75 0.50 Overrun: 51% Fair Value to Bottom: 7 Years Fair Value to Fair Value: 12 Years -63% 26 28 30 32 34 36 38 40 42 44 46 48 50 52 54 -51% 54 56 58 60 62 64 66 68 70 72 74 76 78 80 82 84 86 0.25 Japan vs. EAFE ex-Japan 3.75 Cumulative Relative Return 3.25 2.75 2.25 1.75 1.25 0.75 0.25 79 81 83 85 87 89 91 Overrun: 53%? Fair Value to Bottom: 5 Years? Fair Value to Fair Value: >6 Years -53% 93 95 97 99 01 Source: GMO, as of 9/30/02 T2 Partners LLC -42- Slide 43: Economic Weakness Creates an Additional Headwind for Home Prices Slide 44: The Economy Shed 533,000 Nonfarm Jobs in November, the Most in 34 Years 600 400 200 0 Ja n90 Ja n91 Ja n92 Ja n93 Ja n94 Ja n95 Ja n96 Ja n97 Ja n98 Ja n99 Ja n00 Ja n01 Ja n02 Ja n03 Ja n04 Ja n05 Ja n06 Ja n07 Ja n08 -200 -400 There have been job losses every month this year -600 Source: Bureau of Labor Statistics T2 Partners LLC -44- Slide 45: The Unemployment Rate Hit 6.7% in November, a 15-Year High Since the start of the recession, the economy has lost 1.9 million jobs, the number of unemployed people increased by 2.7 million and the jobless rate rose by 1.7 percentage points. The unemployment rate would have been higher had 422,000 people not left the workforce in November, likely out of frustration. 8 7 6 5 4 3 Source: Bureau of Labor Statistics T2 Partners LLC Ja n90 Ju l-9 0 Ja n91 Ju l-9 1 Ja n92 Ju l-9 2 Ja n93 Ju l-9 Ja 3 n94 Ju l-9 4 Ja n95 Ju l-9 5 Ja n96 Ju l-9 6 Ja n97 Ju l-9 7 Ja n98 Ju l-9 8 Ja n99 Ju l-9 9 Ja n00 Ju l-0 0 Ja n01 Ju l-0 1 Ja n02 Ju l-0 2 Ja n03 Ju l-0 Ja 3 n04 Ju l-0 4 Ja n05 Ju l-0 5 Ja n06 Ju l-0 6 Ja n07 Ju l-0 7 Ja n08 Ju l-0 8 -45- Slide 46: T2 Partners LLC 100 120 140 160 20 40 60 80 0 Note: 1985=100 Source: The Conference Board (www.pollingreport.com/consumer.htm) Consumer Confidence is Near an All-Time Low All-time low in October Ju n9 O7 ct -9 Fe 7 b9 Ju 8 n9 O8 ct -9 Fe 8 b9 Ju 9 n9 O9 ct -9 Fe 9 b0 Ju 0 n0 O0 ct -0 Fe 0 b0 Ju 1 n01 O ct -0 Fe 1 b0 Ju 2 n0 O2 ct -0 Fe 2 b0 Ju 3 n0 O3 ct -0 Fe 3 b0 Ju 4 n0 O4 ct -0 Fe 4 b0 Ju 5 n0 O5 ct -0 Fe 5 b0 Ju 6 n0 O6 ct -0 Fe 6 b0 Ju 7 n0 O7 ct -0 Fe 7 b0 Ju 8 n0 O8 ct -0 8 -46- Slide 47: Commercial Real Estate is Beginning to Collapse S&L crisis Commercial real estate delinquencies lag residential ones because “many existing properties were recently purchased at prices that were based on overly optimistic pro forma income projections. These loans typically included reserves to pay interest until rents increased (like a negatively amortizing option ARM), and it is likely that many of these deals will blow up when the interest reserve is depleted -- probably in the 2009-2010 period.” -- calculatedrisk.blogspot.com Source: Federal Reserve, http://calculatedrisk.blogspot.com T2 Partners LLC -47- Slide 48: 4,779 Commercial Buildings Worth $107 Billion Are Already Distressed or Troubled Source: Real Capital Analytics, NY Times, 12/18/08 T2 Partners LLC -48- Slide 49: Banks are Tightening Consumer Credit and New Household Borrowing Has Plunged % of U.S. Banks Tightening Consumer Credit $ 4 0 0 .0 New Household Borrowing ($ billions) $ 3 5 0 .0 $ 3 0 0 .0 $ 2 5 0 .0 $ 2 0 0 .0 $ 1 5 0 .0 $ 1 0 0 .0 $ 5 0 .0 $ 0 .0 06/90 06/91 06/92 06/93 06/94 06/95 06/96 06/97 06/98 06/99 06/00 06/01 06/02 06/03 06/04 06/05 06/06 06/07 06/08 Source: Federal Reserve, Carlyle and Paulson presentations T2 Partners LLC -49- Slide 50: The Credit Bubble Led to a Bubble in Financial Profits (& Share of GDP) 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 T2 Partners LLC -50- Slide 51: There Are Only a Few Bits of Good News Slide 52: Mortgage Rates Have Fallen Recently One-Year Trends Three-Year Trends T2 Partners LLC Source: Mortgage-X, http://mortgage-x.com/trends.htm. -52- Slide 53: Mortgage Refinancings Soared in Late November As Lending Rates Fell In late November, “the Federal Reserve announced that it would buy $500 billion in mortgage-backed securities guaranteed by Fannie Mae, Freddie Mac and Ginnie Mae. Mortgage rates immediately dropped, and that led to a surge in mortgage refinancing activity.” * National average rate for conforming loans – loans that are $729,750 or less, depending on the region, and can be sold to Fannie Mae or Freddie Mac. Sources: Mortgage Bankers Association, via Bloomberg; HSH Associates; appeared in NY Times, 12/3/08 T2 Partners LLC -53- Slide 54: But Interest Rates Are Only Falling for Loans That Can Be Guaranteed or Bought by Government (Prime Borrowers) Source: www.ritholtz.com/blog/2008/12/jumbo-prime-‘walk-away’-loans-more-downgrades-coming/ T2 Partners LLC -54- Slide 55: Conforming Single-Family Mortgages Remain Available, Thanks