An Overview Of The Housing/Credit Crisis And Why There Is More Pain To Come
T2 Accredited Fund, LPTilson Offshore Fund, Ltd.
T2 Qualified Fund, LP
T2 Accredited Fund, LPTilson Offshore Fund, Ltd.
T2 Qualified Fund, LP
June 2, 2009
T2 Partners Management L.P. Is A Registered Investment Advisor
145 E. 57th Street 10th FloorNew York, NY 10022
(212) [email protected] www.T2PartnersLLC.com
145 E. 57th Street 10th FloorNew York, NY 10022
(212) [email protected] www.T2PartnersLLC.com
3
For more information…
4
More Mortgage Meltdown Has Just Been Released and Is the #1 Selling Investing Book in the Country
5
The Next Value Investing Congress is October 19-20 in New York City
Register at www.valueinvestingcongress.com
6
Value Investor Insight and SuperInvestor Insight
7
For the Second Half of the 20th Century, Housing Was a Stable Investment
Source: Robert J. Shiller, Irrational Exuberance, Princeton University Press 2000, Broadway Books 2001, 2nd edition, 2005, also Subprime Solution, 2008, as updated by the author at http://www.econ.yale.edu/~shiller/data.htm; Lawler Economic & Housing Consulting
100
125
150
175
200
225
250
275
300
1950
1954
1958
1962
1966
1970
1974
1978
1982
1986
1990
1994
1998
Rea
l Hom
e Pr
ice
Inde
x (1
890=
100)
ShillerLawler
Trend Line
8
…And Then Housing Prices Exploded
SOURCES: Robert J. Shiller, Irrational Exuberance: Second Edition, as updated by the author; Lawler Economic & Housing Consulting.
100
125
150
175
200
225
250
275
300
1950
1954
1958
1962
1966
1970
1974
1978
1982
1986
1990
1994
1998
2002
2006
Rea
l Hom
e Pr
ice
Inde
x (1
890=
100)
ShillerLawler
Trend Line
HousingBubble
9
From 2000-2006, the Borrowing Power of a Typical Home Purchaser Nearly Tripled
Source: Amherst Securities
Factors contributing to the ability to borrow more and more were:1. Slowly rising income2. Lenders being willing to allow much higher debt-to-income ratios3. Falling interest rates4. Interest-only mortgages (vs. full amortizing)5. No money down
$0
$100,000
$200,000
$300,000
$400,000
Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08
Pre-Tax IncomeBorrowing Power
3.3x in January 2000
9.2x in January 2006
10
Housing Became Unaffordable in Many Areas
SOURCES: NAHB/Wells Fargo Housing Opportunity Index, which measures percentage of households that could afford the average home with a standard mortgage
0
10
20
30
40
50
60
70
80
Q1 199
6
Q1 199
7
Q1 199
8
Q1 199
9
Q1 200
0
Q1 200
1
Q1 200
2
Q3 200
4
Q3 200
5
Q3 200
6
Q3 200
7
Hou
sing
Opp
ortu
nity
Inde
x
Riverside, CALos Angeles, CASan Diego, CA
11
Americans Have Borrowed Heavily Against Their Homes Such That the Percentage of Equity in Their Homes Has Fallen Below 50% for the First Time on Record Since 1945
SOURCE: Federal Reserve Flow of Fund Accounts of the United States
$0
$2,000
$4,000
$6,000
$8,000
$10,000
$12,000
1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
Mor
tgag
e D
ebt (
Bn)
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
Equity as a %
of Hom
e Value
1945Mortgage Debt: $18.6 billionEquity: $97.5 billion
2008Mortgage Debt: $10.5 trillionEquity: $8.5 trillion
12
There Was a Dramatic Decline in Mortgage Lending Standards from 2001 through 2006
• In 2005, 29% of new mortgages were interest only — or less, in the case of Option ARMs — vs. 1% in 2001
• In 1989, the average down payment for first- time home buyers was 10%; by 2007, it was 2%
• The sale of new homes costing $750,000 or more quadrupled from 2002 to 2006. The construction of inexpensive homes costing $125,000 or less fell by two-thirds
7474
76
81
83
84
81
68
70
72
74
76
78
80
82
84
86
2001 2002 2003 2004 2005 2006 2007
Com
bine
d Lo
an to
Val
ue (%
)
1% 1%
3%
9%
14%
17%
8%
0%
2%
4%
6%
8%
10%
12%
14%
16%
18%
2001 2002 2003 2004 2005 2006 2007
Perc
ent o
f Orig
inat
ions
33%
39%
45%
49%
56%
63%65%
0%
10%
20%
30%
40%
50%
60%
70%
2001 2002 2003 2004 2005 2006 2007
Perc
ent o
f Orig
inat
ions
0% 0%
1%
4%
8%
11%
5%
0%
2%
4%
6%
8%
10%
12%
2001 2002 2003 2004 2005 2006 2007
Perc
ent o
f Orig
inat
ions
Combined Loan to Value 100% Financing
Limited Documentation 100% Financing & Limited Doc
SOURCES: Amherst Securities, LoanPerformance; USA Today (www.usatoday.com/money/economy/housing/2008-12-12-homeprices_N.htm)
13
Among the Many Causes of The Great Mortgage Bubble, Two Stand Out
• The companies making crazy loans didn’t care very much if the homeowner ended up defaulting for two reasons:1. Either they didn’t plan to hold the loan, but instead intended to pass it along
to Wall Street, which would bundle, slice-and-dice it and sell it (along with any subsequent losses) to investors around the world;
2. Or, if they did plan to hold the loan, they assumed home prices would keep rising, such that homeowners could either refinance before loans reset or, if the homeowner defaulted, the losses (i.e., severity) would be minimal.
• There were many other reasons, of course – a bubble of this magnitude requires what Charlie Munger calls “Lollapalooza Effects”– The entire system – real estate agents, appraisers, mortgage lenders,
banks, Wall St. firms and ratings agencies – became corrupted by the vast amounts of quick money to be made
– Regulators and politicians were blinded by free market ideology or the dream that all Americans should own their homes, causing them to fall asleep at the switch, not want to take the punch bowl away and/or get bought off by the industries they were supposed to be overseeing
– Debt became increasingly available and acceptable in our culture– Millions of Americans became greedy speculators and/or took on too much
debt– Greenspan kept interest rates too low for too long– Institutional investors stretched for yield, didn’t ask many questions and
took on too much leverage– In general, everyone was suffering from irrational exuberance
14
As Long As Home Prices Rise Rapidly, Even Subprime Mortgages Perform Well – But If Home Prices Fall, Look Out Below!
