Presented by: Jeremy Bass
The PFM Group99 Summer Street, Suite 1020Boston, MA 02110
The Subprime Mortgage Crisis andIts Impact on the Tax-Exempt Market
CHEFA Board Meeting
January 22, 2008
1
PFMTable of Contents
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
2
PFM
HOUSING OVERVIEW AND MORTGAGE SECURITIZATION
3
PFMHousing Market Boom…Existing and New Home SalesJanuary 2001 – December 2005
Source: Bloomberg
3,000,000
4,000,000
5,000,000
6,000,000
7,000,000
8,000,000
9,000,000
2001 2002 2003 2004 2005
New Homes
Existing Homes
4
PFMHousing Market Boom…Building Permits and Housing Starts
January 2001 – December 2005
Source: Bloomberg
05
1500
1600
1700
1800
1900
2000
2100
2200
2300
2400
Jan01
Apr01
Jul01
Oct01
Jan02
Apr02
Jul02
Oct02
Jan03
Apr03
Jul03
Oct03
Jan04
Apr04
Jul04
Oct04
Jan05
Apr05
Jul05
Oct
Building Permits
Housing Starts
5
PFMHousing Market Boom…Home Values
January 2001 – December 2005
Source: Bloomberg
0.00%
2.00%
4.00%
6.00%
8.00%
10.00%
12.00%
14.00%
16.00%
18.00%
Mar01
Jun01
Sep01
Dec01
Mar02
Jun02
Sep02
Dec02
Mar03
Jun03
Sep03
Dec03
Mar04
Jun04
Sep04
Dec04
Mar05
Jun05
Sep05
Dec05
6
PFM…and Bust
Existing and New Home SalesJanuary 2003 – November 2007
Source: Bloomberg
3,000,000
4,000,000
5,000,000
6,000,000
7,000,000
8,000,000
9,000,000
2003 2004 2005 2006 2007
New Homes
Existing Homes
7
PFM…and BustBuilding Permits and Housing Starts
January 2003 – November 2007
Source: Bloomberg07
1100
1300
1500
1700
1900
2100
2300
2500
Jan03
Apr03
Jul03
Oct03
Jan04
Apr04
Jul04
Oct04
Jan05
Apr05
Jul05
Oct05
Jan06
Apr06
Jul06
Oct06
Jan07
Apr07
Jul07
Oct
Building PermitsHousing Starts
8
PFM…and BustHome Values
January 2003 – September 2007
Source: Bloomberg
-10.00%
-5.00%
0.00%
5.00%
10.00%
15.00%
20.00%
Mar03
Jun03
Sep03
Dec03
Mar04
Jun04
Sep04
Dec04
Mar05
Jun05
Sep05
Dec05
Mar06
Jun06
Sep06
Dec06
Mar07
Jun07
Sep07
9
PFMSubprime Lending
• 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
10
PFMThe Subprime Mortgage/ Variable Rate Connection
Variable25%
Fixed75%
Variable67%
Fixed33%
Percent of Total Mortgages Percent of Subprime Mortgages
Source: Bloomberg and Bankrate.com
11
PFMForeclosures IncreaseAdjustable Subprime Foreclosures as a Percentage
of All LoansMarch 2002 – September 2007
Source: Bloomberg
Adjustable Rate
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
3.5%
4.0%
4.5%
5.0%
Mar-02 Dec-02 Sep-03 Jun-04 Mar-05 Dec-05 Sep-06 Jun-07
Adjustable Rate
12
PFMSIV – Structured Investment Vehicles
• Companies created by banks and other firms to sell short-term debt to buy assets and finance company bonds with higher yields.