to the U.S. Government Agency Mortgage Origination Volume ($B) By Year $1,400 By Month $140 $1,200 $120 $1,000 $100 $800 $80 $600 $60 $400 $40 $200 $20 $0 2005 2006 2007 2008 (Jan-Sept) $0 Jan-07 Mar-07 May-07 Jul-07 Sep-07 Nov-07 Jan-08 Mar-08 May-08 Jul-08 Sep-08 Note: Agencies are Fannie Mae, Freddie Mac and Ginnie Mae Source: Bloomberg T2 Partners LLC -55- Slide 56: But Almost No Subprime, Alt-A and Jumbo Mortgages Are Being Issued Non-Agency Mortgage Issuance Source: Deutsche Bank, Merrill Lynch, Paulson presentation T2 Partners LLC -56- Slide 57: The Outlook Is Grim • • Defaulting subprime and Alt-A loans drove the first stage of the mortgage crisis The next leg down of the mortgage crisis will be driven by defaulting prime loans, primarily Option ARMs, home equity lines of credit (HELOCs) and second liens (closed-end seconds) Losses outside of the mortgage sector will also continue to rise due to commercial real estate, leveraged loans, junk bonds, etc. • T2 Partners LLC -57- Slide 58: About $440 Billion of Adjustable Mortgages Reset in 2008 We are here Loans with teaser rates were never supposed to reset. Reinforced by many years of experience, both lenders and borrowers assumed that home prices would keep rising and easy credit would keep flowing, allowing borrowers to refinance before the reset. Now that home prices are falling and the mortgage market has frozen up, very few borrowers can refinance, which, as shown later in this presentation, is leading to a surge in defaults – in many cases, even before the interest rate resets! Actual reset & IO simultaneous Sources: LoanPerformance, Deutsche Bank; slide from Pershing Square presentation, How to Save the Bond Insurers, 11/28/07. T2 Partners LLC -58- Slide 59: The Chart on the Previous Page Misses the Fact That Alt-A and Option ARM Resets Will Surge in 2010-11 Monthly Mortgage Rate Resets $B Source: Credit Suisse. T2 Partners LLC -59- Slide 60: The Alt-A Train Wreak is Unfolding Rapidly • About 3 million U.S. borrowers have Alt-A mortgages totaling $1 trillion, compared with $855 billion of subprime loans outstanding, according to Inside Mortgage Finance, a trade publication in Bethesda, Maryland. Of the Alt-A borrowers, 70 percent may have exaggerated their income, said David Olson, president of mortgage research firm Wholesale Access in Columbia, Maryland. Almost 16 percent of securitized Alt-A loans issued since January 2006 are at least 60 days late, data compiled by Bloomberg show. Defaults will accelerate next year and continue through 2011 as these loans hit their three- and fiveyear reset periods, according to RealtyTrac Inc., an Irvine, California-based foreclosure data provider. “Alt-A will be another headache,” said T.J. Lim, the Londonbased global co-head of markets at Unicredit Group. “I would be very worried about anything issued in the last half of 2006 and the first half of 2007.” • • • Source: Bloomberg, “Alt-A Mortgages Next Risk for Housing Market as Defaults Surge”, 9/12/09. T2 Partners LLC -60- Slide 61: A Primer on Option ARMs: What Is an Option ARM? • 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 20042007 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 interestonly 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) -61- T2 Partners LLC Slide 62: Further Details on Option ARMs From Washington Mutual’s 2007 10K (emphasis added): “The Option ARM home loan product is an adjustable-rate mortgage loan that provides the borrower with the option each month to make a fully-amortizing, interest-only, or minimum payment. As described in greater detail below, the minimum payment is typically insufficient to cover interest accrued in the prior month and any unpaid interest is deferred and added to the principal balance of the loan. The minimum payment on an Option ARM loan is based on the interest rate charged during the introductory period. This introductory rate has usually been significantly below the fullyindexed rate. The fully-indexed rate is calculated using an index rate plus a margin. Once the introductory period ends, the contractual interest rate charged on the loan increases to the fullyindexed rate and adjusts monthly to reflect movements in the index. If the borrower continues to make the minimum monthly payment after the introductory period ends, the payment may not be sufficient to cover interest accrued in the previous month. In this case, the loan will "negatively amortize" as unpaid interest is deferred and added to the principal balance of the loan. The minimum payment on an Option ARM loan is adjusted on each anniversary date of the loan but each