Source: T2 Partners estimates
0%
10%
20%
30%
40%
50%
60%
20% 15% 10% 5% 0% -5% -10% -15% -20% -25% -30% -35% -40%Home Price Appreciation
Cum
ulat
ive
Loss
(%)
Cumulative Five-Year Loss Estimates for a Bubble-Era Pool of Subprime Mortgages
15
Deregulation of the Financial Sector Led to a Surge of Leverage, Profits and Compensation
Source: Ariell Reshef, University of Virginia; Thomas Philippon, NYU; Wall St. Journal, 5/14/09
Ratio of Financial Services Wages to Nonfarm Private-Sector Wages, 1910-2006
• Among the most profitable areas for Wall Street firms was producing Asset-Backed Securities (ABSs) and Collateralized Debt Obligations (CDOs)
• To produce ABSs and CDOs, Wall Street needed a lot of loan “product”• Mortgages were a quick, easy, big source• It is easy to generate higher and higher volumes of mortgage loans: simply lend at higher
loan-to-value ratios, with ultra-low teaser rates, to uncreditworthy borrowers, and don’t bother to verify their income and assets (thereby inviting fraud)
• There’s only one problem: DON’T EXPECT TO BE REPAID!
16Sources: Federal Reserve, BEA, as of Q2 2007, GMO presentation
Low Debt Era Rising Debt Era
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
51 54 57 60 63 66 69 72 75 78 81 84 87 90 93 96 99 02 05
Fina
ncia
l Pro
fits
as P
erce
nt o
f GD
P
100%
150%
200%
250%
300%
350%
Total Debt as Percent of G
DP
Dec-
Total Debt
Financial Profits
Over the Past 30 Years, We Have Become a Nation Gorged in Debt – To The Benefit of Financial Services Firms
17
There Was a Surge of Toxic Mortgages Over the Past 10 Years
SOURCE: Inside Mortgage Finance, published by Inside Mortgage Finance Publications, Inc. Copyright 2009.
$0
$500
$1,000
$1,500
$2,000
$2,500
$3,000
$3,500
$4,000
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
Orig
inat
ions
(Bn)
Conforming, FHA/VAJumboAlt-ASubprimeSeconds
18
Private Label Mortgages (Those Securitized by Wall St.) Are 15% of All Mortgages, But Are 51% of Seriously Delinquent Mortgages
Number of Mortgages (million)Number of Seriously
Delinquent Mortgages (000)
Freddie Mac13
Ginne Mae/FHA6
Private Label8
Fannie Mae18
Banks & Thrifts8
15%
Private Label1734
Banks & Thrifts397
Freddie Mac232
Fannie Mae444
Ginne Mae/FHA378
51%
SOURCE: Freddie Mac, Q4 2008.
Approximately two-thirds of homes have mortgages and of these, 56% are owned or guaranteed by the two government-sponsored enterprises (GSEs), Fannie & Freddie
19
Over 9% of Mortgages on 1-to-4-Family Homes Were Delinquent or in Foreclosure as of Q1 2009
SOURCE: National Delinquency Survey, Mortgage Bankers Association. Note: Delinquencies (60+ days) are seasonally adjusted.
0.0%
1.0%
2.0%
3.0%
4.0%
5.0%
6.0%
7.0%
8.0%
9.0%
10.0%
Q4 197
9Q4 1
980
Q4 198
1Q4 1
982
Q4 198
3Q4 1
984
Q4 198
5Q4 1
986
Q4 198
7Q4 1
988
Q4 198
9Q4 1
990
Q4 199
1Q4 1
992
Q4 199
3Q4 1
994
Q4 199
5Q4 1
996
Q4 199
7Q4 1
998
Q4 199
9Q4 2
000
Q4 200
1Q4 2
002
Q4 200
3Q4 2
004
Q4 200
5Q4 2
006
Q4 200
7Q4 2
008
Perc
enta
ge o
f Hom
e Lo
ans
20
All Types of Loans, Led by Subprime, Are Seeing a Surge in Delinquencies
0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
Q1 199
9Q3 1
999
Q1 200
0Q3 2
000
Q1 200
1Q3 2
001
Q1 200
2Q3 2
002
Q1 200
3Q3 2
003
Q1 200
4Q3 2
004
Q1 200
5Q3 2
005
Q1 200
6Q3 2
006
Q1 200
7Q3 2
007
Q1 200
8Q3 2
008
Perc
ent N
oncu
rrent
Alt AOption ARMJumboSubprimePrimeHome Equity Lines of Credit
SOURCES: Amherst Securities, LoanPerformance; National Delinquency Survey, Mortgage Bankers Association; FDIC Quarterly Banking Profile;T2 Partners estimates. Note: Prime is seasonally adjusted.
21
The Decline in Lending Standards Led to a Surge in Subprime Mortgage Origination
Source: Reprinted with permission; Inside Mortgage Finance, published by Inside Mortgage Finance Publications, Inc. Copyright 2009.
10% 9%9%
10%9%
10%10%
7% 7%8%
18%
20%20%
8%
$0
$100
$200
$300
$400
$500
$600
$700
1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
Origina tions(Bn)
0%
5%
10%
15%
20%
25%
% ofT ota l
22
$0
$5
$10
$15
$20
$25
$30
$35
Jan-06
Apr-06
Jul-0
6Oct-
06Ja
n-07
Apr-07
Jul-0
7Oct-
07Ja
n-08
Apr-08
Jul-0
8Oct-
08Ja
n-09Apr-0
9Ju
l-09
Oct-09
Jan-10
Apr-10
Jul-1
0Oct-
10
Loan
s w
ith P
aym
ent S
hock
(Bn)
Sources: LoanPerformance, Deutsche Bank; slide from Pershing Square presentation, How to Save the Bond Insurers, 11/28/07.
The Wave of Resets from Subprime Loans Is Mostly Behind Us
We are here
23
Numerous Areas of the Mortgage Market Will Suffer Significant Losses Going Forward
SOURCES: Federal Reserve Flow of Funds Accounts of the United States, IMF Global Financial Stability Report October 2008, Goldman Sachs Global Economics Paper No. 177, FDIC Quarterly Banking Profile, OFHEO, S&P Leverage Commentary & Data, T2 Partners estimates.
