You broke it you own it

• Housing In the New Millennium: A Home Without Equity Is Just a Rental With Debt June 29, 2001 – "Specifically, it appears that a large portion of the housing sector’s growth in the 1990’s came from the easing of the credit underwriting process. Such easing includes: • The drastic reduction of minimum down payment levels from 20% to 0% a focused effort to target the “low income” borrower • The reduction in private mortgage insurance requirements on high loan to value mortgages • The increasing use of software to streamline the origination process and modify/recast delinquent loans in order to keep them classified as ‘current’ • Changes in the appraisal process which has led to widespread overappraisal/over- valuation problems. • If these trends remain in place, it is likely that the home purchase boom of them past decade will continue unabated. Despite the increasingly more difficult economic environment, it may be possible for lenders to further ease credit standards and more fully exploit less penetrated markets."

• MEDLEY GLOBAL ADVISORS Banking: Regulators Look At Retail Vs Commercial Exposure March 18, 2005 – While there is little question as to whether interest rates will rise toward a more "neutral" level there are many questions about the impact it will have on consumer spending and credit quality. We may be at the cyclical turning point where lenders must again hope that the initial resurgence in commercial activity becomes well entrenched and becomes the driver of stability (if not growth).

• MEDLEY GLOBAL ADVISORS Housing, Code Orange: Historic Performance Does Not Guarantee Future Results May 17, 2005 – In June of 2001, I wrote that "a large portion of the housing sector's growth in the 1990s came from the easing of the credit underwriting, appraisal and loss mitigation processes. It now appears there is an increasing risk that these trends may be reaching their limit."

• MEDLEY GLOBAL ADVISORS Housing And Mortgage Finance: Chicken Little On Wall Street November 16, 2005 – We continue to expect consumer mortgage credit quality to show deterioration in the third quarter (largely from energy prices and Hurricane Katrina) and expect that it will continue to rise from there. Refinancing activity will likely remain at surprisingly strong levels as consumers choose not to look at the internal economics of a refinancing transaction and instead choose to look at the economics of refinancing as part of their personal portfolio management. – To assume that a slowdown in the housing market will quickly translate in unmanageable losses, panicky regulators, or a disallowance of new product offerings is unrealistic.

• MEDLEY GLOBAL ADVISORS Home Is Where Your Wallet Is November 1, 2005 – "When the third-quarter mortgage delinquency data is released (mid December), investors will recognize that the cycle has begun to turn. Since these increases will be driven by higher energy prices and hurricanes many will choose to see the increases as aberrational. We would caution this data is almost certainly the first leg in what will become a declining environment for consumer credit quality. Seasoning, higher ARM exposure, and increasing subprime originations finally appear to warrant the concerns that have been unwarranted as home appreciation rates were robust."

• MEDLEY GLOBAL ADVISORS Mortgage Magic Making Defaults Disappear March 31, 2006 – While structural changes in the reporting and management of seriously delinquent mortgage loans has dramatically reduced the ratio of problem loans to foreclosures this will become harder to effect as home price appreciation slows unless incomes rise materially. Moreover, the obfuscation of the data has created a false sense of comfort with historical implications of published delinquency and default data.

• MEDLEY GLOBAL ADVISORS Not Your Father’s Housing Cycle NOVEMBER 17, 2006

– "The ISSUE is whether over the reliance of each upon the other fostered a mispricing of risk and WHETHER structural changes created on the cyclical upswing be tested in a downturn. Ultimately, the unfolding housing and mortgage market story is not one of regional economic activity, as housing cycles have historically been, but rather a financial market confidence game. Unlike prior housing cycles in which prices were primarily driven by regional commercial activity and demographics, the current cycle has been driven by a massive democratization in mortgage credit and the growth of innovations in securitized markets. Due to short term economic incentives to do so, these changes have been under-appreciated by the mortgage industry, the Nationally Recognized Statistical Rating Organizations, and investors. If the market demand for mortgage backed securities and collateralized debt obligations decline and assumptions by rating agencies are incorrect, the risks may be transmitted from the market to the real economy. " – "If non-conforming MBS demand wanes significantly or if MBS performance models prove inadequate, we could witness a market driven downward cycle of model assumption problems leading to downgrades, reduced mortgage liquidity and further downward pressure on home prices This would be especially likely in markets that have seen dramatic speculative and second home purchases. As home prices fell the new breed of speculative homebuyers would begin to list investment properties putting further downward pressure on prices. As this spiral continues we could see prepayment and default models falter again, thus reasserting this "death spiral." Unfortunately, it is unlikely Congress will act until after a crisis of some uncertain magnitude has presented itself. The risk of spillover into the economy. Perhaps investors will not get spooked or become markedly credit risk averse and we will get that hoped for soft-landing as regional economic activity suggests. However, if history can be used as a guide it would force consideration that excess liquidity in financial markets tends to dry up abruptly. Given the size of these markets a reversal in liquidity, due to endogenous or exogenous factors, could result in significant impact on the real economy.

