Deutsche Bank on Digesting the Credit Crunch

Peter HooperChief Economist

Deutsche Bank Securities

Presentation to UCSD Economics RoundtableApril 22, 2008

Digesting the Credit Crunch Home Prices Are Key

DISCLAIMER AND ANALYST CERTIFICATION ARE LOCATED ON THE LAST PAGE

2

Key Issues

Central Scenario: Mild Recession, sluggish recovery

Risks: Deep/prolonged recession vs. inflation.

Critical Recession Risk factor: Home prices (HP).HP Drivers: and why they point to mild RecessionHP Effects: Credit crunch and Wealth Loss

What the Fed has done, and what more might be done.

Inflation risk.

Conclusions

3

40

60

80

100

120

140

160

1978 1983 1988 1993 1998 2003 2008

Index

40

60

80

100

120

140

160Index

Source: University of Michigan, Conference Board, DB Global Markets Research

Consumer sentiment in mild recession territory

U. Michigan consumer sentiment

Conference board’s consumer confidence

4

-10

-5

0

5

10

Mar-07 May-07 Jul-07 Sep-07 Nov-07 Jan-08 Mar-08

3M %chg, AR

-30

-20

-10

0

10

20

30

3M %chg, AR

Source: BEA, Autodata Corporation, DB Global Markets Research

Key components of consumer spending have been slowing

Core retail sales (ls)

Light vehicle sales (rs)

5

-15.0

-7.5

0.0

7.5

15.0

22.5

2005 2006 2007 2008

3M %chg, AR

-15.0

-7.5

0.0

7.5

15.0

22.5QoQ %chg, AR

Source: BEA, Census, DB Global Markets Research

Business spending softening too

Capital goods orders (ls)

Real private nonresidential investment (rs)

6

Labor market pointing to recession

Source: BLS, DB Global Markets Research

2

4

6

8

10

12

1948 1954 1960 1966 1972 1978 1984 1990 1996 2002 2008

%

2

4

6

8

10

12

%

Unemployment rate

77

-3

-2

-1

0

1

2

3

4

5

6

7

Q/Q%, AR

-3

-2

-1

0

1

2

3

4

5

6

7

Q/Q%, ARConsumer spending (PCE) Nonres investmentRes investment Change in inventoriesNet exports Government

Forecast

Real GDP growthTrend

2003-06 average

Q1 Q2 Q3Q3Q4

Q4 Q4

2007 2008 2009

Mild Recession Scenario

Spending contributions

Source: BEA, DB Global Markets Research

Real GDP Q4/Q4

2007 2.8

2008 0.8

2009 2.3

8

Spending components of GDP in 2007

Net exports, -5%

Government spending, 19%

Business fixed investment,

11%

Residential investment,

5%

Consumer spending, 70%

Change in inventories,

0.00%

Key Components of GDP

Source: BEA, DB Global Markets Research

9

Risk of deeper/more prolonged recession:

Critical factor is how far and how fast home prices fall

Fall in housing equity affects aggregate demand through:

Drop in household wealth depressing consumer spending.Credit crunch: Loss on foreclosures, decline in MBS values, de-leveraging, credit cutbacks.

10

0.8

1.0

1.2

1.4

1.6

1.8

2.0

1990 1994 1998 2002 2006 2010

1991-2003=1.0

0.8

1.0

1.2

1.4

1.6

1.8

2.0

Renormalization of home price/rent ratios points to substantial drop in home prices

Source: Census, DB Global Markets Research

Home price/rent ratios*

*Uses Owners’ equivalent rent from CPI

Case-Shiller, composite 10

OFHEO Purchaseonly price

11

0.8

1.0

1.2

1.4

1.6

1.8

2.0

1990 1994 1998 2002 2006 2010

1991-2003=1.0

0.8

1.0

1.2

1.4

1.6

1.8

2.0

Case-Shiller futures not anticipating full renormalization

Source: Census, DB Global Markets Research

Home price/rent ratios

*Also in line with longer-term trend for Case Shiller price/OER rent ratio.

