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An Overview of the Housing/Credit Crisis

and Why There is More Pain to Come

T2 Accredited Fund, LP
Tilson Offshore Fund, Ltd.
T2 Qualified Fund, LP

April 3, 2009
T2 Partners Management L.P. is a Registered Investment Advisor

145 E. 57th Street ˚ 10th Floor


New York, NY 10022
(212) 386-7160
Info@T2PartnersLLC.com ˚ www.T2PartnersLLC.com

This document is not a solicitation to invest in any investment product, nor is it intended to provide investment advice. It is intended for information
purposes only and should be used by sophisticated investors who are knowledgeable of the risks involved. All data and comments herein are believed to
be correct, but there are no guarantees and readers should do their own work. Please refer to the relevant Confidential Private Placement Memorandum for
full details on investment products and strategies of T2 Partners LLC.
Prior to This Decade, Housing Had Been a Stable Investment,
Increasing at Less Than ½ of 1% Per Year After Inflation…

220

200

Real H ome Price Index


(1890=100)

180

160

140

Trend Line
120

100

Source: Robert J. Shiller, Irrational Exuberance, Princeton University Press 2000, Broadway Books 2001, 2nd edition,
2005, also Subprime Solution, 2008, as updated by the author at http://www.econ.yale.edu/~shiller/data.htm
-2-
…And Then Housing Prices Exploded

220

200
R e a l H ome P rice Inde x
(1890=100)

180
Housing Bubble
160

140

Trend Line
120

100

Source: Robert J. Shiller, Irrational Exuberance, Princeton University Press 2000, Broadway Books 2001, 2nd edition,
2005, also Subprime Solution, 2008, as updated by the author at http://www.econ.yale.edu/~shiller/data.htm
-3-
From 2000-2006, the Borrowing Power of a Typical
Home Purchaser More Than Tripled
$400,000
Pre-Tax Income
Borrowing Power

$300,000

$200,000

9.2x in January 2006

$100,000

3.3x in January 2000

$0
Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08

Factors contributing to the ability to borrow more and more were:


1. Slowly rising income
2. Lenders being willing to allow much higher debt-to-income ratios
3. Falling interest rates
4. Interest-only mortgages (vs. full amortizing)
5. No money down
Source: Amherst Securities

-4-
Housing Became Unaffordable in Many Areas

80
Los Angeles, CA
Riverside, CA
San Diego, CA
70

60
Housing Opportunity Index

50

40

30

20

10

0
Q1 1996 Q1 1997 Q1 1998 Q1 1999 Q1 2000 Q1 2001 Q1 2002 Q3 2004 Q3 2005 Q3 2006 Q3 2007

Source: NAHB/Wells Fargo Housing Opportunity Index, which measures percentage


of households that could afford the average home with a standard mortgage
-5-
Americans Have Borrowed Heavily Against Their Homes
Such That the Percentage of Equity in Their Homes Has
Fallen Below 50% for the First Time on Record Since 1945
$12,000 90%

80%

$10,000

70%

$8,000 60%

Equity as a % of Home Value


1945
Mortgage Debt: $18.6 billion
Mortgage Debt (Bn)

50%
Equity: $97.5 billion
$6,000
2008 40%
Mortgage Debt: $10.5 trillion
Equity: $8.5 trillion
$4,000 30%

20%

$2,000

10%

$0 0%
1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
Source: Federal Reserve Flow of Fund Accounts of the United States
-6-
There Was a Dramatic Decline in Mortgage
Lending Standards from 2001 through 2006
Combined Loan to Value 100% Financing • In 2005, 29% of
new mortgages
86 18%
17%
84
84
83
16%
were interest
82
81 81
14%
14%
only — or less,
80 12% in the case of
Combined Loan to Value (%)

Percent of Originations
78 10%
9%
Option ARMs —
76
76
8%
8%
vs. 1% in 2001
74
74 74 6%
• In 1989, the
72 4%
3% average down
70 2% payment for first-
1%

time home
1%
68 0%
2001 2002 2003 2004 2005 2006 2007

buyers was
2001 2002 2003 2004 2005 2006 2007

10%; by 2007, it
Limited Documentation 100% Financing & Limited Doc was 2%
70% 12%

• The sale of new


65%
63% 11%

homes costing
60%
56% 10%

50%
45%
49%

8%
$750,000 or
8%

more quadrupled
Percent of Originations
Percent of Originations

40% 39%

33% 6% from 2002 to


2006. The
5%
30%
4%

20%
4%
construction of
2%
inexpensive
10% 1%
homes costing
$125,000 or less
0% 0%

0% 0%
2001 2002 2003 2004 2005 2006 2007 2001 2002 2003 2004 2005 2006 2007

fell by two-thirds
Source: LoanPerformance, Paulson presentation; USA Today (www.usatoday.com/money/economy/housing/2008-12-12-homeprices_N.htm)
-7-
The Decline in Lending Standards Led to a
Surge in Subprime Mortgage Origination
$700 25%

$600
20%
20% 20%

18% % of
$500
T ota l
Origina tions
(Bn)
15%
$400

$300
10% 10% 10%
10% 10%
9% 9%
9%

8%
$200 7% 8%
7%

5%

$100

$0 0%
1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Source: Reprinted with permission; Inside Mortgage Finance, published by Inside Mortgage
Finance Publications, Inc. Copyright 2009.
-8-
But Subprime Mortgages Are Only a
Tiny Part of the Mortgage Problem
Prime Mortgage

Commercial Real Estate

Alt-A

Other Corporate

Commercial & Industrial

Subprime

High-Yield / Leveraged Loans

Jumbo Prime

Home Equity

Credit Card

Auto

Option ARM

Construction & Development

Other Consumer

CDO/ CLO

$0.0 $0.5 $1.0 $1.5 $2.0 $2.5 $3.0 $3.5 $4.0 $4.5 $5.0
Amount Outstanding (Trillion)

