One Year Later: An Overview and Analysis of the Credit, Liquidity, and Housing Crisis

Jonathan B. Hartley

Institutional Sales and Trading Manager

August 2008

Disclaimer

This material is not an offer to sell or buy any security or financial product, and the information in these materials is subject to change. The information set forth is for informational purposes only. The Seattle Bank does not warrant or guarantee the accuracy of the information presented. The information presented is not investment, financial, accounting, regulatory, tax, or related advice, and you are advised to consult your accounting, tax, and financial advisers regarding any questions you may have about the information presented. The rates and other values presented in this material are indications only; the actual amounts may vary. All terms are subject to change without notice. Any member who engages in any transaction described in this material will be required to execute a written agreement with the Federal Home Loan Bank of Seattle that will govern the terms and conditions of that transaction. It is the member's sole responsibility to review any such agreement prior to signing it. In the event of any inconsistencies between this information and any such agreement, the agreement shall be determinative.

The views and opinions expressed in this report reflect those of the author, and do not necessarily reflect those of the Federal Home Loan Bank of Seattle.

What Went Wrong?

Predictable fallout from a bubble?

Rampant speculation and/or fraud?

Excessive financial engineering?

Weakness in credit underwriting?

Rating agency breakdown? Excessive leverage? Too much securitization, not

enough portfolio? Too little regulation? A run on capital? Off-balance sheet vehicles?

Who’s to Blame?

Greenspan and the Fed? The rating agencies? Regulators? Wall Street? Mortgage brokers? Homeowners? Investors? The FASB? Congress? The monoline insurers?

Timeline of a Crisis

August 10, 2006 In one of several grave warnings of an impending ARM-reset tidal wave, Business Week reports

that ARMs made during the height of housing boom will begin resetting by the fall of 2006, causing mortgage payments to balloon as much as 20%, potentially pushing defaults and foreclosures to dangerous economic proportions.

February 8, 2007 – The Opening Skirmish HSBC announces it is provisioning 20% more than planned for loan losses as home loans to the

riskiest U.S. borrowers are deteriorating at a much faster pace than expected.

February 27, 2007 Amid rumors that authorities are going to raise interest rates to curb inflation and clamp-down on

rampant speculation, the Shanghai stock market plunges 8.8%, triggering a global equity rout. The Dow drops 416 points in the biggest single-day drop since the post-9/11 re-opening.

April 2, 2007 Overwhelmed by customer defaults, Irvine, California-based subprime lending specialist New

Century Financial Corp. files for Chapter 11 bankruptcy protection.

June 20, 2007 The Wall Street Journal reports that two highly leveraged internal Bear Stearns hedge funds are on

the verge of collapse from large losses on subprime mortgage securities and heavy investor withdrawals.

Timeline of a Crisis (continued)

August 1, 2007 Both Bear Stearns hedge funds file for Chapter 15 bankruptcy protection, and the company

freezes redemptions on a third fund after investors start to panic.

August 9, 2007 – A Full-Blown Global Crisis Unfolds BNP Paribas freezes investor redemptions on three structured credit funds because the

bank cannot obtain accurate valuations on the underlying assets.   The European Central Bank (ECB) pumps €95 billion ($130 billion) into the banking system

in a so-called emergency “fine-tuning” operation—the largest single-day liquidity injection ever for the ECB.

August 10, 2007 The Fed funds effective rate plunges from 5.25% to 1.0% after the Fed conducts a massive

$38-billion MBS repo following a $24-billion MBS repo on August 9—the largest amount of liquidity injected by the Fed since September 12, 2001.

August 17, 2007 The Fed unexpectedly cuts the Discount Rate by 0.50% to 5.75%, while leaving the Fed

funds target unchanged at 5.25%.

Timeline of a Crisis (continued)

September 18, 2007 The Fed eases the Fed funds target by 0.50% to 4.75% in the first of seven rate cuts

totaling 3.25%, which ultimately brings the Fed funds target down to 2.0%.

October 30, 2007 – Investors Demand their Pound of Flesh! Following the announcement of an $2.24-billion third quarter loss—the largest in the firm’s

history—Stanley O’Neal is ousted as chairman and CEO of Merrill Lynch.

November 4, 2007 Citigroup CEO Charles Prince steps down under pressure after the bank warns of

additional write-downs of up to $11 billion on subprime-related assets—on top of the $6 billion already announced for the third quarter.

December 12, 2007 The Fed announces the Term Auction Facility (TAF)—a series of cash auctions offering

term cash funds to depository institutions against a wide variety of collateral.

January 11, 2008 Bank of America announces plans to fully acquire Countrywide for about $4 billion in stock

following an initial $2-billion, convertible preferred stock investment in August 2007.

