Disclaimer

Good day, everyone, and welcome to todays Moodys Capital Markets Research Live Webcast Where are we in the credit cycle? Todays programme is being recorded. 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. We ask 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.

Agenda
09:00 BST Opening Remarks 09:10 BST Outlook for the European economies and key credit indicators Ruth Stroppiana - Chief International Economist, Moody's Economy.com 09:55 BST Outlook for the US economy and key credit indicators John Lonski - Managing Director and Chief Economist, Capital Markets Research Group 10:40 BST Break 10:55 BST Signals of risks and opportunities from the capital markets David Munves - Divisional Managing Director, Capital Markets Research Group 11:40 BST Key sector analysis Michael Love - Director and Financial Institutions Analyst, Capital Markets Research Group 12:25 BST Closing Remarks

Where Are We In the Credit Cycle?

Capital Markets Research Group

Economy.com
September 2008

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

Outlook for the European Economies and Key Credit Indicators

Presented by: Ruth Stroppiana, Chief International Economist September, 2008

Presentation Overview

Mounting cost of the subprime debacle and subsequent credit squeeze in Europe The credit cycle in Western Europe:

Where are we?

Where are we going?

Economic Outlook and risks

Euro Zone
United Kingdom

Impact of the Credit Squeeze in Europe

Subprime Write-Downs and Losses High in Europe

Subprime write-downs and capital raised, US$ billions
600 Worldwide 500 400 300 200 100 0 Writedowns and credit losses Capital raised
6

U.S.

Europe

Asia

Source: Bloomberg

Global Financial System Still Stressed

Spread: monetary policy rate and 3 month Libor, basis points
100 90 80 70 60 50 40 30 20 10 0 Jan 07 Mar 07 May 07 Jul 07 Sep 07 Nov 07 Jan 08 Mar 08 May 08 Jul 08
7

U.S.

U.K

Euro zone

Credit Cycle: Where are We? Where Are We Going?

Financial Sector Driving Down Credit Quality

Share of upgrades in Western Europe, 12 month rolling ratio
100% Non-Financial 80% 60% 40% 20%
Source: Moodys Credit Trends

Financial

Total

0% 00 01 02 03 04 05 06 07 08
9

Investment and Speculative-Grade Under Pressure

Share of upgrades in Western Europe, 12 month rolling ratio
100% Investment-Grade 80% 60% 40% 20%
Source: Moodys Credit Trends

Speculative-Grade

Total

0% 00 01 02 03 04 05 06 07 08
10

Corporate Spreads Continue to Climb

Euro composite corporate bond spread, basis points
200 175 150 125 100 75 50 25 0 Jan-07 Apr-07 Jul-07 Oct-07 Euro Investment Grade Spread (L) Euro High Yield Spread (R ) 900 800 700 600 500 400 300 200

Source: Lehman Brothers

100 0

Jan-08

Apr-08

Jul-08
11

Bond Issuance Weakens in Western Europe

Annual issuance volume, US$ billions
250 200 150 100 50 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 YTD
12

Investment grade Speculative grade

Source: Moodys Credit Trends

Corporate Outlook in Western Europe Has Weakened

Share of positive outlook changes, 12 month rolling ratio
100% Total 80% 60% 40% 20%
Source: Moodys Credit Trends

100% Non-Financial Financial 80% 60% 40% 20% 0% Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08
13

0% Jan-02

Downturn in the Credit Cycle Looks Set to Continue

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 <1% currently. Elevated credit premiums will continue to dampen businesses' hiring and expansion plans, further constraining global demand. Downturn in the credit cycle is expected to continue as macroeconomic conditions deteriorate in Western Europe.

14

Economic Outlook: Euro Zone and United Kingdom

Testing Times Ahead for the Euro Zone Economy

Real GDP growth
6 GDP % change 5 4 3 2 1 0 -1 00 01 02 03 04 05 06 07 08F 09F 10F
16

GDP % change year ago

Forecast

Activity will Slow Sharply Across Most of the Region

Real GDP, % change year ago
Ireland Luxembourg Finland Greece Spain Netherlands Austria Belgium Germany France Portugal Italy 0 1 2 3 4

2007 2008F 2009F

6
17

Growth Grinds to a Halt in the U.K.

Real GDP growth
5 GDP % change 4 3 2 1 0 -1 00 01 02 03 04 05 06 07 08F 09F 10F
18

GDP % change year ago

Forecast

Britains Troubled Housing and Mortgage Markets

160 140 120 100 80 60 40 20 0 00 -10 -20 20 10 0 40 30

Mortgage approvals, ths (L) Halifax average house price, % change year ago (R)

01

02

03

04

05

06

07

08
19

Labour Markets Still SupportiveBut Will Weaken

Unemployment rate, %
10.0 9.0 8.0 7.0 6.0 5.0 4.0 00 01 02 03 04 05 06 07 08
20

Euro zone

United Kingdom

High Consumer Prices Hits Households Budgets

CPI, year ago % change
5 4 3 2 1 0 00 01 02 03 04 05 06 07 08
21

Euro zone

United Kingdom

Corporate Profits Squeezed by Surge in Input Costs

PPI, year ago % change
12 10 8 6 4 2 0 -2 00 01 02 03 04 05 06 07 08
22

Euro zone

United Kingdom

Pullback in Commodity Prices Expected to Continue

WTI crude oil, $/barrel
140 120 100 80 60 40 20 0 00 01 02 03 04 05 06 07 08F 09F 10F
23

Forecast

Aggressive Monetary Easing Will Be Required

Key monetary policy rates
6

5 ECB policy rate 4 BoE repo rate

2 Jan06

Apr06

Jul06

Oct06

Jan07

Apr07

Jul07

Oct07

Jan08

Apr08

Jul08
24

Euro and Pound Will Extend Slide Against the Dollar

2.2 USD/EUR 2.0 1.8 1.6 1.4 1.2 1.0 0.8 00 01 02 03 04 05 06 07 08F 09F 10F
25

USD/GBR

Forecast

Weak Business Confidence Remains a Concern

Diffusion business confidence index, 4 wk. MA
40 30 20 10 0
Source: Moodys Economy.com Survey of Business Confidence

Europe

North America

Asia Pacific

South America

-10 Jun 07

Aug 07

Oct 07

Dec 07

Feb 08

Apr 08

Jun 08

Aug 08
26

Western Europe Still Reliant on the U.S.

