1. MORTGAGES, MARKETS AND WHAT WE KNOW SO FAR Detroit Chapter of the Institute of Internal Auditors Robert Van Order University of Michigan 1

2. Basic Observation: Big increase in foreclosures. Why? 2

3. Subprime ARM Defaults are Very Different from Prime and Subprime FRM Loans 90 days or more delinquent or in foreclosure (percent of number) Source: Mortgage Bankers Association (Quarterly data not seasonally adjusted;1998Q1-2007Q3) Prime Conventional FHA & VA Subprime FRM – Recession Subprime ARM 3

4. Stylized Facts and Gatherings from Various Data Sources Credit Risk: A Few Propositions Recent History: Especially Large Early Payment Defaults: Can it be rate adjustments? Changing Loan Characteristics: Hard vs. Soft Data, Technical Change and the Two Decades. Economic Conditions Market Structure: The rise of subprime Securitization: The rise of non-agency securities 4

5. Age of Loan in Number of Months From Origination Date Cumulative REO Rates Are Showing Poor Performance of Recent Origination Vintages Could it have been ARMs? Cumulative REO Rate as a Share of Number of Loans Originated Alt-ASubprime 2002 2003 2004 2005 2006 2007 Source: Loan Performance, a subsidiary of First American Real Estate Solutions Note: the last twelve points on each origination year cohort contain fewer loans progressively as loans issued at earlier dates always age faster. Data through December 2008. 5

6. Credit Risk Underwriting models and history suggested scorecards and diversification worked 6

7. Relative Default Probabilities Note the “Nonlinearity” as you move Northeast More sensitive to mistakes. LTV <70LTV 71-80LTV 81-90LTV 91-95 FICO <620 0.964.811.0419.68 FICO 620-679 0.462.35.299.43 FICO 680-720 0.212.34.1 FICO >720 0.080.40.921.64 7

8. Price Performance Matters. So Does (Did?) Diversification 8

9. So looking back, you would have thought that controlling FICO and LTV was a big deal, you couldn’t have a credit problem without changes in FICO-LTV distribution, and a diversified portfolio would perform well. But Performance Got Really Bad. Especially in Early Months 9

10. Underwriting has changed over time, but not in ways you might have thought. 10

11. High LTVs went up in 90s. Fell lately 11

12. Recent observables haven’t changed all that much (Tales?) 12

13. We Seem To Have Two Explanations Left Economic Conditions. Structure and Moral Hazard 13

14. The Case-Shiller Index

15. Single-family Construction 1- to 4-Family Housing Starts (thousands of units, SAAR) Sources: Bureau of Census, Freddie Mac – Recession Third Quarter 2005 record: 1.8 million units Forecast Fourth Quarter 2007: 0.9 million units

16. Source: Freddie Mac Purchase-Only Conventional Mortgage Home Price Index (Annualized Quarterly Rates for 3 rd Quarter 2007) Price Changes by State: Third Quarter 2007 Pacific -5.8% Mountain 0.4% West South Central 4.9% East South Central -0.1% South Atlantic -2.7% Middle Atlantic -0.9% New England -3.6% East North Central -3.8% West North Central -0.8% > 5% Quarterly Change < 0% Quarterly Change 0 – 5% Quarterly Change < -5% Quarterly Change DC United States -2.2% (3 rd Quarter Annualized Growth)

17. How favorable were economic conditions? 17

18. The structure of the Market Has Changed More Subprime and Alt-A Non Agency Securitization 18

19. Subprime used to be about 10% of originations, but it’s share increased a lot after 2003 19

20. Securitization Changes Note the nonagency share went up after the subprime share went up and around the time the vintages got worse. 20

21. SUBPRIME SECURITIZATION Credit risk is more important than for Agency securities. The risk has been handled (poorly) by structuring. So securitization could have been a big part of the problem, because it is so susceptible of moral hazard/asymmetric information. Recall that to some extent the recent subprime loans didn’t look that bad on paper. Hard vs. soft information. 21

22. Subprime Foreclosures Started: 4-yr Distributed Lag of Multipliers 22

23. As an aside there have been spillovers that don’t match with actual risk.

24. About half way through the eventual increases in defaults 24