The Subprime Mortgage Crisis and Its Impact on the Tax-Exempt Market - - PowerPoint PPT Presentation

Presented by: Jeremy Bass

The PFM Group

99 Summer Street, Suite 1020 Boston, MA 02110

The Subprime Mortgage Crisis and Its Impact on the Tax-Exempt Market

CHEFA Board Meeting January 22, 2008

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Table 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

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HOUSING OVERVIEW AND MORTGAGE SECURITIZATION

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Housing Market Boom…

Existing and New Home Sales January 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

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Housing Market Boom…

Building Permits and Housing Starts January 2001 – December 2005

Source: Bloomberg

05 1500 1600 1700 1800 1900 2000 2100 2200 2300 2400 Jan 01 Apr 01 Jul 01 Oct 01 Jan 02 Apr 02 Jul 02 Oct 02 Jan 03 Apr 03 Jul 03 Oct 03 Jan 04 Apr 04 Jul 04 Oct 04 Jan 05 Apr 05 Jul 05 Oct Building Permits Housing Starts

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Housing 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% Mar 01 Jun 01 Sep 01 Dec 01 Mar 02 Jun 02 Sep 02 Dec 02 Mar 03 Jun 03 Sep 03 Dec 03 Mar 04 Jun 04 Sep 04 Dec 04 Mar 05 Jun 05 Sep 05 Dec 05

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…and Bust

Existing and New Home Sales January 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

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…and Bust

Building Permits and Housing Starts January 2003 – November 2007

Source: Bloomberg

07 1100 1300 1500 1700 1900 2100 2300 2500 Jan 03 Apr 03 Jul 03 Oct 03 Jan 04 Apr 04 Jul 04 Oct 04 Jan 05 Apr 05 Jul 05 Oct 05 Jan 06 Apr 06 Jul 06 Oct 06 Jan 07 Apr 07 Jul 07 Oct Building Permits Housing Starts

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…and Bust

Home Values January 2003 – September 2007

Source: Bloomberg

• 10.00%
• 5.00%

0.00% 5.00% 10.00% 15.00% 20.00% Mar 03 Jun 03 Sep 03 Dec 03 Mar 04 Jun 04 Sep 04 Dec 04 Mar 05 Jun 05 Sep 05 Dec 05 Mar 06 Jun 06 Sep 06 Dec 06 Mar 07 Jun 07 Sep 07

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Subprime 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

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The Subprime Mortgage/ Variable Rate Connection

Variable 25% Fixed 75% Variable 67% Fixed 33% Percent of Total Mortgages Percent of Subprime Mortgages

Source: Bloomberg and Bankrate.com

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Foreclosures Increase

Adjustable Subprime Foreclosures as a Percentage

• f All Loans

March 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

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SIV – 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 Investors Asset- Backed Securities

Purchases Securities Repayments of Underlying Assets Issues Commercial Paper Purchases CP Receive $

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Asset-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

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CREDIT SPREADS

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Fear Factor: Credit Spreads Widen on Subprime Mortgage 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

• n new bank charges, losses

3-Mo LIBOR - Treasury Bill Spread

Weekly Data, December 10, 1993 - January 11, 2008

0.25 0.5 0.75 1 1.25 1.5 1.75 2 2.25 1 2 / 1 / 9 3 6 / 1 / 9 4 1 2 / 1 / 9 4 6 / 1 / 9 5 1 2 / 1 / 9 5 6 / 1 / 9 6 1 2 / 1 / 9 6 6 / 1 / 9 7 1 2 / 1 / 9 7 6 / 1 / 9 8 1 2 / 1 / 9 8 6 / 1 / 9 9 1 2 / 1 / 9 9 6 / 1 / 1 2 / 1 / 6 / 1 / 1 1 2 / 1 / 1 6 / 1 / 2 1 2 / 1 / 2 6 / 1 / 3 1 2 / 1 / 3 6 / 1 / 4 1 2 / 1 / 4 6 / 1 / 5 1 2 / 1 / 5 6 / 1 / 6 1 2 / 1 / 6 6 / 1 / 7 1 2 / 1 / 7