OFHEO Purchase

C-Sfutures

Case-Shiller, composite 10

1991-2003 average*

12

0.8

1.0

1.2

1.4

1.6

1.8

2.0

1990 1994 1998 2002 2006 2010

1991-2003=1.0

0.8

1.0

1.2

1.4

1.6

1.8

2.0

Conventional home price indexes may overstate the problem—price run-up reflected improving quality

Source: Census, DB Global Markets Research

Home price/rent ratios*

*Uses Owners’ equivalent rent from CPI

OFHEO PurchaseConstant QualityNew Home Price

C-Sfutures

Case-Shiller, composite 10

13

Factors Driving Home Prices Lower

1.Underlying supply and demand fundamentals:Excess stock of housing = total no. of housing units minus no. of households Change in excess housing stock = housing completions – (household formations + demolitions (removals))

2. Shift in demand from owner-occupied to rental units, due to:Rising foreclosure rate.But increase in home affordability is beginning to shift demand back from rental to owner-occupied, a plus for prices.

1414

2.5

3.0

3.5

4.0

4.5

5.0

5.5

6.0

6.5

7.0

1968 1973 1978 1983 1988 1993 1998 2003 2008

Ratio

-8

-6

-4

-2

0

2

4

6

8

10

12

yoy%

Stock of vacant homes inversely correlated with HPA

Source: Census, Realtor, DB Global Markets Research

Real conventional mortgage price inflation (rs)

Vacant houses for sale: months supply (ls)

Correl. = -0.70

15

7000

8000

9000

10000

11000

12000

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

Thousands

7000

8000

9000

10000

11000

12000Thousands

Excess Housing Stock now at about 900k units

Source: Census, DB Global Markets Research

Vacant homes*

Trend calculated from 1965 to 2003

* Includes homes for sale, homes for rent, and homes held off the market; excludes seasonal homes and second homes not used a primary residence.

16

0

500

1000

1500

2000

2500

1999 2000 2001 2002 2003 2004 2005 2006 2007 20080

500

1000

1500

2000

2500

Thousands Thousands

Growth of housing stock has now fallen below long-run average growth in demand

Source: Census,NAR, DB Global Markets Research

Housing permits

Home completions

Trend growth in demand

17

0

500

1000

1500

2000

2500

1999 2000 2001 2002 2003 2004 2005 2006 2007 20080

500

1000

1500

2000

2500

Thousands Thousands

“Demand” fluctuates around trend; returns to trend implies runoff of excess stock could exceed 500k AR.

Source: Census,NAR, DB Global Markets Research

Housing permits

New home completions

“Demand” (household formations + removals

Household formations

18

Percent of US residential mortgages

0.0

0.5

1.0

1.5

2.0

2.5

1979 1983 1987 1991 1995 1999 2003 2007

%

0.0

0.5

1.0

1.5

2.0

2.5

%

Source: MBA, DB Global Markets Research

Shift from owner-occupied to rental units: Foreclosures are soaring and depressing prices

Homes in foreclosure

Foreclosures started (per qtr)

19

80

90

100

110

120

130

140

150

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

Index

100

110

120

130

140

150

160

170

180

190

200Index

Source: UM ICH, NAR, DB Global Markets Research

Strong bounce-back in housing “affordability” will help

Mich Survey: home buying conditions (rs)

Housing affordability (ls)

2020

95

100

105

110

115

120

125

130

135

1402001 2002 2003 2004 2005 2006 2007 2008

Index

85

90

95

100

105

110

115

120

125

Index, 2002=100

Affordability has improved as home prices have declined relative to income.

Source: REALTOR, BEA, DB Global Markets Research

Existing home sales price/ income ratio (rs)

Housing affordability index (inverted, ls)

21

Home price/rent ratios*

0.8

1.0

1.2

1.4

1.6

1.8

2.0

1990 1994 1998 2002 2006 20100.8

1.0

1.2

1.4

1.6

1.8

2.0

1991-2003=1.0

Case-Shiller

OFHEO Purchase price C-S

futures

Quality-adjusted price index

Median sales price for existing single family

homes

Affordability index uses median existing home sales price

Source: OFHEO, NAR, BLS, Census, DB Global Markets Research

*Uses Owners’ equivalent rent from CPI

2222

4500

5000

5500

6000

6500

7000

7500

8000

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Thousands

4500

5000

5500

6000

6500

7000

7500

8000

Thousands

Source: Realtor, Census, DB Global Markets Research

Home sales may be starting to respond to improvement in affordability

Total home sales

23

How lower home prices impact the economy

Wealth Effect: effect of declining housing wealth on consumer spending

Credit crunch Effect: effect of declining housing asset values on mortgage-related financial losses; implications for cost of credit as de-leveraging occurrs.

