December 2008 Forecast Results through June 30, 2009 on positions in real estate loan

portfolios.

October 5, 2009

Presented By: Marc R. Thompson, CRE, CCIM, FRICS, Senior Vice President at Bank of the West, Walnut Creek, CA. Marc.Thompson@BankoftheWest.com

Disclaimer: The views expressed herein are those of the author. They are not to be construed in any way as the views of Bank of the West or its senior management.

Prepared by: Marc R. Thompson, CRE, CCIM, FRICS

2

Marc’s forecast time-table• In March 2003, published an article in Real Estate Issues called “Deflation

Risk in Income Property Loan Portfolios”. This article provided a foundation for the hypothesis that high growth in aggregate debt correlates to a high risk of deflation risk in later years. This hypothesis was based on 10 years of working out distressed income property loan portfolios in two Savings and Loans from 1987 to 1997.

• In 4th Qtr 2005,observed first hand home price weakness in Sacramento market indicating that a turning point in the marketplace was beginning in California.

• Observed exuberance in NY income property real estate prices in 05, 06, and 07.

• Began extensive research into whether the hypothesis of a high growth in aggregate real estate debt and its potential deflation effect on future prices was becoming more of a high threat of being confirmed in the summer 2007.

• At annual CRE meeting in SF in Oct 2007, I forecasted as a member of the Capital Markets Panel an income property downturn at a scale larger than the S&L crisis in the 1990’s.

• In March 2008, I backed up my forecast in a published article in Real Estate Issues called “Deflation Risk in Income Property Loan Portfolios: a 2008 update”.

Prepared by: Marc R. Thompson, CRE, CCIM, FRICS

3

Marc’s forecast time-table (con’t)

• While at a Santa Fe Institute session in NY in Oct 2008 on “Risk Management” proposed to George Soros as an audience member a question as to whether he thought a proposal to regulate the growth of aggregate debt relative to an inflation index was a good idea. He encouraged my efforts by answering, yes!

• In March 2009, I published an article in Real Estate Issues that provided a methodology for forecasting income property loan losses by each year of origination relative to a natural debt growth curve pegged to the CPI index. This article also criticized Basel II proposed regulation for banks as it relates to real estate lending and capital requirements.

• In April 2009, presented before the American Real Estate Society (ARES) in Monterey, CA on the concept of using a CPI index methodology to regulate debt growth on income property and single family houses.

• Currently, I am working on a book on real estate investment called “The Relativity of Real Estate Investing”.

Prepared by: Marc R. Thompson, CRE, CCIM, FRICS

4

Speculation Risk

• Using a Relativity to Index Value methodology, speculation risk can be quantified in real estate loan portfolios.

• The author estimates that speculation risk is embedded in permanent income property loan portfolios in the amount of up to $1.1 Trillion.

• In addition, speculation risk in single-family loan portfolios are in the amount of up to $3.5 Trillion.

Prepared by: Marc R. Thompson, CRE, CCIM, FRICS

5

Relativity to Index Value I

• Index: MIT Center for Real Estate Transactions Based Index (TBI Price Index)

• The TBI Price Index is based on data received by MIT/CRE on a quarterly basis by the National Council of Real Estate Investment Fiduciaries (NCREIF).

Prepared by: Marc R. Thompson, CRE, CCIM, FRICS

6

Relativity to Index Value II

• The TBI is based only on the transactions data supplied quarterly by NCREIF members with estimated portfolio values of approximately $1 Trillion.

• The TBI Relative Price Index represents movements in transaction prices in closed deals in the market.

• Appraisals are used in the TBI Relative Price Index only to control for cross-sectional differences in properties, not to influence the longitudinal price changes tracked by this index.

Prepared by: Marc R. Thompson, CRE, CCIM, FRICS

7

Relativity to Index Value III

• MIT/CRE indicates on its website that the TBI Price Index can often provide a more up to date or precise picture of movements in the real estate market than other types of commercial real estate indexes. It is also being provided for research purposes as a service to the industry and academic research communities.

Prepared by: Marc R. Thompson, CRE, CCIM, FRICS

8

Relativity to Index Value IV

• The author concluded based on trend analysis that the TBI Price Index as an index is best to start in 2000. Inflating it at a CPI rate of 2.5% annually to help identify speculation risk in income property loan portfolios.

• The product types included in the TBI Relative Price Index are office, retail, hotel, warehouse/industrial, and multi-family.

• For single-family loan portfolios, the S&P Case/Shiller price index was used beginning at the same base year of 2000 and inflated at 2.5% annually to help identify speculation risk in home mortgage portfolios.