Real GDP, % change year ago, 4 quarter MA
6 5 4 3 2 1 0 00 01 02 03 04 05 06 07 08F 09F 10F
27

World Euro Zone

United States United Kingdom

Forecast

In Summary,

Risks to economic growth and the credit cycle in Western Europe 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

www.economy.com

A Macro View of the US Corporate Credit Cycle

Presented by: John Lonski,

Chief Economist

September 2008

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

Prospects For US Consumer Spending, Capital Spending And Exports

Yearly Percentage Point Change of Unemployment Rate Puts the US in a Recession

1.6 1.1 0.6 0.1 -0.4 -0.9 -1.4 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 Signal Weak Spending, but Employment Income Tops Pace of Jun-01 through Jun-03: 6 month averages
24 7.5 19 5.5

14

3.5

1.5

-1
Feb-95 Oct-96 Jun-98 Feb-00 Oct-01 Jun-03 Feb-05 Oct-06 Jun-08

-0.5 Consumers' Income Expectations Index ( L ) Employment Income: YoY % change ( R )

34

Deceleration of Employment Income Weakens Prospects for Retail Sales

9 8 7 6 5 4 3 2 1 9 8 7 6 5 4 3 2 1

0 0 Jun-93 Feb-95 Oct-96 Jun-98 Feb-00 Oct-01 Jun-03 Feb-05 Oct-06 Jun-08 Retail Sales Employment Income
35

YY % change of 6-mo. averages

2008 Should be the Worst of Nine Straight Annual Setbacks for Domestic Unit Sales of the US' Big 3Transplants Will Outperform US' Big 3 for 10th Straight Year in 2008
YoY % change of unit sales of cars and light trucks sold in the US
US Built: Foreign-Owned Transplants 3b 20.2 6.2 11.8 -0.8 2.5 7.8 2.7 2.9 -2.8 5.9 10.5 5.3 -3.6 2.5 -6.1

Total 1 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Jan-Aug 08 8.4 -2.2 2.5 0.2 2.8 8.7 2.7 -1.0 -2.3 -1.0 1.1 0.8 -2.3 -2.8 -12.2

Imports 2 -0.8 -11.0 -10.2 13.7 4.5 22.4 14.9 8.0 6.0 1.0 1.8 2.7 12.6 2.8 -4.5

US Built 3 10.0 -0.7 4.4 -1.6 2.5 6.6 0.6 -2.7 -4.1 -1.4 0.9 0.3 -6.0 -4.4 -14.6

US Built: Big Three 3a 8.4 -1.5 1.7 -1.6 2.5 6.4 -1.6 -4.6 -4.6 -3.7 -2.3 -1.6 -7.0 -7.5 -18.8

36

Home Price Deflation Worry Stops Improved Home Affordability From Steadying Home Sales Lower Mortgage Yields to Boost Affordability: YoY % change of 6-mo. avgs.
16.2 15.5 10.5 5.5 6.2 0.5 1.2 -4.5 -9.5 -14.5 -8.8 -19.5

11.2

-3.8

-13.8 -24.5 Jul-88 Sep-90 Nov-92 Jan-95 Mar-97 May-99 Jul-01 Sep-03 Nov-05 Jan-08 Home Affordability Index ( L ) Total Sales of 1-Family Homes ( R )
37

Bottoms -- and little else -- Materialize for Indices of Pending and Actual Sales of Existing Homes
130
Pending Sales of Existing Homes: index

125 120 115 110 105 100 95 90 85

7,200
Unit Sales of Existing Homes: (000s)

6,700

6,200

5,700

5,200

80 4,700 Sep-01 Jul-02 May-03 Mar-04 Jan-05 Nov-05 Sep-06 Jul-07 May-08 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 Worth and Real Consumer Spending is a Significant, but far from Impressive, 0.42

15.5

5.2

10.5

4.2

3.2 5.5 2.2 0.5 1.2 -4.5

0.2

-9.5

-0.8

85 Q 86 4 Q 87 4 Q 88 4 Q 89 4 Q 90 4 Q 91 4 Q 92 4 Q 93 4 Q 94 4 Q 95 4 Q 96 4 Q 97 4 Q 98 4 Q 99 4 Q 00 4 Q 01 4 Q 02 4 Q 03 4 Q 04 4 Q 05 4 Q 06 4 Q 07 4 Q 4
Household Net Worth: YoY % dif ( L ) Real Consumer Spending: YoY % dif ( R )
39

Capital Spending's Resilience May Limit the Downside for Payrolls Employment
13 3.4

Real Business Capital Spending

9 2.4 5 1.4 1 0.4 -3 -0.6

-7

-11 85Q4 87Q4 89Q4 91Q4 93Q4 95Q4 97Q4 99Q4 01Q4 03Q4 05Q4 07Q4 Real Business Capital Spending Payroll Jobs

-1.6

YoY % dif of yearlong sums

40

Payroll Jobs

Rapid Growth of Business Outlays on Structures Should Fade Impact of Slow Economy on Cap Ex May Not Be Apparent Until Year's End Cap Ex Should Avoid Collapse of 01-02
Total Business Fixed-Investment Spending
1

Business Structures
2

Software
3

Information Technology Equipment

4

Computer Equipment
4a

Equipment excluding Info Tech

5

Industrial Equipment
5a

Transportation Equipment 5b

Amount in $ billions: (nominal)

2007 1,504 480 227 290 94 506 8.2 5.5 181 157

Average annualized % change: 1993-2000 9.1 2003-2007 7.1 YoY % change: 2001 2002 2003 2004 2005 2006 2007 H1-08 07Q2 07Q3 07Q4 08Q1 08Q2 -4.5 -9.4 1.0 7.2 10.3 11.1 6.3 5.9 6.1 6.3 7.1 6.7 5.2

7.7 11.5 3.0 -13.5 -0.7 7.6 13.2 21.6 17.0 16.1 15.7 16.1 17.2 16.3 15.9

14.9 6.3 -0.9 -4.0 2.2 6.8 6.6 5.5 10.5 10.6 10.9 11.0 11.5 10.8 10.4

9.4 4.6 -10.0 -11.7 1.5 4.8 3.9 7.9 5.0 5.2 4.8 3.9 7.9 4.5 5.9

11.0 3.9 -15.8 -9.5 7.0 3.2 1.7 8.7 5.5 3.6 4.2 3.8 7.8 3.6 3.6

7.0 5.9 -7.9 -7.5 3.7 -0.7 12.4 9.0 5.5 2.3 6.3 7.3 3.7 5.8 -1.0

10.1 4.5 -11.9 -10.9 -6.3 20.8 15.1 7.6 -11.1 -18.9 -9.7 -12.3 -14.4 -15.5 -22.5
41

