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California Society of Municipal Finance Officers
Housing Market and the Credit Crisis
Wells Fargo Bank
HCFG Credit Risk
Presented by: Dan Van Dyke, Ph.D.
Senior Vice President
925.686.7098
February 19, 2009
Outline
 Why did housing market fundamentals get so out of equilibrium?
 How did the housing market create our current situation?
 Real Economy
 Financial Markets
 What is the right policy?
2
What went wrong in the housing market?
 By now, this is no surprise:
 The belief that house prices would never decline,
 Low interest rates,
 An “agency” problem, wherein ownership at key steps in the mortgage process
was avoided (mortgage banking, brokers),
 Lax underwriting,
 Pressure to lend into the sub-prime market from various sources,
 Weak regulation,
 Poor rating agency performance, and
 Investor skepticism of the equity market after the 2001 collapse.
3
Outline
 Why did housing market fundamentals get so out of equilibrium?
 How did the housing market create our current situation?
 Real Economy
 Financial Markets
 What is the right policy?
4
Credit quality deteriorated. . .
 The third quarter foreclosure at 107 basis points is down from the second quarter rate,
but that decline is the result of a foreclosure moratorium, not a fundamental shift in the
market.
 Delinquency and foreclosure data from the credit bureaus suggest an increase in
foreclosures in the fourth quarter.
Foreclosures Started vs. First Mortgage
Write-Offs--2008Q3
1.40
1.20
0.80
0.60
0.40
0.20
Source: Mortgage Bankers Association
CreditForecast.com
0.00
19
79
19
80
19
81
19
82
19
83
19
84
19
85
19
86
19
87
19
88
19
89
19
90
19
91
19
92
19
93
19
94
19
95
19
96
19
97
19
98
19
99
20
00
20
01
20
02
20
03
20
04
20
05
20
06
20
07
20
08
Percentage Points
1.00
MBA Fcl Rate
Write-Offs (Eqifax)
5
. . .and sales of houses declined.
 The sales rates for existing single family homes was 4.26 million units (annual rate) in
December, down -32.8% from the peak in mid-2005.
7000
Sales of Existing Single Family Homes
December 2008
6500
Thousands of Units, Annual Rate
6000
5500
5000
4500
4000
3500
3000
2500
2000
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
6
Inventories mounted as a result. . .
 Adding all the inventory sources, some progress has been achieved since the second
quarter of 2007. But compared with the ‘normal’ inventory level of about 2.5 million units,
an excess supply of 1.9 million units is still on the market.
 This level of inventory is still far too high, so price pressure will continue to be downward.
Total Inventory: Condos, Single Family,
and New--December 2008
6000
5000
000s of Units
4000
3000
2000
1000
Sources: NAR, Bureau of the
Census
0
1999
2000
2001
2002
2003
Actual
2004
2005
Average thru 2004
2006
2007
2008
7
. . .pushing house prices down.
 By any measure, house prices were falling steeply at the end of 2008.
 Price pressure is still downward, and it will persist most likely through 2009.
House Prices: Paired-Sales vs. Median
November-December 2008
20%
15%
Percent Change vs. Year-Ago
10%
5%
0%
-5%
-10%
-15%
-20%
2001
2002
2003
2004
2005
2006
2007
2008
8
CS 20-City
NAR Median
MRAC 20-City
House prices are subject to momentum. . .
 In past regional episodes, house prices declined for more quarters than has so far
been the case in this current episode.
 The price decline has been far deeper than is past episodes.
Historic House Price Cycles
December 2008
1.1
1
1.00=Peak
0.9
0.8
0.7
0.6
Source: First American Core Logic-MRAC Data; Our calculations.
0.5
1
2
3
4
5
6
7
8
9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36
Quarters After Peak
CA 90s
MA late 80s
TX mid-80s
CA 00s
9
. . .including Northern California. . .