Sources: Federal Reserve Flow of Funds Accounts of the United States, IMF Global Financial Stability Report October 2008, Goldman Sachs
Global Economics Paper No. 177, FDIC Quarterly Banking Profile, OFHEO, S&P Leverage Commentary & Data, T2 Partners estimates

-9-
Among the Many Causes of The Great
Mortgage Bubble, Two Stand Out
• The companies making crazy loans didn’t care very much if the
homeowner ended up defaulting for two reasons:
1. Either they didn’t plan to hold the loan, but instead intended to pass it along
to Wall Street, which would bundle, slice-and-dice it and sell it (along with
any subsequent losses) to investors around the world;
2. Or, if they did plan to hold the loan, they assumed home prices would keep
rising, such that homeowners could either refinance before loans reset or, if
the homeowner defaulted, the losses (i.e., severity) would be minimal.
• There were many other reasons, of course – a bubble of this
magnitude requires what Charlie Munger calls “Lollapalooza Effects”
– The entire system – real estate agents, appraisers, mortgage lenders,
banks, Wall St. firms and ratings agencies – became corrupted by the vast
amounts of quick money to be made
– Regulators and politicians were blinded by free market ideology or the
dream that all Americans should own their homes, causing them to fall
asleep at the switch, not want to take the punch bowl away and/or get
bought off by the industries they were supposed to be overseeing
– Debt became increasingly available and acceptable in our culture
– Millions of Americans became greedy speculators and/or took on too much
debt
– Greenspan kept interest rates too low for too long
– Institutional investors stretched for yield, didn’t ask many questions and
took on too much leverage
– In general, everyone was suffering from irrational exuberance

-10-
As Long As Home Prices Rise Rapidly, Even Subprime Mortgages
Perform Well – But If Home Prices Fall, Look Out Below!

60%

50%

40%
Cumulative Loss (%)

30%

20%

10%

0%
20% 15% 10% 5% 0% -5% -10% -15% -20% -25% -30% -35% -40%
Home Price Appreciation

Source: T2 Partners estimates


-11-
Wall Street’s Demand for Loan “Product” Was a
Major Driver of the Decline in Lending Standards
• As discussed later in this presentation, the Asset-Backed Securities (ABSs) and
Collateralized Debt Obligation (CDO) businesses were enormously profitable for
Wall Street firms
– Structured finance was a big driver of the surge in profitability of financial firms and
their employees:
Financial Services Profits as a % of U.S. Total Financial Services Wages as a % of U.S. Total
11%
50%

10%
40%

9%

Percent of US Total
Percent of US Total

30%

8%

20%

7%

10%
6%

0% 5%
1975 1980 1985 1990 1995 2000 2005 1975 1980 1985 1990 1995 2000 2005

• To produce ABSs and CDOs, Wall Street needed a lot of loan “product”
• Mortgages were a quick, easy, big source
• It is easy to generate higher and higher volumes of mortgage loans: simply lend
at higher loan-to-value ratios, with ultra-low teaser rates, to uncreditworthy
borrowers, and don’t bother to verify their income and assets (thereby inviting
fraud)
• There’s only one problem: DON’T EXPECT TO BE REPAID!
Source: Moody’s Economy.com

-12-
There Was a Surge of Toxic Mortgages
Over the Past 10 Years
$4,000
Conforming, FHA/VA
Jumbo
$3,500 Alt-A
Subprime
Seconds
$3,000

$2,500
Originations (Bn)

$2,000

$1,500

$1,000

$500

$0
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Source: Reprinted with permission, Inside Mortgage Finance, published by Inside Mortgage Finance Publications, Inc. Copyright 2009

-13-
Private Label Mortgages (Those Securitized by Wall St.) Are 15%
of All Mortgages, But Are 51% of Seriously Delinquent Mortgages
Number of Seriously
Number of Mortgages (million) Delinquent Mortgages (000)

Total: 55.0 million Total: 3.5 million


Banks & T hrifts Banks & T hrifts
8 397
Fannie Mae
444

Fannie Mae
18 Freddie Mac
232

Private Label
8
15%
Ginne Mae/FHA
378

Ginne Mae/FHA
6
Private Label
Freddie Mac 1734
13

51%

Approximately two-thirds of homes have mortgages and of these, 56% are owned or
guaranteed by the two government-sponsored enterprises (GSEs), Fannie & Freddie
Source: Freddie Mac, Q4 08

-14-
Nearly 8% of Mortgages on 1- to 4-Family Homes Were
Delinquent or in Foreclosure as of the End of 2008
8.0%

7.0%

6.0%
Percentage of Home Loans

5.0%

4.0%

3.0%

2.0%

1.0%

0.0%

Q 07
Q 95

Q 04
Q 92
Q 83

Q 96
Q 97

Q 03

Q 05
Q 06
Q 80

Q 91

Q 93
Q 94
Q 84
Q 85
Q 86
Q 81
Q 82

Q 98
Q 99

Q 002
Q 990

08
Q 00
Q 01
Q 87
Q 88
Q 89
Q 979

20
19

19
19

20

20

20
19

19

19

19
19

20

20

20
19

19

19
19

19

19

19
19

19

19
19

20
2
1
1

4
4
4
4
4
4
4
4
4
4

4
4
4
4
4
4
4
4
4
4

4
4
4
4
4
4
4
4
4
4
Q

Source: National Delinquency Survey, Mortgage Bankers Association. Note: Delinquencies (60+ days) are seasonally adjusted

-15-
All Types of Loans, Led by Subprime, Are Seeing a Surge
in Delinquencies
45%
Alt A
Option ARM
40% Jumbo
Subprime
Prime
35% Home Equity Lines of Credit

30%
Percent Noncurrent

25%

20%

15%

10%

5%

0%
05

08
06
99

01

02

04

07

07
01

03
00

08
04

06
03
99

00

05
02

20

20
20

20
19

19

20

20

20

20

20

20

20

20

20
20

20

20
20
20

3
1

1
1

1
3

1
1

Q
Q

Q
Q

Q
Q

Source: Amherst Securities, LoanPerformance; National Delinquency Survey, Mortgage Bankers Association;
FDIC Quarterly Banking Profile; T2 Partners estimates. Note: Prime is seasonally adjusted.

