cmrg european presentation sept 16 final v2 update

7/29/2019 Cmrg European Presentation Sept 16 Final v2 Update

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Good day, everyone, and welcome to todays Moodys Capital Markets Research

Live Webcast Where are we in the credit cycle? Todays programme is beingrecorded. This discussion is a conversation and is not intended as a

recommendation to buy, sell, or hold securities, nor is this a conversation intended

to be an offer or solicitation to buy or sell securities. Ratings and other statements

expressed on this call constitute our opinions as of today only and are subject to

limitations and disclaimers set forth on our ratings and research releases, and

listeners on this call should refer to those releases for additional information. Weask that no one record this conversation without Moodys explicit written

permission. No one has permission to quote any of the comments made or

questions asked by the teleconference audience.

Disclaimer

Agenda09:00 BST Opening Remarks09:10 BST Outlook for the European economies and key credit indicators

Ruth Stroppiana - Chief International Economist, Moody's Economy.com09:55 BST Outlook for the US economy and key credit indicators

John Lonski - Managing Director and Chief Economist, Capital Markets Research Group10:40 BST Break10:55 BST Signals of risks and opportunities from the capital markets

David Munves - Divisional Managing Director, Capital Markets Research Group11:40 BST Key sector analysis

Michael Love - Director and Financial Institutions Analyst, Capital Markets Research Group12:25 BST Closing Remarks


2/149

Where Are We In the Credit Cycle?

Capital Markets ResearchGroup

Economy.com

September 2008


3/149

Program Overview

The Outlook for the European Economies and

Key Credit Indicators

A Macro View of the US Credit Cycle

Signals of Risk and Opportunities From the

Capital Markets

Key Sector Analysis Financial Institutions

2


4/149

Outlook for the European Economies

and Key Credit Indicators

Presented by:

Ruth Stroppiana, Chief

International Economist

September, 2008


5/149

Presentation Overview

Mounting cost of the subprime debacle and subsequentcredit squeeze in Europe

The credit cycle in Western Europe:

Where are we?

Where are we going?

Economic Outlook and risks

Euro Zone

United Kingdom

4


6/149

Impact of the

Credit Squeeze in

Europe


7/149

Subprime Write-Downs and Losses High in Europe

0

100

200

300

400

500

600

Writedowns and credit losses Capital raised

Worldwide U.S. Europe Asia

Subprime write-downs and capital raised, US$ billions

Source: Bloomberg

6


8/149

0

1020

30

40

50

60

70

80

90

100

Jan

07

Mar

07

May

07

Jul 07 Sep

07

Nov

07

Jan

08

Mar

08

May

08

Jul 08

U.S. U.K Euro zone

Global Financial System Still Stressed

Spread: monetary policy rate and 3 month Libor, basis points

7


9/149

Credit Cycle:

Where are We?

Where Are We

Going?


10/149

0%

20%

40%

60%

80%

100%

00 01 02 03 04 05 06 07 08

Non-Financial Financial Total

Financial Sector Driving Down Credit Quality

Share of upgrades in Western Europe, 12 month rolling ratio

Source: Moodys Credit Trends

9


11/149

0%

20%

40%

60%

80%

100%

00 01 02 03 04 05 06 07 08

Investment-Grade Speculative-Grade Total

Investment and Speculative-Grade Under Pressure


Share of upgrades in Western Europe, 12 month rolling ratio

10


12/149

Corporate Spreads Continue to Climb

Euro composite corporate bond spread, basis points

0

25

50

75

100

125

150

175

200

Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08

0

100200

300

400

500600

700

800

900

Euro Investment Grade Spread (L)

Euro High Yield Spread (R )

Source: Lehman Brothers

11


13/149

0

50

100

150

200

250

2000 2001 2002 2003 2004 2005 2006 2007 2008

YTD

Investment grade

Speculative grade

Annual issuance volume, US$ billions


Bond Issuance Weakens in Western Europe

12


14/149

0%

20%

40%

60%

80%

100%

Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08

0%

20%

40%

60%

80%

100%

Total Non-Financial Financial

Corporate Outlook in Western Europe Has Weakened

Share of positive outlook changes, 12 month rolling ratio


13


15/149

Widening corporate spreads, reflect expectations of further

weakening in credit fundamentals.

Moodys Default Research forecasts the corporate default rate

in the EU will surge to over 5% in the next 12 months, from


16/149

Economic Outlook:

Euro Zone and

United Kingdom


17/149

-1

0

1

2

3

4

5

6

00 01 02 03 04 05 06 07 08F 09F 10F

GDP % change GDP % change year ago

Testing Times Ahead for the Euro Zone Economy

Real GDP growth

Forecast

16


18/149

0 1 2 3 4 5 6

Italy

PortugalFrance

Germany

Belgium

Austria

NetherlandsSpain

Greece

Finland

Luxembourg

Ireland

2007

2008F

2009F

Activity will Slow Sharply Across Most of the Region

Real GDP, % change year ago

17


19/149

-1

0

1

2

3

4

5

00 01 02 03 04 05 06 07 08F 09F 10F

GDP % change GDP % change year ago

Growth Grinds to a Halt in the U.K.

Real GDP growth

Forecast

18


20/149

0

20

40

60

80

100

120

140

160

00 01 02 03 04 05 06 07 08

-20

-10

0

10

20

30

40Mortgage approvals, ths (L)

Halifax average house price, % change year ago (R)

Britains Troubled Housing and Mortgage Markets

19


21/149

4.0

5.0

6.0

7.0

8.0

9.0

10.0

00 01 02 03 04 05 06 07 08

Euro zone United Kingdom

Labour Markets Still SupportiveBut Will Weaken

Unemployment rate, %

20


22/149

0

1

2

3

4

5

00 01 02 03 04 05 06 07 08


High Consumer Prices Hits Households Budgets

CPI, year ago % change

21


23/149

-2

0

2

4

6

8

10

12

00 01 02 03 04 05 06 07 08


Corporate Profits Squeezed by Surge in Input Costs

PPI, year ago % change

22


24/149

0

20

40

60

80

100

120

140

00 01 02 03 04 05 06 07 08F 09F 10F

Forecast

Pullback in Commodity Prices Expected to Continue

WTI crude oil, $/barrel

23


25/149

Aggressive Monetary Easing Will Be Required

Key monetary policy rates

2

3

4

5

6

Jan-

06

Apr-

06

Jul-

06

Oct-

06

Jan-

07

Apr-

07

Jul-

07

Oct-

07

Jan-

08

Apr-

08

Jul-

08

ECB policy rate BoE repo rate

24


26/149

0.8

1.0

1.2

1.4

1.6

1.8

2.0

2.2

00 01 02 03 04 05 06 07 08F 09F 10F

USD/EUR USD/GBR Forecast

Euro and Pound Will Extend Slide Against the Dollar

25


27/149

Weak Business Confidence Remains a Concern

Diffusion business confidence index, 4 wk. MA

-10

0

10

20

30

40

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

Euro e North America Asia Pacific South America

Source: Moodys Economy.com Survey of Business Confidence

26


28/149

0

1

2

3

4

5

6

00 01 02 03 04 05 06 07 08F 09F 10F

World United States

Euro Zone United Kingdom Forecast

Western Europe Still Reliant on the U.S.

Real GDP, % change year ago, 4 quarter MA

27


29/149

In Summary,

Risks to economic growth and the credit cycle in WesternEurope are to the downside.

