Subprime mortgage debacle: its impact on public funds investing

1. Ohio Association of Public Treasurers 2007 Annual Conference Subprime mortgage debacle: its impact on public funds investing

2. Today’s presenters Productive Portfolios, Inc.a registered investment advisor • Stan Bahorek, Managing Director • Eileen Stanic, Managing Director

4. Presentation Outline • Mortgage-backed securities • The Basics • What are they; how are they created; how do they work? • Issuers of & investors in MBS • Events leading up to current credit crisis • Impact on the US Treasury and agency securities market • Implications for the public funds investor

5. Mortgages – Borrowing under the traditional borrower/lender relationship Source: Testimony of Sheila C. Bair, Chairman, FDIC, Possible Responses to Rising Mortgage Foreclosures, U.S. House of Representatives, Committee on Financial Services, April 17, 2007

6. Mortgages – Borrowing under a securitization structure Source: Testimony of Sheila C. Bair, Chairman, FDIC, Possible Responses to Rising Mortgage Foreclosures, U.S. House of Representatives, Committee on Financial Services, April 17, 2007

8. MBS

9. Mortgage-Backed Securities (MBS) • What are they? • Debt obligations • Represent claims to the cash flows from pools of mortgage loans (most commonly on residential property) • Cash flows = principal & interest payments made by borrowers • Cash flows may speed up, slow down . . . • or STOP!

10. Mortgage-Backed Securities (MBS) • How are they created? • Mortgage loans are originated by banks, mortgage companies or other originators • Loans are purchased from originators and assemble into pools (“packaged” or “pooled”) by a governmental, quasi-governmental or private entity • Entity issues securities (sells securities to investors) that represent claims on the principal and interest payments made by borrowers; a process known as securitization

11. Mortgage-Backed Securities (MBS) • Who are the issuers: • U.S. Government Agency • Government National Mortgage Association (GNMA or Ginnie Mae) • U.S Government-Sponsored Enterprise (GSE) • Federal National Mortgage Association (FNMA or Fannie Mae) • Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac) • Private institutions • Brokerage firms, banks, homebuilders • “Private Label” or “non-agency” mortgage securities

12. Mortgage-Backed Securities (MBS) • Some important characteristics • U.S. Government Agency – GNMA • Guarantees that investors receive timely payments • Backed by the full faith & credit of the U.S. government • U.S Government-Sponsored Enterprise (GSE) – FNMA or FHLMC • Provide certain guarantees • NOT backed by the full faith & credit of the U.S. government • Have special authority to borrow from the U.S. Treasury • Private institutions • Sole obligation of their issuer • NOT guaranteed by any governmental entity

13. Mortgage-Backed Securities (MBS) • Structure • Most basic type • Pass-through participation certificates (PCs) • Entitles holder to a pro-rata share of all principal & interest payments in the pool • More complicated • Collateralized mortgage obligations (CMOs) • Real Estate Mortgage Investment Conduit (REMIC) • May be designed to protect investors from or expose investors to various types of risks • An important risk with regard to residential mortgage payments = prepayments • Homeowners tend to refinance when interest rates fall • Principal is returned to investors when options to reinvest are less attractive

14. $2.6 Trillion $410.5 Billion outstanding

15. Mortgage-Backed Securities (MBS) • To learn more • U.S. Securities and Exchange Commission • http://www.sec.gov/answers/mortgagesecurities.htm • Securities Industry and Financial Markets Association (SIFMA) • http://www.sifma.org/education.html • http://www.investinginbonds.com/ • FDIC Speeches & Testimony • http://www.fdic.gov/news/news/speeches/chairman/spapr1707.html

16. Events leading up to current crisis • To meet the demand for homeownership & to qualify more persons for financing: • Credit review/standards were loosened • “Riskier” mortgage loans were issued • Interest only, ARMs • Alt-A, “no-doc”, no verification of income • The promise of rising home values would provide the means to refinance out of increasing mortgage payments

17. Events leading up to current crisis • ARMs underlying MBS reset to higher rates • Borrows who can’t afford new, higher payments expect to refinance into more traditional mortgage loans • Since home prices haven’t appreciated as planned, cannot refinance into new affordable mortgages • Delinquencies begin • Defaults occur

18. Events leading up to current crisis • Market value of MBS securities adversely affected by delinquencies/defaults • Value of underlying mortgages (collateral) and hence the value of the MBS is difficult if not impossible to determine • July 2007 Moody’s & S&P downgraded $6 Billion of sub-prime MBS • Declining value of assets creates “margin calls” • Demand for MBS declines (dries up) reducing (eliminating) issuers ability to access market • Lines of credit are tapped to fund cash flow

19. Events leading up to current crisis • Investors begin to re-price their risk • Concerns regarding risk spread to other markets • Then . . .

20. Events leading up to current crisis • August 16th, 2007 • $45.5 billion in short-term IOUs issued outside the U.S. by corporations & others matured and had to be rolled over. • Demand for this paper dried up. • 7:30 am in NYC Countrywide Financial Corp. announces that it is tapping $11.5 million in bank credit lines – a sign that it cannot raise capital in the financial markets as it usually could.

21. Events leading up to current crisis • August 16th, 2007 (cont.) • “Flight to quality”– investors began buying up U.S. Treasury securities • Yield on 3-month T-bills drops to 3.4% from 4% • Spread between T-bills and corporate paper widens sharply. • Friday morning the Fed cuts the discount rate by 50 b.p. to 5.75%

22. Fed Funds Source: Bloomberg Professional Service Sep 18 Aug 16 Aug 10

23. Impact on the US Treasury & agency securities market

24. Impact on the US Treasury & agency securities market

25. Impact on the US Treasury & agency securities market

26. Impact on the US Treasury & agency securities market

27. Impact on the US Treasury & agency securities market 50 basis points (.5%)

29. Impact on the US Treasury & agency securities market • Current market • Lower rates in general (as of 9/28, 10:05 am) • STAR Ohio = 5.03% (down from 5.22% 1 yr ago) • 6 month Agency DN = 4.56% • 2 yr UST = 3.95% • 2 yr agency bullet = 4.41% • Things to ponder as an investor • “One and done” for the Fed? • Is a recession really on the horizon? • Is inflation looming?

30. The “real” problem? The real reason you’re broke, Liz Pulliam Weston, MSN.Money website, September 27, 2007http://articles.moneycentral.msn.com/SavingandDebt/SaveonaCar/TheRealReasonYoureBroke.aspx • “Assuming they can afford a payment simply because a lender approved it. Thirty years ago, there was some truth in the idea that a lender wouldn't let you get in over your head. No longer. Not only are lending standards much looser, but many auto finance companies make loans knowing that a substantial portion of their borrowers will miss payments or default altogether. Lenders count on high interest rates to cover their risks. In short, they don't really care if you can afford the payment or not -- they're gambling on making enough from the loan that they'll profit either way.”

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33. Ohio Association of Public Treasurers 2007 Annual Conference Subprime mortgage debacle: its impact on public funds investing