The Subprime Mortgage Crisis and Its Impact on the Tax-Exempt Market CHEFA Board Meeting January 22, 2008 The PFM Group Presented by: 99 Summer Street, Suite 1020 Jeremy Bass Boston, MA 02110
Table of Contents PFM I. Housing Overview and Mortgage Securitization II. Credit Spreads III. Bond Insurance IV. Variable Rate Debt Market V. Swap Counterparty Risk VI. Investment Considerations VII. Summary and CHEFA Considerations 1
PFM 2 MORTGAGE SECURITIZATION HOUSING OVERVIEW AND
Housing Market Boom… PFM Existing and New Home Sales January 2001 – December 2005 9,000,000 New Homes Existing Homes 8,000,000 7,000,000 6,000,000 5,000,000 4,000,000 3,000,000 2001 2002 2003 2004 2005 Source: Bloomberg 3
Housing Market Boom… PFM Building Permits and Housing Starts January 2001 – December 2005 2400 Building Permits 2300 Housing Starts 2200 2100 2000 1900 1800 1700 1600 1500 Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct 01 01 01 01 02 02 02 02 03 03 03 03 04 04 04 04 05 05 05 05 Source: Bloomberg 4
Housing Market Boom… PFM Home Values January 2001 – December 2005 18.00% 16.00% 14.00% 12.00% 10.00% 8.00% 6.00% 4.00% 2.00% 0.00% Mar Jun Sep Dec Mar Jun Sep Dec Mar Jun Sep Dec Mar Jun Sep Dec Mar Jun Sep Dec 01 01 01 01 02 02 02 02 03 03 03 03 04 04 04 04 05 05 05 05 Source: Bloomberg 5
…and Bust PFM Existing and New Home Sales January 2003 – November 2007 9,000,000 New Homes Existing Homes 8,000,000 7,000,000 6,000,000 5,000,000 4,000,000 3,000,000 2003 2004 2005 2006 2007 Source: Bloomberg 6
…and Bust PFM Building Permits and Housing Starts January 2003 – November 2007 2500 Building Permits Housing Starts 2300 2100 1900 1700 1500 1300 1100 Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct 03 03 03 03 04 04 04 04 05 05 05 05 06 06 06 06 07 07 07 07 Source: Bloomberg 7
…and Bust PFM Home Values January 2003 – September 2007 20.00% 15.00% 10.00% 5.00% 0.00% -5.00% -10.00% Mar Jun Sep Dec Mar Jun Sep Dec Mar Jun Sep Dec Mar Jun Sep Dec Mar Jun Sep 03 03 03 03 04 04 04 04 05 05 05 05 06 06 06 06 07 07 07 Source: Bloomberg 8
Subprime Lending PFM • The practice of making loans to borrowers who do not qualify for the best market rates because their credit history is less than ideal. – Benefits – Gives credit to people who would not otherwise not have access to the credit markets – Downsides – Can likely lead to default, seizure of collateral and foreclosures 9
The Subprime Mortgage/ Variable Rate PFM Connection Percent of Total Mortgages Percent of Subprime Mortgages Variable Variable 25% 67% Fixed Fixed 33% 75% Source: Bloomberg and Bankrate.com 10
Foreclosures Increase PFM Adjustable Subprime Foreclosures as a Percentage of All Loans March 2002 – September 2007 5.0% Adjustable Rate 4.5% Adjustable Rate 4.0% 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% Mar-02 Dec-02 Sep-03 Jun-04 Mar-05 Dec-05 Sep-06 Jun-07 Source: Bloomberg 11
SIV – Structured Investment Vehicles PFM • Companies created by banks and other firms to sell short-term debt to buy assets and finance company bonds with higher yields. Issues Purchases Commercial Paper Securities Asset- Backed SIV Investors Securities Repayments of Purchases CP Underlying Assets Receive $ 12
Asset-Backed Securities PFM • Linked to packages of mortgages – including subprime mortgages • Pass through Securities – As mortgage payments are made they are passed through to investors • Defaults in Mortgages causing problems for owners of these securities – Cash Flows have essentially dried up – SIV are defaulting or near default – Causing Financial Institutions to report huge losses 13
14 PFM CREDIT SPREADS
Fear Factor: Credit Spreads Widen on Subprime PFM Mortgage Woes • The yield difference or spread between risk-free (Treasury bills) and risky (LIBOR deposits) assets historically widens in times of financial stress – After narrowing in September, spread has moved back out near August highs on new bank charges, losses 3-Mo LIBOR - Treasury Bill Spread Weekly Data, December 10, 1993 - January 11, 2008 2.25 Avg: 0.43% 2 Min: 0.7 U.S. sub-prime Max: 2.08 mortgage crisis Std: 0.27 1.75 Russian debt default crisis 1.5 Spread (%) 1.25 1 0.75 0.5 0.25 0 3 4 5 6 7 8 9 0 1 2 3 4 5 6 7 4 5 6 7 8 9 0 1 2 3 4 5 6 7 9 9 9 9 9 9 9 9 9 9 9 9 9 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 / / / / / / / / / / / / / / / / / / / / / / / / / / / / / 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 / / / / / / / / / / / / / / / / / / / / / / / / / / / / / 6 2 2 6 2 6 2 6 2 6 2 6 2 6 2 6 2 6 2 6 2 6 2 6 2 6 2 6 2 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 15