A combination of tight credit conditions, elevated

borrowing costs, and high prices will continue to crimp

economic activity and credit growth in the medium term.

Monetary policy easing will be forthcoming but will not be

a silver bullet.

Testing times for policymakers.

28


30/149

www.economy.com


31/149

A Macro View of the US Corporate

Credit Cycle

September 2008

Presented by:

John Lonski,

Chief Economist


32/149

Topics for Discussion

1. Prospects for US consumer spending, capital spending

and exports.

2. Likely direction of Federal Reserve policy and benchmark

interest rates.

3. Outlook for nonfinancial-corporate credit risk premia.

31


33/149

Prospects For US ConsumerSpending, Capital Spending

And Exports


34/149

Yearly Percentage Point Change of UnemploymentRate Puts the US in a Recession

-1.4

-0.9

-0.4

0.1

0.6

1.1

1.6

Jun-88 Jun-90 Jun-92 Jun-94 Jun-96 Jun-98 Jun-00 Jun-02 Jun-04 Jun-06 Jun-08

Business Cycle: recessions are shaded

YY % Point Change of Unemployment Rate

33

Employment Income and Record Low Income Outlook


35/149

Employment Income and Record-Low Income OutlookSignal Weak Spending, but Employment Income TopsPace of Jun-01 through Jun-03: 6 month averages

-1

4

9

14

19

24

Feb-95 Oct-96 Jun-98 Feb-00 Oct-01 Jun-03 Feb-05 Oct-06 Jun-08

-0.5

1.5

3.5

5.5

7.5

Consumers' Income Expectations Index ( L )

Employment Income: YoY % change ( R )

34


36/149

Deceleration of Employment Income WeakensProspects for Retail Sales

0

1

2

3

4

5

6

7

8

9

Jun-93 Feb-95 Oct-96 Jun-98 Feb-00 Oct-01 Jun-03 Feb-05 Oct-06 Jun-08

0

1

2

3

4

5

6

7

8

9

Retail Sales Employment Income

YY % change of 6-mo. averages

35


37/149

2008 Should be the Worst of Nine Straight Annual Setbacks forDomestic Unit Sales of the US' Big 3Transplants Will OutperformUS' Big 3 for 10th Straight Year in 2008

Total Imports US Built

US Built: Big

Three

US Built:

Foreign-Owned

Transplants

1 2 3 3a 3b

1994 8.4 -0.8 10.0 8.4 20.2

1995 -2.2 -11.0 -0.7 -1.5 6.2

1996 2.5 -10.2 4.4 1.7 11.8

1997 0.2 13.7 -1.6 -1.6 -0.8

1998 2.8 4.5 2.5 2.5 2.5

1999 8.7 22.4 6.6 6.4 7.8

2000 2.7 14.9 0.6 -1.6 2.7

2001 -1.0 8.0 -2.7 -4.6 2.9

2002 -2.3 6.0 -4.1 -4.6 -2.8

2003 -1.0 1.0 -1.4 -3.7 5.9

2004 1.1 1.8 0.9 -2.3 10.52005 0.8 2.7 0.3 -1.6 5.3

2006 -2.3 12.6 -6.0 -7.0 -3.6

2007 -2.8 2.8 -4.4 -7.5 2.5

Jan-Aug 08 -12.2 -4.5 -14.6 -18.8 -6.1

YoY % change of unit sales of cars and light trucks sold in the US

36

Home Price Deflation Worry Stops Improved Home


38/149

Home Price Deflation Worry Stops Improved HomeAffordability From Steadying Home Sales Lower MortgageYields to Boost Affordability: YoY % change of 6-mo. avgs.

-13.8

-8.8

-3.8

1.2

6.2

11.2

16.2

Jul-88 Sep-90 Nov-92 Jan-95 Mar-97 May-99 Jul-01 Sep-03 Nov-05 Jan-08

-24.5

-19.5

-14.5

-9.5

-4.5

0.5

5.5

10.5

15.5

Home Affordability Index ( L ) Total Sales of 1-Family Homes ( R )

37


39/149

Bottoms -- and little else -- Materialize for Indices ofPending and Actual Sales of Existing Homes

80

85

90

95

100105

110

115

120

125

130

Sep-01 Jul-02 May-03 Mar-04 Jan-05 Nov-05 Sep-06 Jul-07 May-08

PendingSalesofExistingHomes:index

4,700

5,200

5,700

6,200

6,700

7,200

UnitSalesofExistingHomes:(000s)

Pending Sales of Existing Homes: index ( L )

Unit Sales of Existing Homes: (000s) ( R )

moving 3-month averages

38

Correlation Between YY % Changes of Household Net


40/149

Correlation Between YY % Changes of Household NetWorth and Real Consumer Spending is a Significant,but far from Impressive, 0.42

-9.5

-4.5

0.5

5.5

10.5

15.5

85Q4

86Q4

87Q4

88Q4

89Q4

90Q4

91Q4

92Q4

93Q4

94Q4

95Q4

96Q4

97Q4

98Q4

99Q4

00Q4

01Q4

02Q4

03Q4

04Q4

05Q4

06Q4

07Q4

-0.8

0.2

1.2

2.2

3.2

4.2

5.2

Household Net Worth: YoY % dif ( L ) Real Consumer Spending: YoY % dif ( R )

39


41/149

Capital Spending's Resilience May Limit the Downsidefor Payrolls Employment

-11

-7

-3

1

5

9

13

85Q4 87Q4 89Q4 91Q4 93Q4 95Q4 97Q4 99Q4 01Q4 03Q4 05Q4 07Q4

RealBusinessCapitalSpending

-1.6

-0.6

0.4

1.4

2.4

3.4

PayrollJ

obs

Real Business Capital Spending Payroll Jobs

YoY % dif of yearlong sums

40

Rapid Growth of Business Outlays on Structures Should Fade


42/149

Rapid Growth of Business Outlays on Structures Should Fade Impact of Slow Economy on Cap Ex May Not Be ApparentUntil Year's End Cap Ex Should Avoid Collapse of 01-02

Total BusinessFixed-Investment

Spending

Business

Structures Software

InformationTechnology

EquipmentComputer

Equipment

Equipmentexcluding

Info TechIndustrial

EquipmentTransportation

Equipment

1 2 3 4 4a 5 5a 5b

Amount in $ billions: (nominal)2007 1,504 480 227 290 94 506 181 157

Average annualized % change:1993-2000 9.1 7.7 14.9 9.4 11.0 8.2 7.0 10.1

2003-2007 7.1 11.5 6.3 4.6 3.9 5.5 5.9 4.5

YoY % change:2001 -4.5 3.0 -0.9 -10.0 -15.8 -7.6 -7.9 -11.9

2002 -9.4 -13.5 -4.0 -11.7 -9.5 -7.1 -7.5 -10.9

2003 1.0 -0.7 2.2 1.5 7.0 1.5 3.7 -6.3

2004 7.2 7.6 6.8 4.8 3.2 8.4 -0.7 20.8

2005 10.3 13.2 6.6 3.9 1.7 13.5 12.4 15.1

2006 11.1 21.6 5.5 7.9 8.7 7.7 9.0 7.6

2007 6.3 17.0 10.5 5.0 5.5 -3.0 5.5 -11.1

H1-08 5.9 16.1 10.6 5.2 3.6 -4.9 2.3 -18.9

07Q2 6.1 15.7 10.9 4.8 4.2 -2.6 6.3 -9.7

07Q3 6.3 16.1 11.0 3.9 3.8 -2.3 7.3 -12.3

07Q4 7.1 17.2 11.5 7.9 7.8 -3.5 3.7 -14.4

08Q1 6.7 16.3 10.8 4.5 3.6 -2.5 5.8 -15.5

08Q2 5.2 15.9 10.4 5.9 3.6 -7.4 -1.0 -22.5

41

Correlation Coefficient Between Core Capital Goods


43/149

Correlation Coefficient Between Core Capital GoodsOrders and Business Investment Spending onEquipment is a Solid 0.88