-16-
Sales of Existing Homes Are Falling and Foreclosures
Are Rising, Leading to a Surge in Inventories
Existing Home Sales Months Supply
7.5 12

7.0
11
3.8 million units, equal to 9.7
10
months as of the end of February
6.5
9

6.0
8
Millions

Months
7
5.5

6
5.0

4.5 4.7 million units as of


4
the end of February 2009
4.0 3
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Source: NATIONAL ASSOCIATION OF REALTORS® Existing Home Sales data series

-17-
24% of Homeowners With a Mortgage Owe More Than the
Home Is Worth, Making Them Far More Likely to Default
Among people who bought homes in the past five years, 30%+ are under water
In Bubble Markets, Far More
Homeowners Are Under Water
Price Index Is % of Last 5 Yrs
at Lowest Price Drop Purchasers Who
Metro Area Level Since Since Peak Are Under Water
New York 2004-Q3 -15.2% 23.0% There Has Been a Dramatic Rise in
Los Angeles 2003-Q4 -32.0% 56.4% Homeowners Who Are Under Water
Boston 2002-Q2 -21.8% 27.8%
Washington 2004-Q1 -24.8% 50.3%
25%
24%
Miami 2004-Q1 -36.6% 65.1%
San Francisco 2003-Q3 -27.8% 51.2%
Atlanta 2004-Q4 -10.4% 23.2%
20%
San Diego 2002-Q4 -34.4% 63.9%
20%

Phoenix 2004-Q3 -37.7% 36.4%


Las Vegas 2003-Q4 -41.8% 61.4%
16%
Percent Underwater
15%

10%

6%

5%
4%

0%
Dec-06 Dec-07 Sep-08 Dec-08 Mar-09

Source: Zillow.com Q4 08 Real Estate Market Report; Moody's Economy.com, First American CoreLogic, T2 Partners estimates;

-18-
Certain Types of Loans are Severely Under Water
80%

73%

70%

60%

50%
50%
Percent Underwater

45%

40%

30%
25%

20%

10%

0%
Prime Alt A Subprime Option ARM

Source: Amherst Securities, LoanPerformance, Standard & Poor’s

-19-
Foreclosure Filings Have Increased Dramatically
• Foreclosures in February rose 30% year-over-year and 6% sequentially
• Starting to flatten due to a number of states and banks plus Fannie and Freddie
implementing foreclosure moratoria
• RealtyTrac estimates that over 1.5 million bank-owned properties are on the market,
representing around a third of all properties for sale in the U.S.
350,000

300,000

250,000
Number of Foreclosures

200,000

150,000

100,000

50,000

0
6

8
05

06

06

07
07

08

08

09
05

06

07

08
6
5

8
-0

-0
-0

-0

-0
-0

-0
r-0

-0

r-0

-0
b-

n-

b-

b-

n-

b-
g-

g-
n-

n-
c-

c-
ug

ug
ec
ct

ec
ct
pr
ct

ct
Ap

Ap
Fe

Fe
Ju

Ju
Au

Au
Fe

Fe
Ju

Ju
De

De
O

O
A
D

A
Note: Foreclosure filings are defined as default notices, auction sale notices and bank repossessions
Sources: RealtyTrac.com U.S. Foreclosure Market Report
-20-
In Bubble Markets, Prices Are Way Down Driven By a
Surge in the Number of Homes Sold Out of Foreclosure
$500 California 70%

60%

$400

50%
Median Home Price (000s)

Foreclosure Resale %
$300
40%

30%
$200

20%

$100

10%

$0 0%
08
06

8
8

09
6

07

8
6

7
-0

l-0

-0

-0
r-0
r-0

-0

l-0
l-0

n-

n-
n-

n-

pr

ct

ct
ct

Ju

Ju
Ju

Ap
Ap

Ja

Ja

Ja
Ja

O
O

O
A

Source: MDA Dataquick. Note: Includes new construction

-21-
Home Prices Are in an Unprecedented Freefall
220

S&P/Case-Shiller U.S. National Home Price Index

S&P/Case-Shiller 20-City Composite


200 OFHEO Purchase-Only Index

NAR Median Sales Price of Existing Homes

180

160

140

120

100
Q2 2000
Q3 2000
Q4 2000
Q1 2001

Q3 2001

Q1 2002

Q3 2002

Q1 2003

Q3 2003

Q1 2004

Q3 2004

Q1 2005

Q3 2005

Q3 2006
Q1 2006

Q4 2006
Q1 2007
Q2 2007

Q4 2007

Q2 2008

Q4 2008
Q2 2001

Q4 2001

Q2 2002

Q2 2003

Q3 2007

Q3 2008
Q1 2000

Q4 2002

Q4 2003

Q2 2004

Q4 2004

Q2 2005

Q4 2005

Q2 2006

Q1 2008
Source: Standard & Poor’s, OFHEO Purchase-Only Index, NATIONAL ASSOCIATION OF REALTORS® Existing Home Sales data series

-22-
Home Prices Need to Fall Another 13% to Reach Trend Line

220

200
Real Home Price Index (1890=100)

180

160
-32% from
Peak
140

Trend Line -13% to


120
Trend

100
50

54

62
58

82

90

98
86

94

02
74
66

70

78

06
19

19

19

19

19

19

19

19

19

19

19

20

20
19

19

Sources: Robert J. Shiller, Irrational Exuberance, 2nd. Edition, Princeton University Press,2005, Broadway Books 2006,
also Subprime Solution, 2008, as updated by author at http://www.econ.yale.edu/~shiller/data.htm
-23-
The Housing Affordability Index Shows
Houses Are Now Affordable
Before concluding that houses are cheap, however, there are three big caveats: first, low rates are only
available to those who qualify for conforming mortgages, which doesn’t help millions of homeowners or
potential homeowners who have spotty credit histories or are underwater on their current mortgages.
Second,
26 with low enough interest rates, almost anything looks affordable; if rates rise, houses won’t look
so reasonably priced based on these metrics. Finally, in light of the severe economic downturn, average
income may fall for quite some time.
Mortgage Payment on Median Priced Home as % of Family Income