SIV InvestorsAsset-Backed
Securities
PurchasesSecurities
Repayments ofUnderlying Assets
IssuesCommercial Paper
Purchases CPReceive $
13
PFMAsset-Backed Securities
• 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
14
PFM
CREDIT SPREADS
15
PFMFear Factor: Credit Spreads Widen on SubprimeMortgage 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 SpreadWeekly Data, December 10, 1993 - January 11, 2008
0
0.25
0.5
0.75
1
1.25
1.5
1.75
2
2.25
12/1
0/93
6/10
/94
12/1
0/94
6/10
/95
12/1
0/95
6/10
/96
12/1
0/96
6/10
/97
12/1
0/97
6/10
/98
12/1
0/98
6/10
/99
12/1
0/99
6/10
/00
12/1
0/00
6/10
/01
12/1
0/01
6/10
/02
12/1
0/02
6/10
/03
12/1
0/03
6/10
/04
12/1
0/04
6/10
/05
12/1
0/05
6/10
/06
12/1
0/06
6/10
/07
12/1
0/07
Spre
ad (
%)
Avg: 0.43% Min: 0.7 Max: 2.08 Std: 0.27
Russian debt default crisis
U.S. sub-prime mortgage crisis
16
PFMFlight-to-Quality in U.S. Bond Market
Rate Changes - January 2, 2007 to Present
2.50
3.00
3.50
4.00
4.50
5.00
5.50
6.00
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
/200
711
/2/2
007
12/2
/200
71/
2/20
08
Date
Inte
rest
Rat
eTreasury 1 yrTreasury 30 yrAAA GO 30 yr
BAA GO 30 yrA Hospital 30 yr
Source: Thomson Financial
IndexRate Change - 1/2/07 to
1/17/2008
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%
17
PFMFlight-to-Quality in U.S. Bond Market
Change in credit spreads - January 2, 2007 to Present
-0.60-0.40-0.200.000.200.400.600.801.001.20
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
/200
7
11/2
/200
7
12/2
/200
7
1/2/
2008
Date
Inte
rest
Rat
e Sp
read
Spread 30 Year Treasury to "A" Hospital
Spread 30 Year "AAA" MMD to "A"Hospital
Source: Thomson Financial
IndexSpread Change - 1/2/07 to
1/17/2008Spread 30 Year Treasury to "A" Hospital 1.11%Spread 30 Year "AAA" MMD to "A" Hospital 0.54%
18
PFM
BOND INSURANCE
19
PFMRadian
• On July 24th 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 31st 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 20th 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 5th 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).
20
PFMRadian variable rate performance
Auction Rate Performance - Griffin Hospital (Radian Insured)
2.90%
3.40%
3.90%
4.40%
4.90%
5.40%
5.90%
6.40%
6.90%
7.40%5/
15/0
7
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
10/1
6/07
10/3
0/07
11/1
3/07
11/2
7/07
12/1
1/07
12/2
5/07
1/8/
08
Date
Inte
rest
Rat
e
Series C Series D - Taxable SIFMA 1-Month LIBOR
21
PFMOther 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 subprimethrough direct guarantees and credit default swaps
22
PFMBond Insurance Residential Mortgage Backed Security (RMBS) Exposure
ACA Assured Guaranty Ambac CIFG FGIC FSA MBIA Radian XLCA
Total RMBS Exposure (Mil. $) $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
RMBS Rating DistributionAAA 0.00% 81.80% 18.00% 57.00% 12.30% 51.90% 26.10% 25.70% 34.30%AA 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 (Mil. $) $0.0 $51.5 $1,647.3 $161.4 $2,305.3 $382.6 $3,009.4 $1.6 $596.0
Present Value of Losses (Mil. $) $0.0 $44.6 $1,426.4 $139.8 $1,996.2 $331.3 $2,605.9 $1.4 $516.1
After Tax Net RMBS 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
23
PFMBond Insurance Turmoil• The existing status of the bond insurers ratings is presented below
– FSA and Assured Guaranty are the only AAA insurers with stable ratings from all three agencies
– MBIA and Ambac put on Negative Watch last week by Moody’s– Ambac downgraded two notches by Fitch to “AA” on Friday, January 18th