Prepared by: Marc R. Thompson, CRE, CCIM, FRICS

9

General Forecast Assumptions I

• The forecast was based on a cascading effect whereas all participants in the marketplace froze on investment transactions accelerating the TBI Price Index fall.

• A beginning of a recovery in income property values in 2015 and 2020 for single-family homes.

• The U.S. government is the largest provider of mortgages for residential income property (multi-family and senior housing) and single-family home mortgage debt.

• Assumes a disintermediation of private investors in the real estate mortgage market due to excessive mortgage losses and because of compromised investor/lender mortgage collection rights because of foreclosure moratoriums and mortgage modification initiatives.

Prepared by: Marc R. Thompson, CRE, CCIM, FRICS

10

General Forecast Assumptions II

• The negative slope rate of both price indexes is equal to the positive slope rate as price indexes were going up from 2000 through to the price index apex point.

• The down slope rate stops at a point the author forecasts to be at a bottom price index point whereas the velocity of continued foreclosures and mortgage short-sales suppress price index increases through 2015 for income property and through 2020 for single-family homes.

Prepared by: Marc R. Thompson, CRE, CCIM, FRICS

11

Prepared by: Marc R. Thompson, CRE, CCIM, FRICS

13

Real Estate Price Forecast Results Through 6-30-09

• The negative slope rate of both price indexes forecasted supported the forecasting methodology through June 30, 2009. The actual results compared to the forecast indicated a much steeper slope or a higher deterioration in price index than forecasted.

• With a higher deterioration in both price indexes than forecasted in December 2008, the longer range forecast appears to be more certain of being realized. In any event, after receiving feedback from actual results, I have made no changes to my December 2008 forecast.

Prepared by: Marc R. Thompson, CRE, CCIM, FRICS

14

Income Property Debt Forecast Assumptions

• Banks and CMBS investors employ a strategy to modify most defaulted loans to wait-out the depressed market and/or postpone losses.

• Actual losses on all income property loans exceed new originating debt gains beginning in the first quarter of 2009.

• The aggregate debt level decreases accelerate after loan modifications begin failing in 2010 through 2014.

• In 2015, most of the overleveraged income properties have cleared the market. Investors begin to forecast an opportunity of higher occupancy, rent growth, and increased cash flow resulting in appreciation on most property types from low trough price levels.

Prepared by: Marc R. Thompson, CRE, CCIM, FRICS

15

Prepared by: Marc R. Thompson, CRE, CCIM, FRICS

16

Prepared by: Marc R. Thompson, CRE, CCIM, FRICS

17

Income Property Debt Forecast Results Through 6-3-09

• The deleveraging of income property aggregate debt outstandings has started.

• Actual losses on all income property loans exceed new originating debt gains began as forecasted in the first quarter of 2009 although at a higher rate than forecasted at $32B through 6-30-09 relative to the forecast at $43B for the entire year of 2009.

• The forecast is expected to have aggregate debt level decreases accelerate to $170B in 2010.

• The December 2008 forecast is expected to hold over the long-term even though losses in aggregate loan outstandings are currently forecasted to occur at a higher rate than forecasted.

Prepared by: Marc R. Thompson, CRE, CCIM, FRICS

18

Single-Family Residence Debt Forecast Assumptions I

• Banks, RMBS servicers, and Federal and State governments employ a strategy to modify most defaulted loans to wait-out the depressed market, to keep people in their homes, and/or postpone losses.

• Collection and lender remedy rights are subordinated to the public interest to “save the economy from financial collapse”. This is in the form of foreclosure moratoriums for example passed by the California legislature.

Prepared by: Marc R. Thompson, CRE, CCIM, FRICS

19

Single-Family Residence Debt Forecast Assumptions II

• Actual losses on mortgages exceed new loan originations lowering the aggregate debt level beginning in the 2nd Qtr of 2008. Actual losses accelerate after unsustainable loan modifications begin failing in 2008 and continue through 2020.

• Home prices remain unstable through 2020 given that a consistent amount of foreclosed homes continue to be sold at low auction prices by sellers offering no representations or warranties on the home auctioned for sale.

• In 2020, over-leveraged SFR’s have cleared the market and private mortgage investors begin investing back into the market.

Prepared by: Marc R. Thompson, CRE, CCIM, FRICS

22

Single-Family Residence Debt Forecast Results through 6-30-09

• The actual losses on mortgages already started to exceed new loan originations lowering the aggregate debt level beginning in the 2nd Qtr of 2008 with $18B. Actual losses accelerated aggregate debt decreases after unsustainable loan modifications began failing and foreclosure rates increased in 2008 with 3rd Qtr 08 increasing to $55B to 4th Qtr 2008 increasing again to $97B.