 Price declines are steep—between 13% and 28%—but they are declining now at a
somewhat slower rate than several months ago.
HPI--Northern California
November 2008
35%
30%
25%
20%
% Change vs. Year-Ago
15%
10%
5%
0%
-5%
-10%
-15%
-20%
-25%
Source: MRAC
-30%
2003
2004
Chico
2005
Oakland
Sac'to
2006
San Fran
2007
San Jose
2008
Santa Rosa
Yuba City
10
. . .and Southern California.
 Price declines are also steep in Southern California—between 15% and 29%.
HPI--Southern California
November 2008
40%
35%
30%
25%
% Change vs. Year-Ago
20%
15%
10%
5%
0%
-5%
-10%
-15%
-20%
-25%
Source: MRAC
-30%
2003
2004
LA
2005
Oxnard
Riverside
2006
San Diego
2007
Santa Ana
2008
SLO
11
And we’ve come full circle.
 Declining house prices result in poor loan performance. That in turn results in tightened
lending standards and weaker market conditions, with lower prices.
Foreclosures Started vs. First Mortgage
Write-Offs--2008Q3
1.40
1.20
0.80
0.60
0.40
0.20
Source: Mortgage Bankers Association
CreditForecast.com
0.00
19
79
19
80
19
81
19
82
19
83
19
84
19
85
19
86
19
87
19
88
19
89
19
90
19
91
19
92
19
93
19
94
19
95
19
96
19
97
19
98
19
99
20
00
20
01
20
02
20
03
20
04
20
05
20
06
20
07
20
08
Percentage Points
1.00
MBA Fcl Rate
Write-Offs (Eqifax)
12
Housing has many linkages with the broader economy.
 Construction,
 Finance,
 Insurance,
 Real estate sales and servicing (brokerage, management, title),
 Consumer durable goods purchases (furniture and fixtures, building materials),
 Purchase of big ticket items through home equity withdrawal,
 Through the multiplier linkage of these sectors with all other sectors, the economy in
general is affected by housing.
13
Unemployment rates have risen sharply. . .
 The national unemployment rate has risen from 4.4% to 7.6%. The California
unemployment rate has risen from 4.8% to 9.3%.
 Both the national and state unemployment rate will rise further.
14
Unemployment rates across the country.
15
Outline
 Why did housing market fundamentals get so out of equilibrium?
 How did the housing market create our current situation?
 Real Economy
 Financial Markets
 What is the right policy?
16
Mortgage-backed securities prices fell with house prices.
 This AAA bond is backed by home equity loans. It was issued 24 months ago.
 The price as of February 13 was 35. The subordination level for this security was not high
enough to warrant a AAA rating. Maybe no subordination level would have been high
enough.
17
The TED spread is elevated.
 Since January 28, the TED spread (3-month LIBOR minus the 3-month Treasury bill rate) has
been trading in a narrow range, just under 100 basis points. On February 12, the spread was
94 basis points. The Lehman Panic is clearly evident.
 The current spread compares with a pre-crisis norm of 37 basis points to 50 basis points.
TED Spread--Three Month
February 12, 2009
5.00
4.50
4.00
3.00
2.50
2.00
1.50
1.00
0.50
Sources: Federal Reserve, Bloomberg, our calculations
0.00
11
/1
11 /20
/1 07
5
11 /20
/2 07
9
12 /20
/1 07
3
12 /20
/2 07
7/
2
1/ 00
10 7
/2
1/ 00
24 8
/2
0
2/ 08
7/
20
2/
21 08
/2
0
3/ 08
6/
20
3/
20 08
/2
0
4/ 08
3/
20
4/
17 08
/2
0
5/ 08
1/
20
5/
15 08
/2
5/ 00
29 8
/2
6/ 00
12 8
/2
6/ 00
26 8
/2
7/ 00
10 8
/2
7/ 00
24 8
/2
0
8/ 08
7/
20
8/
21 08
/2
0
9/ 08
4/
20
9/
18 08
/2
10 00
/2 8
10 /20
/1 08
6
10 /20
/3 08
0
11 /20
/1 08
3
11 /20
/2 08
7
12 /20
/1 08
1
12 /20
/2 08
5/
20
1/ 08
8/
2
1/ 00
22 9
/2
0
2/ 09
5/
20
09
Percentage Points
3.50
18
Corporate sector credit conditions still weak, but better.