Flight-to-Quality in U.S. Bond Market PFM Treasury 1 yr Rate Changes - January 2, 2007 to Present Treasury 30 yr AAA GO 30 yr 6.00 BAA GO 30 yr A Hospital 30 yr 5.50 5.00 Interest Rate 4.50 4.00 3.50 3.00 2.50 7 7 7 7 7 7 7 7 7 7 7 7 8 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 2 2 2 2 2 2 2 2 2 2 2 2 2 / / / / / / / / / / / / / 2 2 2 2 2 2 2 2 2 2 2 2 2 / / / / / / / / / / / / / 1 2 3 4 5 6 7 8 9 0 1 2 1 1 1 1 Date Rate Change - 1/2/07 to 1/17/2008 Index Treasury 1 yr -2.19% Treasury 30 yr -0.53% AAA GO 30 yr 0.04% BAA GO 30 yr 0.58% A Hospital 30 yr 0.58% Source: Thomson Financial 16
Flight-to-Quality in U.S. Bond Market PFM Change in credit spreads - January 2, 2007 to Present 1.20 1.00 Interest Rate Spread 0.80 0.60 0.40 0.20 0.00 Spread 30 Year Treasury to "A" Hospital -0.20 Spread 30 Year "AAA" MMD to "A" -0.40 Hospital -0.60 1/2/2007 2/2/2007 3/2/2007 4/2/2007 5/2/2007 6/2/2007 7/2/2007 8/2/2007 9/2/2007 10/2/2007 11/2/2007 12/2/2007 1/2/2008 Date Spread Change - 1/2/07 to 1/17/2008 Index Spread 30 Year Treasury to "A" Hospital 1.11% Spread 30 Year "AAA" MMD to "A" Hospital 0.54% Source: Thomson Financial 17
18 PFM BOND INSURANCE
Radian PFM On July 24 th Radian, a “AA” bond insurer, reports net income of $21.1 • million for Q2, a 86% decline from the period last year causing disruption for planned merger with MGIC. On July 31 st Fitch puts Radian’s AA on negative watch, saying the rating • would drop at least one notch if its merger with MGIC fails. One August 20 th MGIC sues Radian in federal court, calling for it to turn • over information MGIC says it needs to decide whether or not to move forward with the merger. On September 5 th Fitch downgrades Radian to “A+” and the next day • Radian asks Fitch to withdraw its ratings. Fitch is the only one of the major three rating agencies to downgrade Radian. • Beginning in August and continuing today institutions with variable rate debt backed by Radian insurance saw their rates increase 75 – 300 basis points (depending on underlying rating and investors). 19
Radian variable rate performance PFM Auction Rate Performance - Griffin Hospital (Radian Insured) 7.40% 6.90% 6.40% 5.90% Interest Rate 5.40% 4.90% 4.40% 3.90% 3.40% 2.90% 5/15/07 5/29/07 6/12/07 6/26/07 7/10/07 7/24/07 8/7/07 8/21/07 9/4/07 9/18/07 10/2/07 10/16/07 10/30/07 11/13/07 11/27/07 12/11/07 12/25/07 1/8/08 Date Series C Series D - Taxable SIFMA 1-Month LIBOR 20
PFM Other Bond Insurers • In October, the rating agencies announced they would be taking a look at the capital adequacy of all of the bond insurers to determine if those companies need to raise capital in order to preserve their existing ratings given exposure to subprime through direct guarantees and credit default swaps 21
Bond Insurance Residential Mortgage Backed Security PFM (RMBS) Exposure A CA A ssured G uaranty A m bac CIFG FG IC FSA M BIA Radian X LC A Total RM BS E xposure (M il. $) $8.5 $10,325.0 $34,728.0 $3,348.2 $28,976.5 $18,635.8 $29,674.2 $627.2 $8,769.5 RM BS Rating D istribution A A A 0.00% 81.80% 18.00% 57.00% 12.30% 51.90% 26.10% 25.70% 34.30% A A 0.00% 3.40% 4.80% 0.80% 3.50% 4.20% 1.30% 3.00% 17.50% A 0.00% 1.70% 17.20% 11.00% 15.80% 0.70% 4.90% 12.40% 2.60% BBB 0.00% 12.50% 56.10% 30.20% 66.30% 26.30% 54.80% 31.00% 45.60% BB and lower 100.00% 0.50% 3.80% 1.00% 2.10% 16.80% 13.00% 28.00% 0.00% Total Projected Losses (M il. $) $0.0 $51.5 $1,647.3 $161.4 $2,305.3 $382.6 $3,009.4 $1.6 $596.0 Present V alue of Losses (M il. $) $0.0 $44.6 $1,426.4 $139.8 $1,996.2 $331.3 $2,605.9 $1.4 $516.1 A fter Tax N et RM BS Losses $0.0 $29.0 $927.1 $90.8 $1,297.5 $215.3 $1,693.8 $0.9 $335.4 Source: Standard & Poor’s report dated December 19, 2007 22
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