increase or decrease is limited to a maximum of 7.5% of the minimum payment amount on such date until a "recasting event" occurs. A recasting event occurs every 60 months or sooner upon reaching a negative amortization cap. When a recasting event occurs, a new minimum monthly payment is calculated without regard to any limits on the increase or decrease in amount that would otherwise apply under the annual 7.5% payment cap. This new minimum monthly payment is calculated to be sufficient to fully repay the principal balance of the loan, including any theretofore deferred interest, over the remainder of the loan term using the fully-indexed rate then in effect. A recasting event occurs immediately whenever the unpaid principal balance reaches the negative amortization cap, which is expressed as a percent of the original loan balance. Prior to 2006, the negative amortization cap was 125% of the original loan balance... For all Option ARM loans originated in 2006, the negative amortization cap was 110% of the original loan balance. For Option ARM loans originated in 2007, the negative amortization cap was raised to 115%... In the first month that follows a recasting event, the minimum payment will equal the fullyamortizing payment. T2 Partners LLC -62- Slide 63: Beginning in March 2005, High-FICO-Score Borrowers Opted for an Above-Market-Rate Option ARM in Exchange for the Low Teaser Rate Source: Amherst Securities, Bloomberg T2 Partners LLC -63- Slide 64: Options ARMs Were Most Common in Housing Bubble States That Are Suffering the Greatest Home Price Declines California 18% Other 44% Nevada 12% Florida 9% Arizona 8% Hawaii 9% Note: Based on 2006 originations; Source: First American CoreLogic, as reported in Defaults Rising Rapidly For 'Pick-a-Pay' Option Mortgages, WSJ, 4/30/08. T2 Partners LLC -64- Slide 65: Rising Delinquencies Among Option ARMs • “’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.’" “In Q1, Countrywide Financial Corp. said that 9.4% of the option ARMs in its bank portfolio were at least 90 days past due, up from 5.7% at the end of December and 1% a year earlier.” “Washington Mutual Inc. reported earlier this month that option ARMs account for 50% of prime loans in its bank portfolio, but 70% of prime nonperforming loans.” “At Wachovia Corp., non-performing assets in the company's option ARM portfolio, which was acquired with the company's purchase of Golden West Financial Corp., climbed to $4.6 billion in the first quarter from $924 million a year earlier.” • • • Source: Defaults Rising Rapidly For 'Pick-a-Pay' Option Mortgages, WSJ, 4/30/08. T2 Partners LLC -65- Slide 66: Option ARMs are Recasting Much Faster Than Expected Due to Negative Amortization $18 $16 $14 $12 $10 Original recast schedule (5 yrs from origination) Recast schedule based on current neg am $8 $6 $4 $2 $pr -0 Ju 8 n0 A8 ug -0 O8 ct0 D8 ec -0 Fe 8 b0 A9 pr -0 9 Ju n0 A9 ug -0 O9 ct0 D9 ec -0 Fe 9 b1 A0 pr -1 Ju 0 n1 A0 ug -1 O0 ct1 D0 ec -1 Fe 0 b1 A1 pr -1 Ju 1 n1 A1 ug -1 O1 ct1 D1 ec -1 Fe 1 b1 A2 pr -1 2 Ju n1 A2 ug -1 2 T2 Partners LLC A -66- Slide 67: Comments From a Federal Senior Bank Examiner “The next problem is with the Option ARM product. Approximately 80-90% are paying the minimum credit card payment and most loans are negatively amortizing. Here the payment shock is two-fold – rate and principal – and the increase in payments can be astronomical: 200% or higher, not the 10 to 100% that subprime has experienced. Also, the dollars exposed in Alt-A are nearly 50% higher than subprime (Alt-A average balance is $299k versus $181k for subprime). Also, 73% were underwritten with Low or No Doc. The option arm books of many lenders are already showing significant deterioration and they have not even recast yet. This is the next tsunami to hit the housing market. This will hit much higher price points $600k and above as this was the affordability product used by higher income/higher FICO score households to buy that dream home.” T2 Partners LLC -67- Slide 68: A Primer on HELOCs and Closed-End Second Mortgages (Second Liens) Home Equity Lines of Credit (HELOC) and Closed-end Second Mortgages (CES) are junior to even the most subordinated tranches of a typical first mortgage securitization. HELOCs and CES are in a first-loss position and are leveraged to a decline in housing values. First Lien RMBS AAA High grade CDO AA A A BBB BB BB Equity Decline in Home Value House First Mortgage Mezzanine CDO Second Mortgage Equity Second Lien RMBS AAA AA A A BBB BB Equity Source: “How to Save the Bond Insurers”, Pershing Square presentation, 11/28/07. HELOCs / CES T2 Partners