24

-2

0

2

4

6

8

10

12

14

1950 1956 1962 1968 1974 1980 1986 1992 1998 2004

%

4.0

4.5

5.0

5.5

6.0

6.5ratio

Source: BEA, FRB, DB Global Markets Research

Household saving rate should rise as wealth/income ratio recedes

Personal saving rate (ls)

Wealth-to-income ratio (rs)

Stock -25%, House prices -15% from peaks

25

The Credit Crunch

26

Interbank risk spreads have remained wide despite Fed rate cuts

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

5.5

6.0

Apr-07 Jun-07 Aug-07 Oct-07 Dec-07 Feb-08 Apr-08

%

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

5.5

6.0

%

Source: Bloomberg, Haver, FRB, DB Global Markets Research

3 month LIBOR

3 month USD swap OIS

Fed funds target

27

Private long-term rates rising, or declining only slowly

Source: Bloomberg, Haver, FRB, DB Global Markets Research

3

4

5

6

7

8

9

10

11

12

Mar-07 May-07 Jul-07 Sep-07 Nov-07 Jan-08 Mar-08

%

3

4

5

6

7

8

9

10

11

12%Home equity loans

US home mrtgage 30 yr Jumbo national avgUS conventional 30 yr mortgage

High grade corp.

High yield corp.

28

Corporate funding costs up sharply

14010

220

180

175

340

0

100

200

300

400

500

600

50-year average 2006-07 average Latest week

Credit spread (Baa Corp - 10yr Treas)

Yield curve (10yr Treas - 3mo T-bill)bp

Source: FRB, Bloomberg, DB Global Markets Research

320

185

560

29

Securitized mortgage lending has disappeared

0

100

200

300

400

500

600

700

800

900

2001 2002 2003 2004 2005 2006 20071Q

20072Q

20073Q

20074Q

2008(Jan &Feb)

$ bn, AR

0

100

200

300

400

500

600

700

800

900Alt-A Subprime Jumbo

$ bn, AR

Source: MBA, DB Global Markets Research

30

But bank credit conditions for households are tightening

Source: Federal Reserve Senior Loan Officer Survey, DB Global Markets Research

-20

-10

0

10

20

30

40

50

60

70

1996 1998 2000 2002 2004 2006 2008

%

-60

-50

-40

-30

-20

-10

0

10

20

30

%

Mortgages (ls)

Consumer Loans (ls)

Credit Cards (ls)

Banks' willingness to make consumerloans (inverted, rs)

Fed Survey: banks tightening lending standards

31

-100

-80

-60

-40

-20

0

20

40

60

80

100

1966 1972 1978 1984 1990 1996 2002 2008

%

-0.03

-0.02

-0.01

0.00

0.01

0.02

0.03d log

Source: FRB, DB Global Markets Research

Residuals show relationship to banks willingness to extend consumer credit around recessions

Estimated coef on BW is signif and indicates that -10 on BW reduces PCE growth by 0.4% pt.

Banks’ willingness to make consumer installment credit loans (ls)

Residuals (rs)

32

Summing up Downside Risks

For every 10% additional drop in home prices:

– Household wealth falls by $2 trn

– Consumer spending is reduced by 1% via wealth effects

– Financial sector losses on foreclosures increase by $50-100bn

– Tightening of credit conditions associated with de-leveraging could reduce GDP by an additional 1/4-1/2%

There is considerable uncertainty surrounding the magnitude of these wealth and credit effects.

33

0

2

4

6

8

10

1987 1990 1993 1996 1999 2002 2005 2008

%

0

2

4

6

8

10

%

* FFnom = 2.5 - 2*(UR - NAIRU) + 0.5*(Core PCE inflation - 1.75) + Core PCE inflation

Source: FRB, BEA, CBO, DB Global Markets Research

Fed has cut unusually aggressively in response to downside risks

Taylor rule specification with employment gap*

Actual Fed funds rate

34

US Policy Actions to Address Housing and Credit CrunchFed rate cuts: 300 bps.

Liquidity enhancements:Fed Discount Window penalty cut 75bps, term increased to 90 daysTAF 28-day credit to banks, broad (DW) collateral, auction det. rate TSLF 28-day credit to primary dealers, AAA-rated collateral, auction det. ratePDCF Overnight loan facility for primary dealers BBB or better collateral, DW rateLarge scale FHLB advances to banks, favorable rates, broad collateral.Fed $29bn rescue package for Bear StearnsSwap arrangement with ECB and other central banks.