-7.6 -7.1 1.5 8.4 13.5 7.7 -3.0 -4.9 -2.6 -2.3 -3.5 -2.5 -7.4

Correlation Coefficient Between Core Capital Goods Orders and Business Investment Spending on Equipment is a Solid 0.88
13.0

Nondefense Capital Goods Orders ex Aircraft

11.0 9.0 6.0 5.0

1.0

1.0

-3.0 -4.0 -7.0 -9.0 -11.0 -14.0 -15.0

-19.0
85Q4 88Q1 90Q2 92Q3 94Q4 97Q1 99Q2 01Q3 03Q4 06Q1 08Q2

-19.0 Nondefense Capital Goods Orders ex Aircraft Business Investment Spending on Equipment: nominal

YoY % change of moving yearlong observations

42

Business Investment Spending

Plunge by Architectural Billings Index Warns of a Late 2008 Contraction by Real Spending on Business Structures
13 8 3 -2 -7 -12 -17 57 55 53 51 49 47 45

-22 43 Jun-96 Dec-97 Jun-99 Dec-00 Jun-02 Dec-03 Jun-05 Dec-06 Jun-08 Real Business Investment Spending on Structures: YY % change of 6-mo. avg. AIA's Architectural Billings Index: 6-mo. avg. ( R )
43

Diminished Supply of Bank Credit to Businesses Bodes Poorly for Capital Spending: 2-Qtr Avgs.
13 30 8 10 3 -10 -2

-30

-50

-7

-70 90Q4

-12 92Q4 94Q4 96Q4 98Q4 00Q4 02Q4 04Q4 06Q4 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 World Economic Growth Helps Thin US Trade Gap: % change

4.7 3.7 2.7 1.7 0.7 -0.3 -1.3

07 E0 8 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06

World Real GDP Growth: IMF estimate, ( L ) US Real Domestic Spending Growth: ( R )
45

US Merchandise Trade With the EU Still Compares Favorably With 2001's Recession

27.4 22.4 17.4 12.4 7.4 2.4 -2.6 -7.6 -12.6 -17.6

86 Q 4

88 Q 4

90 Q 4

92 Q 4

94 Q 4

96 Q 4

98 Q 4

00 Q 4

02 Q 4

04 Q 4

US Imports from EU

US Exports to EU

YY % change of 6-mo. averages

46

06 Q 4

Likely Direction Of Federal Reserve Policy And Benchmark Interest Rates

A Declining Rate of Labor Market Utilization Favors a Fed Rate Cut

65 10 9 8 7 6 5 4 3 2 1
Mar-87 Mar-90 Mar-93 Mar-96 Mar-99 Mar-02 Mar-05 Mar-08

64

63

62

61

Fed Funds Rate Target ( L )

Employment as % of Working-Age Population

48

Lower Energy Prices Will Soon Slow Headline CPI Inflation Core CPI Inflation Still Lags 2.9% YY Pace of Sep-06
6.5

5.5

4.5

3.5

2.5

1.5

0.5 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 Treasury YieldsShare of Outstanding US Treasury Debt Held by Non-US Investors Rises from 1998's 31% to 2008's 47%
6.8 6.3 5.8 5.3 4.8 4.3 3.8 3.3 2.8 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

Outlook For NonfinancialCorporate Credit Risk Premia

High-Yield Bond Spread Is Priced for Steeper Default RateRising Default Rate Will Limit Any Narrowing of High-Yield Bond Spread
12.5 1,020 920 820 720 620 520 420 2.5 320 220 0.5 Jul-86 Jan-89 Jul-91 Jan-94 Jul-96 Jan-99 Jul-01 Jan-04 Jul-06 Jan-09 US Speculative-Grade Bond Yield Spread: basis points, ( L ) US Speculative-Grade Bond Default Rate: %, act. & proj.
52

10.5

8.5

6.5

4.5

Bonds' Rated B3 or Lower Record Share of High-Yield Bonds Outstanding Supports 800 Basis Point HighYield Bond Spread
47 950 850 750 37 650 550 450 27 350 250 87Q4 22 90Q2 92Q4 95Q2 97Q4 00Q2 02Q4 05Q2 07Q4 Speculative-Grade Yield Spread: basis points ( L ) B3 or Lower as % of Total US High Yield Bonds Outstanding
53

42

32

High Yield Bond Spread Seems Wide Compared to Average EDF Of US' High-Yield CompaniesRelatively Low EDF Follows From Healthier Balance Sheets Compared to 1998-2002
Composite US Speculative-Grade Bond Yield Spread Over Treasuries: basis points

Average Expected Default Frequency Of US NonInvestment Grade Companies: %

13

1,050 950 850

11

9 750 7 650 550 450 3 350 1

Jan- Dec- Nov- Oct- Sep- Aug- Jul-01 Jun- May- Apr- Mar- Feb- Jan- Dec96 96 97 98 99 00 02 03 04 05 06 07 07

250

Average Expected Default Frequency Of US High-Yield Companies: %, EOM US Speculative-Grade Bond Yield Spread Over Treasuries: basis points
54

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 is shaped by the market value of net worth after adjustment for stock price volatility.
55

Both VIX and High-Yield Bond Spread Fall Short of Highs of Previous Credit Market Slump
39 1,050 950 850 29 750 24 650 550 450 14 350 9
Jan-90 May-92 Sep-94 Jan-97 May-99 Sep-01 Jan-04 May-06

34

19

250
Sep-08

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 Volatility and US Economic Slump to Boost % of Defaulted Bonds Not Recovered
% of Defaulted Avg. Sr. Unsecured Bonds NOT Recovered

82 77 72 67 62 57 52 47 42 37 32 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 % of Defaulted Avg. Sr. Unsecured Bonds NOT Recovered Speculative-Grade Bond Yield Spread: basis points

875
Speculative-Grade Bond Yield Spread: basis points

775

675

575

475

375

275

57

High-Yield and Investment-Grade Upgrade Ratios Avoid Lows of Two Previous Slumps: 6-mo. ratio of upgrades to # of rating revisions
66 56 46 36 26 16 6 86Q2 88Q2 90Q2 92Q2 94Q2 96Q2 98Q2 00Q2 02Q2 04Q2 06Q2 08Q2 Recessions are shaded Investment-Grade Upgrade Ratio: %
58