24

22

20

18

16

14
1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Source: NATIONAL ASSOCIATION OF REALTORS® Housing Affordability Index

-24-
Mortgage Rates Have Fallen Recently

8
Jumbo 30 Yr FRM
Jumbo 5/1 Hybrid ARM
Conforming 30 Yr FRM
Conforming 5/1 Hybrid ARM
7
10-Year Treasury

6
Rate (%)

09
4

5
5

8
07
04

05

06

07

08
4

06

06

07

08
4

8
-0

-0

-0

-0
-0
-0

-0

-0

-0

-0
b-

b-

b-

b-

b-
g-

g-

v-

v-
b-

v-
ug

ug

ug
ov

ov
ay

ay

ay

ay
ay
Fe

Fe

Fe
Au

No

Au

No

No
Fe

Fe

Fe
A

A
M

M
Source: HSH Associates, Yahoo! Finance.com

-25-
The Home Price-to-Rent Ratio Has
Returned to Normal Levels
27

25
Median Home Price to Median Gross Rent

23

21

19

17

15
1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Source: NATIONAL ASSOCIATION OF REALTORS® Existing Home Sales data series, U.S. Census Bureau, T2 Partners estimates

-26-
A Study of Bubbles Shows That All of Them
Eventually Return to Trend Line
Stocks
S&P 500 S&P 500 Japan vs. EAFE ex-Japan S&P 500
1920-1932 1946-1984 1981-1999 1992-October 2008
* 2.3 2.5 3.0 2.4

Detrended Real Price


Detrended Real Price

Detrended Real Price


2.0 2.5

Relative Return
1.8 2.0
2.0
1.5
1.3 1.5 1.6
Tre nd Line 1.0
Tre nd Line 1.0
0.8 0.5 1.2
0.5 Tre nd Line Trend Line
0.3 0.0 0.0 0.8
20 21 22 23 24 25 26 27 28 29 30 31 46 50 54 58 62 66 70 74 78 82 81 83 85 87 89 91 93 95 97 99 92 94 96 98 00 02 04 06 08

Currencies
U.S. Dollar U.K. Pound Japanese Yen Japanese Yen
1979-1992 1979-1985 1983-1990 1992-1998
2.0 1.4 1.4 1.4
1.3 1.3

Cumulative Return
Cumulative Return

1.8
Cumulative Return

Cumulative Return
1.3
1.6 1.2 1.2 1.2
1.4 1.1 1.1 1.1
1.2 1.0 1.0 1.0
1.0 0.9 0.9 0.9
0.8 0.8 0.8 0.8
79 81 83 85 87 89 91 79 80 81 82 83 84 83 84 85 86 87 88 89 90 92 93 94 95 96 97

Commodities
Gold Crude Oil Nickel Cocoa
1970-1999 1962-1999 1979-1999 1970-1999
2000 250
80 600
1600 200 500
60
400
Real Price
Real Price

Real Price
Real Price

1200 150
40 300
800 100
200
400 20 50 100
0 0 0 0
70 74 78 82 86 90 94 98 62 66 70 74 78 82 86 90 94 98 79 81 83 85 87 89 91 93 95 97 70 74 78 82 86 90 94 98

Note: For S&P charts, trend is 2% real price appreciation per year. Source: GMO. Data through 10//10/08.
* Detrended Real Price is the price index divided by CPI+2%, since the long-term trend increase in the price of the S&P 500 has been on the order of 2% real.

-27-
The Biggest Danger is That Home Prices Overshoot on the
Downside, Which Often Happens When Bubbles Burst
S&P 500 1927-1954
2.50

Overrun: 59%
2.25
Fair Value to Bottom: 1.5 Years
2.00
Fair Value to Fair Value: 23 Years
Detrended Real S&P 500 Stock Price Index

1.75

1.50

1.25

1.00

0.75

0.50

0.25 -59% S&P 500 1955-1986


2.25

0.00
Overrun: 45%
1927 1930 1933 1936 1939 1942 1945 1948 1951 1954 2.00 Fair Value to Bottom: 7 Years
Fair Value to Fair Value: 12 Years
1.75

Detrended Real S&P 500 Stock Price Index


1.50

1.25

1.00

0.75

0.50

-45%
0.25

0.00
1955 1957 1959 1961 1963 1965 1967 1969 1971 1973 1976 1978 1980 1982 1984 1986
Source: GMO

-28-
Home Prices Have Already Crashed Through the Trend
Line in California – And There Is No Sign of Stabilization
$600
Median Sales Price
4% Trend

$500

$400
Median Price ($000s)