Insurer Prior
RatingRevised Rating
Prior Outlook Revised Outlook
Prior Rating
Revised Rating
Prior Outlook Revised Outlook
Prior Rating
Revised Rating
Prior Outlook Revised Outlook
FGIC Aaa Aaa StableNegative Watch
(12/14/2007) AAA AAA StableNegative Watch
(12/19/2007) AAA AAA StableNegative Watch
(12/17/2007)
MBIA Aaa Aaa StableNegative Watch
(1/17/08) AAA AAA StableNegative
(12/19/2007) AAA AAA Stable Stable (1/16/08)
XL Capital Aaa Aaa StableNegative Watch
(12/14/2007) AAA AAA StableNegative
(12/19/2007) AAA AAA StableNegative Watch
(12/12/2007)FSA Aaa Aaa Stable Stable AAA AAA Stable Stable AAA AAA Stable Stable
CIFG Aaa Aaa StableNegative
(12/14/2007) AAA AAA StableNegative
(6/7/2007) AAA AAA Stable StableAssured Guaranty Aaa Aaa Stable Stable AAA AAA Stable Stable AAA AAA Stable Stable
Ambac Aaa Aaa StableNegative Watch
(1/16/08) AAA AAA StableNegative
(12/19/2007) AAA AA StableNegative Watch
(12/21/2007)
ACA NR ACCC
(12/19/2007)Negative Watch
Developing Watch(12/19/2007) NR
Radian Aa3 Aa3 Stable Stable AA AA Negative Stable (6/29/2007) AAA+
(9/5/2007)
Negative Watch
(7/31/2007)Evolving Watch
(9/5/2007)
Moody's Investor Services Standard & Poor's Rating Services Fitch Rating Services
24
PFMBond Insurance Trading Spreads• Currently FSA and Assured Guaranty have not
seen a material impact on their trading value – Assured Guaranty is trading roughly 10 basis points
lower than FSA which is consistent with historical spreads between the two companies
• The other bond insurance companies (MBIA, Ambac, FGIC, XL, CIFG, Radian) are trading primarily based on the underlying credit as investors are looking past the bond insurance
25
PFMBond Insurance Market for New Deals• We expect to see an increase in the price of the insurance
premium– Increased focus on the capital charges necessary for the rating
agency requirements– FSA and Assured Guaranty face less price competition given
the vulnerability of their competition and their prices will be increased accordingly
• FSA and Assured Guaranty may require additional security because they have a more favorable market position
• For the other AAA bond insurers, we expect financial covenants to be consistent with what has previously been required by the insurers
26
PFMBond Insurance Capital Infusion• Several of the bond insurers are in the process of raising capital or
evaluating strategies to raise capital in order to bolster reserves
– MBIA• $1 billion private equity capital infusion from Warburg Pincus in early
December• $1 billion surplus note offering in early January
– Fitch affirms the AAA rating/stable on January 16th in response to capital infusion
– Ambac announced its plan to issue $1 billion of equity linked notes to increase its capital reserves on January 16
• On January 18th Ambac announced that it will hold on it equity offering to raise capital stating that “it has determined that as a result of market conditions and other factors, raising equity is not at attractive option at this time. The Company is continuing to evaluate its alternatives.”
– Fitch downgraded Ambac two notches to “AA” that same day and kept Ambac on Negative Watch
27
PFMNew Player in Bond Insurance• On December 28, 2007 it was announced that Warren Buffet invested $105
million to fund Berkshire Hathaway Assurance Corporation
• Currently licensed in New York and seeking licenses in California, Texas, Puerto Rico, Illinois, and Florida.