LLC 68 -68- Slide 69: HELOC & CES Exposure Is Effectively Mortgage Insurance • • • Mortgage insurers insure junior-most ~25% of high-LTV mortgage loans Closed-end seconds are junior to first mortgages, accrued interest, foreclosure costs, brokerage commissions, and other expenses HELOC and CES risk is actually structurally inferior to mortgage insurance risk • Mortgage insurers at least have the option to acquire the underlying first mortgage in order to improve recoveries • In a flat to declining home price environment, we believe HELOCs and CES are likely to suffer 100% loss severity upon default • MBIA agrees: in its Q1 08 earnings release, the company assumes 100% severity upon HELOC and CES default • Standard & Poor’s reported that delinquencies on home-equity lines of credit issued in 2005 and 2006 jumped in March 2008 to 9.2% of lines issued in 2005 and 11.5% of loans issued in 2006, both up 6.5% from February. Source: “How to Save the Bond Insurers”, Pershing Square presentation, 11/28/07; WSJ, 4/21/08. T2 Partners LLC 69 -69- Slide 70: Pools of HELOCs and CESs Can Suffer Astronomical Losses Due to 100%+ Severities On One Second Lien Deal, Ambac Expected Losses of 10-12% -- But Now Estimates 81.8% From Ambac slide: • This is a second lien deal that closed in April 2007 • NCL to date 9.9% • Projected NCL 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 1012%, with the transaction having an A+ rating at inception and being structured to withstand 28-30% collateral loss T2 Partners LLC Source: Ambac Q1 08 presentation; funds managed by T2 Partners are short Ambac -70- Slide 71: Many Banks Have Large Exposures to Home Equity Loans Source: U.S. Home Equity Woes: Banks Grapple With Higher Losses, Fitch, 3/14/08 T2 Partners LLC -71- Slide 72: The Timing Indicates That We Are Still in the Early Stages of the Bursting of the Great Mortgage Bubble • • Mortgage lending standards became progressively worse starting in 2000, but really went off a cliff beginning in early 2005 The worst loans are those with two-year teaser rates. As the subsequent pages show, they are defaulting at unprecedented rates, especially once the interest rates reset Such loans made in Q1 2005 started to default in high numbers in Q1 2007, which not surprisingly was the beginning of the current crises The crisis has continued to worsen as even lower quality 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 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, 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 early 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. T2 Partners LLC -72- Slide 73: A Closer Look at Mortgage Loans That Were Securitized: Quantity and Quality Slide 74: Hundreds of Billions of Dollars of Mortgages Were Securitized, Many On Terms With No Historical Precedent Securitized First Liens – Origination Volume These are the worst loans: $828 billion worth Green: Loans with historical precedent Yellow: Loans with limited historical precedent Red: Loans with no historical precedent Source: Amherst Securities Group, L.P. T2 Partners LLC -74- Slide 75: Tens of Billions of Dollars of 2nd Lien Mortgages Were Also Securitized, Many On Terms With No Historical Precedent Securitized Second Liens – Origination Volume Another $56 billion of even bigger problems Green: Loans with historical precedent Yellow: Loans with limited historical precedent Red: Loans with no historical precedent Source: Amherst Securities Group, L.P. T2 Partners LLC -75- Slide 76: Volume of June 2005 Fixed Rate and 2/28* Full Doc Securitized Mortgage Loans Fixed Full Doc – June 2005 Production Total Volume: $ 8.1 billion Green: 70.0%; Yellow: 9.3%; Red: 5.4% Loan-to-Value 2/28 Full Doc – June 2005 Production Total Volume: $16.4 billion Green: 39.9%; Yellow: 25.2%; Red: 26.1% Loan-to-Value FICO Note: Green: Loans with historical precedent; Yellow: Loans with limited historical precedent; Red: Loans with no historical precedent * 2-28 loans are those with two-year teaser interest rates that then reset to much higher rates, which triggers a surge in defaults. Because they offer the lowest monthly payments (for the first two years), they are generally the lowest-quality loans, preferred by speculators and the most over-stretched borrowers. T2 Partners LLC Source: Amherst Securities Group, L.P. -76- Slide 77: Volume of June 2005 Fixed Rate and 2/28 Low Doc Securitized Mortgage Loans Fixed Low Doc – June 2005 Production Total Volume: $ 7.7 billion Green: 49.2%; Yellow: 25.8%; Red: 8.0% 2/28 Low Doc – June 2005 Production Total Volume: $14.1 billion Green: 17.0%; Yellow: 33.4%; Red: 31.1% Source: Amherst Securities Group, L.P. T2 Partners LLC -77- Slide 78: Origination Volume of Fixed Rate, Full Doc Securitized Mortgage Loans, January 2005 In the best category of loans (full doc, fixed rate), in January 2005, just before mortgage lending standards collapsed, nearly all securitized mortgages were green, meaning they had FICO and LTV characteristics with historical precedent. Prime Alt-A Subprime T2 Partners LLC -78- Slide 79: Origination Volume of Fixed Rate, Full Doc Securitized Mortgage Loans, June 2005 Mortgage lending standards began to worsen by June 2005. T2 Partners LLC -79- Slide 80: Origination Volume of Fixed Rate, Full Doc Securitized Mortgage Loans, January 2006 By January 2006, mortgage lending standards had deteriorated substantially, even more the best loans, with large percentages yellow and red, meaning they had FICO and LTV characteristics with little or no historical precedent. T2 Partners LLC -80- Slide 81: Origination Volume of Fixed Rate, Full Doc Securitized Mortgage Loans, June 2006 By June 2006, mortgage lending standards had collapsed, even for the best loans, with large percentages yellow and red, meaning they had FICO and LTV characteristics with little or no historical precedent. T2 Partners LLC -81- Slide 82: Origination Volume of 2/28, Low Doc Securitized Mortgage Loans, January 2005 For the worst category of loans (low/no doc with two-year teaser rates), mortgage lending standards were abysmal as early as January 2005 – and got worse from there. T2 Partners LLC -82- Slide 83: Origination Volume of 2/28, Low Doc Securitized Mortgage Loans, June 2005 T2 Partners LLC -83- Slide 84: Origination Volume of 2/28, Low Doc Securitized Mortgage Loans, January 2006 T2 Partners LLC -84- Slide 85: Origination Volume of 2/28, Low Doc Securitized Mortgage Loans, June 2006 A very high percentage of these loans will never be repaid. T2 Partners LLC -85- Slide 86: A Closer Look at Mortgage Loans That Were Securitized: Defaults Slide 87: Default Rates of June 2005 Fixed Rate and 2/28 Full Doc Securitized Mortgage Loans Fixed Full Doc – June 2005 Production Total Volume: $ 8.1 Green: 83.0%; Yellow: 10.3%; Red: 6.7% 2/28 Full Doc – June 2005 Production Total Volume: $16.4 Green: 46.9%; Yellow: 26.0%; Red: 27.2% Unprecedented default rates – and lending standards got much worse subsequent to June 2005! T2 Partners LLC Source: Amherst Securities Group, L.P. -87- Slide 88: Default Rates of June 2005 Fixed Rate and 2/28 Low Doc Securitized Mortgage Loans Default rates are much higher for no/low doc “liars” loans Fixed Low Doc – June 2005 Production Total Volume: $7.7 billion Green: 64.3%; Yellow: 27.0%; Red: 8.7% 2/28 Low Doc – June 2005 Production Total Volume: $14.1 billion Green: 29.2%; Yellow: 37.0%; Red: 33.8% Source: Amherst Securities Group, L.P. T2 Partners LLC -88- Slide 89: Monthly Default Rate for Fixed Rate Securitized Mortgage Loans (Green) 10% 9% 8% Defaults are defined as loans that are 90 days or more delinquent. MDR measures the percentage of loans that become 90 days or more delinquent during the month, as a percentage of non-delinquent loans at the beginning of the month. 12/2004 7% 6% MDR 5% 4% This chart shows the performance of the very best (fixed rate, green) mortgages. Note that late 2004 and early 2005 vintage loans have MDRs of approximately 30 basis points, which translates into a 3% cumulative default rate over three years, whereas more recent vintage loans are quickly spiking up to a 1% MDR, which translates into an 11.4% cumulative default rate in one year. 9/06 12/04 03/2005 06/2005 09/2005 12/2005 03/2006 06/2006 09/2006 12/2006 03/2007 3% 2% 1% 0% 38 28 32 30 22 26 16 20 14 10 12 18 Age (in m onths) Source: Amherst Securities Group, L.P. T2 Partners LLC 24 34 36 42 44 40 2 0 4 6 8 -89- Slide 90: Monthly Default Rate for Fixed Rate Securitized Mortgage Loans (Yellow) 10% 9% 8% 7% In this chart, late 2004 and early 2005 vintage loans have MDRs of approximately 50 basis points, which translates into a 5.8% cumulative default rate in one year, whereas more recent vintage loans are quickly spiking up to a 2.0% MDR, which translates into an 21.5% cumulative default rate in one year. 12/2004 03/2005 6% MDR 06/2005 09/2005 5% 12/2005 03/2006 06/2006 4% 09/2006 12/2006 3% 03/2007 2% 1% 0% 10 12 14 16 18 20 22 24 26 28 30 32 34 36 38 40 42 44 0 2 4 6 8 Age (in m onths) Source: Amherst Securities Group, L.P. T2 Partners LLC -90- Slide 91: Monthly Default Rate for Fixed Rate Securitized Mortgage Loans (Red) 10% 9% 8% 7% In this chart, late 2004 and early 2005 vintage loans have MDRs of approximately 1%, which translates into an 