$0.0 $0.5 $1.0 $1.5 $2.0 $2.5 $3.0 $3.5 $4.0 $4.5 $5.0
CDO/ CLO
Other Consumer
Construction & Development
Option ARM
Auto
Credit Card
Home Equity
Jumbo Prime
High-Yield / Leveraged Loans
Subprime
Commercial & Industrial
Other Corporate
Alt-A
Commercial Real Estate
Prime Mortgage
Amount Outstanding (Trillions)
24
Two Waves of Losses Are Behind Us… But Three Are Looming
Losses Mostly Behind Us• Wave #1: Borrowers committing (or the victim of) fraud & speculators, who
defaulted quickly. Timing: beginning in late 2006 (as soon as home prices started to fall) into 2008. Mostly behind us.
• Wave #2: Borrowers who defaulted when their mortgages reset due to payment shock. Timing: early 2007 (as two-year teaser subprime loans written in early 2005 started to reset) to the present. Now tapering off as low interest rates mitigate payment shock.
Losses Mostly Ahead of Us• Wave #3: Prime loans (most of which are owned or guaranteed by the
GSEs) defaulting due to job loss and home price declines (i.e., underwater homeowners). Timing: started to surge in early 2008 to the present.
• Wave #4: Jumbo prime, second lien and HELOCs (most of which are on banks’ books) defaulting due to job loss and home price declines/ underwater homeowners. Timing: started to surge in early 2008 to the present.
• Wave #5: Losses among loans outside of the housing sector, the largest of which will be in the $3.5 trillion area of commercial real estate. Timing: started to surge in early 2008 to the present.
25
Recent Signs of Stabilization Are Likely the Mother of All Head Fakes
• Rather than representing a true bottom, recent signs of stabilization are likely due to two short-term factors:1. Home sales and prices are seasonally strong in April, May and June
due to tax refunds and the spring selling season2. A temporary reduction in the inventory of foreclosed homes
– Shortly after Obama was elected, his administration promised a new, more robust plan to stem the wave of foreclosures so the GSEs and many other lenders imposed a foreclosure moratorium
– Early this year, the Obama administration unveiled its plan, the Homeowner Affordability and Stabilization Plan, which is a step in the right direction – but even if it is hugely successful, we estimate that it might only save 20% of homeowners who would otherwise lose their homes
– The GSEs and other lenders are now quickly moving to save the homeowners who can be saved – and foreclose on those who can’t
– This is necessary to work our way through the aftermath of the bubble, but will lead to a surge of housing inventory later this year, which will further pressure home prices
26
There Is a Surge of Notices of Default and Foreclosures Among the GSEs
Prime Notices of Default
Subprime Notices of Default
Prime ForeclosuresSubprime Foreclosures
SOURCE: The Field Check Group.
27
Future Losses Will Be Driven By Three Primary Factors
1. The Economy• Especially unemployment
2. Interest rates• Ultra-low rates have helped mitigate some of the damage• But if the recent spike in rates continues, it could lead to an even greater surge
in defaults and losses3. Behavior of homeowners who are underwater
• Roughly one-fourth of homeowners with mortgages are currently underwater, some deeply so
• For many, it is economically rational for them to walk – so called “jingle mail” – but how many will do so?
• There is little historical precedent – we are in uncharted waters• As home prices continue to fall and homeowners become more and more
underwater, they are obviously more likely to default, thereby creating a vicious cycle, but what exactly will the relationship be? Have millions of foreclosures led to a diminution of the stigma of losing one’s home?
• Our best guess is that there will be rough symmetry: for homeowners 5% underwater, an additional 5% will default due to being underwater; 10% underwater will lead to 10% more defaults, and so forth…
28
24% of Homeowners With a Mortgage Owe More Than the Home Is Worth, Making Them Much More Likely to Default
There Has Been a Dramatic Rise in Homeowners Who Are Underwater
In Bubble Markets, Far More Homeowners Are Underwater
Source: Zillow.com Q4 08 Real Estate Market Report; Moody's Economy.com, First American CoreLogic, T2 Partners estimates
Among people who bought homes in the past five years, 30%+ are underwater*
4%
6%
16%
20%
24%
0%
5%
10%
15%
20%
25%
Dec-06 Dec-07 Sep-08 Dec-08 Mar-09
Perc
ent U
nder
wat
er
Price Index Is % of Last 5 Yrsat Lowest Price Drop Purchasers Who
Metro Area Level Since Since Peak Are Under WaterNew York 2004-Q3 -15.2% 23.0%Los Angeles 2003-Q4 -32.0% 56.4%Boston 2002-Q2 -21.8% 27.8%Washington 2004-Q1 -24.8% 50.3%Miami 2004-Q1 -36.6% 65.1%San Francisco 2003-Q3 -27.8% 51.2%Atlanta 2004-Q4 -10.4% 23.2%San Diego 2002-Q4 -34.4% 63.9%Phoenix 2004-Q3 -37.7% 36.4%Las Vegas 2003-Q4 -41.8% 61.4%
* The actual figures are likely even worse, as this data doesn’t capture people who bought since 2003 and subsequently did a cash-out refi or after-the-fact second mortgage. 50% of all subprime and Alt-A loans in existence when the collapse happened were cash-out refis that carried a higher loan balance than the original purchase loan amount.
*
29
Certain Types of Loans Are Severely Underwater
SOURCES: Amherst Securities, LoanPerformance, Standard & Poor’s.
73%
50%
45%
25%
0%
10%
20%
30%
40%
50%
60%
70%
80%
Prime Alt A Subprime Option ARM
Per
cent
Und
erw
ater
30
Outlook for Housing Prices
• We think housing prices will reach fair value/trend line, down 40% from the peak based on the S&P/Case-Shiller national (not 20-city) index, which implies a 5-10% further decline from where prices where as of the end of Q1 2009. It’s almost certain that prices will reach these levels
• The key question is whether housing prices will go crashing through the trend line and fall well below fair value. Unfortunately, this is very likely. In the long-term, housing prices will likely settle around fair value, but in the short-term prices will be driven both by psychology as well as supply and demand. The trends in both are very unfavorable
– Regarding the former, national home prices have declined for 33 consecutive months since their peak in July 2006 through April 2009 and there’s no end in sight, so this makes buyers reluctant – even when the price appears cheap – and sellers desperate.