-19.0

-14.0

-9.0

-4.0

1.0

6.0

11.0

85Q4 88Q1 90Q2 92Q3 94Q4 97Q1 99Q2 01Q3 03Q4 06Q1 08Q2

Non

defenseCapitalGoods

OrdersexAircraft

-19.0

-15.0

-11.0

-7.0

-3.0

1.0

5.0

9.0

13.0

BusinessInvestmen

tSpending

Nondefense Capital Goods Orders ex Aircraft Business Investment Spending on Equipment: nominal

YoY % change of moving yearlong observations

42

Plunge by Architectural Billings Index Warns of a Late


44/149

Plunge by Architectural Billings Index Warns of a Late2008 Contraction by Real Spending on BusinessStructures

-22

-17

-12

-7

-2

3

8

13

Jun-96 Dec-97 Jun-99 Dec-00 Jun-02 Dec-03 Jun-05 Dec-06 Jun-08

43

45

47

49

51

53

55

57

Real Business Investment Spending on Structures: YY % change of 6-mo. avg.

AIA's Architectural Billings Index: 6-mo. avg. ( R )

43


45/149

Diminished Supply of Bank Credit to Businesses BodesPoorly for Capital Spending: 2-Qtr Avgs.

-70

-50

-30

-10

10

30

90Q4 92Q4 94Q4 96Q4 98Q4 00Q4 02Q4 04Q4 06Q4

-12

-7

-2

3

8

13

Index of Bank Supply of Credit to Business

Real Business Investment Spending: YY % dif, ( R )

44

Much Slower Rise of US Domestic Spending Vis--vis


46/149

Much Slower Rise of US Domestic Spending Vis visWorld Economic Growth Helps Thin US Trade Gap: %change

-1.3

-0.3

0.7

1.7

2.7

3.7

4.7

85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 E08

World Real GDP Growth: IMF estimate, ( L )

US Real Domestic Spending Growth: ( R )

45


47/149

US Merchandise Trade With the EU Still ComparesFavorably With 2001's Recession

-17.6

-12.6

-7.6

-2.6

2.4

7.4

12.4

17.4

22.4

27.4

86Q4

88Q4

90Q4

92Q4

94Q4

96Q4

98Q4

00Q4

02Q4

04Q4

06Q4

US Imports from EU US Exports to EU

YY % change of 6-mo. averages

46


48/149

Likely Direction Of FederalReserve Policy And

Benchmark Interest Rates


49/149

A Declining Rate of Labor Market Utilization Favors aFed Rate Cut

1

2

3

4

5

6

7

8

9

10

Mar-87 Mar-90 Mar-93 Mar-96 Mar-99 Mar-02 Mar-05 Mar-08

61

62

63

64

65

Fed Funds Rate Target ( L ) Employment as % of Working-Age Population

48

Lower Energy Prices Will Soon Slow Headline CPI


50/149

gyInflation Core CPI Inflation Still Lags 2.9% YY Paceof Sep-06

0.5

1.5

2.5

3.5

4.5

5.5

6.5

Jul-89 May-91 Mar-93 Jan-95 Nov-96 Sep-98 Jul-00 May-02 Mar-04 Jan-06 Nov-07

CPI: YY % change Core CPI : YY % change

49

Firmer Dollar and Lower Euro Zone Bond Yields Help to Ease US


51/149

Firmer Dollar and Lower Euro-Zone Bond Yields Help to Ease USTreasury YieldsShare of Outstanding US Treasury Debt Held byNon-US Investors Rises from 1998's 31% to 2008's 47%

2.8

3.3

3.8

4.3

4.8

5.3

5.8

6.3

6.8

Jan-99 Mar-00 May-01 Jul-02 Sep-03 Nov-04 Jan-06 Mar-07 May-08

US 10-year Treasury Yield: % German 10-year Bund Yield: %

50


52/149

Outlook For Nonfinancial-Corporate Credit Risk

Premia

High-Yield Bond Spread Is Priced for Steeper Default


53/149

g p pRateRising Default Rate Will Limit Any Narrowing ofHigh-Yield Bond Spread

220

320

420

520

620

720

820

920

1,020

Jul-86 Jan-89 Jul-91 Jan-94 Jul-96 Jan-99 Jul-01 Jan-04 Jul-06 Jan-09

0.5

2.5

4.5

6.5

8.5

10.5

12.5

US Speculative-Grade Bond Yield Spread: basis points, ( L )

US Speculative-Grade Bond Default Rate: %, act. & proj.

52

Bonds' Rated B3 or Lower Record Share of High-Yield


54/149

Bonds Outstanding Supports 800 Basis Point High-Yield Bond Spread

250

350

450

550

650

750

850

950

87Q4 90Q2 92Q4 95Q2 97Q4 00Q2 02Q4 05Q2 07Q4

22

27

32

37

42

47

Speculative-Grade Yield Spread: basis points ( L )

B3 or Lower as % of Total US High Yield Bonds Outstanding

53

High Yield Bond Spread Seems Wide Compared to Average EDF Of


55/149

High Yield Bond Spread Seems Wide Compared to Average EDF OfUS' High-Yield CompaniesRelatively Low EDF Follows FromHealthier Balance Sheets Compared to 1998-2002

1

3

5

7

9

11

13

Jan-

96

Dec-

96

Nov-

97

Oct-

98

Sep-

99

Aug-

00

Jul-01 Jun-

02

May-

03

Apr-

04

Mar-

05

Feb-

06

Jan-

07

Dec-

07

AverageExpectedDefaultFrequencyOfUSNo

InvestmentGra

deCompanies:%

250

350

450

550

650

750

850

950

1,050

CompositeUSSpeculativ

e-GradeBondYieldSpre

a

OverTreasuries:basispoints

Average Expected Default Frequency Of US High-Yield Companies: %, EOM

US Speculative-Grade Bond Yield Spread Over Treasuries: basis points

54


56/149

What is an Expected Default Frequency (EDF) ?

1. The Expected Default Frequency (EDF) is the probability that a

firm will default within a given time horizon, which is within one

year for the accompanying charts.

2. Default is defined as failure to make scheduled principal or

interest payments.

3. The main drivers of the EDF are the market value of the firm

(asset value), the level of its debt obligations (default point), and

the volatility of firm value (asset volatility). In short, the EDF isshaped by the market value of net worth after adjustment for stock

price volatility.

55


57/149

Both VIX and High-Yield Bond Spread Fall Short ofHighs of Previous Credit Market Slump

9

14

19

24

29

34

39

Jan-90 May-92 Sep-94 Jan-97 May-99 Sep-01 Jan-04 May-06 Sep-08

250

350

450

550

650

750

850

950

1,050

VIX Index of Stock Price Volatility ( L )

High-Yield Bond Spread Over Treasuries: basis points ( R )

56

High-Yield Spread Expects Credit Crunch, Stock Price


58/149

g p p ,Volatility and US Economic Slump to Boost % ofDefaulted Bonds Not Recovered

32

37

42

47

52

57

62

67

72

77

82

1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007

%o

fD

efaultedAvg.

