11

The Great Mortgage The Great Mortgage Market Implosion of 2007Market Implosion of 2007

The Evolution of Risk Based Real Estate LendingThe Evolution of Risk Based Real Estate Lending

George W. LawrenceGeorge W. LawrenceMember, Master Instructor FacultyMember, Master Instructor Faculty

California Association of REALTORSCalifornia Association of REALTORS®®

September 2008September 2008

22

1994: The Beginning of the Boom1994: The Beginning of the Boom FOUR EVENTS AIDED BIRTH OF NEW LOAN FOUR EVENTS AIDED BIRTH OF NEW LOAN

PLANS AND SOURCES OF FUNDS TO PLANS AND SOURCES OF FUNDS TO STIMULATE LENDINGSTIMULATE LENDING CREDIT SCORING & RISK BASED CREDIT SCORING & RISK BASED

UNDERWRITINGUNDERWRITING AUTOMATED UNDERWRITING AUTOMATED UNDERWRITING CREATIVE SECURITIZATIONCREATIVE SECURITIZATION COMMUNITY REINVESTMENT ACT COMMUNITY REINVESTMENT ACT

AMENDMENTS OF 1995.AMENDMENTS OF 1995.

33

Birth of Creative Loan ProgramsBirth of Creative Loan Programs

SUBPRIME LOANSSUBPRIME LOANS

NEGATIVE AMORTIZATION LOANSNEGATIVE AMORTIZATION LOANS

INTEREST ONLY LOANSINTEREST ONLY LOANS

REDUCED DOCUMENTATION LOANSREDUCED DOCUMENTATION LOANS

44

Securitization: Key to ExplosionSecuritization: Key to Explosion $50 B IN SUBPRIMES ORIGINATED IN 1994$50 B IN SUBPRIMES ORIGINATED IN 1994 $665 B ORIGINATED IN 2005$665 B ORIGINATED IN 2005 SECONDARY MARKET INVESTORS SECONDARY MARKET INVESTORS

PACKAGED MORTGAGE BACKED PACKAGED MORTGAGE BACKED SECURITIES AS CDO’SSECURITIES AS CDO’S

FINANCIAL ENGINEERING ALLOWED THE FINANCIAL ENGINEERING ALLOWED THE CDO TO BE RISK RATEDCDO TO BE RISK RATED

RATING GAVE APPEARANCE OF LOW RISK RATING GAVE APPEARANCE OF LOW RISK INVESTMENT TO GLOBAL INVESTORS.INVESTMENT TO GLOBAL INVESTORS.

5

Subprime Explosion

• 1994: START OF SUBPRIME “EXPLOSION”• PRE 1994: ONLY 70 SUBPRIME LENDERS• 1994-97: NUMBER GREW TO 210• PRE 1994: 32% OF SUBPRIMES WERE

“PACKAGED” AS MORTGAGE BACKED SECURITIES (MBS’)

• SINCE 1994: 81% OF SUBPRIMES WERE PACKAGED AS MBS

• PRE 1994: 64% HOMEOWNERSHIP RATE• SINCE 1994 RATE ROSE TO OVER 69%.

6

Subprime Loans Originated1994-2007

$0

$100

$200

$300

$400

$500

$600

$700

Bill

ions

Subprime defaults begin Wall Street Subprime funds collapse.

Housing Market cools

Recession 2000-2001

Fed Raises Fed Funds Rate

7

California Median Home Prices 1973 to 2008

0

100000

200000

300000

400000

500000

600000

Subprime Era

1994 to 2007

8

Prime Mortgage Securitization

AAA

AA

MEZZANINE B

JUNIOR/EQUITYUNRATED-UNINSURED

Borrowers Lender/ServicerSecondary Market

Investor

SPE

NOTES

$MBS

$

$

Collateralized Debt Obligation Bond

AAA

Rated

Subprime Securitization

MBS

9

Collateralized Debt Obligation Bond - Example

AAA

AA

MEZZANINE “B”

JUNIOR/EQUITY UNRATED, UNINSURED

ABSORBS ALL LOSSES UNTIL TRANCHE IS DEPLETED

ABSORBS NEXT LOSSES UNTIL TRANCHE IS DEPLETED

ABSORBS NEXT LOSSES UNTIL TRANCHE IS DEPLETED

ABSORBS FINAL LOSSES

IS PAID FIRST,LOWEST YIELD

IS PAID NEXTWITH HIGHER YIELD

IS PAID THIRD,EVEN HIGHER YIELD

IS PAID LAST,GETS HIGHEST YIELD

10

AAA

AA

MEZZANINE B

JUNIOR/EQUITYUNRATED-UNINSURED

Borrowers Lender/ServicerSecondary Market

Investor

SPE

Global Investors

SPE

NOTES

$MBS

$

$

Collateralized Debt Obligation Bond

Subprime Securitization

MBS

$

1111

Negative Amortization LoansNegative Amortization Loans ALLOWS PAYMENT LESS THAN THE ALLOWS PAYMENT LESS THAN THE