– Regarding the latter, there is a huge mismatch between supply and demand, due largely to the tsunami of foreclosures. In March 2009, distressed sales accounted for just over 50% of all existing home sales nationwide – and more than 57% in California. In addition, the “shadow” inventory of foreclosed homes already likely exceeds one year and there will be millions more foreclosures over the next few years, creating a large overhang of excess supply that will likely cause prices to overshoot on the downside, as they are already doing in California.
• Therefore, we expect housing prices to decline 45-50% from the peak, bottoming in mid-2010• We are also quite certain that wherever prices bottom, there will be no quick rebound • There’s too much inventory to work off quickly, especially in light of the millions of foreclosures
over the next few years• While foreclosure sales are booming in many areas, regular sales by homeowners have plunged,
in part because people usually can’t sell when they’re underwater on their mortgage and in part due to human psychology: people naturally anchor on the price they paid or what something was worth in the past and are reluctant to sell below this level. We suspect that there are millions of homeowners like this who will emerge as sellers at the first sign of a rebound in home prices
• Finally, we don’t think the economy is likely to provide a tailwind, as we expect it to contract the rest of 2009, stagnate in 2010, and only then grow tepidly for some time thereafter
31
Delinquencies of Prime Mortgages Are Soaring
SOURCE: Mortgage Bankers Association National Delinquency Survey.
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
3.5%
4.0%
4.5%
5.0%
Q1 199
9Q3 1
999
Q1 200
0Q3 2
000
Q1 200
1Q3 2
001
Q1 200
2Q3 2
002
Q1 200
3Q3 2
003
Q1 200
4Q3 2
004
Q1 200
5Q3 2
005
Q1 200
6Q3 2
006
Q1 200
7Q3 2
007
Q1 200
8Q3 2
008
Perc
ent N
oncu
rrent
(60+
day
s)
32
15 States With the Highest Prime Mortgage Foreclosure Rates
SOURCE: New York Times, 5/24/09.
33
Delinquencies of Prime and Alt-A Mortgages Are Soaring
SOURCE: New York Times, 5/24/09.
34
There Are $2.4 Trillion of Alt-A Mortgages and Their Resets Are Mostly Ahead of Us
$0
$1
$2
$3
$4
$5
$6
$7
$8
$9
$10
Jan-1
0
Jul-1
0Ja
n-11
Jul-1
1Ja
n-12
Jul-1
2Ja
n-13
Jul-1
3Ja
n-14
Jul-1
4Ja
n-15
Jul-1
5
Am
ount
(Bn)
$0$50
$100$150
$200$250
$300E
stimated C
umulative R
eset Am
ount (Bn)
We are here
SOURCES: Credit Suisse, LoanPerformance.
NOTE: This chart only shows resets for a small fraction of Alt-A loans, but is representative of all of them.
35
Delinquencies of Securitized Alt-A Mortgages Are Soaring
SOURCES: Amherst Securities, LoanPerformance.
0%
5%
10%
15%
20%
25%
Jan-9
9Ju
l-99
Jan-0
0Ju
l-00
Jan-0
1Ju
l-01
Jan-0
2Ju
l-02
Jan-0
3Ju
l-03
Jan-0
4Ju
l-04
Jan-0
5Ju
l-05
Jan-0
6Ju
l-06
Jan-0
7Ju
l-07
Jan-0
8Ju
l-08
Jan-0
9
Perc
ent N
oncu
rrent
(60+
day
s)
36
Alt-A Delinquencies By Vintage Show the Collapse in Lending Standards in 2006 and 2007
SOURCES: Amherst Securities, LoanPerformance.
0%
5%
10%
15%
20%
25%
30%
0 5 10 15 20 25 30 35 40 45 50 55 60Months of Seasoning
Per
cent
Non
curr
ent (
60+
days
)
2007 2006
2005
2004
2003
37
Delinquencies of Securitized Jumbo Prime Mortgages Are Soaring
SOURCES: Amherst Securities, LoanPerformance.
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
3.5%
4.0%
Jan-9
9Ju
l-99
Jan-0
0Ju
l-00
Jan-0
1Ju
l-01
Jan-0
2Ju
l-02
Jan-0
3Ju
l-03
Jan-0
4Ju
l-04
Jan-0
5Ju
l-05
Jan-0
6Ju
l-06
Jan-0
7Ju
l-07
Jan-0
8Ju
l-08
Jan-0
9
Perc
ent N
oncu
rrent
(60+
day
s)
38
HELOCs and Home Equity Loans Soared in Popularity During the Bubble
$0
$100
$200
$300
$400
$500
$600
$700
$800
$900
$1,000
Q1 200
0
Q1 200
1
Q1 200
2
Q1 200
3
Q1 200
4
Q1 200
5
Q1 200
6
Q1 200
7
Q1 200
8
Am
ount
(Bn)
Closed-End Junior Lien Mortgages
Home Equity Lines of Credit
Note: Does not include approximately $200 billion of securitized HELOCs and junior liens. SOURCE: FDIC Quarterly Banking Profile.
39
• As home prices have declined and other funding sources have dried up, millions of consumers have maxed out on home equity debt.
• In hot markets like California and Florida, a significant percentage of all consumers tapped into the value of their homes to help finance their new cars, according to CNW Marketing Research.
• Clearly this dynamic does not bode well for HELOC recovery rates or new car sales.
Many Borrowers Used HELOCs to Buy New Cars
SOURCE: New York Times 5/27/2008.
40
Delinquencies of HELOCs and CESs Are Soaring
SOURCE: FDIC Quarterly Banking Profile.
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
3.5%
4.0%
4.5%
Q1 200
4Q2 2
004
Q3 200
4Q4 2
004
Q1 200
5Q2 2
005
Q3 200
5Q4 2
005
Q1 200
6Q2 2
006
Q3 200
6Q4 2
006
Q1 200
7Q2 2
007
Q3 200
7Q4 2
007
Q1 200
8Q2 2
008
Q3 200
8Q4 2
008
Q1 200
9
Per
cent
Non
curr
ent (
90+
days
)
Closed-End Junior Lien MortgagesHome Equity Lines of Credit
41
A Primer on Option ARMs
• An Option ARM is an adjustable rate mortgage typically made to a prime borrower• Sold under various names such as “Pick-A-Pay”• Banks typically relied on the appraised value of the home and the borrower’s high
FICO score, so 83% of Option ARMs written in 2004-2007 were low- or no-doc (liar’s loans)
• Each month, the borrower can choose to pay: 1) the fully amortizing interest and principal; 2) full interest; or 3) an ultra-low teaser interest-only rate (typically 2-3%), in which case the unpaid interest is added to the balance of the mortgage (meaning it is negatively amortizing)
• Approximately 80% of Option ARMs are negatively amortizing• Lenders, however, booked earnings as if the borrowers were making full interest
payments• A typical Option ARM is a 30- or 40-year mortgage that resets (“recasts”) after five
years, when it becomes fully amortizing• If an Option ARM negatively amortizes to 110-125% of the original balance (depending
on the terms of the loan), this triggers a reset even if five years have not elapsed• Upon reset, the average monthly payment can jump significantly, though the payment
shock is currently mitigated by ultra-low interest rates• ‘My sense is that many option ARM borrowers are in a worse position than subprime
borrowers,’ says Kevin Stein, associate director of the California Reinvestment Coalition, which combats predatory lending. ‘They wind up owing more and the resets are more significant.’