 As the housing market correction has spread economy-wide, credit conditions in the nonfinancial corporate sector have also deteriorated.
 Spreads approaching 150 basis points in the past have been associated with additional
corporate bond and loan defaults. The spread on February 10 was 276 basis points, off its
high of about 330 basis points, but still substantially elevated.
Risk Spread: Baa to Aaa Corp Bond
February 10, 2009
4.00
Source: H.15
3.50
Feb 10 = 276 basis points
2.50
2.00
1.50
1.00
0.50
0.00
19
7
19 0
7
19 1
7
19 2
7
19 3
7
19 4
7
19 5
7
19 6
7
19 7
7
19 8
7
19 9
8
19 0
8
19 1
8
19 2
8
19 3
8
19 4
8
19 5
8
19 6
8
19 7
8
19 8
8
19 9
9
19 0
9
19 1
9
19 2
9
19 3
9
19 4
9
19 5
9
19 6
9
19 7
9
19 8
9
20 9
0
20 0
0
20 1
0
20 2
0
20 3
0
20 4
0
20 5
0
20 6
0
20 7
0
20 8
09
Percentage Points
3.00
19
Mortgage spreads have come in, but are still elevated.
 Despite the Treasury conservatorship of the GSEs, and a $400 billion war chest that the
Fed has to support the mortgage-backed market, spreads have been stubbornly high.
 The Fannie Mae coupon spread to the 10-year Treasury bond yield was 123 basis points
on February 12, a little elevated from the pre-crisis spread of 110 basis points. But the
retail spread is still elevated at 239 basis points (compared with a norm of about 160 basis
points).
Mortgage Spreads:
Fannie Coupon and Freddie Commitment Rate
3.5
Feb 12 = 239 bp
2.5
2.0
1.5
Feb 12 = 123 bp
1.0
0.5
0.0
3/
1
3/ /2 0
22 0
4/ / 20 7
12 0
/ 7
5/ 200
3/ 7
5/ 2 0
24 0
6/ / 20 7
14 0
/ 7
7/ 200
5/ 7
7/ 2 0
26 0
8/ / 20 7
16 0
/ 7
9/ 200
6/ 7
9/ 2 0
2
10 7/ 2 07
/1 00
8
11 /20 7
/8 07
11 / 2
/2 0
12 9 /2 07
/2 00
0
1/ /20 7
10 0
1/ / 20 7
31 0
2/ / 20 8
21 0
8
3/ / 20
13 0
/2 8
4/ 00
3
4/ /2 0 8
24 0
5/ / 20 8
15 0
/ 8
6/ 200
5/ 8
6/ 2 0
26 0
7/ / 20 8
17 0
/ 8
8/ 200
7/ 8
8/ 2 0
28 0
9/ / 20 8
18 0
10 / 20 8
10 /9/ 2 08
/3 0
11 0 /2 08
/2 00
12 0 /2 8
/1 00
1/ 8
1/ 200
1
1/ /2 0 8
22 0
2/ / 20 9
12 0
/2 9
00
9
Percentage Points
3.0
Fannie Coupon -10 Yr Treasury
Freddie Commitment Rate - 10Yr Treasury
20
Outline
 Why did housing market fundamentals get so out of equilibrium?
 How did the housing market create our current situation?
 Financial Markets
 Real Economy
 What is the right policy?
21
Why this recession is unlike past recessions.
 It was not primarily caused by the Federal Reserve tightening monetary policy to quell
inflation.
 It is global in nature.