High-Yield Upgrade Ratio: %

Steepest Relative Frequency of High-Yield Downgrades Since H2-02 Helps to Widen High-Yield Bond Spreads
90 950 80 850 750 650 550 50 450 350 250 86Q4 40 70

60

30 89Q2 91Q4 94Q2 96Q4 99Q2 01Q4 04Q2 06Q4

Speculative-Grade Yield Spread: basis points ( L ) Downgrades as % of Number of US High-Yield Company Credit Rating Changes: 6-month ratio ( R )
59

More Downgrades to "Caa3 or Lower" Widen HighYield Bond Spreads

85 75 850 65 750 55 650 45 550 450 350 250 97Q2 35 25 15 5 98Q3 99Q4 01Q1 02Q2 03Q3 04Q4 06Q1 07Q2 08Q3 Speculative-Grade Yield Spread: basis points ( L ) US Downgrades to Caa3 or Lower: count, 6-month sum
60

950

US Upgrade Ratios: Bank & Finance Resembles 19901991 Low, Nonfinancials Sink to Recessionary Level: 6mo. ratio of upgrades to # of rating revisions
86 76 66 56 46 36 26 16 6
86Q2 88Q2 90Q2 92Q2 94Q2 96Q2 98Q2 00Q2 02Q2 04Q2 06Q2 08Q2

Recessions are shaded Nonfinancial-Company Upgrade Ratio: %

Financial Institutions Upgrade Ratio: %

61

Tightness of Supply of Business Credit from Banks Favors Wide High-Yield Bond Spreads
69 49 29 9 -11 450 -31 -51 90Q4 350 250 92Q4 94Q4 96Q4 98Q4 00Q4 02Q4 04Q4 06Q4 Index of Tightness of Bank Supply of Credit to Business High-Yield Bond Spread over Treasuries: basis points ( R )
62

950 850 750 650 550

Wider High-Yield Bond Spread Anticipates a Further Narrowing of the Profit Margin Ratio
15 14 13 460 12 11 10 9 8 7 960 6 85Q4 88Q2 90Q4 93Q2 95Q4 98Q2 00Q4 03Q2 05Q4 08Q2 560 660 760 860 260 360

Profit Margin Ratio: %, derived from NIPA accounts ( L ) High-Yield Bond Spread: INVERTED, in basis points ( R )
63

Consensus Sees a H1-09 Bottom for Capacity Utilization, Which Implies Only a Limited Narrowing for the Profit Margin Ratio
16 15 14 13 12 11 10 9 8 7 6
85Q4 88Q2 90Q4 93Q2 95Q4 98Q2 00Q4 03Q2 05Q4 08Q2 Profit Margin Ratio: %, derived from NIPA accounts % of Industrial Capacity in Use, act. & pred. ( R )
64

85 83

81 79 77

75 73

Projected Mid-09 Narrowing of the Unemployment Rate's Yearly Rise Might Help to Thin the High-Yield Bond Spread
1,100 1,000 900 800 0.7 700 600 500 400 300 200 Dec-85 Jun-88 Dec-90 Jun-93 Dec-95 Jun-98 Dec-00 Jun-03 Dec-05 Jun-08 US Speculative-Grade Bond Yield Spread: basis points ( L ) Unemployment Rate: 3-mo. avg. of YY change in % pts. ( R )
65

1.7 1.2

0.2 -0.3 -0.8 -1.3

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

Moody's Analytics
Economics Group

John Lonski

(212) 553-7144 (212) 553-4732

lonskij@moodys.com benjamin.garber@moodys.com

Ben Garber
Chris Snyder Luis Valentin

(212) 553-7951
(212) 553-3857

chris.snyder@moodys.com
luis.valentin@moodys.com

67

Signals of Risk and Opportunities From the Capital Markets

David Munves, CFA

david.munves@moodys.com

Capital Markets Research Group September 2008

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 Large Negative Ratings Gaps Appendix II: Additional MIR-based Default Analysis
69

Market Implied Ratings; A Brief Overview

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

Moodys Rating and Implied Ratings for General Motors

71

Bond- and CDS-implied Ratings are Determined with Reference to Median Spread Curves, Which Are Updated Daily
Sample Bond Market Median Credit Spreads

Credit Spread (bp)

Years to Maturity

72

We Calculate Positive and Negative Ratings Gaps with Reference to These Curves
Spreads and Spread Ranges by Category, 5yr Maturities*

At a spread of 140 bp, an Aa2 rated issuer trades cheaply for its rating

Aa2 Sprd = 95 bp

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

* Excluding the 5% tails of each distribution

73

The MIR dataset covers issuers with Moodys ratings and traded debt, CDS, and equities.
Market Implied Ratings Coverage
BondImplied 2,900 66% 34% 68% 5% 22% 5% 1/1/99 EquityImplied 1,800 79% 21% 66% 5% 18% 10% 1/1/99 CDSImplied 2,000 75% 25% 55% 9% 27% 9% 1/1/01 LCDSImplied 300 9% 91% 93% 0% 7% 0% 8/06 MDPImplied 1,600 51% 49% 72% 4% 15% 9% 1/1/99

Number of Issuers Investment Grade Speculative Grade Geographic Breakdown Americas Asia EMEA Japan Time Series Start Date

74

We Harness Market Signals by Analyzing them Systematically Over Time

Applications of Market Implied Ratings-Based Research

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

75

Using Market Implied Ratings as Early Warning Signals of Credit Direction and Default

MIRs Ability to Isolate Idiosyncratic Risk Means It Works Well as an Early Warning Indicator. In 1Q07 BSCs CDS Spread Widened Modestly While the Market 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 3Notch Fall in its CDS-Implied Rating Bear Stearns CDS-Implied Ratings and Moodys Rating

Period noted in the previous slide

78

Market Trading Levels Tend to Lead Moodys. The Bigger the Initial Ratings Gap, the Stronger this Effect Becomes.
Moodys Rating Change Frequency as a Function of the RG, 1-Year Horizon
D/G rate of ~30%

100% 75% 50% 25% 0% >6 5 4 3 Upgraded 2 1 0 -1 -2 Unchanged Downgraded -3 -4 -5 <-6

