2. I. MORTGAGE ORIGINATION PROCESS Borrower Mortgage Originator Borrower Mortgage Originator Housing Market Housing Market Down Payment Mortgage Loan Payment

3.  Mortgage Origination Example 500,000 = Property Value 500,000 = Property Value (20%)100,000 = Down Payment (20%)100,000 = Down Payment 400,000 = Mortgage Loan @ 7.5% 400,000 = Mortgage Loan @ 7.5% Term = 30 yr fixed Term = 30 yr fixed  Mortgage Loans are secured by a lien on the property. The home serves as collateral for the loan made by the originator.  Mortgage rate is a fee paid on borrowed money. This fee is determined by an evaluation of the borrowers credit worthiness. The level of this rate is dependent on the perceived amount of risk associated with the loan.  Failure to pay the loan will result in foreclosure of the mortgage and ultimately repossession of the property by the lien holder.

5.  Measure of Risk Higher coupon = Higher Risk Higher coupon = Higher Risk  Motives  Borrower Motives - To own a home  Originator Motives - 1. Profits made on closing costs and coupon (Volume driven). 2. To provide buyers with liquidity based on risk 2. To provide buyers with liquidity based on risk parameters. parameters. Loan TypeRate RiskCharacteristics PrimeLow Rate Low Risk High Fico - 720+, Flawless credit history AltA Medium Rate Medium Risk Med Fico - <720, Good credit history SubprimeHigh Rate High Risk Low Fico - Shaky Credit history

6. II. MBS TRADING  Originator wants to lend more to make more money through increasing volumes.  In order to make more loans the originator needs to clean up warehouse lines through loan sales.  This liquidity is provided by: 1. Investment Banks 2. FNMA FHLMC – Gov’t agencies 2. FNMA FHLMC – Gov’t agencies 3. Hedge Funds – Buy across sectors 3. Hedge Funds – Buy across sectors BorrowersOriginators Principal & Interest

7.  Origination Liquidity Cycle  Originator puts whole loan package out for bid to street firms.  Street firms put bid on loan package and winner will eventually receive principal and interest payments.  Motive : Originators can now originate more loans and make more money.  Investment banks use loans as collateral for securitizations and receive interest payments. Originators Wall Street Firms

8. III. Wall Street Profits   Securitization  Loans are sold to a special purpose vehicle (SPV) which allows cash flows to be redirected to create several tranches of bonds.  The tranches make up collateralized mortgage obligations (CMO’s)  Tranches turn a profit on the spread between the loans bought and the point where bonds trade + excess interest.  Motives : Hold on to loans - make a profit by collecting interest payments. Securitize – Loans are given off balance sheet treatment, and usually turns a larger profit. Securitize – Loans are given off balance sheet treatment, and usually turns a larger profit.  Securitization Lifecycle: SPV Cash Flow to Bond Holders RawLoans

9.  Example: A Wall Street firm buys 119mm of 7.5% 30 year fixed rate loans @ 95.00% Cost basis = 119mm *.95 = 114mm

10.  Bond Ratings

11. IV. Subprime Meltdown Housing Market Borrowers Originators Wall Street Investors Rating Agencies Market begins to depreciate, increase in delinquencies Borrowers locking loans they cannot afford using new exotic lending instruments. Originating based on volume rather than fundamentals. Using loose underwriting to ensure high volumes. Providing liquidity to originators with loose underwriting guidelines. Holding loans and securities that are declining in value. Investing in securities backed by questionable collateral. Holding on to securities that are declining in value. Giving too much credit to securitization. Deals should have been rated more strictly with a closer eye on the credit worthiness of the collateral.