• How Resilient Are Mortgage Backed Securities to Collateralized Debt Obligation Market Disruptions? Feb 15, 2007 – This report reviews the rise of Collateralized Debt Obligations (CDOs), the relaxation of lending standards, the implementation of loan mitigation practices and whether these structural changes have created an environment of understated risk to investors of MBS. Even investment grade rated CDOs will experience significant losses if home prices depreciate, leading to broader imbalances in the U.S. economy that, if left unchecked, could lead to prolonged economic difficulties.

• Reuters July 27, 2008 – "The Japanese experience of holding large losses as opposed to taking a hit and moving on was a direct cause of the Japanese malaise," said Josh Rosner, author of the report and a managing director at Graham Fisher, an investment research firm in New York.

So… we broke it and now will have to pay for it… • Remember when Clinton bragged about the budget as he moved housing assets off the governments (Ginnie's) balance sheet by eliminating the 30-year? – They supported GSE debt issuance to drive the off balance sheet bubble... That debt is shifting back onto the UST and we have a liability mismatch with UST duration of about 4 years and GSE debt closer to 30

Govt will have to remain entangled • But how? But why? When models fail...ex. – Agg LTV – Ownership peaked in 2003 (historically no higher than 64.5 2x… reached 69%)… bubble was refinancing and equity extraction – Securitization – Markets closed… except Ginnie’s, GSEs, – Consumer and commercial lending continues to contract… except to strong balance sheets who will see the value inflated away… corp duration of debt is too short…

Tailwinds become headwinds • Secular shift from one income families to two income families driven by inflation of the 70’s without corresponding increases in wages… 2nd income increased consumption but also fragility • Exiting 1984 recession with largest generation hitting peak earnings… now savers with less equity in historically largest retirement and intergenerational wealth transfer asset • Democ of credit… when you were a child… now deleveraging

Rather than fix this • France and Germany fight against higher capital and real leverage ratios • Basel ignores that CVA trading desks may mitigate institutional risk but create correlated risk to system • Ignore that neither liquidity nor reputational risk are adequately focused on in Basel • CDS risk should be addressed… FNM/FRE didn’t blow up on interest rate risk for a reason… required to put risk in market… do the same for banks… CDS for economic hedging purposes… t+10 to get flat on the exposure... That way their aggregate exposures would always be a function of the number of days of recent transactions. • Central banks are transferring risks from bank sector to public sector • The government is helping to avoid market pricing because our banks would be back in trouble – second lien - NPV test and banks – This game may be out of their control as new info emerges on who knew what when… expect it soon… and documented

We fight the buy side to protect the sell side but… • Central bankers ignore that banks and I-banks are now low margin utilities… no longer aggregate and allocate capital… position for clients, arb client info, commission rates gone, trade prop and needed leverage to generate historical roe on low roa • Asset managers have replaced buggy banks • Real issue is hidden debt – Worldcom, Enron, Tyco, Bear, LEH, AIG, MER, FNM, FRE, WaMu, INDY, CIT, Greece... – Yet no regulators are pressing banks to accept their losses and the ultimately necessary dilution of equity issuance... Instead we issue false stress tests and accept bank growth estimates which assume they can build provisions through the cycle... IS CONTINUING TO HIDE LOSSES A SOLUTION OR DOES IT ENSURE A JAPAN LIKE PERIOD? – Even though there is no borrower demand from good creditors, lending continues to contract, banks have benefitted from unsustainable eps drivers of trading, writing up level 3 assets and surfing the curve...

Level 3

So… what are we failing to do? • Home/Host- intermediate holding co’s of foreign banks have no capital in host country… when crisis hit home country refused to downstream capital leaving host country on hook for home country obligations (Iceland) Tier 1 leverage of HSBC, DB, Barclays, TD, BNP

Ratings • It is not about issuer or investor pays… it is about compensation structure… initial rating vs. surveillance… standardize the data and release it pre-issuance and each month and you open the market to reprice to value each month and reduce volatility

Securitization • Securitization funded: – 50% of all revolving consumer credit – 20% of non-revolving consumer credit – 60% of private label mortgages

All AAA are not equal

Does this make sense?

Why couldn’t they price for value?

What do we need to restart securitization? • NO single standard definition for fundamental concepts like: -“True Sale” -Delinquency -Default -Servicer advance • Investors need timely loan-level performance data in an electronically manageable and standardized format. • Information should be made available for a reasonable period (not less than two-weeks) before a deal is sold and brought to market. • Standard contract – 300, 300p docs when EPD’s rose… investors ran for the hills

No standards • Opacity and information asymmetry = Investors became suspicious and distrustful. • Capital fled and funding disappeared for real economic activity. • Why? Like a broken transmission, the securitization market stalled the financial system.

What will happen? • Fed liquidity programs gone • Housing rolling over • EPS driven by G&A not top line… greater risk to US… Dollar Euro at $1.20 shave 1% from GDP