# of Notches CDS-Implied Above Moody's Rating

CDS Data Set for 1/1/01 7/31/08
79

The Market Also Reacts for Large Gap Entities, but with a Greater Frequency Than Moodys
CDS-IR Rating Change Frequency as a Function of the RG, 1-Year Horizon
Market overshoot and recovery rate of ~55%

100% 75% 50% 25% 0%

>6

3 2 Upgraded

1 0 -1 -2 -3 -4 Unchanged Downgraded

-5

<-6

# of Notches CDS-Implied Above Moody's Rating

CDS Data Set for 1/1/01 7/31/08
80

Thus, Ratings Gaps Close Over Time, with Moodys Ratings and Market Trading Levels Converging.
Average Changes in Moodys Ratings and Implied Ratings
3
The market movements are much greater than Moodys for both pos. and neg. gap names

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

Change in Ratings Notches

2 1 0 -1 -2 -3 -4 6 5 4 3 2 1 0 -1 -2 -3 -4 -5 # of notches BIR Away From Moody's Rating Moody's BIR -6

Bond Data Set, 1-year horizon

81

Not Surprisingly, Implied Ratings are More Volatile than Moodys Ratings
Annual Change Rates for Moodys Rating vs. Bond-Implied Ratings

Moody's Rating Action Rate Large Rating Action Rate*

*Changes of two notches or more

Bond-Implied Ratings 98% 28%

24% 4%

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

82

MIR Also Provides Useful Short-Term Default Signals

Default Rates Vary Considerably by Ratings Gap
Moody's Rating Baa1 Baa2 Baa3 Ba1 Ba2 Ba3 B1 B2 B3 Caa Ca-C Default Rates Grouped by their Ratings Gaps 1 0 -1 -2 -3 0.2% 0.1% 0.6% 0.5% 0.8% 0.3% 0.1% 0.0% 0.3% 0.9% 0.0% 0.1% 0.7% 0.8% 1.6% 0.1% 0.2% 0.1% 1.2% 1.1% 0.2% 0.4% 0.2% 0.8% 3.0% 0.1% 0.6% 1.0% 0.6% 2.1% 0.3% 0.8% 3.1% 7.3% 8.6% 1.3% 4.2% 7.3% 14.6% 26.9% 2.1% 6.2% 12.4% 22.4% 30.5% 4.0% 11.0% 13.1% 15.5% 14.0%

Moody's* 0.1% 0.1% 0.3% 0.7% 0.8% 1.8% 2.6% 4.3% 8.5% 15.4% 32.9%

Issuers 3 2 0.3% 0.2% 0.0% 0.0% 0.0% 0.1% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.5% 0.2% 0.2% 0.6% 1.0% 1.8% 3.0% 4.4%

* 1983-2007 One-Year Time Horizon for Bond Data Covering 1/1/99 7/31/08
83

Recent Developments

The Wider CDS Spreads Over the Past Year on Financial Institutions vs. Industrials and Utilities
A 5-year CDS spreads for FIs and Industrials
Spread (bp) 270 240 210 180 150 120 90 60 30 0 Jan 07 Mar 07 May 07 Spread (bp) 270 240 210 180 150 120 90 60 30 0 Sep 08

Jul 07

Sep 07 Nov 07

Jan 08 Mar 08 May 08 All

Jul 08

Financials

Corporates

85

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

Entities with CDS-IR Gaps of -5 and Below

86

This is at Odds with the Normal Pattern, Which Features Relatively Few Large Gaps
Ratings Gap Distribution by Model
Frequency 30% 25% 20% 15% 10% 5% 0%
>8 8 7 6 5 4 3 2 1 0 -1 -2 -3 -4 -5 -6 -7 -8 <-8

Frequency 30% 25% (StDev)

BIR (2.2) CDS (2.3)

20% 15% 10% 5% 0%

87

Not Surprisingly, Banks Dominate the Cheap Names in the FI Sector

CDS Ratings Gap Distributions for FI Subsectors
Number of Issuers 50 40 30 20 10 0 -8 -7 -6 -5 -4 -3 -2 -1 Banking Insurance 0 1 2 3 4 5 6 Non-Banking Finance
Only 9 of 221 banks have positive gaps

Number of Issuers 50 40 30 20 10 0

88

The Corresponding Opposite Reaction Is That There Are A Lot of Corporates With Big Positive Gaps. The Market Doesnt Love these Names. 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 Very Different Than the Historical Average
CDS Ratings Gap Distributions for FIs and Corporates (Aug. 2008)
Frequency 30% 25% 20% 15% 10% 5% 0%
>8 8 7 6 5 4 3 2 1 0 -1 -2 -3 -4 -5 -6 -7 -8 <-8

Frequency 30% 25% 20% 15% 10% 5% 0% Financial Corporate CDS-IR

90

The Picture is Similar, Although not as Extreme, in the Corporate Bond Market
Bond Ratings Gap Distributions for FIs and Corporates (Aug. 2008)
Frequency 25% 20% 15% 10% 5% 0%
>8 8 7 6 5 4 3 2 1 0 -1 -2 -3 -4 -5 -6 -7 -8 <-8

Frequency 25% 20% 15% 10% 5% 0%

Financial

Corporate

BIR

91

A Striking Aspect of the Crisis is the Limited Differentiation in the Market Among Many Financial Institutions, and the Fact that this didnt Change After the BSC and Frannie Rescues

Market Metrics and Moodys Ratings for Selected FIs

January 2007 Moody's Institution Royal Bank of Scotland JP Morgan Chase Goldman Sachs US Bancorp Washington Mutual MBIA Lehman Brothers Fannie Mae Rating O/L CDS-IR Aa1 Aa3 Aa3 Aa2 A3 Aa2 A1 Aaa STA STA STA STA STA STA POS STA Aaa A2 A3 Aa2 A3 A3 A3 Aa2 Moody's CDS Gap to Sprd Rating Moody's (bp) 1 4 Aaa -2 -3 0 0 -4 -2 -2 17 24 8 24 24 24 7 Aa2 Aa3 Aa2 Baa2 Aa3 A1 Aaa O/L NEG STA STA STA STA NEG POS STA(m) CDS-IR Baa1 Baa2 Baa2 A2 B1 Caa1 Ba1 A2 January 2008 September 2008 Moody's

CDS CDS Gap to Gap to Sprd Rating O/L CDS-IR Sprd Moody's Moody's (bp) (bp) -7 69 Aa1 STA Baa2 -7 127 -6 -5 -3 -5 -13 -6 -5 78 94 47 411 909 144 52 Aa2 Aa3 Aa2 STA STA STA Baa2 Baa3 Baa2 Ca Caa1 B2 Aa1 -6 -6 -6 -10 -8 -9 -1 131 182 150 288 1288 613 42