42
About $750 Billion of Option ARMs Were Written, Nearly All at the Peak of the Bubble
SOURCES: 2008 Mortgage Market Statistical Annual, published by Inside Mortgage Finance Publications, Inc. Copyright 2008. T2 Partners estimates.
5%
9%
1%
8%
5%
$0
$50
$100
$150
$200
$250
$300
2004 2005 2006 2007 2008
Orig
inat
ions
(Bn)
0%
1%
2%
3%
4%
5%
6%
7%
8%
9%
Percent of Total
43
Options ARMs Were a Bubble State Phenomenon
SOURCES: Amherst Securities, LoanPerformance.
California58%
Florida10%
Nevada3%
Arizona3%
Other25%
44
Beginning in March 2005, High-FICO-Score Borrowers Opted for an Above-Market-Rate Option ARM in Exchange for the Low Teaser Rate
SOURCE: Amherst Securities, BloombergFinance, L.P.
4.0
4.5
5.0
5.5
6.0
6.5
7.0
7.5
8.0
8.5
Jan-0
2Apr-
02Ju
l-02
Oct-02
Jan-0
3Apr-0
3Ju
l-03
Oct-03
Jan-0
4Apr-0
4Ju
l-04
Oct-04
Jan-05
Apr-05
Jul-0
5Oct-
05Ja
n-06
Apr-06
Jul-0
6Oct-
06Ja
n-07
Apr-07
Jul-0
7Oct-
07Ja
n-08
Inte
rest
Rat
e (%
)
Fannie Mae 30 Year FRM IndexOption ARM Index
Nearly all option ARM borrowers during this period (when nearly all option ARMS were written) can’t afford a fully- amortizing mortgage – otherwise they would have taken one
45
Delinquencies of Securitized Option ARMs Are Soaring
SOURCES: Amherst Securities, LoanPerformance, T2 Partners estimates.
0%
5%
10%
15%
20%
25%
30%
35%
Jan-9
9Ju
l-99
Jan-0
0Ju
l-00
Jan-0
1Ju
l-01
Jan-0
2Ju
l-02
Jan-0
3Ju
l-03
Jan-0
4Ju
l-04
Jan-0
5Ju
l-05
Jan-0
6Ju
l-06
Jan-0
7Ju
l-07
Jan-0
8Ju
l-08
Jan-0
9
Perc
ent N
oncu
rrent
(60+
day
s)
46
Option ARM Delinquencies By Vintage Show the Collapse in Lending Standards in 2005-2007
SOURCE: Amherst Securities, LoanPerformance.
0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
0 5 10 15 20 25 30 35 40 45 50 55 60Months of Seasoning
Perc
ent N
oncu
rren
t (60
+ da
ys) 2007
2006
2005
2004
2003
47
Existing Homes Sales Are Falling and Foreclosures Are Rising, Leading to a Surge in Inventories
SOURCE: NATIONAL ASSOCIATION OF REALTORS® Existing Home Sales data series.
Months Supply
Existing Home Sales
3
4
5
6
7
8
9
10
11
12
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Mon
ths
4.0 million units, equal to 10.2 months as of the end of April 2009
4.0
4.5
5.0
5.5
6.0
6.5
7.0
7.5
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Milli
ons
4.7 million units as of the end of April 2009
48
Foreclosure Filings Have Increased Dramatically
• Foreclosures in April rose 32% year-over-year, but only 1% sequentially• April was the highest monthly total since RealtyTrac began issuing its report in January 2005
despite a decrease in bank repossessions (REOs)• RealtyTrac estimates that over 1.5 million bank-owned properties are on the market, representing
around a third of all properties for sale in the U.S.
Note: Foreclosure filings are defined as default notices, auction sale notices and bank repossessions. SOURCE: RealtyTrac.com U.S. Foreclosure Market Report.
0
50,000
100,000
150,000
200,000
250,000
300,000
350,000
400,000
Jun-0
5Aug
-05Oct-
05Dec
-05Feb
-06Apr-
06Ju
n-06
Aug-06
Oct-06
Dec-06
Feb-07
Apr-07
Jun-0
7Aug
-07Oct-
07Dec
-07Feb
-08Apr-
08Ju
n-08
Aug-08
Oct-08
Dec-08
Feb-09
Apr-09
Num
ber o
f For
eclo
sure
s
49
Home Prices Are in an Unprecedented Freefall
SOURCES: Standard & Poor’s, OFHEO Purchase-Only Index, NATIONAL ASSOCIATION OF REALTORS® Existing Home Sales data series.
100
120
140
160
180
200
220
Q1 200
0Q3 2
000
Q1 200
1Q3 2
001
Q1 200
2Q3 2
002
Q1 200
3Q3 2
003
Q1 200
4Q3 2
004
Q1 200
5Q3 2
005
Q1 200
6Q3 2
006
Q1 200
7Q3 2
007
Q1 200
8Q3 2
008
Q1 200
9
S&P/Case-Shiller U.S. National Home Price IndexS&P/Case-Shiller 20-City CompositeOFHEO Purchase-Only IndexNAR Median Sales Price of Existing Homes
50
Home Prices Need to Fall Another 5-10% to Reach Trend Line
SOURCES: Robert J. Shiller, Irrational Exuberance: Second Edition, as updated by the author; Lawler Economic & Housing Consulting.