Spread (%)

Avg: 0.43% Min: 0.7 Max: 2.08 Std: 0.27

Russian debt default crisis U.S. sub-prime mortgage crisis

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Flight-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 / 2 7 2 / 2 / 2 7 3 / 2 / 2 7 4 / 2 / 2 7 5 / 2 / 2 7 6 / 2 / 2 7 7 / 2 / 2 7 8 / 2 / 2 7 9 / 2 / 2 7 1 / 2 / 2 7 1 1 / 2 / 2 7 1 2 / 2 / 2 7 1 / 2 / 2 8

Date Interest Rate Treasury 1 yr Treasury 30 yr AAA GO 30 yr BAA GO 30 yr A Hospital 30 yr Source: Thomson Financial Index Rate 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%

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Flight-to-Quality in U.S. Bond Market

Change in credit spreads - January 2, 2007 to Present

• 0.60
• 0.40
• 0.20

0.00 0.20 0.40 0.60 0.80 1.00 1.20

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 10/2/2007 11/2/2007 12/2/2007 1/2/2008

Date Interest Rate Spread Spread 30 Year Treasury to "A" Hospital Spread 30 Year "AAA" MMD to "A" Hospital

Source: Thomson Financial

Index Spread Change - 1/2/07 to 1/17/2008 Spread 30 Year Treasury to "A" Hospital 1.11% Spread 30 Year "AAA" MMD to "A" Hospital 0.54%

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BOND INSURANCE

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Radian

• 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
• ver 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).

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Radian 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% 5/15/07 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 10/16/07 10/30/07 11/13/07 11/27/07 12/11/07 12/25/07 1/8/08 Date Interest Rate Series C Series D - Taxable SIFMA 1-Month LIBOR

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Other 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 subprime through direct guarantees and credit default swaps

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Bond Insurance Residential Mortgage Backed Security (RMBS) Exposure

A CA A ssured G uaranty A m bac CIFG FG IC FSA M BIA Radian X LC A Total RM BS E xposure (M

• il. $)

$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 RM BS Rating D istribution A A A 0.00% 81.80% 18.00% 57.00% 12.30% 51.90% 26.10% 25.70% 34.30% A A 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 (M

• il. $)

$0.0 $51.5 $1,647.3 $161.4 $2,305.3 $382.6 $3,009.4 $1.6 $596.0 Present V alue of Losses (M

• il. $)

$0.0 $44.6 $1,426.4 $139.8 $1,996.2 $331.3 $2,605.9 $1.4 $516.1 A fter Tax N et RM BS 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

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Bond 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 Rating Revised Rating Prior Outlook Revised Outlook Prior Rating Revised Rating Prior Outlook Revised Outlook Prior Rating Revised Rating Prior Outlook Revised Outlook FGIC Aaa Aaa Stable Negative Watch (12/14/2007) AAA AAA Stable Negative Watch (12/19/2007) AAA AAA Stable Negative Watch (12/17/2007) MBIA Aaa Aaa Stable Negative Watch (1/17/08) AAA AAA Stable Negative (12/19/2007) AAA AAA Stable Stable (1/16/08) XL Capital Aaa Aaa Stable Negative Watch (12/14/2007) AAA AAA Stable Negative (12/19/2007) AAA AAA Stable Negative Watch (12/12/2007) FSA Aaa Aaa Stable Stable AAA AAA Stable Stable AAA AAA Stable Stable CIFG Aaa Aaa Stable Negative (12/14/2007) AAA AAA Stable Negative (6/7/2007) AAA AAA Stable Stable Assured Guaranty Aaa Aaa Stable Stable AAA AAA Stable Stable AAA AAA Stable Stable Ambac Aaa Aaa Stable Negative Watch (1/16/08) AAA AAA Stable Negative (12/19/2007) AAA AA Stable Negative Watch (12/21/2007) ACA NR A CCC (12/19/2007) Negative Watch Developing Watch (12/19/2007) NR Radian Aa3 Aa3 Stable Stable AA AA Negative Stable (6/29/2007) AA A+ (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