Timeline of a Crisis (continued)

January 22, 2008 In response to a massive stock market selloff in Asia and Europe over the Martin Luther

King holiday, the Fed conducts an emergency inter-meeting easing of 0.75%, its largest single cut since 1984 and first inter-meeting easing since January 2001.

January 25, 2008 French bank Societe Generale discloses a loss of €4.9 billion ($7 billion) due to

unauthorized “rogue” trading by 31-year-old, equity-index futures trader Jerome Kerviel.

February 13, 2008 – Bi-partisan Action Can be Swift in an Election Year $152-billion Economic Stimulus Act of 2008 is signed into law.

February 17, 2008 After suffering a crippling run on deposits, the U.K. government announces plans to

nationalize struggling mortgage bank Northern Rock.

March 5, 2008 Oil closes at $104.52/barrel, officially surpassing the price record set during the second oil

shock in April 1980 of $39.50 (approx. $103.76 in today’s dollars).

Timeline of a Crisis (continued)

March 11, 2008 The Fed announces the Term Securities Lending Facility (TSLF), whereby they will swap up

to $200 billion of U.S. Treasury securities with primary dealers for up to 28 days in exchange for less liquid securities.

March 16, 2008 Fed introduces the Primary Dealer Credit Facility (PDCF), opening the Discount Window

directly to investment banks for the first time, allowing the 20 primary dealers to borrow overnight funds in exchange for a wide range of collateral, including non-agency MBS.

March 17, 2008 – A Venerable Wall Street Titan Falls As creditors abandon Bear Stearns en masse, the U.S. Treasury and the Fed engineer a

fire sale of the 85-year-old firm to J.P. Morgan for $240 million (about $2/share), and in a controversial move, lend J.P. Morgan $29 billion against Bear’s “less liquid” assets to finance the deal. J.P. Morgan ultimately raised the bid to about $10/share.

March 19, 2008 OFHEO lifts temporary mortgage portfolio caps and capital surcharges on Fannie and

Freddie as part of an agreement with the GSEs that they would buy more mortgages and eventually raise new capital.

Timeline of a Crisis (continued)

March 24, 2008 To add support to the housing market, the Federal Housing Finance Board permits the

FHLBanks to double their MBS holdings from 3x capital to 6x capital for up to two years.

June 19, 2008 One year after the story broke, ex-Bear Stearns Fund Managers Ralph Cioffi and Matthew

Tannin are arrested and indicted on federal mail fraud and conspiracy charges.

July 9, 2008 Dragged down by financial shares, the S&P 500 Index closes down 20% from its October

2007 high, touching off the first official bear market since 2002.

July 11, 2008 – The Contagion Spreads from Wall Street to Main Street In the second-largest bank failure in history, the FDIC closes Pasadena, California-based

IndyMac Bank, which held total assets of $32 billion and deposits of $19 billion.

July 16, 2008 The SEC announces new rules to curb short-selling in stocks of Fannie Mae, Freddie Mac,

and 17 other financial firms, acting on information that rumor and speculation played a large role in the demise of Bear Stearns.

Housing and Economic Recovery Act of 2008, signed into Law on July 30Highlights of the Act: Creates a new regulator, the Federal Housing Finance Agency (FHFA), for Fannie Mae, Freddie

Mac, and the FHLBank System, replacing OFHEO, the Federal Housing Finance Board, and some HUD functions.

Permanently raises the conforming loan limit to the greater of $417,000 or 115% of the local median home price, capped at $625,000.

Grants the U.S. Treasury authority to increase lines of credit to the GSEs and standby authority to buy preferred stock in Fannie/Freddie if needed.

Establishes the FHA “Hope for Homeowners” program, supported by $300 billion in new insurance authority, to refinance existing borrowers into fixed-rate FHA loans.

Provides the FHFA with discretion to: (1) impose restrictions on the size of Fannie/Freddie mortgage portfolios, (2) set capital requirements, (3) review existing activities, (3) shut down financially troubled entities, and (4) to require Fannie/Freddie to obtain prior approval before offering new products.

Encourages a nation-wide licensing and registry system for loan originators.

How the Legislation Affects the FHLBank System & Its Members Requires the FHFA to recognize the unique differences between the

FHLBank System and Fannie/Freddie.

Raises the definition of Community Financial Institution (CFI) from $500 million to $1 billion, opening expanded collateral types to more members.

Establishes new procedures for election of directors and mandates that 40% of directors be from non-member institutions.

Authorizes issuance of LOCs in support of tax-exempt bonds on behalf of members.

Permits voluntary mergers of FHLBanks and allows a reduction in the total number of FHLBanks to below the current minimum of eight.

Have We Reached the Bottom of the Credit Cycle Yet?