– No word on plans to get license in Connecticut
• Preliminary review of capital capacity suggests underwriting capacity of $10 billion
– Modest in comparison to Ambac’s total muni portfolio of$550 billion for example
“Be fearful when others are greedy and be greedy when others are fearful” – Warren Buffet
28
PFM
VARIABLE RATE DEBT MARKET
29
PFMGrowth in the Variable Rate Market
• Over the past decade the variable rate market has more than doubled with most of the growth coming from the auction rate market
• The auction rate product was very attractive for borrowers because it traded at lower rates than VRDO’s and did not require liquidity support
VRDO vs. Auction Rate Issuance
-10,00020,000
30,00040,00050,00060,00070,00080,000
90,000100,000110,000
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
Variable Rate Auction Rate
30
PFMAuction Rate Performance – CHEFA Higher Ed/Secondary Schools
• Another impact of the credit crisis has been the poor performance of the auction rate market driven several factors
– 1) Investors seeking liquidity in times of credit stress and thereby having discomfort with the no-put feature of auction rate securities
– 2) The turmoil with the bond insurers who insure most of the municipal auction rate market
– 3) Capital pressure on broker-dealers limiting their ability to provide aggressive bids to support their auctions at a favorable rate
31
PFM“AAA” Insured 7-Day Auction Rate Performance – CHEFA Higher Ed/Secondary Schools
Auction Rate Performance in 2007 - CHEFA Higher Education / Secondary Schools
2.90%
3.10%
3.30%
3.50%
3.70%
3.90%
4.10%
1/1/
07
2/1/
07
3/1/
07
4/1/
07
5/1/
07
6/1/
07
7/1/
07
8/1/
07
9/1/
07
10/1
/07
11/1
/07
12/1
/07
1/1/
08
Date
Inte
rest
Rat
e
Average Interest Rate SIFMA
Includes Fairfield University, Trinity College, and Choate Rosemary Hall
32
PFM“AAA” Insured 7-Day Auction Rate Performance –CHEFA Healthcare
Auction Rate Performance - CHEFA Healthcare
2.90%
3.10%
3.30%
3.50%
3.70%
3.90%
4.10%1/
1/07
2/1/
07
3/1/
07
4/1/
07
5/1/
07
6/1/
07
7/1/
07
8/1/
07
9/1/
07
10/1
/07
11/1
/07
12/1
/07
1/1/
08
Date
Inte
rest
Rat
e
Average Interest Rate SIFMA
Includes Hospital of Saint Raphael, William Backus Hospital, Danbury Hospital, Yale New Haven Hospital, and Middlesex Hospital
33
PFMImpact on Liquidity / Letter of Credit Market
• As auction rate securities continue to result in rates with significant spreads to the SIFMA Index, many institutions are considering converting their auction rate bonds to variable rate demand obligations supported with either liquidity or a letter of credit
– Several letter of credit and liquidity providers are providing feedback that they cannot support exposure to certain bond insurers
• Concern that the demand for letters of credit or liquidity facilities will be so great that the price will increase, security/covenants will be more stringent, facility term will beshortened and the availability with be limited
34
PFM
SWAP COUNTERPARTY RISK
35
PFMFinancial Institutions Report Losses
• Large Wall Street Firms Report large losses due to investments in subprime mortgage market have resulted in downgrades of several swap counterparties
Bank Counterparty Rating Agency Rating Change DateBear Stearns Capital Markets Inc. SnP A 11/15/2007Bear Stearns Capital Markets Inc. Moodys A2 12/20/2007Citibank, N.A., New York Fitch AA 11/5/2007Citibank, N.A., New York Moodys Aa1 12/13/2007Citibank, N.A., New York SnP AA 1/15/2008Citigroup Financial Products Inc. Moodys Aa2 11/5/2007Citigroup Financial Products Inc. Fitch AA 11/5/2007Citigroup Financial Products Inc. Moodys Aa3 12/13/2007Citigroup Financial Products Inc. SnP AA- 1/15/2008Deutsche Bank AG - New York Branch SnP AA 8/2/2007Merrill Lynch Capital Services SnP A+ 10/24/2007Merrill Lynch Capital Services Moodys A1 10/24/2007Merrill Lynch Capital Services Fitch A+ 10/24/2007Morgan Stanley Bank SnP AA- 7/30/2007Morgan Stanley Capital Group Inc. SnP AA- 7/30/2007Morgan Stanley Capital Services Inc. SnP AA- 7/30/2007SMBC Capital Markets, Inc. Fitch A+ 10/3/2007UBS AG SnP AA 10/1/2007UBS AG Fitch AA 12/10/2007
36
PFMIncreased Focus on Counterparty Risk
• Institutions that maintain contracts with a bank in the form of a swap agreement should be aware of the trigger points such that they can exercise the option to have collateral posted as creditprotection