Measures to bolster mortgage market.Agency loan limits raised to reflect diff. median home price levels across regionsAgency capital limits increased and requirements relaxed, allowing $400bn more Agency purchases.FHLB purchases of Agency MBS doubled ($100+ bn)

Fiscal stimulus package: $168bn tax rebates to households, credits to firms.

Possible further measures.Fed purchases of Agency MBS.Mortgage write-down proposals.Government purchases of private mortgages and MBS..

35

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

1996 1998 2000 2003 2005 2008

yoy%

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0yoy%

Source: BEA,DB Global Markets Research

Inflation: Headline running well above comfort zone

Fed’sComfortzone

Consumer prices (PCE)

Core (ex food and energy)Headline

36

-80

-40

0

40

80

120

160

1997 1999 2001 2003 2005 2007

yoy %

-80

-40

0

40

80

120

160

yoy %Crude oil priceCPI: energyPPI: energy goods

Surge in oil prices still poses inflation risk

Source: BLS, WSJ, DB Global Markets Research

37Source: BLS, CRB, DB Global Markets Research

Food prices still look troublesome too

-30

-20

-10

0

10

20

30

40

50

1997 1999 2001 2003 2005 2007

yoy%

-30

-20

-10

0

10

20

30

40

50

yoy%CPI: foodCRB Commodity price index: FoodCore CPIPPI: Intermediate foods and feeds

38

Falling dollar means more import price inflation

Source: BLS,FRB, DB Global Markets Research

-10

-8

-6

-4

-2

0

2

4

6

2004 2005 2006 2007 2008

yoy%

-3.0

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0

5.0yoy%

Import price index: excl. fuels (rs)

Nominal broad trade-weighted exchange value of US$ (ls)

39

1.5

2.0

2.5

3.0

3.5

Jan-04 Jan-05 Jan-06 Jan-07 Jan-08

%

1.5

2.0

2.5

3.0

3.5

%

Longer term inflation expectations moving upward

Source: U.Mich,Bloomberg,Phil Fed, DB Global Markets Research

Philly Fed (SPF) PCE inflation expectations

Philly Fed (SPF) CPI inflation expectations

5Y5Y breakeven inflation expectations UMich 5-10 year

inflation expectations

40

3

4

5

6

7

8

9

10

11

1970 1980 1990 20003

4

5

6

7

8

9

10

11% %

Source: BLS,CBO,DB Global Markets Research

Labor market easing

Estimated NAIRU range

Unemployment rate

Mild Recession

41

-2

-1

0

1

2

3

4

5

6

1990 1993 1996 1999 2002 2005 2008

%

-2

-1

0

1

2

3

4

5

6

%

Unit labor cost inflation receding

Source: BLS, DB Global Markets Research

Unit labor cost (4q % change)

Core PCE price index

42

Conclusions

US economy likely in mild recession.

Housing overhang should begin to drop significantly in next several quarters.

This should limit further drop in home prices, and along with monetary and fiscal stimulus, help keep recession mild.

Risks to this view are weighted more to the downside than the upside, given ongoing credit crunch.

Inflation risks still present, but receding as growth slows andlabor market softens.

Fed likely to cut rates moderately further.

Expect a relatively sluggish recovery through 2009.

43

Peter HooperManaging Director, Chief Economist

Deutsche Bank Securities, Inc.

Peter Hooper oversees a team of economists that analyze and forecast developments in the US economy and financial markets. Dr. Hooper joined Deutsche Bank Securities in the fall of 1999 as Chief US Economist, and was appointed Chief Economist in 2006. Dr. Hooper frequently comments on US economic and financial developments in the news media.

Prior to joining the firm, Dr. Hooper enjoyed a distinguished 26-year career at the Federal Reserve Board in Washington, D.C. He held numerous positions at the Fed, including as an economist on the FOMC and as Deputy Director of the Division of International Finance. In doing so, he developed an informed view of the Fed's policy making process.

Dr. Hooper earned a BA in Economics (cum laude) from Princeton University and an MA and Ph.D. in Economics from University of Michigan. He has published numerous books, journal articles, and reviews on economics and policy analysis.

44

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Analyst CertificationThe views expressed in this report accurately reflect the personal views of the undersigned lead analyst(s). In addition, the undersigned lead analyst(s) has not and will not receive any compensation for providing a specific recommendation or view in this report. Peter Hooper