September 2008 Ethan Harris An L -Shaped Recovery Confidential

September 2008 Ethan Harris An “L”-Shaped Recovery Confidential Presentation

Us and Them Lehman Brothers forecast and consensus 1

Triple Threat u Housing hiatus u Credit crunch u Commodity costs …but some positive offsets… 2

Housing Hiatus – A Mountain of Inventory New single family home sales, starts and inventory Forecast ________ Source: Census Bureau, Lehman Brothers Global Economics. Note: Starts only include single family built for sale. 3 m saar

Housing Hiatus – Construction Correction Real residential investment (% q-o-q ar) (0) ________ Source: Commerce Department, Lehman Brothers Global Economics. 4

Housing Hiatus – Falling Behind Mortgage delinquencies and foreclosure starts Delinquencies by sector Foreclosures started by quarter % total of loans ________ Source: MBA 5

Housing Hiatus – Foreclosure Frenzy Single family foreclosed homes Foreclosures, millions of homes, ar Foreclosures, % of existing home sales Forecasts ________ Source: Lehman Brothers Mortgage Research, Lehman Brothers Economics 6

Housing Hiatus – Imbalance Total home sales and inventories (million units, saar) ________ Source: National Association of Realtors, Census Bureau, Lehman Brothers. 7

Housing Hiatus – Unstuck Prices Forecast National home prices (% y-o-y) ________ Source: OFHEO, S&P / Case-Shiller, and Lehman Brothers Global Economics. 8

Consumption – Collateral Damage Wealth effect on consumption growth (%q-o-q ar) Forecast ________ Source: Federal Reserve Flow of Funds, Commerce Dept, Lehman Brothers; Note: Housing wealth effect assumes consumers spend 6¢ for every additional dollar of housing wealth over a two year adjustment period. Stock market wealth effect assumes consumer spend 4¢ for every additional dollar of equity wealth over a three year adjustment period (assuming no change in equities from now through year-end and 8% average increase next year). 9

Consumption – Record Rebates Comparison of rebate plans Total Amount ($bn) 8 Economic Growth and Tax Relief Reconciliation Act of 2001 Jobs and Growth and Tax Relief Reconciliation Act of 2003 The Economic Stimulus Act of 2008 ________ Source: Lehman Brothers Global Economics. 10 0. 5 36 0. 4 14 0. 1 106. 7 Tax Reduction Act of 1975 % GDP 0. 8

Consumption – A Shot of Caffeine Disposable personal income ($bn) Forecast ________ Source: Commerce Department and Lehman Brothers Global Economics; Note: Assumes rebates received over ten week period starting in late May. 11

Consumption – Choppy Fade Real consumption expenditures (%) Forecast ________ Source: BEA and Lehman Brothers Global Economics. 12

Credit Crunch – Clogged Transmission Open market operations Reserves Monetary base Fed funds rate Money supply Market interest rates Loan supply Asset price levels Real rates Infl. exp. Exchange rate Relative asset prices Collateral Aggregate demand ________ Source: FBNY Economic Policy Review / May 2002. 13

Credit Crunch – Tight Financial Conditions Financial conditions 9/8/08 Core Markets 2 -year Treasury Yield 2. 24% 10 -year Treasury Yield 3. 66% 30 -year Jumbo Mtg. Rate 7. 13% S&P 500 1, 242 Money Market Fed Funds Rate 2. 00% 3 -month LIBOR 2. 81% Spread to Expected FF 80 bp 3 -month TED Spread 114 bp Credit Spreads Investment Grade Corp. 312 bp CDX. IG 151 bp High Yield Corp. 818 bp CDX. HY 698 bp LCDX (Loans) 399 bp AAA ABX (Subprime) 1105 bp AAA CMBX (CMBS) 173 bp ________ Source: Bloomberg, Markit, Lehman Brothers. 3/14/08 4 Q 07 3 Q 07 2 Q 07 1. 42 3. 42 7. 05 1, 288 3. 07 4. 03 6. 71 1, 468 3. 96 4. 58 6. 92 1, 527 4. 88 5. 03 6. 53 1, 503 4. 57 4. 64 6. 06 1, 421 3. 00 2. 76 83 154 4. 25 4. 70 67 135 4. 75 5. 23 67 151 5. 25 5. 36 12 64 5. 25 5. 35 11 40 293 190 806 771 473 864 263 198 77 569 494 310 483 65 145 55 403 208 18 97 41 292 340 181 19 7 92 39 275 293 – 19 7 14

Credit Crunch – Tighter Bank Lending Standards Net percent of banks reporting tighter lending standards (%) ________ Source: Federal Reserve; Note: only prime loans included in residential mortgages from April 2007 -Present. 15

Credit Crunch – Lagged Restraint Growth in credit card debt and credit standards %y-o-y Net % reporting tighter standards ________ Source: Federal Reserve. 16

Credit Crunch – Hard to Quantify Impact of credit shock on 4 -quarter GDP growth (%y-o-y) Quarters ________ Source: Lehman Brothers Global Economics; Note: Recreation of VAR model in IMF’s April 2008 Global Financial Stability Report; “Crunch” and “Squeeze” scenarios assume borrowing growth falls to 1% and 4% of outstanding private sector credit, respectively; For model details see The Missing Link, 2 May 2008. 17