Sr.

Unsec

uredBondsNOT

Recovere

275

375

475

575

675

775

875

Sp

eculative-GradeBondYieldSpread:basispoint

% of Defaulted Avg. Sr. Unsecured Bonds NOT Recovered

Speculative-Grade Bond Yield Spread: basis points

57

High-Yield and Investment-Grade Upgrade Ratios


59/149

Avoid Lows of Two Previous Slumps: 6-mo. ratio ofupgrades to # of rating revisions

6

16

26

36

46

56

66

86Q2 88Q2 90Q2 92Q2 94Q2 96Q2 98Q2 00Q2 02Q2 04Q2 06Q2 08Q2

Recessions are shaded High-Yield Upgrade Ratio: %

Investment-Grade Upgrade Ratio: %

58

Steepest Relative Frequency of High-Yield Downgrades


60/149

Steepest Relative Frequency of High-Yield DowngradesSince H2-02 Helps to Widen High-Yield Bond Spreads

250

350

450

550

650

750

850

950

86Q4 89Q2 91Q4 94Q2 96Q4 99Q2 01Q4 04Q2 06Q4

30

40

50

60

70

80

90


Downgrades as % of Number of US High-Yield Company Credit Rating Changes: 6-month ratio ( R )

59

More Downgrades to "Caa3 or Lower" Widen High


61/149

More Downgrades to Caa3 or Lower Widen High-Yield Bond Spreads

250

350

450

550

650

750

850

950

97Q2 98Q3 99Q4 01Q1 02Q2 03Q3 04Q4 06Q1 07Q2 08Q3

5

15

25

35

45

55

65

75

85


US Downgrades to Caa3 or Lower: count, 6-month sum

60

US Upgrade Ratios: Bank & Finance Resembles 1990-fi i l i k i l


62/149

1991 Low, Nonfinancials Sink to Recessionary Level: 6-mo. ratio of upgrades to # of rating revisions

6

16

26

36

46

56

66

76

86

86Q2 88Q2 90Q2 92Q2 94Q2 96Q2 98Q2 00Q2 02Q2 04Q2 06Q2 08Q2

Recessions are shaded Financial Institutions Upgrade Ratio: %

Nonfinancial-Company Upgrade Ratio: %

61

Tightness of Supply of Business Credit from Banks


63/149

Tightness of Supply of Business Credit from BanksFavors Wide High-Yield Bond Spreads

-51

-31

-11

9

29

49

69

90Q4 92Q4 94Q4 96Q4 98Q4 00Q4 02Q4 04Q4 06Q4

250

350

450

550

650

750

850

950

Index of Tightness of Bank Supply of Credit to Business

High-Yield Bond Spread over Treasuries: basis points ( R )

62


64/149

Wider High-Yield Bond Spread Anticipates a FurtherNarrowing of the Profit Margin Ratio

6

7

8

9

10

11

12

13

14

15

85Q4 88Q2 90Q4 93Q2 95Q4 98Q2 00Q4 03Q2 05Q4 08Q2

260

360

460

560

660

760

860

960

Profit Margin Ratio: %, derived from NIPA accounts ( L )

High-Yield Bond Spread: INVERTED, in bas is points ( R )

63

Consensus Sees a H1-09 Bottom for CapacityU ili i Whi h I li O l Li i d N i


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Utilization, Which Implies Only a Limited Narrowingfor the Profit Margin Ratio

6

7

8

9

10

11

12

13

14

15

16

85Q4 88Q2 90Q4 93Q2 95Q4 98Q2 00Q4 03Q2 05Q4 08Q2

73

75

77

79

81

83

85

Profit Margin Ratio: %, derived from NIPA accounts

% of Industrial Capacity in Use, act. & pred. ( R )

64

Projected Mid-09 Narrowing of the Unemployment


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Rate's Yearly Rise Might Help to Thin the High-YieldBond Spread

200

300

400

500

600

700

800

900

1,000

1,100

Dec-85 Jun-88 Dec-90 Jun-93 Dec-95 Jun-98 Dec-00 Jun-03 Dec-05 Jun-08

-1.3

-0.8

-0.3

0.2

0.7

1.2

1.7

US Speculative-Grade Bond Yield Spread: basis points ( L )

Unemployment Rate: 3-mo. avg. of YY change in % pts. ( R )

65


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In Summary,

1. The US' business and credit cycles may not bottom until mid-2009.

2. A stabilization of the US economy requires lower interest rates

and lower energy prices.

3. An ending of the credit crisis is contingent on a steadying of

housing.

4. Fed policy will put downside economic risks ahead of

troublesome headline inflation.

5. Though aggregate measures of nonfinancial-corporate credit

worth compare favorably with the two previous recessions, their

ongoing deterioration will block an extended narrowing of bond

yield spreads.

66


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Moody's AnalyticsEconomics Group

John Lonski (212) 553-7144 [email protected]

Ben Garber (212) 553-4732 [email protected]

Chris Snyder(212) 553-7951 [email protected]

Luis Valentin (212) 553-3857 [email protected]

67


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Signals of Risk and Opportunities

From the Capital Markets

David Munves, CFA

[email protected]

Capital Markets Research Group

September 2008
mailto:[email protected]:[email protected]


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Presentation Overview

Market Implied Ratings; A Brief Overview

Using Market-Implied Ratings as Early

Warning Signals of Credit Direction and Default

Recent Developments

Appendix I: Selected Institutions with LargeNegative Ratings Gaps

Appendix II: Additional MIR-based Default

Analysis

69


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Market Implied Ratings; ABrief Overview

MIR is a Simple Product Showing Market and Other Signals of


72/149

MIR is a Simple Product, Showing Market and Other Signals ofCredit Risk on the Familiar Moodys Rating Scale.

Moodys Rating and Implied Ratings for General Motors

71

Bond- and CDS-implied Ratings are Determined withReference to Median Spread Curves Which Are Updated


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Reference to Median Spread Curves, Which Are UpdatedDaily

Sample Bond Market Median Credit Spreads

Years to Maturity

CreditSpread

(bp)

72

We Calculate Positive and Negative Ratings Gaps with


74/149

We Calculate Positive and Negative Ratings Gaps withReference to These Curves

Spreads and Spread Ranges by Category, 5yr Maturities*

* Excluding the 5% tails of each distribution

At a spread of 140 bp, an

Aa2 rated issuer trades

cheaply for its rating

This equates to an A2 impliedrating, or a ratings gap of -3

Aa2 Sprd =

95 bp

73

The MIR dataset covers issuers with Moodys


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ratings and traded debt, CDS, and equities.