Baa3 RUR Baa2 NEG A2 Aaa RUR STA

92

RBS as an Example: Its CDS Spread Has Widened Together with the Baa2 Median Spread, Although It Had a Brief Rally Around the Time of the BSC Bailout
RBS CDS Spread and the Baa2 Median Credit Spread
Spread (bp) 225 200 175 150 125 100 75 50 25 0 Jul04 Jan05 Jul05 Jan06 Baa2 Jul06 Jan07 Jul07 Jan08 Jul08 Spread (bp) 225 200 175 150 125 100 75 50 25 0 Royal Bank of Scotland

93

So its CDS-Implied Rating has Remained Mostly in the Baa Range

Moodys Rating and CDS-Implied Rating for RBS

94

What Lies Behind this Wholesale Spread Widening for FIs in the CDS Market?
Drivers of Market Behavior

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.

95

One Way to Analyze Ratings Gaps for Financial Institutions is in Relation to the Sector Averages. For Banks, -4 Becomes the New Zero.
Average CDS-IR ratings gaps for key sectors
BANKING BASIC INDUSTRY COMMUNICATION & TECHNOLOGY CONSUMER CYCLICAL CONSUMER NON CYCLICAL ELECTRIC & GAS ENERGY INSURANCE NON BANKING FINANCE TRANSPORTATION -5 -4 -3 -2 -1 7/31/2008 0 1 2 3 4 5

8/29/2008

96

As we have Seen, Moodys Ratings Actions Follow the Market, Although with More Discrimination
Entities with CDS-IR Gaps of -5 and Below
No. of Issuers 200 No. of Downgrade 200

160 120

160 120

80 40

80 40

0 0 Jan 07 Mar 07 May 07 Jul 07 Sep 07 Nov 07 Jan 08 Mar 08 May 08 Jul 08 Sep 08 Financials (LS) No. of Downgrade (FI, RS)

97

Appendix I: Selected Financial Institutions with Large Negative Ratings Gaps

Selected FIs with Large CDS-Implied Ratings Gaps

CDS-IR Baa1 Organization Name
Alliance & Leicester plc American Financial Group, Inc.

Moody's Rating
A1 Baa2

Outlook
RUR STA

CDS-IR Gap
-3 1

CDS Spread (bp)

108 102

AMP Bank Limited

AXA Banco Bilbao Vizcaya Argentaria, S.A. Banco Santander Central Hispano, S.A. Bank One, National Association Berkshire Hathaway Finance Corporation CALYON Citibank, N.A.

A2
A2 Aa1 Aa1 Aaa Aaa Aa1 Aa1

STA
STA STA STA STA STA RUR NEG

-2
-2 -6 -6 -7 -7 -6 -6

103
102 100 102 116 100 101 112

Credit Agricole S.A.

Fortis Bank Nederland (Holding) N.V.

Aa1
Aa3

RUR
STA

-6
-4

100
122

ING Groep N.V.

JPMorgan Chase & Co. Le Credit Lyonnais S.A. Nationwide Financial Services, Inc.

Aa2
Aa2 Aa1 A3

STA
STA RUR STA

-5
-5 -6 -1

112
122 100 115

99

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

CDS-IR Baa1 Organization Name
Prudential Insurance Company of America Royal Bank of Canada SEB AB St.George Bank Limited

Moody's Rating
A1 Aaa Aa2 Aa2 A2 A1 Aa3 Aa2 Aa1 Baa1 A1

Outlook
STA STA POS RUR STA STA STA NEG NEG STA STA

CDS-IR Gap
-3 -7 -5 -5 -3 -4 -5 -6 -7 -1 -4

CDS Spread (bp)

118 105 110 101 154 141 132 139 140 154 149

Baa2

AEGON N.V. Banco BPI S.A. Banco Espirito Santo, S.A. Bank of America Corporation Barclays Bank PLC BAWAG P.S.K. China Development Bank

JPMorgan Chase Bank, NA

National Westminster Bank PLC Natixis Royal Bank of Scotland Group plc Swedbank AB U.S. Bancorp

Aaa
Aa1 Aa3 Aa2 Aa2 Aa2

STA
STA STA(m) STA NEG STA

-8
-7 -5 -6 -6 -6

124
135 155 129 125 142

100

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

CDS-IR Baa2 Organization Name
UBS AG Wells Fargo & Company

Moody's Rating
Aa2 Aa1

Outlook
STA STA

CDS-IR Gap
-6 -7

CDS Spread (bp)

136 132

Baa3

Allied Irish Banks, p.l.c.

Citigroup Inc. Goldman Sachs Group, Inc. (The) Industrial Bank of Korea Korea Development Bank Lloyds TSB Group plc MetLife, Inc. Nationwide Building Society Northern Rock plc Skipton Building Society SunTrust Banks, Inc. Yorkshire Building Society

Aa2
Aa3 Aa3 Aa3 Aa3 Aa1 A2 Aa2 A2 A2 A1 A2 A1 Aa3 Baa2 Aa2

STA
NEG STA STA NEG(m) STA STA NEG DEV STA STA STA RUR RUR STA STA

-7
-6 -6 -6 -6 -8 -4 -7 -4 -4 -5 -4 -6 -7 -2 -8

179
180 166 216 191 189 214 166 186 177 165 185 247 246 238 225

Ba1

American Express Company American Express Credit Corporation Bank of India Bank of Ireland

101

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

CDS-IR Ba1

Organization Name
Bank of Scotland BES Finance Ltd. Britannia Building Society

Moody's Rating
Aa1 Aa3 A2

Outlook
NEG STA STA(m)

CDS-IR Gap
-9 -7 -5

CDS Spread (bp)

237 242 308

Caja de Madrid
HBOS plc Irish Life & Permanent plc Morgan Stanley

Aa1
Aa2 Aa3 A1 A2 Aa2 Aa3 A2 A2 Aa2 A1 Baa1 Baa3

STA
NEG NEG STA STA NEG STA NEG STA NEG NEG RUR RUR

-9
-8 -7 -6 -6 -9 -8 -6 -6 -9 -7 -5 -4

260
236 245 236 369 367 314 335 322 316 318 444 538

Ba2

Capital One Bank Countrywide Financial Corporation HSBC Finance Corporation Lehman Brothers Holdings Inc. Merrill Lynch & Co., Inc. Wachovia Bank, N.A. Wachovia Corporation