100
125
150
175
200
225
250
275
300
1950
1954
1958
1962
1966
1970
1974
1978
1982
1986
1990
1994
1998
2002
2006
Rea
l Hom
e Pr
ice
Inde
x (1
890=
100)
ShillerLawler
Trend Line
HousingBubble
51
A Study of Bubbles Shows That All of Them Eventually Return to Trend Line
StocksS&P 5001920-1932
0.3
0.8
1.3
1.8
2.3
20 21 22 23 24 25 26 27 28 29 30 31
Det
rend
ed R
eal P
rice
Trend Line
S&P 5001946-1984
0.0
0.5
1.0
1.5
2.0
2.5
46 50 54 58 62 66 70 74 78 82
Det
rend
ed R
eal P
rice
Trend Line
Japan vs. EAFE ex-Japan1981-1999
0.00.51.01.52.02.53.0
81 83 85 87 89 91 93 95 97 99
Rel
ativ
e R
etur
n
Trend Line
S&P 5001992-October 2008
0.8
1.2
1.6
2.0
2.4
92 94 96 98 00 02 04 06 08
Det
rend
ed R
eal P
rice
Trend Line
CurrenciesU.S. Dollar1979-1992
0.81.01.21.41.61.82.0
79 81 83 85 87 89 91
Cum
ulat
ive
Ret
urn
U.K. Pound1979-1985
0.80.91.01.11.21.31.4
79 80 81 82 83 84
Cum
ulat
ive
Ret
urn
Japanese Yen1983-1990
0.80.91.01.11.21.31.4
83 84 85 86 87 88 89 90C
umul
ativ
e R
etur
n
Japanese Yen1992-1998
0.80.91.01.11.21.31.4
92 93 94 95 96 97
Cum
ulat
ive
Ret
urn
CommoditiesGold1970-1999
0
400
800
1200
1600
2000
70 74 78 82 86 90 94 98
Rea
l Pric
e
Crude Oil1962-1999
0
20
40
60
80
62 66 70 74 78 82 86 90 94 98
Rea
l Pric
e
Nickel1979-1999
0
50
100
150
200
250
79 81 83 85 87 89 91 93 95 97
Rea
l Pric
e
Cocoa1970-1999
0100200300400500600
70 74 78 82 86 90 94 98
Rea
l Pric
eSOURCE: GMO LLC. Note: For S&P charts, trend is 2% real price appreciation per year. Source: GMO. Data through 10//10/08.* Detrended Real Price is the price index divided by CPI+2%, since the long-term trend increase in the price of the S&P 500 has been on the order of 2% real.
52
The Biggest Danger is That Home Prices Overshoot on the Downside, Which Often Happens When Bubbles Burst
S&P 500 1927-1954
S&P 500 1955-1986
0.00
0.25
0.50
0.75
1.00
1.25
1.50
1.75
2.00
2.25
2.50
1927 1930 1933 1936 1939 1942 1945 1948 1951 1954
Det
rend
ed R
eal S
&P
500
Stoc
k Pr
ice
Inde
x
-59%
Overrun: 59%Fair Value to Bottom: 1.5 Years
Fair Value to Fair Value: 23 Years
0.00
0.25
0.50
0.75
1.00
1.25
1.50
1.75
2.00
2.25
1955 1957 1959 1961 1963 1965 1967 1969 1971 1973 1976 1978 1980 1982 1984 1986
Det
rend
ed R
eal S
&P
500
Stoc
k Pr
ice
Inde
x
-45%
Overrun: 45%Fair Value to Bottom: 7 Years
Fair Value to Fair Value: 12 Years
SOURCE: GMO LLC, T2 Partners calculations.
53
In Bubble Markets, Prices Are Way Down, Driven By a Surge in the Number of Homes Sold Out of Foreclosure
SOURCE: MDA Dataquick. Note: Includes new construction
California
$0
$100
$200
$300
$400
$500
Jan-0
6Apr-
06Ju
l-06
Oct-06
Jan-0
7Apr-
07Ju
l-07
Oct-07
Jan-0
8Apr-
08Ju
l-08
Oct-08
Jan-0
9Apr-
09
Med
ian
Hom
e P
rice
(000
s)
0%
10%
20%
30%
40%
50%
60%
70%
Foreclosure Resale %
54
Home Prices Have Crashed Through the Trend Line in California, But Stabilized in March
SOURCE: California Association of REALTORS ® . All rights reserved. www.rebsonline.com, T2 Partners estimates.
$0
$100
$200
$300
$400
$500
$600
Jan-7
9Ja
n-81
Jan-8
3Ja
n-85
Jan-8
7Ja
n-89
Jan-9
1Ja
n-93
Jan-9
5Ja
n-97
Jan-9
9Ja
n-01
Jan-0
3Ja
n-05
Jan-0
7Ja
n-09
Med
ian
Pric
e ($
000s
)
Median Sales Price4% Trend
55
The Housing Affordability Index Shows Houses Are Now Affordable
Before concluding that houses are cheap, however, there are three big caveats: first, low rates are only available to those who qualify for conforming mortgages, which doesn’t help millions of homeowners or potential homeowners who have spotty credit histories or are underwater on their current mortgages. Second, with low enough interest rates, almost anything looks affordable; if rates rise, houses won’t look so reasonably priced based on these metrics. Finally, in light of the severe economic downturn, average income may fall for quite some time.
SOURCE: NATIONAL ASSOCIATION OF REALTORS® Housing Affordability Index
14
16
18
20
22
24
26
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
Mor
tgag
e P
aym
ent o
n M
edia
n P
riced
Hom
e as
% o
f Fam
ily In
com
e
56
Mortgage Rates Have Fallen Recently
2
3
4
5
6
7
8
9
10
Feb-04
May-04
Aug-04
Nov-04
Feb-0
5May
-05Aug
-05Nov
-05Fe
b-06
May-06
Aug-06
Nov-06
Feb-0
7May
-07Aug
-07Nov
-07Feb
-08May
-08Aug
-08Nov
-08Feb
-09May
-09R
ate
(%)
Jumbo 30 Yr FRMJumbo 5/1 Hybrid ARMConforming 30 Yr FRMConforming 5/1 Hybrid ARM10-Year Treasury
SOURCES: HSH ASSOCIATES, Freddie Mac PMMS, Yahoo! Finance.
57
The Home Price-to-Rent Ratio Has Returned to Normal Levels
15
17
19
21
23
25
27
1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
Med
ian
Hom
e Pr
ice
to M
edia
n G
ross
Ren
t
SOURCE NATIONAL ASSOCIATION OF REALTORS® Existing Home Sales data series, U.S. Census Bureau, T2 Partners estimates
58
Are We Seeing the Beginnings of a Bottom in Hard-Hit Markets?
SOURCE: NY Times, 5/4/09.