Market Implied Ratings Coverage

Bond-

Implied

Equity-

Implied

CDS-

Implied

LCDS-

Implied

MDP-

Implied

Number of Issuers 2,900 1,800 2,000 300 1,600

Investment Grade 66% 79% 75% 9% 51%Speculative Grade 34% 21% 25% 91% 49%

Geographic Breakdown

Americas 68% 66% 55% 93% 72%

Asia 5% 5% 9% 0% 4%EMEA 22% 18% 27% 7% 15%Japan 5% 10% 9% 0% 9%

Time Series Start Date 1/1/99 1/1/99 1/1/01 8/06 1/1/99

74

We Harness Market Signals by Analyzing them


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We Harness Market Signals by Analyzing themSystematically Over Time

Deriving early warnings of downgrades and defaults

Bond and CDS market relative value analysis

Recovery value analysis

Analysis of structured credit products

Portfolio risk and return analysis

A further question is what model or market works best

for the different applications

Applications of Market Implied Ratings-Based Research

75


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Using Market ImpliedRatings as Early Warning

Signals of Credit Directionand Default

MIRs Ability to Isolate Idiosyncratic Risk Means It Works Well as an EarlyW i I di t I 1Q07 BSC CDS S d Wid d M d tl Whil th


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Warning Indicator. In 1Q07 BSCs CDS Spread Widened Modestly While theMarket Was Tightening. The Result Was a 3-Notch Drop in its IR.

Bear Stearnss CDS Spread vs. the Market

BSC widens by~25 bp, CDS IR

falls by 3 notches

77

The Bear Stearns Example (cont.):The 25 bp Rise in BSCs CDS Spread in March Translated into a 3


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The ~25 bp Rise in BSCs CDS Spread in March Translated into a 3-Notch Fall in its CDS-Implied Rating

Bear Stearns CDS-Implied Ratings and Moodys Rating

Period noted inthe previousslide

78

Market Trading Levels Tend to Lead Moodys. The Bigger


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Market Trading Levels Tend to Lead Moody s. The Biggerthe Initial Ratings Gap, the Stronger this Effect Becomes.

Moodys Rating Change Frequency as a Function of the RG, 1-Year Horizon

CDS Data Set for 1/1/01 7/31/08

0%

25%

50%

75%

100%

>6 5 4 3 2 1 0 -1 -2 -3 -4 -5


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0%

25%

50%

75%

100%

>6 5 4 3 2 1 0 -1 -2 -3 -4 -5


82/149

Thus, Ratings Gaps Close Over Time, with Moody s Ratingsand Market Trading Levels Converging.

Average Changes in Moodys Ratings and Implied Ratings

Bond Data Set, 1-year horizon

-4

-3

-2

-1

0

1

2

3

6 5 4 3 2 1 0 -1 -2 -3 -4 -5 -6

Change

in

Rat

ingsNotches

-4

-3

-2

-1

0

1

2

3

# of notches BIR Away From Moody's Rating

Moody's BIR

The market movements aremuch greater than Moodys forboth pos. and neg. gap names

81

Not Surprisingly, Implied Ratings are More


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Volatile than Moodys Ratings

Annual Change Rates for Moodys Rating vs. Bond-Implied Ratings

Moody's Bond-Implied Ratings

Rating Action Rate 24% 98%

Large Rating Action Rate* 4% 28%

Source: Credit Policy Group, Corp. Bond Rating Performance Rep

*Changes of two notches or more

82

MIR Also Provides Useful Short-Term


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Default Signals

Default Rates Vary Considerably by Ratings Gap

* 1983-2007

One-Year Time Horizon for Bond Data Covering 1/1/99 7/31/08

83


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Recent Developments

The Wider CDS Spreads Over the Past Year on Financial


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pInstitutions vs. Industrials and Utilities

A 5-year CDS spreads for FIs and Industrials

0

30

60

90

120

150

180

210

240

270

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

Spread (bp)

0

30

60

90

120

150

180

210

240

270

Spread (bp)

Financials Corporates All

85

Have Translated into a Huge Jump in the Number of FIs with CDS-ImpliedRatings Gaps of 5 or Greater Some 40% of All FIs with Implied Ratings are


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Ratings Gaps of -5 or Greater. Some 40% of All FIs with Implied Ratings arein this Category.

Entities with CDS-IR Gaps of -5 and Below

86

This is at Odds with the Normal Pattern, Which Features


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,Relatively Few Large Gaps

Ratings Gap Distribution by Model

87

Not Surprisingly, Banks Dominate the Cheap


89/149

Names in the FI Sector

CDS Ratings Gap Distributions for FI Subsectors

0

10

20

30

40

50

-8 -7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6

Number of Issuers

0

10

20

30

40

50

Number of Issuers

Banking Insurance Non-Banking Finance

Only 9 of 221banks have positivegaps

88

The Corresponding Opposite Reaction Is That There Are A Lot ofCorporates With Big Positive Gaps. The Market Doesnt Love these


90/149

p g pNames. It just Hates Them Less Than Financials.

Entities with CDS-IR Gaps of +5 and Above

89

Thus, the Current Distributions of CDS Ratings Gaps Looks


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Very Different Than the Historical Average

CDS Ratings Gap Distributions for FIs and Corporates (Aug. 2008)

0%

5%

10%

15%

20%

25%

30%

>8 8 7 6 5 4 3 2 1 0 -1 -2 -3 -4 -5 -6 -7 -8


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Corporate Bond Market

Bond Ratings Gap Distributions for FIs and Corporates (Aug. 2008)

0%

5%

10%

15%

20%

25%

>8 8 7 6 5 4 3 2 1 0 -1 -2 -3 -4 -5 -6 -7 -8


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g y , gAfter the BSC and Frannie Rescues

Market Metrics and Moodys Ratings for Selected FIs

92

RBS as an Example: Its CDS Spread Has Widened Together with theBaa2 Median Spread, Although It Had a Brief Rally Around the Time

f th BSC B il t


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of the BSC Bailout

RBS CDS Spread and the Baa2 Median Credit Spread

0

25

50

75

100

125

150

175

200

225

Jul04 Jan05 Jul05 Jan06 Jul06 Jan07 Jul07 Jan08 Jul080

25

50

75

100

125

150

175

200

225

Baa2 Royal Bank of Scotland

Spread (bp)Spread (bp)

93

So its CDS-Implied Rating has Remained Mostly in theB R


95/149

Baa Range

Moodys Rating and CDS-Implied Rating for RBS

94

What Lies Behind this Wholesale Spread Wideningf FI i th CDS M k t?


96/149

for FIs in the CDS Market?

Continued expectations of bad news around FIs and the

tendency of the sector to trade as a block

The failure of earlier attempts to pick winners

Balance sheet opaqueness

Where does too big to fail stop?

Bottom fishing by investors via purchasing portfolios

of assets, and not by selling protection on entities.

Drivers of Market Behavior

95

One Way to Analyze Ratings Gaps for Financial Institutionsis in Relation to the Sector Averages. For Banks, -4 Becomesh


97/149

the New Zero.