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Bond 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

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Bond 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

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Bond 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

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New 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

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VARIABLE RATE DEBT MARKET

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Growth 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

• 10,000

20,000 30,000 40,000 50,000 60,000 70,000 80,000 90,000 100,000 110,000 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Variable Rate Auction Rate

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Auction 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

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“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 Interest Rate Average Interest Rate SIFMA

Includes Fairfield University, Trinity College, and Choate Rosemary Hall

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“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 Interest Rate Average Interest Rate SIFMA

Includes Hospital of Saint Raphael, William Backus Hospital, Danbury Hospital, Yale New Haven Hospital, and Middlesex Hospital

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Impact 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 be shortened and the availability with be limited

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SWAP COUNTERPARTY RISK

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Financial 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 Date Bear Stearns Capital Markets Inc. SnP A 11/15/2007 Bear Stearns Capital Markets Inc. Moodys A2 12/20/2007 Citibank, N.A., New York Fitch AA 11/5/2007 Citibank, N.A., New York Moodys Aa1 12/13/2007 Citibank, N.A., New York SnP AA 1/15/2008 Citigroup Financial Products Inc. Moodys Aa2 11/5/2007 Citigroup Financial Products Inc. Fitch AA 11/5/2007 Citigroup Financial Products Inc. Moodys Aa3 12/13/2007 Citigroup Financial Products Inc. SnP AA- 1/15/2008 Deutsche Bank AG - New York Branch SnP AA 8/2/2007 Merrill Lynch Capital Services SnP A+ 10/24/2007 Merrill Lynch Capital Services Moodys A1 10/24/2007 Merrill Lynch Capital Services Fitch A+ 10/24/2007 Morgan Stanley Bank SnP AA- 7/30/2007 Morgan Stanley Capital Group Inc. SnP AA- 7/30/2007 Morgan Stanley Capital Services Inc. SnP AA- 7/30/2007 SMBC Capital Markets, Inc. Fitch A+ 10/3/2007 UBS AG SnP AA 10/1/2007 UBS AG Fitch AA 12/10/2007

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Increased 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 credit protection

• Institutions should also be aware that a downgrade to underlying

bonds 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

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INVESTMENT CONSIDERATIONS

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Credit Risk

• Risk of default or decline in security value due to conditions
• utside investors control

– Bankruptcy – Rating agency downgrades – Regulatory changes

• CHEFA investment typically fall into the lower credit risk

High Low

U.s. Treasury Obligations U.S. Government Agencies and Instrumentalities Repos with Treasuries as Collateral Corporate Obligations (CP, CDs, Notes)

Credit Risk

Municipal Obligations (State, County, City)

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Credit Spreads – 2-Year U.S. Treasury & Agency

Spread Between Two Year U.S. Treasury and Two Year Agency Yield January 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.

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Flight to Quality and Breakdown of Asset-Backed CP Markets Impacts Financial Services Issuers

Money Market Yields January 2007 – January 2008

Source: Bloomberg

2.50% 3.00% 3.50% 4.00% 4.50% 5.00% 5.50% 6.00% 6.50% Jan 07 Feb 07 Mar 07 Apr 07 May 07 Jun 07 Jul 07 Aug 07 Sep 07 Oct 07 Nov 07 Dec 07 Jan 08 Asset-Backed CP Financial CP Industrial CP Agency DN Treasury Bills

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GUARANTEED 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

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OTHER 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 to withdraw 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

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SUMMARY AND CHEFA CONSIDERATIONS

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CHEFA 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

• nerous 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

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CHEFA 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

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Questions?

• Feel free to contact me directly if you’d like to discuss more

Jeremy Bass Senior Managing Consultant Public Financial Management, Inc. 99 Summer Street, Suite 1020 Boston, MA 02110 617-330-6914 phone bassj@pfm.com email