59
Home Prices in Sacramento More Than Tripled in Six Years – And Have Now Fallen 47%
SOURCE: Zillow.com.
60
The Vast Majority of Sacramento Homeowners Who Purchased During the Bubble Years Are Now Underwater
SOURCE: Zillow.com.
61
In Sacramento Country, Home Sales Have Rebounded – But Are Still Outweighed by Defaults
SOURCES: MDA Dataquick; The Field Check Group -- data provided by ForeclosureRadar.com. Note: Includes new construction.
Monthly Notices-of-Default in Sacramento
62
Home Prices Are Stabilizing in Sacramento Country, In Part Due to More Higher End Homes Being Sold Off
SOURCE: The Field Check Group -- data provided by ForeclosureRadar.com.
Sacramento House Prices at theTime of Foreclosure/REO
Sacramento Mix of Houses atthe Time of Foreclosure/REO
63
Comments From Mark Hanson (1) The Field Check Group, May 5, 2009
California housing – at the low end – is 'bottoming' mostly because: a) median prices are down 55% from their peak over the past two years, thereby making the low end affordable; b) foreclosures have temporarily been cut by 66% through moratoriums reducing supply; and c) demand is picking up going into the busy season.
But the moratoriums are ending and the number of foreclosures in the pipeline is massive – they will start showing themselves as REO over the near to mid-term. The Obama plan held the foreclosure wave back, creating a huge backlog and now the servicers are testing hundreds of thousands of defaults against the new loss mitigation initiatives. We presently see the Notice of Defaults at record highs and Notice of Trustee Sales back up to nine-month highs – there is no reason for a loan to go to the Notice of Trustee Sale stage if indeed it wasn't a foreclosure. However, the new 'batch' are not only from the low end but a wide mix all the way up to several million dollars in present value.
Because the majority of buyers are in ultra low and low-mid prices ranges, the supply- demand imbalance from foreclosures and organic supply will crush the mid-to-upper priced properties in 2009. We already have early seasonal hard data proving this. As the mid-to-upper end go through their respective implosions this year and the volume of sales in these bands increase as prices tumble, the mix shift will raise median and average house prices creating the ultimate in false bottoms. We also have data proving this phenomenon.
64
Comments From Mark Hanson (2) The Field Check Group, May 5, 2009
After a year or so the real pain will occur when the mid to upper bands are down 40% from where they are now, and the price compression has made the low to low-mid bands much less attractive – the very same bands that are so hot right now. Rents are tumbling and those that bought these properties for investment will be at risk of default (investors have been buying all the way down). Investors have just started to get taken to the woodshed from all of the supply and this will get much worse. Mid-to- upper end rental supply is also flooding on the market making it much better to rent a beautiful million dollar house than putting $300,000 down and buying.
After investors are punished -- and with move-up buyers gone for years – it will leave first-time homeowners to fix the housing market on their own. Good luck and good night. Five years from now when things look to be stabilizing, all of these terrible kick-the-can-down-the-road modifications that leave borrowers in 5-year-teaser, ultra-high-leverage, 150% LTV, balloon loans will start adjusting upward and it will be Mortgage Implosion 2.0. These loan mods will turn millions of homeowners into over-levered, underwater, renters and ensure housing is a dead asset class for years to come.
Due to a confluence of events including a national foreclosure moratorium and near-zero sales in the mid to upper end during the off season, the broader housing data show signs of stabilization. Taken in context, it is a blip. There are no silver linings or green shoots in housing whatsoever other than by these first-time homeowners – former renters – who now find it cheaper to own than rent. This is a very good thing, but it only applies to a small segment of the population and will not be able to support the market. In addition, the first-time buyers who come out of the rental market put continuous pressure on rents.
Our data shows that the mid-to-upper end housing market is on the precipice of the exact cliff that the market fell off of in 2007, led by new loan defaults. What happens to the economy when you hit the mid- to-upper end earners the same way the low-to-mid end was hit with the subprime implosion? We will find out soon enough. When we look back on housing at the end of 2009, anyone that made positive housing predictions this year will not believe how far off they were.
65
There Have Been 5.7 Million Jobs Lost So Far in This Recession, More Than 3 Million in the Past Five Months
SOURCE: Bureau of Labor Statistics.
-1000
-800
-600
-400
-200
0
200
400
600
Jan-9
0Ja
n-91
Jan-9
2Ja
n-93
Jan-9
4Ja
n-95
Jan-9
6Ja
n-97
Jan-9
8Ja
n-99
Jan-0
0Ja
n-01
Jan-0
2Ja
n-03
Jan-0
4Ja
n-05
Jan-0
6Ja
n-07
Jan-0
8Ja
n-09
Cha
nge
in N
onfa
rm P
ayro
ll E
mpl
oym
ent (
000s
)
There have been job losses every month
since December 2007
66
The Unemployment Rate Jumped to 8.9% in April, the Highest Level Since 1983
SOURCE: Bureau of Labor Statistics.
3%
4%
5%
6%
7%
8%
9%
10%
11%
12%
Jan-7
0Ja
n-73
Jan-7
6Ja
n-79
Jan-8
2Ja
n-85
Jan-8
8Ja
n-91
Jan-9
4Ja
n-97
Jan-0
0Ja
n-03
Jan-0
6Ja
n-09
Une
mpl
oym
ent R
ate
If part-time and discouraged workers are factored in, the unemployment rate would have been 15.8% in April. In addition, the average work week in April was 33.2 hours, a record low.
67
The Decline from Peak Employment Now Exceeds the Past Five Recessions
SOURCE: Bureau of Labor Statistics
-4.5%
-4.0%
-3.5%
-3.0%
-2.5%
-2.0%
-1.5%
-1.0%
-0.5%
0.0%
0 6 12 18 24 30 36 42 48Months after pre-recession peak
19802001 - 05
1990 - 931974 - 76
2007-
1981 - 83
68
Consumer Confidence Rebounded in April and May
Note: 1985=100. SOURCE: The Conference Board (www.pollingreport.com/consumer.htm)
0
20
40
60
80
100
120
140
160
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Con
sum
er C
onfid
ence
Inde
x
69
Banks are Tightening Consumer Credit and New Household Borrowing Has Plunged
SOURCE: Federal Reserve Board.