Average CDS-IR ratings gaps for key sectors

-5 -4 -3 -2 -1 0 1 2 3 4 5

BANKING

BASIC INDUSTRY

COMMUNICATION & TECHNOLOGY

CONSUMER CYCLICAL

CONSUMER NON CYCLICAL

ELECTRIC & GAS

ENERGY

INSURANCE

NON BANKING FINANCE

TRANSPORTATION

7/31/2008 8/29/2008

96

As we have Seen, Moodys Ratings Actions Followthe Market Although with More Discrimination


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the Market, Although with More Discrimination

Entities with CDS-IR Gaps of -5 and Below

0

40

80

120

160

200

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

No. of Issuers

0

40

80

120

160

200

No. of Downgrade

Financials (LS) No. of Downgrade (FI, RS)

97


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Appendix I: SelectedFinancial Institutions with

Large Negative RatingsGaps

Selected FIs with Large CDS-Implied Ratings Gaps


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Selected FIs with Large CDS Implied Ratings Gaps

CDS-IR Organization Name Moody's Rating Outlook CDS-IR Gap CDS Spread (bp)

Baa1 Alliance & Leicester plc A1 RUR -3 108

American Financial Group, Inc. Baa2 STA 1 102

AMP Bank Limited A2 STA -2 103

AXA A2 STA -2 102

Banco Bilbao Vizcaya Argentaria, S.A. Aa1 STA -6 100

Banco Santander Central Hispano, S.A. Aa1 STA -6 102

Bank One, National Association Aaa STA -7 116

Berkshire Hathaway Finance Corporation Aaa STA -7 100

CALYON Aa1 RUR -6 101

Citibank, N.A. Aa1 NEG -6 112

Credit Agricole S.A. Aa1 RUR -6 100

Fortis Bank Nederland (Holding) N.V. Aa3 STA -4 122

ING Groep N.V. Aa2 STA -5 112

JPMorgan Chase & Co. Aa2 STA -5 122

Le Credit Lyonnais S.A. Aa1 RUR -6 100

Nationwide Financial Services, Inc. A3 STA -1 115

99

S l t d FI ith L CDS I li d R ti G ( t )


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Selected FIs with Large CDS-Implied Ratings Gaps (cont.)

CDS-IR Organization Name Moody's Rating Outlook CDS-IR Gap CDS Spread (bp)Baa1 Prudential Insurance Company of America A1 STA -3 118

Royal Bank of Canada Aaa STA -7 105

SEB AB Aa2 POS -5 110

St.George Bank Limited Aa2 RUR -5 101

Baa2 AEGON N.V. A2 STA -3 154Banco BPI S.A. A1 STA -4 141

Banco Espirito Santo, S.A. Aa3 STA -5 132

Bank of America Corporation Aa2 NEG -6 139

Barclays Bank PLC Aa1 NEG -7 140

BAWAG P.S.K. Baa1 STA -1 154

China Development Bank A1 STA -4 149

JPMorgan Chase Bank, NA Aaa STA -8 124

National Westminster Bank PLC Aa1 STA -7 135

Natixis Aa3 STA(m) -5 155

Royal Bank of Scotland Group plc Aa2 STA -6 129

Swedbank AB Aa2 NEG -6 125

U.S. Bancorp Aa2 STA -6 142

100



102/149

Se ected s t a ge C S p ed at gs Gaps (co t )


Baa2 UBS AG Aa2 STA -6 136

Wells Fargo & Company Aa1 STA -7 132

Baa3 Allied Irish Banks, p.l.c. Aa2 STA -7 179

Citigroup Inc. Aa3 NEG -6 180

Goldman Sachs Group, Inc. (The) Aa3 STA -6 166

Industrial Bank of Korea Aa3 STA -6 216

Korea Development Bank Aa3 NEG(m) -6 191

Lloyds TSB Group plc Aa1 STA -8 189

MetLife, Inc. A2 STA -4 214

Nationwide Building Society Aa2 NEG -7 166

Northern Rock plc A2 DEV -4 186

Skipton Building Society A2 STA -4 177

SunTrust Banks, Inc. A1 STA -5 165

Yorkshire Building Society A2 STA -4 185

Ba1 American Express Company A1 RUR -6 247

American Express Credit Corporation Aa3 RUR -7 246

Bank of India Baa2 STA -2 238

Bank of Ireland Aa2 STA -8 225

101



103/149

g p g p ( )


Ba1 Bank of Scotland Aa1 NEG -9 237

BES Finance Ltd. Aa3 STA -7 242

Britannia Building Society A2 STA(m) -5 308

Caja de Madrid Aa1 STA -9 260

HBOS plc Aa2 NEG -8 236

Irish Life & Permanent plc Aa3 NEG -7 245

Morgan Stanley A1 STA -6 236

Ba2 Capital One Bank A2 STA -6 369

Countrywide Financial Corporation Aa2 NEG -9 367

HSBC Finance Corporation Aa3 STA -8 314

Lehman Brothers Holdings Inc. A2 NEG -6 335

Merrill Lynch & Co., Inc. A2 STA -6 322

Wachovia Bank, N.A. Aa2 NEG -9 316

Wachovia Corporation A1 NEG -7 318

Ba3 Bradford & Bingley plc Baa1 RUR -5 444

B1 IKB Deutsche Industriebank AG Baa3 RUR -4 538

102

Selected FIs with Large CDS Implied Ratings Gaps (cont )


104/149



B1 Landsbanki Islands hf A2 STA -8 505

B2 Financial Security Assurance Holdings Ltd. Aa2 RUR -12 680

Financial Security Assurance Inc. Aa1 RUR -13 610

Kaupthing Bank hf A1 STA -10 785

B3 Ambac Assurance Corporation A1 NEG -11 1140

Glitnir banki hf A2 STA -10 897

MGIC Investment Corporation Baa1 NEG -8 977

Caa1 Alliance Bank Ba2 RUR -5 1233

Ambac Financial Group, Inc. A3 NEG -10 1470

Capmark Financial Group Inc. Baa3 STA -7 1527

Ford Motor Credit Company LLC B1 NEG -3 1454

MBIA Inc. Baa2 NEG -8 1257

MBIA Insurance Corporation A3 NEG -10 1295

National City Corporation A3 STA -10 1200

PMI Group, Inc. (The) Baa3 NEG -7 1257

Washington Mutual Bank Baa2 RUR -8 1590

Washington Mutual, Inc. Baa3 RUR -7 1607

Caa2 GMAC LLC B3 NEG -2 2127

103

Selected FIs with Large CDS Implied Ratings Gaps (cont )


105/149



Ca Radian Asset Assurance, Inc. Baa1 NEG -12 2645

Radian Group Inc. Ba1 NEG -9 2700

C CIFG Assurance North America, Inc. Ba3 RUR -8 3903

FGIC Corporation Caa2 NEG -3 6820

Financial Guaranty Insurance Company B2 NEG -6 3764

Residential Capital, LLC Ca RUR -1 8555

104


106/149

Appendix II: AdditionalMIR-based Default

Analysis

Measuring Ratings Power to DiscriminateBetween Defaulters and Non-Defaulters


107/149

Between Defaulters and Non Defaulters

Introducing the Cumulative Accuracy Profile (CAP) Curve

45 degree line

Accuracy Ratio Definition

AR = A/(A+B)

B A

One Year Horizon

106

Markets are generally good 1-Year Identifiers ofDefault Risk


108/149

1-Year Accuracy Ratios, Calculated on a Matched Pair Basis*

* Each cell only contains issuers that appear in both datasets on a per cohort basis

107

While The Performance of Moodys RatingsImproves on a 3-year Horizon


109/149

p y

3-Year Accuracy Ratios, Calculated on a Matched Pair Basis*

* Each cell only contains issuers that appear in both datasets on a per cohort basis

108

The Bond and Equity Markets-based Accuracy Ratios HaveTracked Each Other Over Time


110/149

One Year Horizon

BIR and EIR Accuracy Ratios vs. the SPX and HY Def. Rate

50%

60%

70%

80%

90%

100%

110%

120%

2000 2001 2002 2003 2004 2005 2006 2007 2008

0%

2%

4%

6%

8%

10%

12%

SPX (LS) BIR (LS) EIR (LS) Global HY Default Rate (RS)

109

Implied Ratings Momentum Strengthens theDefault Signal


111/149

Default Signal

HY Def. Rates Conditioned on BIR Momentum* and Ratings Gaps

* Momentum means a BIR change of 2 notches or more in a positive (upward) or

negative (downward) direction in the previous 3 months

0%

5%

10%

15%

20%

=4 3 2 1 0 -1 -2 -3 =-4# of Notches BIR Above Moody's Ratings (Today)

1

YrDefaultRate

.