Positive Offsets – Modest Investment Decline Business fixed investment (% q-o-q ar) Forecast ________ Source: Commerce Department and Lehman Brothers Global Economics. 18

Commodity Shock – The Income Squeeze CPI inflation and average hourly earnings (%y-o-y) ________ Source: Bureau of Labor Statistics. 19

Commodity Shock – Crushing Confidence Consumer confidence (Index) ________ Source: University of Michigan. Note: Shaded areas denote NBER recessions. 20

Positive Offsets – Lean and Mean Corporations Non-farm payrolls and business fixed investment (% y-o-y) Forecast ________ Source: Bureau of Labor Statistics, Commerce Dept. Note: Shaded areas denote NBER recessions. 21

Positive Offsets – Modest Job Cuts Non-farm payroll employment (change, ’ 000) Forecast ________ Source: BLS and Lehman Brothers Global Economics. 22

Growth – Major Economies Growth is set to slow across the board ________ Source: Lehman Brothers Global Economics. 23

Positive Offsets – Trade Turn Net exports contribution to GDP growth (percentage points) Forecast ________ Source: Commerce Department and Lehman Brothers Global Economics. 24

Growth – Adding It Up GDP Components (%Q 4/Q 4) Home Construction 2006 2007 2008 2009 -7. 1 -17. 9 -20. 5 Private Consumption 3. 0 2. 8 0. 9 Business Investment 7. 5 4. 9 3. 4 -1. 8 Reluctant fade Government Expenditures 1. 7 2. 1 2. 4 1. 5 Stressed states Exports 9. 1 8. 4 8. 7 4. 8 Okay global economy Imports 6. 0 2. 2 -2. 2 0. 1 Consumer slowdown GDP 2. 4 2. 3 1. 3 ________ Source: Commerce Department and Lehman Brothers. 25 -6. 9 Four years of recession 0. 1 Sharp slowdown 1. 5

Inflation – High Now, Low Later u Case for higher inflation – Tight commodity markets – Rising import prices u Case for lower inflation – Below potential growth – Weak consumer spending – Softer labor market – Rent relief 26

Inflation – Tight Commodity Markets ISM prices paid (Index) ________ Source: Institute of Supply Management. 27

Inflation – Import Competition Cools Consumer Goods Import Prices and Broad Dollar Index %y-o-y Index, Jan 1997 = 100 ________ Source: Federal Reserve, Bureau of Labor Statistics. 28

Inflation – Below Potential GDP Actual and potential GDP growth (% q-o-q ar) Potential ________ Sources: Commerce Department, CBO, and Lehman Brothers Global Economics. Note: Congressional Budget Office (CBO) estimate of potential real GDP growth. 29

Inflation – Softer Labor Market Unemployment rate and NAIRU (%) ________ Source: Bureau of Labor Statistics and Lehman Brothers. Note: Inflation threshold (or “NAIRU”) is based on regression of change in core CPI inflation on the lagged unemployment rate for the 1990– 2006 period. 30

Inflation – Rent Relief Rent and owner equivalent rent (OER) inflation (%y-o-y) ________ Source: Bureau of Labor Statistics. 31

Inflation – Recessions Kill Inflation Core CPI inflation and recessions (%y-o-y) ________ Source: BLS. Note: Shaded areas denote NBER recessions. 32

Inflation – Oil’s Overshooting West Texas Intermediate crude oil ($/bl) ________ Source: Federal Reserve Bank of Saint Louis. 33

Inflation – Peaking Now CPI inflation (%y-oy) Forecast Headline CPI Using oil futures Core CPI ________ Source: Bureau of Labor Statistics. 34

Fed – Back to Square One Federal funds rate (%) ________ Source: Federal Reserve and Lehman Brothers. Note: Market expectations derived Fed funds and Eurodollar futures on August 11. 35

Fed – Inflation Expectations 5 y 5 y inflation breakeven rate (%, annual rate) ________ Source: Lehman Brothers; Note: Straight lines indicate +/- one standard deviation from sample mean. 36

Fed – Hairy History Funds rate and 24 m expectations derived from ED futures (%) ________ Note: Expectations are calculated using Eurodollar futures. We use a model-based term premium after 1994 and a term premia of 15 bp per year prior to 1994. The LIBOR-Fed funds basis is assumed to be 14 bp through 2006, but with the recent market turmoil, from 2007 on we adjusted for the FF-LIBOR spread using basis swaps. Shaded areas denote NBER recessions. 37

Fed – Another Weak Recovery Unemployment rate and Fed turning points (%) Last rate cut First rate hike Fed forecast ________ Source: BLS, Federal Reserve, Lehman Brothers Global Economics; Note: Shaded Bars denote NBER recessions. 38

Outlook at a Glance ________ Notes: Real GDP is expressed as a seasonally adjusted annual rate. Unemployment is measured as a percentage of the labor force. Core PCE inflation is y-o-y percent change. Interest rate forecasts are end of period. Payrolls are monthly average changes. Table last revised August 22. 39

Appendix

Recessionomics – Worse Than 1990 or 2001 Real GDP outlook (indexed to 100 at peak) ________ Source: BEA, Lehman Brothers Global Economics. 40

Recessionomics – Flat, not negative growth ISM purchasing managers indexes ________ Source: ISM. 41

Recessionomics – A New Definition Unemployment rate (%) ________ Source: BLS and NBER; Note: Shaded areas indicate NBER recession rates. 42

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