11.4% cumulative default rate in one year, whereas more recent vintage loans are quickly spiking up to a 3.0% MDR, which translates into an 30.6% cumulative default rate in one year. 12/2004 03/2005 06/2005 09/2005 6% MDR 5% 12/2005 03/2006 06/2006 4% 09/2006 12/2006 3% 03/2007 2% 1% 0% 10 12 14 16 18 20 22 24 26 28 30 32 34 36 38 40 42 44 0 2 4 6 8 Age (in m onths) Source: Amherst Securities Group, L.P. T2 Partners LLC -91- Slide 92: Monthly Default Rate for 2-28 Securitized Mortgage Loans (Green) 10% 9% 2-28 loans are those with two-year teaser interest rates that then reset, often to much higher rates, which triggers a surge in defaults. In this chart, note the surge in MDR shortly after the two-year reset, as well as the rapidly rising MDR even before the reset in more recent vintage loans – compare 12/04, 9/05 and 9/06 loans, for example. A 4.0% MDR translates into a 38% cumulative default rate in one year. 9/06 (pre-reset) 9/05 (pre-reset) 12/04-6/05 (pre-reset) 10 12 14 16 18 Source: Amherst Securities Group, L.P. 8% 7% 12/2004 03/2005 06/2005 09/2005 12/2005 03/2006 06/2006 6% MDR 5% 4% 09/2006 12/2006 03/2007 3% 2% 1% 0% 20 22 24 26 28 30 32 0 2 4 6 8 Age (in m onths) T2 Partners LLC 34 36 38 40 42 44 -92- Slide 93: Monthly Default Rate for 2-28 Securitized Mortgage Loans (Yellow) 12% 11% 10% 9% 12/2004 8% 7% MDR 6% 5% 4% 3% 2% 1% 0% 10 12 14 16 18 20 22 24 26 28 30 32 34 36 38 40 42 44 0 2 4 6 8 2006 and 2007 loans are defaulting at 4-5% per month even before the reset 03/2005 06/2005 09/2005 12/2005 03/2006 06/2006 09/2006 12/2006 03/2007 Age (in m onths) Source: Amherst Securities Group, L.P. T2 Partners LLC -93- Slide 94: Monthly Default Rate for 2-28 Securitized Mortgage Loans (Red) 11% 10% 9% For recent vintage 2-28 red loans, MDRs are jumping to 5-6% long before the reset 12/2004 03/2005 8% 7% 06/2005 09/2005 MDR 6% 5% 12/2005 03/2006 06/2006 09/2006 12/2006 03/2007 4% 3% 2% 1% 0% 10 12 14 16 18 20 22 24 26 28 30 32 34 36 38 40 42 44 0 2 4 6 8 Age (in m onths) Source: Amherst Securities Group, L.P. T2 Partners LLC -94- Slide 95: Voluntary Prepayment Rate for Fixed Rate Securitized Mortgage Loans (Green) 100% 90% 80% 70% The Voluntary Prepayment Rate measures the rate at which borrowers are refinancing and paying off their loans. For example, a VPR of 20% for a particular month means that if one annualizes that month’s prepayment rate, 20% of the loans in the pool would be paid off in one year. A 6% VPR means only one half of 1% of loans are prepaying every month (compare this to the percentages that are defaulting every month). A high VPR reduces the default rate of a pool of loans because loans that prepay (by definition at 100 cents on the dollar) can’t default. In this chart, the VPR is low because green (i.e., better credit) borrowers with fixed rate mortgages have little incentive to prepay. Note, however, that for more recent vintage loans (12/06 and 3/07, for example), the VPR does not rise as high and declines more quickly than older vintage loans, which is not a good sign for lenders. There are two reasons for this – see next slide. 12/2004 03/2005 06/2005 09/2005 12/2005 03/2006 06/2006 09/2006 12/2006 03/2007 60% VPR 50% 40% 30% 20% 10% 0% 10 12 14 0 2 4 6 8 3/07 16 18 12/06 20 22 24 26 28 30 32 34 36 38 40 42 Source: Amherst Securities Group, L.P. Age (in m onths) T2 Partners LLC 44 -95- Slide 96: Voluntary Prepayment Rate for Fixed Rate Securitized Mortgage Loans (Yellow) The VPR is higher for yellow and red loans vs. green ones because borrowers, due to their poorer credit, are paying higher interest rates and thus have more incentive to refinance. As with the previous page, the VPR is rising less and declining more quickly for more recent vintage loans. There are two reasons for this: 1) Due to declining credit standards, more recent borrowers are of lower credit quality and thus have less ability to refinance; and 2) Borrowers in 12/04 benefited from the subsequent 2½ years of declining lending standards, a long period in which it was easy to refinance. Borrowers in 3/07, in contrast, had almost no opportunity to refinance. 