$300

$200

$100

$0
79

85

89

97

09
87

99

05

07
81

93

03
83

91

95

01
n-

n-

n-
n-
n-

n-

n-

n-
n-

n-

n-

n-
n-

n-

n-

n-
Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja
Ja

Ja

Ja
Source: Reprinted with permission of the California Association of REALTORS ® . All rights
reserved. www.rebsonline.com, T2 Partners estimates.
-29-
Outlook for Housing Prices
• We think housing prices will reach fair value/trend line down 40% from the peak
based on the S&P/Case-Shiller national (not 20-city) index, which implies a 10-15%
further decline from where prices where as of the end of 2008. It’s almost certain that
prices will reach these levels
• The key question is whether housing prices will go crashing through the trend line and
fall well below fair value? Unfortunately, this is very likely. In the long-term, housing
prices will likely settle around fair value, but in the short-term prices will be driven both
by psychology as well as supply and demand. The trends in both are very
unfavorable
– Regarding the former, national home prices have declined for 30 consecutive months since
their peak in July 2006 through January 2009 and there’s no end in sight, so this makes
buyers reluctant – even when the price appears cheap – and sellers desperate.
– Regarding the latter, there is a huge mismatch between supply and demand, due largely to
the tsunami of foreclosures. In January 2009, distressed sales accounted for 45% of all
existing home sales nationwide – and more than 60% in California. In addition, the “shadow”
inventory of foreclosed homes already likely exceeds one year and there will be millions more
foreclosures over the next few years, creating a large overhang of excess supply that will
likely cause prices to overshoot on the downside, as they are already doing in California.
• Therefore, we expect housing prices to decline in the 45-50% range, bottoming
in mid-2010
• We are also quite certain that wherever prices bottom, there will be no quick rebound
– There’s too much inventory to work off quickly, especially in light of the millions of
foreclosures over the next few years.
– While foreclosure sales are booming in many areas, regular sales by homeowners have
plunged, in part because people usually can’t sell when they’re under water on their
mortgage and in part due to human psychology: people naturally anchor on the price they
paid or what something was worth in the past and are reluctant to sell below this level. We
suspect that there are millions of homeowners like this who will emerge as sellers at the first
sign of a rebound in home prices.
– Finally, we don’t think the economy is likely to provide a tailwind, as we expect it to contract
the rest of 2009, stagnate in 2010, and only then grow tepidly for some time thereafter. -30-
There Have Been 5 Million Jobs Lost So Far in This
Recession, More Than 3 Million in the Past Five Months
600

400
Change in Nonfarm Payroll Employment (000s)

200

-200

-400

-600 There have been job


losses every month
-800
since December 2007
-1000
92

93

94

96

97

98

01

02

05

06

09
90

99

07
91

95

00

03

04

08
n-

n-

n-

n-

n-
n-

n-

n-

n-

n-

n-

n-

n-

n-

n-

n-
n-

n-

n-

n-
Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja
Ja

Ja

Ja

Ja
Source: Bureau of Labor Statistics
-31-
The Unemployment Rate Jumped to 8.5% in March,
the Highest Level Since 1983
If part-time and discouraged workers are factored in, the unemployment
12%
rate would have been 15.6% in March. In addition, the average work
week in dropped to 33.2 hours, a new record low.
11%

10%

9%
Unemployment Rate

8%

7%

6%

5%

4%

3%
73

76

79

82

88
85

91

94

97

03
00

06

09
70
n-

n-

n-

n-

n-

n-

n-

n-

n-

n-

n-

n-

n-

n-
Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja
Source: Bureau of Labor Statistics
-32-
The Decline from Peak Employment Now
Exceeds the Past Five Recessions
0.0%

1980 1974-76 1981-83 1990-93 2001-05


-0.5%

-1.0%

-1.5%

-2.0%

-2.5%

-3.0%

-3.5%

2007-
-4.0%
0 6 12 18 24 30 36 42 48
Months after pre-recession peak

Source: Bureau of Labor Statistics


-33-
Consumer Confidence is at an All-Time Low
160

140

120
Consumer Confidence Index

100

80

60

40

Near all-time low


20

0
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Note: 1985=100
Source: The Conference Board (www.pollingreport.com/consumer.htm)

-34-
Banks are Tightening Consumer Credit and
New Household Borrowing Has Plunged
Percent of US Banks Tightening Consumer Credit

70%

60%

50%

40%

30%

20%

10%

0%

-10%

-20%
02

06
00

04

08
1

7
00

04

08
02

06

Household Borrowing 1990-2008


-0
-0

-0

-0

p-
n-

n-

n-

n-

n-
p-

p-

p-

p-
ay

ay

ay

ay
Ja

Ja

Ja

Ja
Se

Se

Se

Se

Se
Ja

(Seasonally-Adjusted Annual Rate)


Credit Cards Other Consumer Loans
$1,200
($ billions)

$1,000

$800

$600

$400

$200

Source: Federal Reserve $0


1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

-35-
The Credit Bubble Led to a Bubble in
Financial Profits (& Share of GDP)

3.0% 350%
Low Debt Era Rising Debt Era
Financial Profits as Percent of GDP

2.5%

Total Debt as Percent of GDP


300%

2.0%
250%

1.5%
Total Debt

Financial Profits 200%


1.0%

150%
0.5%

0.0% 100%
Dec- 51 54 57 60 63 66 69 72 75 78 81 84 87 90 93 96 99 02 05

Sources: Federal Reserve, BEA, as of Q2 2007, GMO presentation

-36-
The Outlook Is Grim

• Defaulting subprime and Alt-A loans drove the first stage of the
mortgage crisis
• The next leg down of the mortgage crisis will be driven by
defaulting Alt-A, Option ARM, jumbo prime and prime loans as
well as home equity lines of credit (HELOCs) and second liens
(closed-end seconds)
• Losses outside of the mortgage sector will also continue to rise
due to commercial real estate, leveraged loans, junk bonds, etc.

-37-
The Wave of Resets from Subprime Loans
Is Mostly Behind Us
$35

$30 We are
here
$25
Loans with Payment Shock (Bn)

$20

$15

$10

$5

$0
08

09

0
07

7
6

0
6

09

0
10
6
06

9
-0
-0

-1
-0

l-0

l-0

l-1
l-0

r-0

-0

-0

-1
-0

l-0

n-
n-

n-
n-

r-
n-

ct
pr

pr
pr

ct

ct

ct
ct

Ju

Ju

Ju
Ju

Ju
Ap

Ap
Ja

Ja

Ja
Ja
Ja

O
O

A
A

Sources: LoanPerformance, Deutsche Bank; slide from Pershing Square presentation, How to Save the Bond Insurers, 11/28/07.

