1 The Great Mortgage Market Implosion of 2007 The Evolution of Risk Based Real Estate Lending George W. Lawrence Member, Master Instructor Faculty California Association of REALTORS® September 2008 September 2008

2 1994: The Beginning of the Boom  FOUR EVENTS AIDED BIRTH OF NEW LOAN PLANS AND SOURCES OF FUNDS TO STIMULATE LENDING  CREDIT SCORING & RISK BASED UNDERWRITING  AUTOMATED UNDERWRITING  CREATIVE SECURITIZATION  COMMUNITY REINVESTMENT ACT AMENDMENTS OF 1995.

3 Birth of Creative Loan Programs  SUBPRIME LOANS  NEGATIVE AMORTIZATION LOANS  INTEREST ONLY LOANS  REDUCED DOCUMENTATION LOANS

4 Securitization: Key to Explosion  $50 B IN SUBPRIMES ORIGINATED IN 1994  $665 B ORIGINATED IN 2005  SECONDARY MARKET INVESTORS PACKAGED MORTGAGE BACKED SECURITIES AS CDO’S  FINANCIAL ENGINEERING ALLOWED THE CDO TO BE RISK RATED  RATING GAVE APPEARANCE OF LOW RISK INVESTMENT TO GLOBAL INVESTORS.

5 Subprime Explosion 1994: START OF SUBPRIME “EXPLOSION” PRE 1994: ONLY 70 SUBPRIME LENDERS : 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 Originated Subprime defaults begin Wall Street Subprime funds collapse. Housing Market cools Recession Fed Raises Fed Funds Rate

7 California Median Home Prices 1973 to 2008 Subprime Era 1994 to 2007

8 Prime Mortgage Securitization AA A AA MEZZANINE B JUNIOR/EQUITY UNRATED-UNINSURED BorrowersLender/Servicer Secondary 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 FINAL LOSSES IS PAID FIRST, LOWEST YIELD IS PAID NEXT WITH HIGHER YIELD IS PAID THIRD, EVEN HIGHER YIELD IS PAID LAST, GETS HIGHEST YIELD

10 AA A AA MEZZANINE B JUNIOR/EQUITY UNRATED-UNINSURED BorrowersLender/Servicer Secondary Market Investor SPE Global Investors SPE NOTES $ MBS $ $ Collateralized Debt Obligation Bond Subprime Securitization MBS $

11 Negative Amortization Loans  ALLOWS PAYMENT LESS THAN THE ACTUAL INTEREST AMOUNT DUE  START RATE PAYMENT AS LOW AS 1%  INTEREST ONLY PAYMENT ALLOWED  NOTE RATE 5 – 6% HIGHER OR MORE  PAYMENT RESETS AFTER 5 YEARS  AT CURRENT NOTE RATE  FOR 25 YEAR TERM  A GAMBLE!

12 Negative Amortization ARMs NOTE RATE VS. START RATE FULL PAYMENT: $3, Mo START RATE PAYMENT $1, Mo

13 Negative Amortization ARMs  THE “SHOCK”  AFTER 5 YEARS PAYING START RATE PAYMENT  IF ACTUAL RATE REMAINS STABLE, NEW PAYMENT COULD BE AT LEAST $3, AT LEAST $3, AN INCREASE OF $2, MONTHLY

14 Negative Amortization Loans  THE REAL SHOCK:  AT THE “LIFE TIME CAP RATE” THE PAYMENT COULD JUMP FROM $1749 TO: $5, Monthly… an INCREASE OF $3,596.87!

15 Negative Amortization Loans  75% OF BORROWERS MADE ONLY MINIMUM PAYMENT  GREATEST NUMBER ORIGINATED BETWEEN 2003 AND 2005  PAYMENT RESETS BEGAN IN AUG 2008  RESETS WILL PEAK JUNE 2010  RESETS SHOULD END BY DEC  AVERAGE LOAN BALANCE AT RESET IS 115% TO 125% OF ORIGINAL LOAN AMOUNT  MOST LOANS EXCEED PROPERTY’S VALUE.

16 Adjustable Rate Loans Reset Calendar June 2008 to Dec. 2011

17 Interest Only & Reduced Documentation Loans  STATED INCOME: INCOME IS STATED NOT VERIFIED  FICO AND LTV DETERMINE RATE  SOME PLANS ALLOWED “INTEREST ONLY”  IRS FORM 4506-T NOW USUALLY REQUIRED.

18 Stated Income Loans  80% OF NEGATIVE AMORTIZATION LOANS WERE STATED INCOME  90% OF BORROWERS OVERSTATED INCOME 5% OR MORE  60% OVERSTATED INCOME OVER 50%  NEARLY IMPOSSIBLE TO MAKE NEW RESET PAYMENT BASED ON ACTUAL INCOME.  Source: Mortgage Asset Research Institute Inc., Lender’s Tax Return Audit for IRS

19 New Laws for Predatory Lending Practices Federal Agencies Take Steps to Regulate Subprime Lending Industry

20 Amendments to Regulation “Z”, Truth in Lending Act  RULES FOR “HIGHER PRICED” PRICED LOANS EFFECTIVE OCTOBER 1, 2009  APPLY TO FIRST MORTGAGES HAVING INTEREST RATES GREATER THAN 1.5% OVER THE AVERAGE MARKET RATE  APPLY TO SECOND MORTGAGES HAVING INTEREST RATES GREATER THAN 3.5% OVER THE AVERAGE MARKET RATE.

21 Amendments to Regulation “Z”, Truth in Lending Act  NEW REGULATIONS FOR SUBPRIME LOANS:  LENDERS MUST VERIFY BORROWER’S INCOME AND ASSETS  PREPAY PENALTIES PROHIBITED IF LOAN PAYMENT ADJUSTS IN LESS THAN 4 YEARS, MAXIMUM 2 YEARS OTHERS.  EFFECTIVE APRIL 2010, TAXES & INSURANCE REQUIRED IN LOAN PAYMENT FOR THE FIRST YEAR REGARDLESS OF DOWN PAYMENT.

22 Regulating Predatory Lending  HINDSIGHT IS ALWAYS 20/20  IN 2004 FORMER FED CHAIRMAN ALAN GREENSPAN PRAISED SUBPRIME LENDING  HOME OWNERSHIP MADE POSSIBLE FOR MILLIONS PREVIOUSLY DISENFRANCHISED  STATED IN 2007 “HE DIDN’T GET IT (THE DEGREE OF DEFAULT RISK) UNTIL LATER”  HOME OWNERSHIP FOR MOST SUBPRIME BORROWERS WAS TEMPORARY.

23 The Outlook  THE OUTLOOK:  ECONOMISTS DIVIDED ON HOUSING MARKET RECOVERY, FROM LATE 2009 TO LATE 2010  FANNIE MAE & FREDDIE MAC ARE LIKELY TO SURVIVE  BARNEY FRANK AND CHRIS DODD LIKELY TO GUARANTEE IT  GLOBAL INVESTORS WILL RETURN LIQUIDITY TO WALL STREET.