Current Developments in Real Estate Finance January, 2009

1. Current Developments in Real Estate FinanceJanuary, 2009 Prepared By: William B. Brueggeman, Ph.D. Corrigan Chair in Real Estate COX SCHOOL OF BUSINESS - SMU

2. Review • SUMMARY/REVIEW: In response to: (a) the recession, the financial crisis of 2000-2001, and (b) the low employment growth thereafter, the Federal Reserve reduced its target Fed Funds rate during much of 2001-2004 (Exhibit 1). • In hindsight, most observers have concluded that this policy produced an excessive amount of credit and caused distortions in many sectors of the economy. • Result: Excessive growth occurred in housing, mortgage markets, (Sub-prime – Alt-A) and in the banking and financial services sectors of the economy. • Aftermath: • Overbuilt housing market • Falling house prices • Grid locked capital markets • Bank failures • Federal bailout programs • Current policy initiatives: • TARP • Federal Reserve security purchases

3. Exhibit 1Fed Funds Rate: Jan. 2000 – Dec. 2008

4. Household Debt as % of GDP • During the past 10 years, total household debt has increased from about 79% to over 90% of GDP (Exhibit 2). • Although consumer debt increased from 16.4% to over 18% of GDP, most of the increase in total household debt is attributable to mortgage loans which increased from 46.7% to 60.5% of GDP. • Much of this debt was originated by purchases new home and condominiums. It was also the result of refinancings and home equity loans based on appreciated house values. Because of this housing “wealth effect”, much of the proceeds were used for other forms of consumption and retail spending. • After reaching a peak during 2007, this pattern has changed and household debt now represents a lower percentage of GDP. This is now affecting both the housing market as well as retail spending.

5. Exhibit 2Household Debt as % of GDP Total Household Debt 91.2% (3Q) 92.5% (1 Yr.) 78.5% (10 Yr.) Mortgage Debt 73.1% (3Q) 74.3% (1 Yr.) 60.5% (10 Yr.) Consumer Debt 18.1% (3Q) 18.2% (1 Yr.) 18.0% (10 Yr.) *Includes car loans, credit card debt , secured and unsecured personal loans for furniture, appliances, etc. Source: Moody’s Economy.com

6. Total Household Debt Outstanding • During 2008, total household debt outstanding increased to over $13 trillion. This is over twice the total outstanding 10 years earlier (Exhibit 3). • Much of this increase was attributable to less stringent underwriting standards. This was coupled with the desire of the Fed to keep interest rates low in order to spur employment growth. • Much of this mortgage debt was securitized as mortgage backed securities (MBS). New loan categories referred to as “sub-prime” and “ALT-A” mortgages were initiated as a part of this major increase in household borrowing. • If growth in household debt would have occurred in the same relationship to GDP that existed prior to 2002, it is estimated that by 2008, household debt would total about $10.4 trillion, or about $2.7 trillion less than its current level. • During 2008, the rate of increase in total household debt outstanding has diminished. • May observers believe that a major pattern of “deleveraging” is underweigh throughout the U.S. economy.

7. Exhibit 3Total Household Debt Outstanding Actual Debt Outstanding $13.2 trillion Forecast $10.4 trillion Source: Moody’s Economy.com and L&B Research

8. Housing Starts • Because of a significant increase in credit availability, during the period 2002-2006, new single family starts exceeded its long-term (previous 10 year) average of 1.3 million units annually (Exhibit 4). • New starts reached a peak of 1.8 million units (+) during 2006. • Starts have declined dramatically since then and are now being produced at about 600,000 units annually.

9. Exhibit 4Housing Starts Sf Housing Starts Peak – Jan 06 – 1,823,000 Low – Oct 08 – 531,000 10 Yr. Avg. – 1,329,000 Data includes single-family detached units only Source: Moody’s Economy.com

10. Inventory of SF and Condos Available For Sale • Because of excessive production, the inventory of single family houses for sale currently stands at 3.5 million units. This is almost 1.5x its previous 10 year average (Exhibit 5). • Condominiums for sale now stand at over 600,000 units. This is over 1.7x its 10 year average. • It may be possible that these numbers are understated, as many sellers may be discouraged from selling because of the available supply. • Foreclosures also have increased the available supply of units for sale.

11. Exhibit 5Inventory of SF and Condos Available For Sale SF Homes For Sale Peak: Jan 08 3,894,390 Current: 3,510,000 10 Yr. Avg.: 2,430,000 Condos Available For Sale Peak: Jul 08 775,000 Current: 630,000 10 Yr. Avg.: 370,000 Source: Moody’s Economy.com

12. Home Sales • Annual new home sales reached a peak of over 6.3 million units during 2005. Condominium sales reached a peak of almost 1 million units during that year (Exhibit 6). • At present, single-family sales volume has slowed to an annual rate of less than 4.5 million units. • Condominium sales have declined to an annual rate of less than 600,000 units.