-38-
But a Wave of Alt-A Resets Is Ahead of Us

$10 $300

$9
We are
$250
here $8

Estimated Cumulative Reset Amount (Bn)


$7
$200

$6
Amount (Bn)

$5 $150

$4

$100
$3

$2
$50

$1

$0 $0
12

13

14
0

5
11
10

15
3

4
l-1

l- 1

l- 1

l-1

l-1
-1
n-
n-

n-

n-

n-

n-
l
Ju

Ju

Ju

Ju

Ju
Ju
Ja

Ja

Ja

Ja
Ja

Ja

Months to 1st reset

Sources: Credit Suisse, LoanPerformance

-39-
There Are $2.5 Trillion of Alt-A Loans Outstanding
When One Includes Those Held by the GSEs
Prime Mortgage

Commercial Real Estate

Alt-A

Other Corporate

Commercial & Industrial

Subprime

High-Yield / Leveraged Loans

Jumbo Prime

Home Equity

Credit Card

Auto

Option ARM

Construction & Development

Other Consumer

CDO/ CLO

$0.0 $0.5 $1.0 $1.5 $2.0 $2.5 $3.0 $3.5 $4.0 $4.5 $5.0
Amount Outstanding (Trillion)

Sources: Federal Reserve Flow of Funds Accounts of the United States, IMF Global Financial Stability Report October 2008, Goldman Sachs
Global Economics Paper No. 177, FDIC Quarterly Banking Profile, OFHEO, S&P Leverage Commentary & Data, T2 Partners estimates

-40-
Percent Noncurrent (60+ days)
Ja
n-

0%
5%
10%
15%
20%
25%
M 99
ay
-
Se 99
p-
9
Ja 9
n-
M 00
ay
-
Se 00
p-
0
Ja 0
n-
M 01
ay
-
Se 01
p-
0

Sources: Amherst Securities, LoanPerformance


Ja 1
n-
M 02
ay
-
Se 02
p-
0
Ja 2
n-
M 03
ay
-
Se 03
p-
0
Ja 3
n-
M 04
ay
-0
Se 4
p-
0
Ja 4
n-
M 05
ay
-
Se 05
p-
0
Ja 5
n-
M 06
ay
-
Se 06
p-
0
Ja 6
n-
M 07
ay
-0
Se 7
p-
Ja 07
n-
M 08
ay
-
Se 08
p-
0
Ja 8
n-
09
Delinquencies of Securitized Alt-A Mortgages Are Soaring

-41-
Alt-A Delinquencies By Vintage Show the Collapse
in Lending Standards in 2006 and 2007
30%

2007 2006
25%
Percent Noncurrent (60+ days)

20%

15%

2005
10%

2004
5%
2003

0%
0 5 10 15 20 25 30 35 40 45 50 55 60
Months of Seasoning

Sources: Amherst Securities, LoanPerformance

-42-
A Primer on Option ARMs

• An Option ARM is an adjustable rate mortgage typically made to a prime


borrower
– Sold under various names such as “Pick-A-Pay”
• Banks typically relied on the appraised value of the home and the borrower’s
high FICO score, so 83% of Option ARMs written in 2004-2007 were low- or no-
doc (liar’s loans)
• Each month, the borrower can choose to pay: 1) the fully amortizing interest and
principal; 2) full interest; or 3) an ultra-low teaser interest-only rate (typically 2-
3%), in which case the unpaid interest is added to the balance of the mortgage
(meaning it is negatively amortizing)
– Approximately 80% of Option ARMs are negatively amortizing
– Lenders, however, booked earnings as if the borrowers were making full interest
payments
• A typical Option ARM is a 30- or 40-year mortgage that resets (“recasts”) after
five years, when it becomes fully amortizing
– If an Option ARM negatively amortizes to 110-125% of the original balance (depending
on the terms of the loan), this triggers a reset even if five years have not elapsed
• Upon reset, the average monthly payment jump 63% from $1,672 to $2,725
($32,700 annually)
• ‘My sense is that many option ARM borrowers are in a worse position than
subprime borrowers,’ says Kevin Stein, associate director of the California
Reinvestment Coalition, which combats predatory lending. ‘They wind up owing
more and the resets are more significant.’

-43-
About $750 Billion of Option ARMs Were Written

$300 9%

9%

8%

$250 8%

7%

$200 6%
Originations (Bn)

Percent of Total
5% 5%

$150 5%

4%

$100 3%

2%

$50

1% 1%

$0 0%
2004 2005 2006 2007 2008

Source: Reprinted with permission, 2008 Mortgage Market Statistical Annual, published by Inside
Mortgage Finance Publications, Inc. Copyright 2008. T2 Partners estimates
-44-
Options ARMs Were a Bubble State Phenomenon

Other, 25%

HI, 1%

AZ, 3%

CA, 58%
NV, 3%

FL, 10%

Source: Amherst Securities, LoanPerformance

-45-
Beginning in March 2005, High-FICO-Score Borrowers Opted for an
Above-Market-Rate Option ARM in Exchange for the Low Teaser Rate
8.5
Fannie Mae 30 Year FRM Index
Option ARM Index
8.0

Option ARM borrowers during this period


7.5 (when nearly all option ARMS were written)
were saying they couldn’t afford a fully-
amortizing mortgage – otherwise they
7.0
would have taken one
Interest Rate (%)

6.5

6.0

5.5

5.0

4.5

4.0
3

7
2

03

04

07

08
6

7
6
2

3
2

05

7
02

06
4

5
-0

-0

-0
-0

-0

-0

l-0
l-0

l-0
l-0

l-0
r-0
-0

-0

-0

-0

-0
l-0

n-
n-
n-

n-

n-

n-

n-
pr

pr
ct

pr

pr
pr

ct

ct

ct
ct

ct
Ju

Ju

Ju
Ju

Ju
Ju

Ap

Ja
Ja

Ja

Ja

Ja

Ja
Ja
O

O
A

A
A

Source: Amherst Securities, Bloomberg Finance L.P.