0.0

25.0

50.0

75.0

100.0

125.0

150.0

175.0

200.0

Sp

read

(Bp

s)

CDX North American Investment Grade Index

Credit Spreads Peak Around Bear Stearns’ Collapse

Credit Risk Arguably Under-Priced

Mortgage Spreads Need to Tighten to in Order to Stabilize Housing…

2.0

2.5

3.0

3.5

4.0

4.5

5.0

5.5

6.0

6.5

7.0

FNMA 5.5% MBS vs. 7.5-Yr Interp. UST

30-Yr FNMA

1.93% Average Spread Since 8/07

7.5-Yr UST

…But Fannie & Freddie are Struggling

$0$5

$10$15$20$25$30$35$40$45$50$55$60$65$70

Fannie and Freddie Share Prices

Fannie hits low of $4.40 on 8/20

Freddie hits low of $2.81 on 8/22

Both Companies’ Stock is Down over 90% on the Year

Housing Prices Have Declined 16% Nationally…

-20.0

-15.0

-10.0

-5.0

0.0

5.0

10.0

15.0

20.0

Jan-0

2

May

-02

Sep-0

2

Jan-0

3

May

-03

Sep-0

3

Jan-0

4

May

-04

Sep-0

4

Jan-0

5

May

-05

Sep-0

5

Jan-0

6

May

-06

Sep-0

6

Jan-0

7

May

-07

Sep-0

7

Jan-0

8

May

-08

S&P/Case-Shiller Composite-20 IndexYear-over-Year Change

Housing Market Peaks in Late 2005

Are We Starting to Level-Off?

Delinquencies Stand at an All-Time High…

3.0

3.5

4.0

4.5

5.0

5.5

6.0

6.5

7.0

Residential Mortgage Delinquencies as a % of Total Loans Outstanding

Excludes bank REO

Record-Keeping Dates Back to 1979

6.35% as of 3/08

And Job Losses Have Accelerated

-51

-76

-51

-47

-67

-88

-83

-500.0

-450.0

-400.0

-350.0

-300.0

-250.0

-200.0

-150.0

-100.0

-50.0

0.0

(in T

ho

usa

nd

s)

Net Change to Non-Farm Payrolls

The banking industry has lost 77,000 jobs since 2007.

463,000 cumulative losses since January 2008

Globally, Credit Losses at Banks Have Topped $500 Billion

4.1

43.4

169.6 171

107.2

9.210.50.0

45.8

87.2

169.7

39

0

20

40

60

80

100

120

140

160

180

All PriorQuarters

Q3 '07 4Q '07 Q1 '08 Q2 '08 Q3 '08

$ in

Bil

lio

ns

Credit Losses Capital Infused

$504.5 in Total Losses vs. $352.2 in New Capital

Thru 8/27

In Response to the Turmoil, the Fed has Aggressively Eased…

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

5.5

Fed Funds Target Rate

The Fed has cut a total of 3.25% in 7 moves.

Steady at 5.25% since June 2006

2.0% Current Target

And Pumped Copious Amounts of Liquidity Into the System

This Cycle: Fed has Eased 3.25% in 7 StepsTSLF

$s in Billions

$686$276

$960

$3,625Total Fed Liquidity Added Since August 2007

$ in Billions, Thru 8/22/08

$686$276

$960

$3,625

RepoTAF

TSLF PDCF

…Yet, Mortgage Rates Remain Stubbornly High, Impeding a Housing Market Recovery

5.5

6.0

6.5

7.0

Freddie Mac Monthly Average 30-Year, Fixed-Rate Mortgage

6.47% Average as of August 21

And Inflation is on the Rise, Restraining Additional Rate Cuts by the Fed …

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

PCE Deflator Year-over-Year Including Food and Energy

Meanwhile, Economic Growth Has Stalled, Indicating a Possible Return to Stagflation

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

8.0

Mar

-00

Sep-0

0

Mar

-01

Sep-0

1

Mar

-02

Sep-0

2

Mar

-03

Sep-0

3

Mar

-04

Sep-0

4

Mar

-05

Sep-0

5

Mar

-06

Sep-0

6

Mar

-07

Sep-0

7

Mar

-08

U.S. Quarterly GDP (Annualized)

Last official NBER recession was in 2001.

A “growth” recession underway?

The FHLBanks Have Been Part of the Solution, Not the Problem

$0

$300

$600

$900

2004 2005 2006 2007 Q2 '08

$ in

bill

ions

>5 Years

>3 <=5 Years

>1 <=3 years

<=1 Year

Source: Office of Finance

Advances Increased by $235 billion or 36.6%

Total System-wide Advances Outstanding

Excludes amortizing advances

How Did We Get Here?

The S&L Crisis Fallout Reg Q laid the groundwork for the ascendency of non-depository lenders (mortgage brokers)

focused on loan volume rather than credit quality. Repeal of Glass-Steagall in 1999 (Gramm-Leach-Bliley) allowed banks to combine traditional

lending with investment banking to build economic scale, but exposed flaws in the conglomerate financial model as concentration risks exacerbated losses.