Ba3 B1

Bradford & Bingley plc IKB Deutsche Industriebank AG

102

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

CDS-IR B1 B2 Organization Name
Landsbanki Islands hf Financial Security Assurance Holdings Ltd. Financial Security Assurance Inc. Kaupthing Bank hf

Moody's Rating
A2 Aa2 Aa1 A1 A1 A2 Baa1 Ba2 A3 Baa3 B1 Baa2 A3 A3 Baa3 Baa2 Baa3 B3

Outlook
STA RUR RUR STA NEG STA NEG RUR NEG STA NEG NEG NEG STA NEG RUR RUR NEG

CDS-IR Gap
-8 -12 -13 -10 -11 -10 -8 -5 -10 -7 -3 -8 -10 -10 -7 -8 -7 -2

CDS Spread (bp)

505 680 610 785 1140 897 977 1233 1470 1527 1454 1257 1295 1200 1257 1590 1607 2127

B3

Ambac Assurance Corporation Glitnir banki hf MGIC Investment Corporation

Caa1

Alliance Bank Ambac Financial Group, Inc. Capmark Financial Group Inc. Ford Motor Credit Company LLC MBIA Inc. MBIA Insurance Corporation National City Corporation PMI Group, Inc. (The) Washington Mutual Bank Washington Mutual, Inc.

Caa2

GMAC LLC

103

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

CDS-IR Ca C

Organization Name
Radian Asset Assurance, Inc. Radian Group Inc. CIFG Assurance North America, Inc. FGIC Corporation Financial Guaranty Insurance Company Residential Capital, LLC

Moody's Rating
Baa1 Ba1 Ba3 Caa2 B2 Ca

Outlook
NEG NEG RUR NEG NEG RUR

CDS-IR Gap
-12 -9 -8 -3 -6 -1

CDS Spread (bp)

2645 2700 3903 6820 3764 8555

104

Appendix II: Additional MIR-based Default Analysis

Measuring Ratings Power to Discriminate Between Defaulters and Non-Defaulters

Introducing the Cumulative Accuracy Profile (CAP) Curve

A
45 degree line
Accuracy Ratio Definition

AR = A/(A+B)

One Year Horizon 106

Markets are generally good 1-Year Identifiers of Default Risk

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

Improves on a 3-year Horizon

While The Performance of Moodys Ratings

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 Have Tracked Each Other Over Time
BIR and EIR Accuracy Ratios vs. the SPX and HY Def. Rate
120% 110% 100% 90% 6% 80% 70% 60% 50% 2000 4% 2% 0% 2001
SPX (LS)

12% 10% 8%

2002

2003
BIR (LS)

2004

2005
EIR (LS)

2006

2007

2008

Global HY Default Rate (RS)

One Year Horizon

109

Implied Ratings Momentum Strengthens the Default Signal

HY Def. Rates Conditioned on BIR Momentum* and Ratings Gaps
20%
Focus on downward momentum more than doubles the signal

1 Yr Default Rate

.
15% 10% 5% 0% =4
*3 Month Momentum

-1

-2

-3

=-4

# of Notches BIR Above Moody's Ratings (Today)

Unconditioned on Momentum Downward Momentum

Upward Momentum

* Momentum means a BIR change of 2 notches or more in a positive (upward) or negative (downward) direction in the previous 3 months 110

The Impact of the Mortgage Crisis on the Credit Standing and Relative Values of Financial Institutions
Michael Love
michael.love@moodys.com

Credit Strategy Group

Agenda

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

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 these assets, 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

The Federal Reserve has been at Lehman since Bear Stearns failed it should have a good idea of counterparty risk
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 modest ability for them to fight back

114

Lehmans Failure will Reshape the US FI Landscape

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

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 Decline in Banks CDS-IRs in August

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

BANKING BASIC INDUSTRY COMMUNICATION & TECHNOLOGY CONSUMER CYCLICAL CONSUMER NON CYCLICAL ELECTRIC & GAS ENERGY INSURANCE NON BANKING FINANCE TRANSPORTATION

-0.6

-0.4

-0.2

0.0 Average

0.2

0.4

0.6

CDS-IR Falls

CDS-IR Rises

117

Financials CDS-IRs: Still the Widest Negative Gaps

CDS-Implied Gap by Sector (Matched)

Banking Basic Industry Communication & Technology Consumer Cyclical Consumer Non Cyclical Electric & Gas Energy Insurance Non Banking Finance Transportation -5 -4 -3 -2 -1 7/31/2008 0 8/29/2008 1 2 3 4 5

118

-7.0 0.0 1.0

-6.0

-5.0

-4.0

-3.0

-2.0

-1.0

Average Ratings Gaps of Global Banks

Average MIR Gaps of Global Banks Very Large Historically

BIR Gap CDS Gap EIR Gap

Ap r-0 1 Ju l-0 1 O ct01 Ja n0 Ap 2 r-0 2 Ju l-0 2 O ct02 Ja n0 Ap 3 r-0 3 Ju l-0 O 3 ct03 Ja n0 Ap 4 r-0 4 Ju l-0 O 4 ct04 Ja n0 Ap 5 r-0 5 Ju l-0 5 O ct05 Ja n0 Ap 6 r-0 6 Ju l-0 6 O ct06 Ja n0 Ap 7 r-0 7 Ju l-0 O 7 ct07 Ja n0 Ap 8 r-0 8 Ju l-0 8

119

CDS-IR Gaps for Biggest Banks In the World What Happened to Too Big to Fail ?
Banks Moodys Sr. CDS-implied CDS Gap Ratings Ratings 6/3v9/08

UBS AG Switzerland
Citigroup USA Mizuho Trust Japan HSBC Hold. United Kingdom Crdit Agricole France BNP Paribas France Deutsche Bank JPMorgan Chase USA Bank of America Corp USA

Aa2
Aa3 Aa2 Aa2 Aa1 Aa1 Aa1 Aa2 Aa2

Baa2
Baa3 A3 A2 A3 A1 A3 Baa2 Baa2

-7
-6 -5 -4 -6 -3 -1 -5 -5

-6
-6 -4 -3 -5 -3 -5 -6 -6

120

Credit Spreads Reflect US Financial Institutions Credit Ratings Trends at Moodys

Over 90 Negative Ratings Actions for US Financials First Half 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 Marketimplied Ratings