• Institutions should also be aware that a downgrade to underlyingbonds caused by an insurer downgrade may trigger a collateral event in which Institutions may need to post collateral to swap counterparties depending on the severity of insurer downgrade and provisions in the swap documents
• Institutions should pay careful attention to the terms in the credit support agreement in structuring new swaps
37
PFM
INVESTMENT CONSIDERATIONS
38
PFMCredit Risk
• Risk of default or decline in security value due to conditions outside investors control
– Bankruptcy– Rating agency downgrades– Regulatory changes
• CHEFA investment typically fall into the lower credit risk
HighLow
U.s
. Tre
asur
y O
blig
atio
ns
U.S
. Gov
ernm
ent
Age
ncie
s an
d In
stru
men
talit
ies
Rep
os w
ith
Trea
surie
s as
C
olla
tera
l
Cor
pora
te
Obl
igat
ions
(CP,
C
Ds,
Not
es)
Credit Risk
Mun
icip
al
Obl
igat
ions
(S
tate
, Cou
nty,
C
ity)
39
PFMCredit Spreads – 2-Year U.S. Treasury & Agency
Spread Between Two Year U.S. Treasury and Two Year Agency YieldJanuary 2003 through January 2008
0.00
20.00
40.00
60.00
80.00
100.00
1/1/03 1/1/04 1/1/05 1/1/06 1/1/07 1/1/08
Average Spread - 26.68
• In recent months, spreads between Treasuries and Agencies have widened to levels of 49-60bps in the 2-5 year area of the curve.
40
PFMFlight to Quality and Breakdown of Asset-Backed CP Markets Impacts Financial Services Issuers
Money Market YieldsJanuary 2007 – January 2008
Source: Bloomberg
2.50%
3.00%
3.50%
4.00%
4.50%
5.00%
5.50%
6.00%
6.50%
Jan07
Feb07
Mar07
Apr07
May07
Jun07
Jul07
Aug07
Sep07
Oct07
Nov07
Dec07
Jan08
Asset-Backed CPFinancial CPIndustrial CPAgency DNTreasury Bills
41
PFMGUARANTEED INVESTMENT CONTRACT CONSIDERATIONS
• The relative yield spread between collateralized and uncollateralized agreements has widened substantially
• Issuers should monitor their GIC providers credit ratings to monitor events which may require calling for collateral
– Typically GIC providers will have to post collateral when their rating falls below the “AA” category
42
PFMOTHER INVESTMENT CONSIDERATIONS
• All Money market funds and investment pools are not created equal
– Several money market funds have been impacted to due underlying SIV exposure
– In extreme cases state-sponsored funds took down large losses causing concern for school and cities investing
• For example in Florida disclosure indicating that their fund held $1.5 billion of downgraded and defaulted debt prompted issues towithdraw funds and the state subsequently froze withdrawals on November 29th
• Issues should conduct due diligence in understanding the underlying security for money market funds in making investment decisions
43
PFM
SUMMARY AND CHEFA CONSIDERATIONS
44
PFMCHEFA Considerations• Decrease in the value of bond insurance due to several factors
– Credit scrutiny for most of the bond insurers has resulted in the bonds trading based on the underlying rating and not the AAA rating of the bond insurer (except in the case of FSA and Assured Guaranty)
– Expected increases in premiums due to rating capital pressure for bond insurers and decreased competition for FSA and Assured Guaranty
– Potentially more onerous security and covenants imposed by FSA and Assured Guaranty due to improved market position
• Expected increase in demand for letters of credit and liquidity facility will have several impacts on CHEFA borrowers
– Banks may have capacity issues resulting in them being more selective in choosing credits
– Facilities will likely become more expensive and covenants/security more onerous for borrowers
• Movement to unenhanced financing alternatives as a result of turmoil impacting credit enhancers & liquidity providers
– Private placements– Limited public offerings– Un-enhanced public offerings
45
PFMCHEFA Considerations Continued • Increased focus on credit quality of underwriters/swap
counterparties – Review collateral provisions in swap documents
• For reinvestment of bond proceeds increased credit diligence for structure investments and money market funds
46
PFMQuestions?• Feel free to contact me directly if you’d like to discuss more
Jeremy BassSenior Managing ConsultantPublic Financial Management, Inc.99 Summer Street, Suite 1020Boston, MA 02110617-330-6914 [email protected] email