Upward Momentum Unconditioned on Momentum Downward Momentum

*3 Month Momentum

Focus ondownwardmomentummore thandoubles the

signal

110

The Impact of the Mortgage Crisis on theC dit St di d R l ti V l f


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Credit Standing and Relative Values ofFinancial Institutions

Michael Love

[email protected]

Credit Strategy Group

Agenda


113/149

First thoughts on Lehman failure

Review of spread and MIR performance

Review of the fundamentals

Market confidence and mark-to-market accounting

Housing market bottoming?

Looking ahead

112

Lehman's Failure will Redefine Too Big to Fail


114/149

The Treasury and Federal Reserve decided not to

support the takeover of Lehman Brothers

Lehman's failure was largely the result of unprecedented

and sudden illiquidity of mortgage assets

The Chapter 11 filing may ease selling pressure on theseassets, but will likely also reduce the appetite of buyers

of the assets

The redefinition of too big to fail will cause investors

reexamine spreads of financial institutions

113

The Fed Took a Calculated Risk


115/149

The Federal Reserve has been at Lehman since Bear

Stearns failed it should have a good idea of counterpartyrisk

The Fed found it necessary to expand the lending

facilities

The BOA takeover of Merrill provides a firewall

Debt refinancing and equity risk for financials

Will market attack other financials if there is modestability for them to fight back

114

Lehmans Failure will Reshape the US FILandscape


116/149

p

Good time for financials that are strong

Very bad for FIs that may need to raise capital

May need to sell themselves

Consolidators

Bank of America with Countrywide and Merrill

JPM with Bear Stearns and possibly WAMU

Near-term focus WAMU and AIG

115

Review of the Financial Meltdown of FIs


117/149

Financial firms have taken MTM losses largely on

mortgage assets

Desire to sell assets with MTM risk puts further

pressure on asset prices

FIs must raise capital to replace MTM losses Once FIs have difficulty raising capital confidence

collapses

116

Modest Improvement in Insurance, Continued Declinein Banks CDS-IRs in August


118/149

CDS-IR Change by Sector - 7/31 to 8/29

-0.6 -0.4 -0.2 0.0 0.2 0.4 0.6

BANKING

BASIC INDUSTRY

COMMUNICATION & TECHNOLOGY

CONSUMER CYCLICAL

CONSUMER NON CYCLICAL

ELECTRIC & GAS

ENERGY

INSURANCE

NON BANKING FINANCE

TRANSPORTATION

AverageCDS-IR Falls CDS-IR Rises

117

Financials CDS-IRs: Still the Widest NegativeGaps


119/149

CDS-Implied Gap by Sector (Matched)

-5 -4 -3 -2 -1 0 1 2 3 4 5

Banking

Basic Industry

Communication & Technology

Consumer Cyclical

Consumer Non Cyclical

Electric & Gas

Energy

Insurance

Non Banking Finance

Transportation

7/31/2008 8/29/2008

118

Average MIR Gaps of Global Banks Very LargeHistorically


120/149

y

Average Ratings Gaps of Global Banks

-7.0

-6.0

-5.0

-4.0

-3.0

-2.0

-1.0

0.0

1.0

Apr-01

Jul-0

1

Oct

-01

Jan-02

Apr-02

Jul-0

2

Oct

-02

Jan-03

Apr-03

Jul-0

3

Oct

-03

Jan-04

Apr-04

Jul-0

4

Oct

-04

Jan-05

Apr-05

Jul-0

5

Oct

-05

Jan-06

Apr-06

Jul-0

6

Oct

-06

Jan-07

Apr-07

Jul-0

7

Oct

-07

Jan-08

Apr-08

Jul-0

8

BIR Gap CDS Gap EIR Gap

119

CDS-IR Gaps for Biggest Banks In the WorldWhat Happened to Too Big to Fail ?


121/149

pp g

Moodys Sr.

Ratings

CDS-implied

Ratings

CDS Gap

6/3v9/08

-6-5Baa2Aa2Bank of America Corp USA-6-5Baa2Aa2JPMorgan Chase USA

-5-1A3Aa1Deutsche Bank

-3-3A1Aa1BNP Paribas France

-5-6A3Aa1Crdit Agricole France

-3-4A2Aa2HSBC Hold. United Kingdom

-4-5A3Aa2Mizuho Trust Japan

-6-6Baa3Aa3Citigroup USA

-6-7Baa2Aa2UBS AG Switzerland

Banks

120

Credit Spreads Reflect US Financial InstitutionsCredit Ratings Trends at Moodys


122/149

Credit Ratings Trends at Moody s

Over 90 Negative Ratings Actions for US Financials FirstHalf of 2008

~50 Ratings Downgrades

Less Than 30 Positive Ratings Actions for US Financials

First Half of 2008 -------only 6 ratings upgrades

However in almost every case, ratings downgrades did

not come anywhere near levels indicated by the Market-

implied Ratings

121

Allowance for Loan Losses is Rising


123/149

Loss allowance to loans ratio

0.80%

1.00%

1.20%

1.40%

1.60%

1.80%

2.00%

3Q06 4Q06 1Q07 2Q07 3Q07 4Q07 1Q08 2Q08

Loss allowance to loans ratioSource: FDIC

122

Asset Quality is Worsening Quickly


124/149

% of Assets in Nonaccrual Status

0.00%

0.20%

0.40%

0.60%

0.80%

1.00%

1.20%

3Q06 4Q06 1Q07 2Q07 3Q07 4Q07 1Q08 2Q08

Source: FDIC Website

Source: FDIC

123

Capitalization Ratios Shrinking Over Time


125/149

Capital Ratios Have Stabilized for now atLargest US Banks:

Tier 1 risk-based capital ratio

8.30%

8.40%

8.50%

8.60%

8.70%

8.80%

8.90%

9.00%

9.10%

9.20%

9.30%

3Q06 4Q06 1Q07 2Q07 3Q07 4Q07 1Q08 2Q08

Tier 1 risk-based capital ratioSource: FDIC

124

Profits Decline From Credit Costs


126/149

Return on Assets is Worsening for Largest Banks:

Return on Average Assets (%)

Return on assets (ROA)

0.00%

0.20%

0.40%

0.60%

0.80%

1.00%

1.20%

1.40%

1.60%

3Q06 4Q06 1Q07 2Q07 3Q07 4Q07 1Q08 2Q08

Return on assets (ROA)Sourc e: FDIC

125

Confidence Remains VERY Fragile


127/149

Major Brokers and Banks Can Not Operate Effectively

Without Strong Credit Ratings

Threat to their Business Model is Where Ratings

Approach Threshold Where Counterparties Flee

Broker Ratings direction appears to be towards single-Afor some broker

Fed Chairman has openly spoken of haircuts for debt

holders in financial rescues

Rumors can cause major moves in equity prices

Mark-to-market requires ability raise equity capital

126

Bear Stearns MIRs Widened in Early 2007


128/149

Moodys Ratings and implied ratings for Bear Stearns

127

Lehman Brothers MIRs has Fallen Amidst aNervous Market


129/149

Lehman Brothers

128

US Residential Mortgage Delinquency Rate Growth Slowed inthe Second Quarter


130/149

Overall Delinquency Rate

4.0

4.5

5.0

5.5

6.0

6.5

Sep 05 Dec 05 Mar 06 Jun 06 Sep 06 Dec 06 Mar 07 Jun 07 Sep 07 Dec 07 Mar 08 Jun 08