• Foreclosure moratoriums decreased aggregate debt decreases to $10B with new FHA loans offsetting decreases aggregate debt in the 1st Qtr 2009.

• In the 2nd Qtr aggregate debt, decreased another $43B indicating that foreclosure moratoriums and new lending was not effective in detering the deleveraging in all US home mortgages.

Prepared by: Marc R. Thompson, CRE, CCIM, FRICS

23

Why existing Basel II Regulation Policy for Banks will impair income property markets

• Probability of Loss and Severity of Loss amounts are ineffective rear-view mirror estimates that proliferate boom-bust cycles. When recent past history on real estate losses are high, banks would have to allocate higher capital amounts. Banks would need to charge very high rates of interest to allocate capital for these high risk new loans based on a Basel II methodology.

• The existing Basel II mathematical models are also very complex: If a Bank President cannot figure it out, neither can the marketplace.

Prepared by: Marc R. Thompson, CRE, CCIM, FRICS

24

Why Commercial Banks will continue to have challenges making money

• Income property Probability of Loss and Loss Severity models in banks have been too optimistic.– JP Morgan Chase acquisition of Washington Mutual– Wells Fargo acquisition of Wachovia– BofA acquisition of Countrywide and Merrill Lynch

• The high fee generating syndicated loan market remains frozen given that bank syndication groups are spending more time on asset management and troubled debt restructures. It is difficult to sell a loan syndication to a bank that your are in disagreement with on another syndicated credit you also own with them.

Prepared by: Marc R. Thompson, CRE, CCIM, FRICS

25

Recommended Solutions for Banks I

• Close or break-up into well capitalized and better managed smaller banks the very large and difficult to manage financially weak money center banks. These institutions are very complex and difficult to manage the overall credit risk it is taking throughout the institution.

• The FDIC has become more efficient in closing failing banks, selling branches and deposits. The main area for improvement is in liquidating distressed loans as with the example of the Resolution Trust Corporation in the 1990’s S&L crisis. The FDIC is moving as fast as it can in this direction.

Prepared by: Marc R. Thompson, CRE, CCIM, FRICS

26

Recommended Solutions for Banks II

• Eliminate or amend Basel II regulation policy to identify the current risk of the income property collateral, not the past high risk experiences of lending on this collateral.

• This is a very good time for well capitalized banks to lend given the collateral values have already deflated close to floor levels in many product types and in many submarkets.

Prepared by: Marc R. Thompson, CRE, CCIM, FRICS

27

Why the Commercial Mortgage Backed Securities market will remain challenged.

• The income property risk assessment methodology and assumptions in existing Credit Rating Agencies remain flawed. S&P earlier this summer tried to change its methodology and assumptions only to withdraw them after a severe backlash by investors. It is difficult to change the rules of a game when you are in the middle of playing it!

• Until a methodology and assumptions by a new credit rating agency (without a current rating history of failing MBS issuances) can be relied upon by AAA investors, the loss of credibility of the existing Credit Rating Agencies will continue to impair the CMBS market’s ability to function.

Prepared by: Marc R. Thompson, CRE, CCIM, FRICS

28

How to get the Commercial Mortgage Backed Securities market healthy.

• Start-up a number of new credit rating agencies with specific competence in assessing risk ratings on all real estate types of debt.

• Ban the existing credit rating agencies from rating any real estate collateralized debt for 10 years to provide time for the new credit rating firms to establish themselves.

• Add a debt growth risk assessment methodology into credit risk ratings for all real estate collateralized mortgages. This methodology will factor in the rate of debt growth above the CPI index year over year from a base year of 2000. This factor would increase the risk of all loans issued within a vintage year above the CPI indexed aggregate debt amount.

Prepared by: Marc R. Thompson, CRE, CCIM, FRICS

29

Forecast Conclusion I

• Real estate investors will experience over the next five years weakness in income property prices due to the long process of clearing the market of distressed and foreclosed real estate debt.

• Most banks with large real estate loan positions on its balance sheets will be managing their existing positions in real estate collateralized loans. Most Banks will most likely not lend in the near future in order to shrink its balance sheet to preserve and stay within existing regulated capital requirements. Expect continued bank consolidations and liquidations over the next three years.

Prepared by: Marc R. Thompson, CRE, CCIM, FRICS

30

Forecast Conclusion II

• Unless a radical shift is made within existing credit rating agencies or unless new credit rating agencies are formed and existing credit rating agencies are banned for 10 years on all MBS, don’t expect the CMBS market to help the income property market in any material way.

• Most residential income property investors have access to permanent financing in the current market environment. Some residential product types such as senior housing have access to even construction financing. Income property types classified outside of what government sponsored entities can provide are currently systemically locked out of financing availability.