-46-
Percent Noncurrent (60+ days)
Ja
n-

0%
5%
10%
15%
20%
25%
30%
35%
M 99
ay
-
Se 99
p-
9
Ja 9
n-
M 00
ay
-
Se 00
p-
0
Ja 0
n-
M 01
ay
-
Se 01
p-
0

Sources: Amherst Securities, LoanPerformance


Ja 1
n-
M 02
ay
-
Se 02
p-
0
Ja 2
n-
M 03
ay
-
Se 03
p-
0
Ja 3
n-
M 04
ay
-0
Se 4
p-
0
Ja 4
n-
M 05
ay
-
Se 05
p-
0
Ja 5
n-
M 06
ay
-
Se 06
p-
0
Ja 6
n-
M 07
ay
-0
Se 7
p-
Ja 07
n-
M 08
ay
-
Se 08
p-
0
Ja 8
n-
09
Delinquencies of Securitized Option ARMs Are Soaring

-47-
Option ARM Delinquencies By Vintage Show the
Collapse in Lending Standards in 2005-2007
45%

2006
40%

35%

2007
Percent Noncurrent (60+ days)

30%
2005
25%

20%

2004
15%

10% 2003

5%

0%
0 5 10 15 20 25 30 35 40 45 50 55 60
Months of Seasoning

Sources: Amherst Securities, LoanPerformance

-48-
Percent Noncurrent (60+ days)
Ja
n-

0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
3.5%
4.0%

M 99
ay
-
Se 99
p-
9
Ja 9
n-
M 00
ay
-
Se 00
p-
0
Ja 0
n-
M 01
ay
-
Se 01

Sources: Amherst Securities, LoanPerformance


p-
0
Ja 1
n-
M 02
ay
-
Se 02
p-
0
Ja 2
n-
Mortgages Are Soaring

M 03
ay
-
Se 03
p-
0
Ja 3
n-
M 04
ay
-0
Se 4
p-
0
Ja 4
n-
M 05
ay
-
Se 05
p-
0
Ja 5
n-
M 06
ay
-
Se 06
p-
0
Ja 6
n-
M 07
Delinquencies of Securitized Jumbo Prime

ay
-0
Se 7
p-
Ja 07
n-
M 08
ay
-
Se 08
p-
0
Ja 8
n-
09
-49-
Delinquencies of Prime Mortgages Are Soaring

5.0%

4.5%

4.0%

3.5%
Percent Noncurrent (60+ days)

3.0%

2.5%

2.0%

1.5%

1.0%

0.5%

0.0%
03
99

99

01

01

02

04

05

06

06

08

08
00

00

02

03

04

05

07
07
20
19

19

20

20

20

20

20

20

20

20

20

20

20

20

20

20

20
20

20
3

3
1

1
Q

Q
Sources: Mortgage Bankers Association National Delinquency Survey

-50-
HELOCs and Home Equity Loans Soared
in Popularity During the Bubble

Home Equity & Junior Lien Loans ($ in billions)

$1,000

$900

$800

$700

$600

$500

$400

$300

$200

$100

$-
Se -01
Ju r-00
Se -00

Ju r-01

Ju r-02
Se -02

Ju r-03
Se -03

Ju -04

Se -05
Se -04

Ju -05

Ju r-06
Se -06

Se -08
Ju r-07
Se -07

Ju r-08
M -01

M -02
D 00
M -00

D -01

D 02

D -03
M -03

D 04
M -04

D -05
M -05

D 06
M -06

M -07
D -07

08
p-

p-

p-

p-

p-
n

n
ar

n
ar

n
ec
ec

ec
p

ec

ec
p

ec

ec

ec
p

p
a

a
M

Home Equity Loans Junior Lien Mortgages

Note: Does not include approximately $200 billion of securitized HELOCs and junior liens
Source: FDIC Quarterly Banking Profile
-51-
Many Borrowers Used HELOCs to Buy New Cars

• As home prices have declined and other funding sources have dried
up, millions of consumers have maxed out on home equity debt.
• In hot markets like California and Florida, a significant percentage of all
consumers tapped into the value of their homes to help finance their
new cars, according to CNW Marketing Research.

• Clearly this dynamic does not bode well for HELOC recovery rates or
new car sales.

Source: New York Times 5/27/2008

-52-
Delinquencies of HELOCs and CESs Are Soaring

3.0%
Closed-End Junior Lien
Mortgages

Home Equity Lines of Credit


2.5%
Percent Noncurrent (90+ days)

2.0%

1.5%

1.0%

0.5%

0.0%
05
04

06

06

07

08

08
04

06

07

07
05

05

06

07

08

08
04

04

05

20

20

20
20

20

20

20

20
20

20

20

20

20
20

20
20

20
20

20
20

1
4

2
1

4
1

Q
Q

Q
Q

Q
Q

Source: FDIC Quarterly Banking Profile

-53-
Pools of HELOCs and CESs Can Suffer
Astronomical Losses Due to 100%+ Severities
On one second lien deal, Ambac expected losses of 10-12% when it guaranteed the senior
tranche. A year ago, Ambac admitted that the pool would likely lose 81.8% of its value – and
based on the pool’s performance since then, this will almost certainly prove to be conservative.
3.0%

2.5%

From Ambac slide, 4/08:


Monthly Loss Rate (3m average)

2.0% • This is a second lien deal that closed in April 2007


• Loss to date 9.9%
• Projected loss: 81.8%
• Projected collateral loss as a % of current collateral: 86%
1.5% • A reasonable estimate of projected collateral loss for the
above transaction might have been 10-12%, with the
transaction having an A+ rating at inception and being
structured to withstand 28-30% collateral loss
1.0%

0.5%

0.0%
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 45 47 49 51 53 55 57 59
Months Since Close