Household Borrowing 1990-2008(Seasonally-Adjusted Annual Rate)
$0
$200
$400
$600
$800
$1,000
$1,200
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
($ billions)
Percent of US Banks Tightening Consumer Credit
-20%
-10%
0%
10%
20%
30%
40%
50%
60%
70%
Jan-00
Sep-00
May-01
Jan-0
2
Sep-02
May-03
Jan-04
Sep-04
May-05
Jan-0
6
Sep-06
May-07
Jan-0
8
Sep-08
Credit Cards Other Consumer Loans
70
Pools of HELOCs and CESs Can Suffer Astronomical Losses Due to 100%+ Severities
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 45 47 49 51 53 55 57 59Months Since Close
Mon
thly
Los
s R
ate
(3m
ave
rage
)
Ambac Projection April 2008Actual
SOURCES: Ambac Q1 08 presentation, Amherst Securities; funds managed by T2 Partners are short Ambac.
On one second lien deal, Ambac expected losses of 10-12% when it guaranteed the senior tranche. A year ago, Ambac admitted that the pool would likely lose 81.8% of its value – and based on the pool’s performance since then, this will almost certainly prove to be conservative.
From Ambac slide, April 2008:
• Second lien deal that closed in April 2007• Loss to date 9.9%; projected loss: 81.8%• Projected collateral loss as a % of current
collateral: 86%• A reasonable estimate of projected collateral
loss for the above transaction might have been 10-12%, with the transaction having an A+ rating at inception and being structured to withstand 28-30% collateral loss
71
The Timing Indicates That We Are Still in the Middle Innings of the Bursting of the Great Housing Bubble
• Mortgage lending standards became progressively worse starting in 2000, but really went off a cliff beginning in early 2005
• The worst loans were subprime ones, which generally had two-year teaser rates and are now defaulting at unprecedented rates
• Such loans made in Q1 2005 started to default in high numbers upon reset in Q1 2007, which not surprisingly was the beginning of the current crises
• The crisis has continued to worsen as even lower quality subprime loans made over the remainder of 2005 reset over the course of 2007, triggering more and more defaults
• It takes an average of 15 months from the date of the first missed payment by a homeowner to a liquidation (generally a sale via auction) of the home
• Thus, the Q1 2005 subprime loans that defaulted in Q1 2007 led to foreclosures and auctions in early 2008
• Given that lending standards got much worse in late 2005 through 2006 and into the first half of 2007, and the many other types of loans that are now with longer reset dates that are now starting to default at catastrophic rates, there are sobering implications for expected defaults, foreclosures and auctions in 2009 and beyond, which promise to drive home prices down further
In summary, today we are only in the middle innings of an enormous wave of defaults, foreclosures and auctions that is hitting the United States. We predicted in early 2008 that it would get so bad that it would require large-scale federal government intervention – which has occurred, and we’re not finished yet.
72
Total Losses Are Now Estimated at $2.1-$3.8 Trillion – And Only a Fraction of This Has Been Realized To Date
SOURCES: Goldman Sachs, International Monetary Fund, RGE Monitor, Bloomberg Finance L.P., T2 Partners estimates.
Banks/Brokers
InsurersGSEs
$0
$500
$1,000
$1,500
$2,000
$2,500
$3,000
$3,500
$4,000
GoldmanSachs Jan
2009
Roubini Jan2009
T2 PartnersMar 2009
IMF Apr 2009 Writedowns toDate
Capital Raised
Am
ount
(Bn)
Corporate
Consumer
CommercialReal EstateResidentialMortgages
$2,083
$2,632
$3,552$3,778
$1,473
$1,214
73
A Breakdown of Our Financial Sector Loss Estimates
$0 $100 $200 $300 $400 $500 $600 $700 $800
CDO/ CLO
Other Consumer
Construction & Development
Option ARM
Auto
Credit Card
Home Equity
Jumbo Prime
High-Yield / Leveraged Loans
Subprime
Commercial & Industrial
Other Corporate
Alt-A
Commercial Real Estate
Prime Mortgage
Amount (Bn)
Total Estimated Financial Sector
Losses = $3.8 trillion
SOURCE: T2 Partners estimates.
74
Institutions Have Been Able to Raise Capital to Mostly Keep Up With Writedowns, But This Will Likely Not Continue
$0
$250
$500
$750
$1,000
$1,250
$1,500
Prior Q3 2007 Q4 2007 Q1 2008 Q2 2008 Q3 2008 Q4 2008 Q1 2009 Q2 2009
Amou
nt (B
n)
Losses & WritedownsCapital Raised
SOURCE: Bloomberg Finance L.P.
75
Where We Are Finding Opportunities
• Blue-chips. The stocks of some of the greatest businesses, with strong balance sheets and dominant competitive positions, are trading at their cheapest levels in years – due primarily to the overall market decline and weak economic conditions rather than any company-specific issues. In this category, we’d put Coca-Cola, McDonald’s, Wal-Mart, Altria, ExxonMobil, Johnson & Johnson, and Microsoft.
• Out of favor blue-chips. For somewhat more adventurous investors looking to buy great companies in the most out-of-favor sectors such as financials and retailers, we own Berkshire Hathaway, Wells Fargo, American Express and Target. All are great businesses, but their stocks have suffered mightily thanks to the economic downturn. We think they’re good bets to rebound when things stabilize.
• Balance sheet plays. For investors who are comfortable with lower-quality businesses but want downside protection, there are many companies trading near or even below net cash on the balance sheet. Examples in our portfolio include digital media equipment company EchoStar Corp. and clothing retailer dELiA*s. Berkshire is the best of both worlds: a premier company but also a balance sheet play.
• Turnarounds. There are countless companies that have gotten clobbered by the economic downturn and are reporting dismal results – with stock prices to match. Investors in those that survive and return to anything close to former levels of profitability will be well rewarded – but picking these stocks isn’t easy. Among our holdings in this category are Wendy’s restaurants, Winn-Dixie supermarkets, Huntsman, a specialty chemical maker, Crosstex, a pipeline company, and Resource America, a specialty finance company.
• Special situations. This is somewhat of a catch-all category that, for us, includes Contango Oil & Gas, a stock that’s declined due to an aborted attempt to sell the company and the sharp drop in the price of natural gas.
• Mispriced options. Every once in a while we take a tiny position in a highly speculative situation – often where the stock price is below $1 – in which there’s a real chance that the outcome is zero, but also a decent chance, in our opinion, of making many multiples of our money. On an expected value basis, therefore, a small portfolio of such investments is attractive. Our holdings include General Growth Properties, TravelCenters of America, Ambassadors International, Borders Group and PhotoChannel Networks.