ACTUAL INTEREST AMOUNT DUEACTUAL INTEREST AMOUNT DUE START RATE PAYMENT AS LOW AS 1%START RATE PAYMENT AS LOW AS 1% INTEREST ONLY PAYMENT ALLOWEDINTEREST ONLY PAYMENT ALLOWED NOTE RATE 5 – 6% HIGHER OR MORENOTE RATE 5 – 6% HIGHER OR MORE PAYMENT RESETS AFTER 5 YEARSPAYMENT RESETS AFTER 5 YEARS

AT CURRENT NOTE RATEAT CURRENT NOTE RATE FOR 25 YEAR TERMFOR 25 YEAR TERM

A GAMBLE!A GAMBLE!

12

Negative Amortization ARMs

NOTE RATE VS. START RATE

0.000%

1.000%

2.000%

3.000%

4.000%

5.000%

6.000%

7.000%

11TH COFI 2.829% 3.050% 5.880% 1.250%

INDEX MARGIN FULL RATE START RATE

FULL PAYMENT:

$3,107.25 Mo

START RATE PAYMENT

$1,749.57 Mo

1313

Negative Amortization ARMsNegative Amortization ARMs

THE “SHOCK” THE “SHOCK” AFTER 5 YEARS PAYINGAFTER 5 YEARS PAYING

START RATE PAYMENTSTART RATE PAYMENT IF ACTUAL RATE REMAINS STABLE, NEW IF ACTUAL RATE REMAINS STABLE, NEW

PAYMENT COULD BEPAYMENT COULD BE

AT LEASTAT LEAST

$3,875.54$3,875.54AN INCREASE OF $2,125.97 MONTHLYAN INCREASE OF $2,125.97 MONTHLY

1414

Negative Amortization LoansNegative Amortization Loans

THE REAL SHOCK:THE REAL SHOCK: AT THE “LIFE TIME CAP RATE” THE PAYMENT AT THE “LIFE TIME CAP RATE” THE PAYMENT

COULD JUMP FROM $1749 TO:COULD JUMP FROM $1749 TO:

$5,346.44$5,346.44 Monthly… an Monthly… an

INCREASE OF INCREASE OF

$3,596.87!$3,596.87!

1515

Negative Amortization LoansNegative Amortization Loans

75% OF BORROWERS MADE ONLY MINIMUM 75% OF BORROWERS MADE ONLY MINIMUM PAYMENT PAYMENT

GREATEST NUMBER ORIGINATED BETWEEN GREATEST NUMBER ORIGINATED BETWEEN 2003 AND 20052003 AND 2005

PAYMENT RESETS BEGAN IN AUG 2008PAYMENT RESETS BEGAN IN AUG 2008 RESETS WILL PEAK JUNE 2010RESETS WILL PEAK JUNE 2010 RESETS SHOULD END BY DEC. 2010RESETS SHOULD END BY DEC. 2010 AVERAGE LOAN BALANCE AT RESET IS 115% AVERAGE LOAN BALANCE AT RESET IS 115%

TO 125% OF ORIGINAL LOAN AMOUNTTO 125% OF ORIGINAL LOAN AMOUNT MOST LOANS EXCEED PROPERTY’S VALUE.MOST LOANS EXCEED PROPERTY’S VALUE.

16

Adjustable Rate Loans Reset Calendar June 2008 to Dec. 2011

ARMS Forecast to Reset

0

5

10

15

20

25

30

35

40

45

50

Jun-

08

Sep

-08

Dec

-08

Mar

-09

Jun-

09

Sep

-09

Dec

-09

Mar

-10

Jun-

10

Sep

-10

Dec

-10

Mar

-11

Jun-

11

Sep

-11

Dec

-11

$ Billion

Subprime Pay Option

1717

Interest Only & Reduced Interest Only & Reduced Documentation LoansDocumentation Loans

STATED INCOME: INCOME IS STATED NOT STATED INCOME: INCOME IS STATED NOT VERIFIEDVERIFIED

FICO AND LTV DETERMINE RATEFICO AND LTV DETERMINE RATE

SOME PLANS ALLOWED “INTEREST ONLY”SOME PLANS ALLOWED “INTEREST ONLY”

IRS FORM 4506IRS FORM 4506--T NOW USUALLY REQUIREDT NOW USUALLY REQUIRED..