 The financial system is wounded, curtailing lending to businesses and individuals.
22
Fiscal policy must be part of the mix.
 Congress has passed, and the president signed on Tuesday, February 17, a $789
billion dollar fiscal stimulus package.
 The new law contains $276 billion in tax cuts and $513 billion in a wide array of spending
measures.
 The “problems” with which fiscal policy must deal are the following:
 An $800 billion negative wealth effect ($0.05 on the dollar for $16 trillion in lost equity and
real estate wealth).
 A $350 billion budget downdraft at the state level that is many billions more when local
governmental units are included.
 An offset of something less than $300 billion due to lower gas prices.
 The new fiscal package is just about enough to offset the first of these economic
downdrafts. We may be ending the year with marked economic weakness and the
prospect of a third fiscal stimulus package being engineered.
23
Financial-monetary policy intervention.
 The three places for possible policy intervention are the following:
 (A) Shore up bank capital directly (the AIG, Bear Stearns, TARP I model),
 (B) Make market—liquefy—the market for mortgage-backed securities and derivatives (the
original TARP model, the current Financial Stability Plan), or
 (C) Deal directly with individual mortgages in trouble (the HERA model, Financial Stability Plan,
Hope for Homeowners, elements of the fiscal package).
Capital
drain
?
Holds in portfolio
Liquidity squeeze
Creditors
House Prices: Paired-Sales vs. Median
August-July 2008
20%
15%
10%
Percent Change vs. Year-Ago
Institution 1:
Unwilling to do business
with
Institution 2
Institution 2
Losses, or potential losses
because of securities
portfolio
Transaction:
Counterparty
Risk
5%
0%
-5%
-10%
-15%
-20%
2001
2002
2003
2004
CS 20-City
2005
NAR Median
2006
MRAC 20-City
2007
2008
24
Financial-monetary policy intervention, con’t.
 C causes B which causes A, which in turn causes C.
 Where is the right place to intervene to break the vicious circle? ANYWHERE and
EVERYWHERE.
Capital
drain
?
Holds in portfolio
Liquidity squeeze
Creditors
House Prices: Paired-Sales vs. Median
August-July 2008
20%
15%
10%
Percent Change vs. Year-Ago
Institution 1:
Unwilling to do business
with
Institution 2
Institution 2
Losses, or potential losses
because of securities
portfolio
Transaction:
Counterparty
Risk
5%
0%
-5%
-10%
-15%
-20%
2001
2002
2003
2004
CS 20-City
2005
NAR Median
2006
MRAC 20-City
2007
2008
25
Other federal reserve actions providing monetary support.
 The Fed has created seven special lending facilities, including the earliest of them,
the Term Auction Facility.
 As a result, it has expanded its balance sheet by nearly $1 trillion, in addition to the
reserves created through the normal monetary policy channels.
 The size of the Fed’s balance sheet has come in somewhat recently, primarily
because the swap facilities with foreign central banks have been unwound as the
LIBOR market has recovered (to some extent).
26
Summary
 We are in the midst of the worst economic downturn since the Great Depression.
 The genesis of this downturn was not the usual Fed tightening to stave of inflation. It
had its genesis in the implosion of the housing bubble. It is an asset deflation
recession.
 Although I’m not sure that policy measures have been well-explained to the American
public, they are designed to fight a two-front war:
 Deal with the economic (real side of the economy) downturn, and
 Deal with the wounded financial system (monetary side of the economy).
 We are not yet out of the woods on either front, and the situation will get worse before
it gets better.
 My personal opinion is that we will not see anything approaching the economy’s
potential growth rate until mid-2010.
 On the financial side, some progress has been made, but financial sector losses
continue, and the vicious circle has not yet been broken. More foreclosures are
coming, house prices will decline further, and financial sector losses will mount,
putting pressure on lending.
 These problems will also take time—an unknown amount of time—to heal.
27
THANK YOU
28