Asian Currency Crisis of 1997 & the Off-shoring Boom of the Early 2000s Dollar pegs were left in place long after Asian economies recovered, which kept currencies

artificially weak and perpetuated mercantilist economies in Asia. Dollar holdings accumulated and were recycled back into the U.S. vis-à-vis purchases of Treasury

bonds, suppressing long-term rates—the engine for mortgage pricing.The Collapse of Hedge Fund LTCM & the Russian Debt Crisis of 1998 After energy commodity prices eventually recovered, a large amount of overseas petrodollars was

invested the credit markets, fanning the flames of asset price inflation.The Tech Bubble, 9/11, & Greenspan’s 2003 Deflation Miscalculation The condition of low, long-term interest rates (due to foreign investment) and overly accommodative

monetary policy (to fight deflation) created a dangerous intersection. Ballooning Federal Deficit $500-billion estimated budget deficit for FY 2009. $9.6 trillion in public debt outstanding. Two wars with no tax increases, Congressional earmarks, lack of entitlement reforms, etc.

How Did We Get Here? (continued)

Yield Curve Inversion Inverted yield curve = “negative carry” = more risk-taking. The Fed tried to slow things down by raising short-term rates, but foreign capital inflows inundated the

bond market and kept long-term rates down, forcing investors to pursue greater credit risk and leverage for returns.

A Push for Too Much Accounting Transparency, Too Fast The law of unintended consequences: the migration to fair value accounting boosted investor

transparency, but at a costly systemic erosion of capital, as assets are marked-to-market.Excess Leverage and Margin Spiral Balance sheets became too heavily geared toward the asset price cycle, forcing highly leveraged

investors to unwind risk in herd-mentality fashion. Monoline Mission Creep Bond insurers strayed from their core business of insuring low-risk municipal bonds to writing policies

on highly structured/highly levered credit products (e.g., CDOs), yet had inadequate capital to withstand policy losses all at once.

Rating Agencies’ Conflict of Interest Can these entities be both completely objective and for-profit?

How Did We Get Here? (continued)

Overconfidence in Models “Set & Forget It” risk management policies failed. Financial models broke down as so-called “Level

3” assets (which have no observable market price) increased.Regulation Too little? Overall, did regulation fail to keep up with the torrid pace of financial innovation? Too much? SEC, Fed, OTS, OCC, FDIC, Treasury, state, etc. Was the government still in a post-Enron/Worldcom mindset, focused more on enforcement than

prevention? Did Greenspan’s mystical aura inhibit challenges to his deeply held laissez-faire views?Housing Ponzi Scheme Serial refi’s and rampant property speculation—investment supplanted consumption as the primary

driver of home buying.Poor Credit Underwriting Standards What came first: payment-option ARMs or expensive houses? Evolution of the “What’s my monthly payment?” economy. Teaser rates, no income/no assets (NINA or “liar” loans); complete and total reliance on real estate

appreciation for debt service. Outright fraud.Beltway Gridlock Missed opportunities to reform Fannie and Freddie following approximately $16 billion in accounting

restatements? Managed to stock analyst/investor expectations. Is it fair to privatize the profits while socializing the

risk?

Wake Me When It’s OverGlobal credit losses currently stand at about $500 billion. In April 2008, the IMF predicted global credit losses will top-out at $1 trillion. If accurate, then we’re

at least halfway through the process.Housing is down about 16% nationally. Some of the frothiest housing markets are down nearly 30%. Since April 2008, price declines appear to have stabilized. Can housing fall more than 30% nationally? If not, then we’re about halfway through.Large banks still need more capital. $500 billion in losses minus $350 billion in new capital = $150 billion deficit. $150-billion shortfall (at an average of 12 times leverage) = approximately $1.8 trillion in spare

lending capacity that is otherwise off the market.More nationalization on the way? The stock market has effectively priced-in a government bailout of Fannie and Freddie. Some institutions are simply “too big to fail;” if they collapse, the government will engineer the

dismantling process to contain the fallout (e.g. Bear Stearns). HUD will own much more mortgage market share going forward. Recapitalization of the FDIC? The fund currently holds about $45 billion, or approx. 1% of all

insured deposits, which is historically low, and the “problem” list of banks grew from 90 to 117 institutions as of 6/30/08.

The credit spread pendulum needs to find an equilibrium resting place. Credit spreads unlikely return to rich, pre-bubble levels, but are extremely wide right now because

capital is so dear.

The Bottom Line

We are probably about half-way through the crisis in terms of dollar losses, but probably closer to one-third of the way through on a timing basis. Once banks begin to regain their trust in each other and the market has full confidence in the Fed, things will improve, but they will never be the same.

“While we’re well along in the credit crunch, we’re in the peak of its impact on the economy.”

-- Lawrence Meyer, Former Fed Governor