121

Allowance for Loan Losses is Rising

Loss allowance to loans ratio

2.00%

1.80%

1.60%

1.40%

1.20%

1.00%

0.80% 3Q06 Source: FDIC 4Q06 1Q07 2Q07 3Q07 4Q07 1Q08 2Q08

Loss allowance to loans ratio

122

Asset Quality is Worsening Quickly

% of Assets in Nonaccrual Status

1.20% Source: FDIC Website 1.00%

0.80%

0.60%

0.40%

0.20%

0.00% 3Q06
Source: FDIC 123

4Q06

1Q07

2Q07

3Q07

4Q07

1Q08

2Q08

Capitalization Ratios Shrinking Over Time

Capital Ratios Have Stabilized for now at Largest US Banks:
Tier 1 risk-based capital ratio
9.30% 9.20% 9.10% 9.00% 8.90% 8.80% 8.70% 8.60% 8.50% 8.40% 8.30% 3Q06 Sourc e: FDIC 4Q06 1Q07 2Q07 3Q07 4Q07 1Q08 2Q08

Tier 1 ris k -bas ed c apital ratio

124

Profits Decline From Credit Costs

Return on Assets is Worsening for Largest Banks: Return on Average Assets (%)
Return on assets (ROA)
1.60% 1.40% 1.20% 1.00% 0.80% 0.60% 0.40% 0.20% 0.00% 3Q06 4Q06 1Q07 2Q07 3Q07 4Q07 1Q08 2Q08

Sourc e: FDIC

Return on assets (ROA )

125

Confidence Remains VERY Fragile

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-A for 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

Moodys Ratings and implied ratings for Bear Stearns

127

Lehman Brothers MIRs has Fallen Amidst a Nervous Market

Lehman Brothers

128

US Residential Mortgage Delinquency Rate Growth Slowed in the Second Quarter

Overall Delinquency Rate
Percent (%) 6.5

6.0

5.5

5.0

4.5

4.0
Sep 05 Dec 05 Mar 06 Jun 06 Sep 06 Dec 06 Mar 07 Jun 07 Sep 07 Dec 07 Mar 08 Jun 08

Source: Mortgage Bankers Association

129

Subprime Delinquency Rate May Have Peeked

Subprime Delinquency Rate
Percent (%) 24 22 20 18 16 14 12 10
Sep 05 Dec 05 Mar 06 Jun 06 Sep 06 Dec 06 Mar 07 Jun 07 Sep 07 Dec 07 Mar 08 Jun 08

Source: Mortgage Bankers Association

130

Home Inventories Though Elevated are Showing Signs of Stabilization

Home Inventories
y/y growth (%) 20 18 16 14 12 10 8 6 4 2
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

Source: National Association of Realtors

131

Home Affordability is Improving

140 130 120 110 100 90 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

Case-Shiller Composite of 20 Home Price
0% -2% -4% -6% -8% -10% -12% -14% -16% -18% Jun-07 Aug-07 Oct-07 Dec-07 Feb-08 Apr-08 Jun-08
Composite-20 (y/y%) 3-month Change (%)

0% -2% -4% -6% -8% -10% -12% -14% -16% -18%

133

Continuing Asset Quality Risks Loom Large

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

U.S. Auto Loan Delinquency Rates Prime+Subprime 90 Days Past Due

0.22 0.20 0.18 0.16 0.14 0.12 0.10

Source: Moodys Economy.Com

134

8Q 19 1 9 8Q 19 4 9 9Q 20 3 0 0Q 20 2 0 1Q 20 1 0 1Q 20 4 0 2Q 20 3 0 3Q 20 2 0 4Q 20 1 0 4Q 20 4 0 5Q 20 3 0 6Q 20 2 0 7Q 20 1 0 7Q 20 4 0 8Q 3

19 9

And so do Credit Cards

U.S.Credit Card Delinquency Rates Prime+Subprime 90 Days Past Due

0.85 0.80 0.75 0.70 0.65 0.60 0.55 0.50 0.45 0.40

Source: Moodys Economy.Com

136

Q 19 1 98 Q 19 4 99 Q 20 3 00 Q 20 2 01 Q 20 1 01 Q 20 4 02 Q 20 3 03 Q 20 2 04 Q 20 1 04 Q 20 4 05 Q 20 3 06 Q 20 2 07 Q 20 1 07 Q 20 4 08 Q3

19 98

Past Crises Have Resulted in Bank Failures

U.S. Bank Failures, 1934-2007

137

Assets of Problem Institutions Below Peak Level of Previous Bank Cycle

Problem Institutions (Assets US $ bn)
US $ bn 1,000 800 600 400 200 0 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 Assets
Source: FDIC
138

Could History Repeat Itself ?

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 1980s

Bank 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 over the near-term

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 new areas of weakness

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 to remain 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

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 of common 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
142

Source: Bloomberg data 9/08/08

Refinancing Risk is High for Major Financial Institutions

50,000 45,000 40,000 35,000 30,000 25,000 20,000 15,000 10,000 5,000 Citigroup Merill Lynch Wachovia Bank Of America Washington Mutual Morgan Stanley JP Morgan Wells Fargo Lehman Chase Brothers

2008

2009

Source: Bloomberg

143

Spreads Tightened in Last Bank Cycle Before Provisions Declined

250 40 35 200 30 25 20 100 15 10 5 0 0

150

50

Source: FDIC and Lehman

144

6/ 30 12 /89 /2 9/ 6/ 8 9 29 12 /90 /3 1/ 6/ 9 0 28 12 /91 /3 1/ 6/ 9 1 30 12 /92 /3 1/ 6/ 9 2 30 12 /93 /3 1/ 6/ 9 3 30 12 /94 /3 0/ 94

Provision

OAS- Financials

Billions of Dollars

OAS (Bp)

US Government Decisions to Influence Path to Recovery

Fannie and Freddie may be run to aid housing market recovery to a greater degree (e.g., lower guarantee fees) 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

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How Will Financials Credit Spreads Recover and Market-implied Ratings Improve ?

Speculators Have Begin to Bottom Fish for Acquisition Targets, Recapitalized Companies or Financials Deemed Too 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 Spreads for all Financials.

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Lessons for Credit Spread Recovery ?

Disagreements Between MIRs and Moodys Ratings Tend to Narrow Over Time- Markets Tend to Overshoot on Both Positive and 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 greater
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