1818

Stated Income LoansStated Income Loans 80% OF NEGATIVE AMORTIZATION LOANS 80% OF NEGATIVE AMORTIZATION LOANS

WERE STATED INCOMEWERE STATED INCOME

90% OF BORROWERS OVERSTATED INCOME 90% OF BORROWERS OVERSTATED INCOME 5% OR MORE5% OR MORE

60% OVERSTATED INCOME OVER 50%60% OVERSTATED INCOME OVER 50%

NEARLY IMPOSSIBLE TO MAKE NEW RESET NEARLY IMPOSSIBLE TO MAKE NEW RESET PAYMENT BASED ON ACTUAL INCOME.PAYMENT BASED ON ACTUAL INCOME. Source: Mortgage Asset Research Institute Inc., Source: Mortgage Asset Research Institute Inc.,

Lender’s Tax Return Audit for IRSLender’s Tax Return Audit for IRS

1919

New Laws for Predatory New Laws for Predatory Lending PracticesLending Practices

Federal Agencies Take Steps to Federal Agencies Take Steps to Regulate Subprime Lending Regulate Subprime Lending

IndustryIndustry

2020

Amendments to Regulation “Z”, Amendments to Regulation “Z”, Truth in Lending ActTruth in Lending Act

RULES FOR “HIGHER PRICED” PRICED RULES FOR “HIGHER PRICED” PRICED LOANS EFFECTIVE OCTOBER 1, 2009LOANS EFFECTIVE OCTOBER 1, 2009 APPLY TO FIRST MORTGAGES HAVING APPLY TO FIRST MORTGAGES HAVING

INTEREST RATES GREATER THAN 1.5% INTEREST RATES GREATER THAN 1.5% OVER THE AVERAGE MARKET RATEOVER THE AVERAGE MARKET RATE

APPLY TO SECOND MORTGAGES HAVING APPLY TO SECOND MORTGAGES HAVING INTEREST RATES GREATER THAN 3.5% INTEREST RATES GREATER THAN 3.5% OVER THE AVERAGE MARKET RATE.OVER THE AVERAGE MARKET RATE.

2121

Amendments to Regulation “Z”, Amendments to Regulation “Z”, Truth in Lending ActTruth in Lending Act

NEW REGULATIONS FOR SUBPRIME LOANS:NEW REGULATIONS FOR SUBPRIME LOANS: LENDERS MUST VERIFY BORROWER’S LENDERS MUST VERIFY BORROWER’S

INCOME AND ASSETSINCOME AND ASSETS PREPAY PENALTIES PROHIBITED IF LOAN PREPAY PENALTIES PROHIBITED IF LOAN

PAYMENT ADJUSTS IN LESS THAN 4 PAYMENT ADJUSTS IN LESS THAN 4 YEARS, MAXIMUM 2 YEARS OTHERS.YEARS, MAXIMUM 2 YEARS OTHERS.

EFFECTIVE APRIL 2010, TAXES & EFFECTIVE APRIL 2010, TAXES & INSURANCE REQUIRED IN LOAN INSURANCE REQUIRED IN LOAN PAYMENT FOR THE FIRST YEAR PAYMENT FOR THE FIRST YEAR REGARDLESS OF DOWN PAYMENT.REGARDLESS OF DOWN PAYMENT.

2222

Regulating Predatory LendingRegulating Predatory Lending HINDSIGHT IS ALWAYS 20/20HINDSIGHT IS ALWAYS 20/20

IN 2004 FORMER FED CHAIRMAN ALAN IN 2004 FORMER FED CHAIRMAN ALAN GREENSPAN PRAISED SUBPRIME LENDINGGREENSPAN PRAISED SUBPRIME LENDING HOME OWNERSHIP MADE POSSIBLE FOR HOME OWNERSHIP MADE POSSIBLE FOR

MILLIONS PREVIOUSLY DISENFRANCHISEDMILLIONS PREVIOUSLY DISENFRANCHISED STATED IN 2007 “HE DIDN’T GET IT (THE DEGREE STATED IN 2007 “HE DIDN’T GET IT (THE DEGREE

OF DEFAULT RISK) UNTIL LATER”OF DEFAULT RISK) UNTIL LATER”

HOME OWNERSHIP FOR MOST SUBPRIME HOME OWNERSHIP FOR MOST SUBPRIME BORROWERS WAS TEMPORARY.BORROWERS WAS TEMPORARY.

2323

The OutlookThe Outlook

THE OUTLOOK:THE OUTLOOK: ECONOMISTS DIVIDED ON HOUSING MARKET ECONOMISTS DIVIDED ON HOUSING MARKET

RECOVERY, FROM LATE 2009 TO LATE 2010RECOVERY, FROM LATE 2009 TO LATE 2010 FANNIE MAE & FREDDIE MAC ARE LIKELY TO FANNIE MAE & FREDDIE MAC ARE LIKELY TO

SURVIVESURVIVE BARNEY FRANK AND CHRIS DODD LIKELY TO BARNEY FRANK AND CHRIS DODD LIKELY TO

GUARANTEE ITGUARANTEE IT GLOBAL INVESTORS WILL RETURN LIQUIDITY TO GLOBAL INVESTORS WILL RETURN LIQUIDITY TO

WALL STREET.WALL STREET.