Percent (%)

Source: Mortgage Bankers Association

129

Subprime Delinquency Rate May Have Peeked


131/149

Subprime Delinquency Rate

10

12

14

16

18

20

22

24

Sep 05 Dec 05 Mar 06 Jun 06 Sep 06 Dec 06 Mar 07 Jun 07 Sep 07 Dec 07 Mar 08 Jun 08

Percent (%)

Source: Mortgage Bankers Association

130

Home Inventories Though Elevated are Showing Signs ofStabilization


132/149

Home Inventories

2

4

6

8

10

12

14

16

18

20

Jul 07 Aug 07 Sep 07 Oct 07 Nov 07 Dec 07 Jan 08 Feb 08 Mar 08 Apr 08 May 08 Jun 08 Jul 08

y/y growth (%)

Source: National Association of Realtors

131

Home Affordability is Improving


133/149

90

100

110

120

130

140

4Q00 2Q01 4Q01 2Q02 4Q02 2Q03 4Q03 2Q04 4Q04 2Q05 4Q05 2Q06 4Q06 2Q07 4Q07 2Q08

Home Affordability

Source: National Association of Realtors

132

Home Prices Showing Signs of Slower Price Decline


134/149

Case-Shiller Composite of 20 Home Price

-18%

-16%

-14%

-12%

-10%

-8%

-6%

-4%

-2%

0%

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

-18%

-16%

-14%

-12%

-10%

-8%

-6%

-4%

-2%

0%

Composite-20 (y/y%) 3-month Change (%)

133

Continuing Asset Quality Risks Loom Large


135/149

Commercial Real Estate Concentrations: Builders and

Developers a rising concern

Option ARM Recasts & I/O Resets

Leveraged Loans and Undistributed LBO debt

Consumer Loans: HELOC, Card, Auto, Installment

Increasing Corporate Bond Default Rate

Economic Climate: Recession-Mild or Worse ?

Employment, Wages and Pain at the Pump

134

Auto Loans Weaken


136/149

U.S. Auto Loan Delinquency Rates

Prime+Subprime 90 Days Past Due

0.10

0.12

0.14

0.16

0.18

0.20

0.22

1998Q1

1998Q4

1999Q3

2000Q2

2001Q1

2001Q4

2002Q3

2003Q2

2004Q1

2004Q4

2005Q3

2006Q2

2007Q1

2007Q4

2008Q3

Source: Moodys Economy.Com

134

And so do Credit Cards


137/149

U.S.Credit Card Delinquency Rates

Prime+Subprime 90 Days Past Due

0.40

0.45

0.50

0.55

0.60

0.65

0.70

0.75

0.80

0.85

1998Q1

1998Q4

1999Q3

2000Q2

2001Q1

2001Q4

2002Q3

2003Q2

2004Q1

2004Q4

2005Q3

2006Q2

2007Q1

2007Q4

2008Q3

Source: Moodys Economy.Com

136

Past Crises Have Resulted in Bank Failures


138/149

U.S. Bank Failures, 1934-2007

137

Assets of Problem Institutions Below Peak Level of PreviousBank Cycle


139/149

Problem Institutions (Assets US $ bn)

0

200

400

600

800

1,000

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

US $ bn

Assets

Source: FDIC

138

Could History Repeat Itself ?


140/149

Several Investment Banks Collapsed or

Were Rescued in Financial Crises of 1980s

First Boston, Pru-Bache, Drexel Burnham, Kidder

Peabody, Shearson-Lehman Brothers

Major Bank Collapses of 1980sBank of New England, M-Bank, First City, Penn Square,

Republic Bank, Southeast Bank of Miami, Continental

Illinois, Crocker, Seafirst, Interfirst, First Pennsylvania,

Bank of Boston

139

Brokers have modest business prospects overthe near-term


141/149

Brokers businesses are weak cyclically and strructurally

M&A fees have evaporated unlikley to rebound soon or

quickly

Structuring business likley permanenetly changed and

less profitable Like the internet business model will come back in a form

that makes sense

Underwriting is weak and not likley to rebound before

the financial system, recovers

140

Banks have good business prospects, but newareas of weakness


142/149

More lending will be done on balance sheet in near

future

Less competition from structured securities

Favors banks and should help core earnings

Premium on deposits as other funding costs likely toremain somewhat elevated

Margins should be higher for lending in upcoming credit

cycle

Consumer asset quality exposure offsets some of the

strengths

141

Raising Capital to Offset Losses


143/149

Subprime Global Write-downs now Exceed $500 Billion-

..and still counting

Many Wall Street estimates of total write-offs related to

Subprime reach $400-$600 billion over 3 years

Banks and Brokers have raised over $360 billion ofcommon and hybrid equity

Raising capital in future may get tougher as investors

have been burned

Many FIs running up against hybrid capital limit and face

large debt refinancing schedule

Source: Bloomberg data 9/08/08

142

Refinancing Risk is High for Major FinancialInstitutions


144/149

-

5,000

10,000

15,000

20,000

25,000

30,000

35,000

40,000

45,000

50,000

Citigroup Merill Lynch Wachovia Bank Of

America

Washington

Mutual

Morgan

Stanley

JP Morgan

Chase

Wells Fargo Lehman

Brothers

2008 2009

Source: Bloomberg

143

Spreads Tightened in Last Bank Cycle BeforeProvisions Declined


145/149

0

50

100

150

200

250

6/30/89

12/2

9/89

6/29/90

12/3

1/90

6/28/91

12/3

1/91

6/30/92

12/3

1/92

6/30/93

12/3

1/93

6/30/94

12/3

0/94

OAS

(Bp)

0

5

10

15

20

25

30

35

40

Billio

nsofDollars

Provision OAS- Financials

Source: FDIC and Lehman

144

US Government Decisions to Influence Path toRecovery


146/149

Fannie and Freddie may be run to aid housing market

recovery to a greater degree (e.g., lower guaranteefees)

FHA program to help distressed borrowers could help

banks balance sheets and home inventories

Open market purchases of MBS could ultimately lower

mortgage rates and stop or reverse some write-downs

Rebuilding of the FDIC insurance fund will need

creativity

145

How Will Financials Credit Spreads Recoverand Market-implied Ratings Improve ?


147/149

Speculators Have Begin to Bottom Fish for Acquisition

Targets, Recapitalized Companies or Financials DeemedToo Big to Fail

Best Companies Are Beginning to Experience Credit

Spreads Stability- as a Flight to Quality Investment

Financials Need to be Able to Prove Their Write-Offs

are Over or at Least Manageable and Loan Quality OK

As a Consensus Builds for a Recovery in the Economy

and Housing, a Sector Rotation Will Tighten Spreadsfor all Financials.

146

Lessons for Credit Spread Recovery ?


148/149

Disagreements Between MIRs and Moodys Ratings Tend to

Narrow Over Time- Markets Tend to Overshoot on Both Positiveand Negative News

Changes in MIR-Gaps Reflect Changes in Investor Sentiment

Spreads will recover before the worse is over

Large high quality US banks look cheap especially during bouts

of spread widening among financials

However, any financial that might need to raise equity capital

should be avoided

Fundamentals and accounting issues look better going forward,

refinancing risk is greater147


149/149

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