13. Exhibit 6Home Sales SF Home Sales Peak: Sep 05 6,340,000 Current: 4,430,000 10 Yr. Avg.: 5,120,000 Condo Sales Peak: Jun 05 932,000 Current: 550,000 10 Yr. Avg.: 680,000 *Data includes single-family detached units only Source: Moody’s Economy.com

14. Single Family Median Home Prices • From 1999 through 2006 median house prices increased by about 7.0% per year as compared to a 3.5% increase in general construction costs. • Excess housing inventories (Exhibit 7) caused prices to decline markedly during 2007 and 2008. • After reaching a peak during 2006, the U.S. median house price has declined by over 10%. • On a year over year (YoY) basis, U.S. house prices fell by an average of 8.7% and by almost 18% in larger metro areas (Exhibit 8). • Given that houses serve as the primary security for mortgage loans, declines in prices reduce appraised values serving as security for mortgage loans. This makes loan underwriting very problematic for lenders.

15. Exhibit 7SF Median Home Prices Construction Cost Index Peak: Sep 04 8.3% Current: 6.9% 10 Yr. Avg. : 3.4% Median Home Price -8.0% (YoY) 4.3% (10 Yr.) Median Home Price Peak: Oct 05 $229,100 Current: $200,260 10 Yr. Avg. : $182,100 Median Home Price – Single Family detached units only – Seasonally adjusted – Based on NAR, Case Shiller data as compiled by Moody’s Economy.com Source: Moody’s Economy.com and Engineering News-Record

16. Exhibit 8Changes in Median Home Prices by MSA Case Shiller Index - Aug. 2008 National Association of Realtors 2Q08

17. Foreclosure Activity • Generally, markets experiencing the largest declines in house prices are also experiencing foreclosure rates far in excess of the national average (Exhibit 9). • As of the end of the (2Q)2008, over 41 MSAs reported foreclosure rates in excess of the U.S. average.

18. Exhibit 9Single Family Housing – Foreclosure Activity(Selected Markets) (2Q) 2008 *An average of one filing was recorded per 171 U.S. households Source: RealtyTrac

19. Mortgage Loans, Sub-prime and Alt-A Loans Outstanding, Past Due and in Foreclosure • Declining house prices and poor mortgage underwriting have caused defaults and foreclosures to increase. • Of the $10.5 trillion in single-family loans outstanding, approximately $1.2 trillion are sub-prime and $1.0 trillion are ALT A loans (Exhibit 10). • Sub-prime loans have a significantly greater “past due” and “in-foreclosure” experience than Alt-A loans. • Important Sub-prime data: • 2.8 million sub-prime loans • About 62% are ARMs • Average FICO score of 618 • Average loan balance as of year-end 2007 was $183,000 • Exhibit 11 shows that as of the end of 2008, about 90% of sub-prime, ARMs had an interest rate reset at least once. This suggests that 10% have yet to be reset. • Most loans were made by owner-occupants (90%+) • During 2008, about 19% of loans were “past due”, 11% in foreclosure • Many sub-prime loans were securitized. • Important Alt-A data: • 2.2 million Alt-A loans • Usually income is not verified on loan application (AKA “low doc-no doc” loans) • Average FICO score 705 • About 54% are ARMs • At year-end 2008, it is estimated that over 50% of Alt-A ARMS at least one interest rate reset. This suggests that 50% have yet to be reset. • Average balance all ALT A about $322,000 • More loans made by non-owner occupants (25%) ( investors) • Credit quality of loans generally better than sub-prime • As of the end of 2007, 17% were “past due” and 6% in foreclosure • Virtually all Alt-A loans were securitized. • As of year-end 2008, most sub-prime ARMs have had at least one interest rate reset (Exhibit 11). These mortgages are more likely to default than Alt-A loans which are lower risk. However, more Alt-A loans are scheduled for interest rate resets which could be problematic in an environment of falling house prices (Exhibit 11).

20. Exhibit 10Mortgage Loans, Sub-prime and Alt-A Loans Outstanding, Past Due and in Foreclosure *Flow of Funds/Federal Reserve Board **Estimated from FirstAmerican CoreLogic *Mortgage Bankers Association **Estimated from FirstAmerican CoreLogic

21. Exhibit 11Estimated % of ARM Interest Rate Resets:Sub-prime and Alt-A Loans(as of year-end 2008) Outstanding $1.2 trillion Outstanding $1.0 trillion % ARM Loans 62% % ARM Loans 54% % Reset 90% % Reset 50% % Yet to Reset* 50% % Yet to Reset* 10% *During next 24 months or more Source: FirstAmerican CoreLogic

22. Sub-prime and Alt-A Loans • Regional concentrations of sub-prime and Alt-A loans (Exhibit 12). • Over 70% of all sub-prime and 75% of Alt-A loans are concentrated in 15 states. • California and Florida account for a total of over 25% of all sub-prime loans and over 40% of Alt-A loans • Of the Alt-A loans, a significant number are believed to be condominium loans made to investors.