12/04 borrowers refinancing in early to mid-2006 100% 90% 80% 70% 12/2004 03/2005 06/2005 09/2005 12/2005 03/2006 06/2006 09/2006 12/2006 03/2007 60% VPR 50% 40% 30% 20% 10% 0% 10 12 14 16 0 2 4 6 8 3/07 18 20 22 24 26 28 30 32 34 36 38 40 42 Source: Amherst Securities Group, L.P. T2 Partners LLC Age (in m onths) 44 -96- Slide 97: Voluntary Prepayment Rate for Fixed Rate Securitized Mortgage Loans (Red) 100% 90% 80% 70% 12/2004 03/2005 60% VPR 06/2005 09/2005 50% 12/2005 03/2006 06/2006 40% 09/2006 12/2006 30% 03/2007 20% 10% 0% 10 12 14 16 20 32 18 24 30 36 22 28 34 40 26 38 42 44 2 0 4 6 8 Age (in m onths) Source: Amherst Securities Group, L.P. T2 Partners LLC -97- Slide 98: Voluntary Prepayment Rate for 2-28 Securitized Mortgage Loans (Green) 100% 90% 80% 70% 60% VPR 50% 40% 30% 20% 10% For 2-28 loans, there is a surge in prepayments when the interest rates reset, as those that are able to refinance do so. Note that, relative to the 12/04 and 3/05 loans, the 6/05 and 9/05 vintage loans have a lower VPR spike upon the reset and the VPR declines more quickly thereafter. Also note the low VPRs for more recent vintage loans that have not yet reset – all ominous signs for lenders. 6/05 9/05 12/2004 03/2005 06/2005 09/2005 12/2005 03/2006 06/2006 09/2006 12/2006 03/2007 More recent vintages 0% 20 12 18 10 16 22 24 14 26 28 30 32 34 36 40 38 42 44 2 0 4 6 8 Age (in m onths) Source: Amherst Securities Group, L.P. T2 Partners LLC -98- Slide 99: Voluntary Prepayment Rate for 2-28 Securitized Mortgage Loans (Yellow) 100% 90% 80% As on the previous page, we see the same phenomenon of low VPRs prior to the reset, a lower spike upon reset and a quicker decline thereafter. 12/2004 03/2005 70% 60% VPR 06/2005 09/2005 50% 12/2005 03/2006 06/2006 40% 09/2006 12/2006 30% 03/2007 20% 10% 0% 10 12 14 16 20 32 18 24 30 36 22 28 34 40 26 38 42 44 2 0 4 6 8 Age (in m onths) Source: Amherst Securities Group, L.P. T2 Partners LLC -99- Slide 100: Voluntary Prepayment Rate for 2-28 Securitized Mortgage Loans (Red) 100% 90% 80% 70% As on the previous two pages, we see the same phenomenon of low VPRs prior to the reset, a lower spike upon reset and a quicker decline thereafter. 12/2004 03/2005 60% VPR 06/2005 09/2005 50% 12/2005 03/2006 06/2006 40% 09/2006 12/2006 30% 03/2007 20% 10% 0% 10 12 14 16 20 32 18 24 30 36 22 28 34 40 26 38 42 44 2 0 4 6 8 Age (in m onths) Source: Amherst Securities Group, L.P. T2 Partners LLC -100- Slide 101: Current MDR and VPR Trends Will Quickly Lead to Unprecedented Default Levels Three-Year Cumulative Defaults (1 yr): Voluntary Prepayment Rate (VPR) Historical levels 2004 green, fixed Late 2005 and thereafter, Green, 2/28 Late 2005 and thereafter, Red, 2/28 Late 2005 and thereafter, Green, fixed T2 Partners LLC Note: Cumulative defaults represent the amount of loans in default as a percentage of the original balance at WALA 36 when keeping MDR and VPR constant for that time period. Source: Amherst Securities Group, L.P. -101- Slide 102: If Current Trends Continue, 37.8% of Performing Mortgages That Comprise the ABX 06-2 Will Default in the Next 12 Months The 20 RMBS Pools That Comprise the ABX 06-2 Monthly default rate Monthly prepay rate Cumulative defaults Annualized default rate Annualized prepay rate An average of 38.5% of the loans have already defaulted (was 26% in March) On average, 4.1% of the performing loans in the pools defaulted during the month The monthly prepay rate only averaged 0.8% (was 2.0% in March) -102- th T2 Partners LLC Source: Amherst Securities Group, November 25 reports, reflecting payments through 10/31/08 Slide 103: The IMF Estimated in October That Total Credit Losses Will Be $1.4 Trillion – And Less Than One Half of This Has Been Realized To Date $1405 bn 1400 1200 $ billion Corporate Consumer Commercial Real Estate $674 bn Prime 1000 800 600 400 200 0 Subprime Alt-A $442 bn CDO IMF For e cast Oct 2008 Wr ite downs to D ate C apital Raise d Sources: International Monetary Fund, Bloomberg, as of October 8, 2008; Paulson presentation T2 Partners LLC -103- Slide 104: A Breakdown of the Writedowns/Losses and Capital Raised T2 Partners LLC Date: 9/09 -104- Slide 105: European Banks Are Far More Leveraged Than U.S. Ones Bank Leverage (Assets/Equity) Overall By Bank Sources: Citigroup, “A Downward Spiral”, 9/17/08; “Greed & Fear”, 9/10/08; Carlyle presentation, 10/15/08 T2 Partners LLC -105- Slide 106: Where Did the Securitized Mortgages End Up? A Primer on ABSs and CDOs Slide 107: Where Did All of These Toxic Loans End Up? They Were Securitized, First Into Asset-Backed Securities Called RMBS’s (Residential Mortgage Backed Security) Quick Review: What is a Securitization? Source: Deutsche Bank Securitization Research; “How to Save the Bond Insurers”, Pershing Square presentation, 11/28/07. T2 Partners LLC -107- Slide 108: A Typical RMBS Had Many Tranches This Is a Pool of Subprime Mortgages ACE Securities Corp - ACE 2006-HE1 Class A1A A1B1 Ratings Aaa (AAA) Aaa (AAA) Aaa (AAA) Aaa (AAA) Aaa (AAA) Aaa (AAA) Aaa (AAA) Aa1 (AA+) Aa2 (AA) Aa3 (AA-) A1 (A+) A2 (A) A3 (A-) Baa1 (BBB+) Baa2 (BBB) Baa3 (BBB-) Ba1 (BB+) Class Amount Outstanding $757,819,000 417,082,000 104,270,000 356,980,000 127,685,000 88,606,000 78,490,000 101,428,000 92,553,000 57,053,000 48,178,000 45,643,000 41,839,000 40,571,000 36,768,000 26,625,000 31,696,000 82,415,903 $2,535,701,903 Subordination Spread to One- Month LIBOR 0.14 This pool had the following characteristics: • Average loan: $204,245 • Average interest rate: 7.7% • Average FICO score: 629 (anything below 660 is subprime) • Most loans were in CA (33.9%), FL (9.6%) & NY (8.8%) • 75.7% of loans were originated by Fremont Investment & Loan (filed for bankruptcy 6/18/08) and 10.9% by Ownit Mortgage Solutions (filed for bankruptcy 1/07) By comparing the interest rate of the underlying loans (7.7%) with the interest paid on nearly all of the pool (LIBOR plus a few basis points), one can see how enormously profitable this structure is to the sponsor 95.5% of the pool was rated investment grade A1B2 A2A A2B A2C A2D M1 M2 M3 M4 M5 M6 M7 M8 M9 M10 76.1% of the pool was rated AAA 23.9% 19.9% 16.2% 14.0% 12.1% 10.3% 8.6% 7.0% 5.6% 4.5% 3.3% 0.15 0.15 0.04 0.09 0.15 0.25 0.27 0.29 0.30 0.45 0.48 0.58 0.95 1.35 2.45 5.50 Source: Paulson presentation Over Collateralization T2 Partners LLC -108- Slide 109: Tranches from Asset-Backed Securities Were Pooled into Collateralized Debt Obligations (CDOs) Loss rates of, say, 20%, in the underlying RMBS’s can lead to catastrophic losses for a CDO This is an example of a “Mezzanine CDO.” A “High-Grade CDO” would select collateral primarily from the A and AA tranches mixed with ~25% senior tranches from other, often mezzanine, CDOs Note: Asset-based securities backed by home mortgages are called Residential Mortgage-Backed Securities (RMBS), those backed by commercial real estate loans are called Commercial Mortgage-Backed Securities (CMBS), etc. Source: Citigroup, All Clogged Up: What’s Ailing the Financial System, 2/13/08 T2 Partners LLC -109- Slide 110: This Chart Shows How One Would Analyze a Typical RMBS The Four Major Variables Are: 1) Severity on Loans That Have Already Defaulted; 2 & 3) % of Performing Loans That Default vs. Prepay; and 4) Severity of New Defaults A New Century Financial 2005 RMBS (pool of mortgages) (MABS-05NC2) We think at least 2/3 of currently performing mortgages will likely eventually default (25%) (30%) Same roll rates In April, UBS projected that $128.5 million (47.5%) of currently performing mortgages will default, resulting in $118.2 million of REO (We think this will prove to be low) UBS assumed 60% severity for both defaulted loans (about right) and future defaults (too low) UBS projected $201 million (22.3%) in total losses for this pool (we think losses will be higher) Source: Bankstocks.com/Second Curve Capital, based on 3/25/08 remittance reports T2 Partners LLC 6 months later (9/25 remittance reports), realized losses rose -110to $38.2 million Slide 111: Trillions of Dollars of ABSs and CDOs Were Created and Distributed Throughout the Financial System Note: This is all ABSs and CDOs, not just those related to mortgages Source: Lehman Brothers, 4/08; Carlyle presentation 10/15/08 T2 Partners LLC -111- Slide 112: The Issuance of ABSs Backed By Subprime and Second-Lien Mortgages Surged in 2004, 2005 and 2006 Source: Thompson Financial, Deutsche Bank; “Who's Holding the Bag?”, Pershing Square presentation, 5/23/07 T2 Partners LLC -112- Slide 113: Hundreds of Billions of Dollars of Tranches of Various Types of ABSs Ended Up in CDOs Source: Bear Stearns; “Who's Holding the Bag?”, Pershing Square presentation, 5/23/07 T2 Partners LLC -113- Slide 114: An Estimated $320 Billion of CDOs Backed by Subprime Securities Were Issued in 2006 and 2007 There are approximately $3.2 trillion in asset-backed and non-agency mortgage-backed securities where the same structuring techniques and “good times” assumptions were employed to create “highly rated” securities. Source: Paulson presentation T2 Partners LLC -114- Slide 115: The Opportunity in Distressed Debt – Specifically, Senior Tranches of Mortgage Pools Slide 116: There is Nearly $10 Trillion of Debt in Areas That Are or Are Likely to Be Distressed ($ Trillion) 4 $ 3.6 $ 3.6 We are focused on opportunities in senior tranches of pools of bubble-era mortgages (RMBSs) 3.5 3 2.5 $ 2.2 Finance Companies & Brokers $ 2.0 (U.S.) $ 1.1 (Europe) 2 1.5 1 0.5 0 Jumbo $ 0.5 Alt-A $ 1.0 Banks $ 1.6 Subprime $ 0.7 $ 2.5 (U.S.) B a n k s / F in a n c e C o m p a n ie s & Sources: Lehman Brothers, Credit Suisse, Federal Reserve, Paulson presentation B ro k e rs T2 Partners LLC S u b p rim e / A lt - A / J um bo Le v e re d Lo a n s / H ig h Yie ld / D is t re s s e d -116-