Ambac Projection April 2008 Actual

Source: Ambac Q1 08 presentation, Amherst Securities; funds managed by T2 Partners are short Ambac
-54-
The Timing Indicates That We Are Still in the Middle
Innings of the Bursting of the Great Mortgage Bubble
• Mortgage lending standards became progressively worse starting in 2000, but really
went off a cliff beginning in early 2005
• The worst loans were subprime ones, which generally had two-year teaser rates and
are now defaulting at unprecedented rates
• Such loans made in Q1 2005 started to default in high numbers upon reset in Q1
2007, which not surprisingly was the beginning of the current crises
• The crisis has continued to worsen as even lower quality subprime loans made over
the remainder of 2005 reset over the course of 2007, triggering more and more
defaults
• It takes an average of 15 months from the date of the first missed payment by a
homeowner to a liquidation (generally a sale via auction) of the home
• Thus, the Q1 2005 subprime loans that defaulted in Q1 2007 led to foreclosures and
auctions in early 2008
• Given that lending standards got much worse in late 2005 through 2006 and into the
first half of 2007, and the many other types of loans that are now with longer reset
dates that are now starting to default at catastrophic rates, there are sobering
implications for expected defaults, foreclosures and auctions in 2009 and beyond,
which promise to drive home prices down further

In summary, today we are only in the middle innings of an enormous


wave of defaults, foreclosures and auctions that is hitting the United
States. We predicted in early 2008 that it would get so bad that it would
require large-scale federal government intervention – which has
occurred, and we’re likely not finished yet.

-55-
Total Losses Are Now Estimated at $2.1-$3.8 Trillion –
And Less Than Half of This Has Been Realized To Date
$4,000 $3,778 Bn
$3,552 Bn
$3,500
Corporate

Corporate
$3,000
Consumer

$2,500 $2,200 Bn Consumer


Commercial
$2,083 Bn Real Estate
Amount (Bn)

$2,000 Commercial
Corporate Real Estate

$1,500 Consumer $1,288 Bn $1,103 Bn


Commercial
Real Estate GSEs
$1,000 Residential Insurers
Residential Mortgages
Mortgages
Residential Banks/
$500 Brokers
Mortgages

$0
Goldman Sachs Jan IMF Jan 2009 Roubini Jan 2009 T2 Partners March Writedowns to Date Capital Raised
2009 2009

Sources: Goldman Sachs, International Monetary Fund, RGE Monitor, Bloomberg Finance L.P., T2 Partners estimates

-56-
A Breakdown of Our Financial Sector Loss Estimates

Amount ( Bn)
$0 $100 $200 $300 $400 $500 $600 $700 $800

CDO/ CLO
Total Estimated
Other Consumer
Financial Sector
Losses = $3.8 trillion
Construction & Development

Option ARM

Auto

Credit Card

Home Equity

Jumbo Prime

High-Y ield / Leveraged Loans

Subprime

Commercial & Industrial

Other Corporate

Alt-A

Commercial Real Estate

Prime Mortgage

Sources: T2 Partners estimates

-57-
Institutions Have Been Able to Raise Capital to Mostly Keep
Up With Writedowns, But This Will Likely Not Continue
$1,500
Losses & Writedowns
Capital Raised

$1,250

$1,000
Amount (Bn)

$750

$500

$250

$0
Prior Q3 2007 Q4 2007 Q1 2008 Q2 2008 Q3 2008 Q4 2008 Q1 2009 Q2 2009

Sources: Bloomberg Finance L.P.

-58-
Where We Are Finding Opportunities
1. Blue-chips. The stocks of some of the greatest businesses, with strong balance sheets and
dominant competitive positions, are trading at their cheapest levels in years – due primarily to
the overall market decline and weak economic conditions rather than any company-specific
issues. In this category, we’d put Coca-Cola, McDonald’s, Wal-Mart, Altria, ExxonMobil,
Johnson & Johnson, and Microsoft.
2. Out of favor blue-chips. For somewhat more adventurous investors looking to buy great
companies in the most out-of-favor sectors such as financials and retailers, we own Berkshire
Hathaway, American Express and Target. All are great businesses, but their stocks have
suffered mightily thanks to the economic downturn. We think they’re good bets to rebound
when things stabilize – but in the meantime, their stocks seem to have no bottom.
3. Balance sheet plays. For investors who are comfortable with lower-quality businesses but
want downside protection, there are many companies trading near or even below net cash on
the balance sheet. Examples in our portfolio include digital media equipment company
EchoStar Corp. and clothing retailer Delia’s. Berkshire is the best of both worlds: a premier
company but also a balance sheet play.
4. Turnarounds. There are countless companies that have gotten clobbered by the economic
downturn and are reporting dismal results – with stock prices to match. Investors in those that
survive and return to anything close to former levels of profitability will be well rewarded – but
picking these stocks isn’t easy. Among our holdings in this category are Wendy’s restaurants,
Winn-Dixie supermarkets, Huntsman, a specialty chemical maker, Crosstex, a pipeline
company, and Resource America, a specialty finance company.
5. Special situations. This is somewhat of a catch-all category that, for us, includes Contango
Oil & Gas, a stock that’s declined due to an aborted attempt to sell the company and the
sharp drop in the price of natural gas.
6. Mispriced options. Every once in a while we take a tiny position in a highly speculative
situation – often where the stock price is below $1 – in which there’s a real chance that the
outcome is zero, but also a decent chance, in our opinion, of making many multiples of our
money. On an expected value basis, therefore, a small portfolio of such investments is
attractive. Our holdings include General Growth Properties, TravelCenters of America,
Ambassadors International, Borders Group and PhotoChannel. Do not buy stocks like this
unless you really know what you’re doing and have a very strong stomach!

-59-
To Learn More…
More Mortgage Meltdown Will Be Available in Mid-May

-61-
The Next Value Investing Congress is May 5-6 in Pasadena

-62-
Value Investor Insight and SuperInvestor Insight

-63-