23. Exhibit 12Regional Concentrations of Sub-prime and Alt-A Loans

24. Consequences of the Housing and Credit “Bubbles” Credit Markets • Most Alt-A mortgages and many sub-prime mortgages were securitized (see MBS chapters 19-20 in BF) • As home prices began to fall in 2006, prices for such MBS also fell. Default risk, particularly for sub-prime backed mortgage pools, also increased and further reduced MBS prices. • Many investment banks (e.g. Bear Sterns, Merrill Lynch, Lehman Bros, and others) assembling and holding inventories of mortgage pools awaiting securitization and sale suffered extensive losses as many MBS issues were downgraded by Moody’s, S&P and Fitch. Because MBS issues had to be “marked to market” firms holding these securities were forced into bankruptcy. Commercial banks and other large originator/lenders including Citigroup, Wachovia, Washington Mutual and Countrywide were similarly affected. • Many of these mortgage backed securities were included in other asset backed pools containing (1) commercial mortgage backed securities (CMBS) and (2) securitized bank loans (which were made to fund leveraged buyouts and mergers/acquisitions). This mixture of securities made-up asset pools which were used, in turn, to issue collateralized debt obligations (CDOs). CDO’s were issued by “off balance sheet”, special purpose entities (SPEs) and special investment vehicles (SIVs) . These entities were created by commercial banks to avoid capital adequacy requirements required for risky assets (tier 3 assets). In addition to CDOs, SPEs and SIVs also issued commercial paper which was purchased by many money market funds, thereby spreading the sub-prime and Alt-A mortgage risks into the short term sectors of investment markets. Many CDOs, although initially rated favorably by Moody’s, S&P and Fitch’s also were subsequently down graded and now are now virtually worthless. • Many investors who purchased these so called “toxic” MBS and CDOs securities simultaneously purchased credit default SWAPS as “insurance” against default. Firms, such as AIG, were counterparties to these SWAPS and collected “premiums” for providing this “default insurance”. As loan defaults occurred, payouts made by AIG and others increased, thereby forcing bankruptcy.

25. Consequences of the Housing and Credit “Bubbles” (con’t) Housing Market • Falling house prices and an excessive inventory of homes for sale currently remain major problems requiring resolution in order for the economy to begin to rebalance. Mortgage lending has slowed dramatically as declining house prices continue to make underwriting and establishing appraised values for all residential housing problematic. • As construction of homes has slowed, construction and employment in related industries has declined. • Because of (1) the “reverse wealth affect” due to falling home prices, (2) more stringent underwriting in all segments of credit and debt markets, spillover effects have negatively affected consumer retail spending which, in turn, has reduced economic growth. Policy Initiatives • Congress has approved the $700 billion TARP (Trouble Asset Relief Program) to be administered by the U.S. Treasury. Thus far, Treasury has committed: • $335 as bailout funding for many banks and other entities (including Citigroup and AIG). Although it was thought that much of the initial bailout was to be used to purchase mortgages/securities, funds more injected (loaned) to banks to (1) protect the banking industry from collapse (2) provide banks with an incentive to dispose of toxic assets at the highest price possible rather than relying on government agencies to engage in reverse auctions. • $14 billion as an investment in FHLMC (Freddie Mac) which has, effectively, been nationalized • $49 billion to purchase mortgage backed securities to support both Fannie Mae and Freddie Mac. This selective purchase program of securities backed by “conforming mortgage loans” appears to have reduced mortgage interest rates.

26. Consequences of the Housing and Credit “Bubbles” (con’t) Policy Initiatives (con’t) • The Federal Reserve also has begun to selectively purchase: • Freddie and Fannie securities in an attempt to raise prices, thereby lowering yields, and placing downward pressure on 15 to 30 year mortgage interest rates. It is hoped that this will motivate people to purchase homes thereby reducing the decline in home prices and (2) encourage homeowners to refinance in lieu of defaulting on their existing loans. • Private sector commercial paper. These short term securities have been used extensively by GMAC, GE credit and other entities engaged in various aspects of housing finance. With investors (money market and fixed income mutual funds) no longer willing to purchase this commercial paper, the Federal Reserve initiated this purchase program. • Federal Reserve 0% target fed funds rate • It is hoped that by reducing short term government rates, that lenders and investors will turn to other investments including commercial paper and corporate bonds. This will increase liquidity and , it is hoped, motivate both lending and borrowing activity.