Situation Analysis

The European Crisis And

What May Lie Ahead
Prepared: December 27, 2011

Executive Summary
The financial crisis enveloping Europe, in our view, is the most significant issue facing world capital markets today. In
a survey recently conducted by U.S. Bank Wealth Management of high net worth investors, concern and uncertainty
about how and when the crisis in Europe may be resolved was rated the largest risk investors currently face.

While the European financial crisis impacts all 27 countries in the European Union, it is most acutely felt within
the 17 countries that have accepted the euro as their currency, which is known as the European Monetary Union.
Similar to the financial crisis centered in the U.S. three years ago, the crisis in Europe is being felt worldwide. In
fact, given that the combined economies of Europe are comparable to that of the U.S., we think it is fair to expect a
similar global impact from the larger European crisis.

While it is impossible to predict the final outcome and ultimate impact of the European crisis, this paper will address
key questions by providing our expectations of what could occur in the coming months. We also provide guidance
for investors attempting to effectively position their assets in light of the crisis.

What are the core issues of the Monetary union without fiscal union
European crisis? At a fundamental level, the EMU is an economic and
monetary union with a common currency shared across
The concept of Europe forming an economic union has
its 17 member countries. However, the EMU has not
been evolving since the end of World War II. In 1957, the
proven to be effective at integrating fiscal (budgetary)
European Economic Community (EEC) was created to
policies among its members.
allow for some economic integration between countries.
Subsequently, the European Union (EU) was formed, When the EMU was formed, member nations were
and finally, the European Monetary Union (EMU) was expected to abide by specific fiscal or budgetary
established around a common currency — the euro. guidelines. For example, annual budget deficits were not
to exceed 3% of an individual member nation’s Gross
In our opinion, three core issues, some institutional and
Domestic Product (GDP), with national debt not to
some driven by policy decisions, appear to be the major
exceed 60% of GDP. However, what was lacking was a
contributors to the challenges facing Europe today.
mechanism to enforce these agreements.
These include:
• The EMU represents a monetary union, but not a Out of control governmental spending
fiscal union. Since the launch of the euro in 1999, several EMU
• Governmental spending by some countries within the member countries began to allow budgetary imbalances
EMU has spiraled out of control. to form, with spending outpacing economic capacity.
Excess spending, of course, needed to be funded by
• Efforts to bring EMU member countries in line have
met resistance, both from cultural differences, as well
as issues of national pride and sovereignty.

Important disclosures provided on page 6.

Situation Analysis
The European Crisis And What May Lie Ahead
borrowing. This lack of discipline was exacerbated by
the fact that, as a part of the EMU, member countries
were able to borrow at interest rates that were often
lower than those the market would otherwise have
dictated if each member countries were to borrow on
a stand alone basis. For example, until just recently,
smaller, poorer countries (like Greece) have borrowed
at interest rates normally associated with richer, more
financially-stable countries (like Germany).
Now, however, investors fear that the European Central
Bank (ECB), the International Monetary Fund (IMF), or
a strong member country like Germany will not come
to the rescue, and the bond market is pricing bonds (the
yield required to entice investors) based on the actual
underlying ability of individual member nations to repay
their debt. Recently, interest rates on bonds issued by
several of the weakest EMU members have experienced
an alarming increase. For example, as events unfolded
during the fall of 2011, investors seemed to become
increasingly concerned about the possibility of weaker
EMU countries defaulting on their sovereign debt. This
resulted in demands for higher interest rates in order to
compensate for the potential risk that bond repayments
would not be made as they should.
Most dramatic has been the rise in yields on ten-year
bonds issued by Greece, lingering above 25% over the
last few months. The market appears to essentially be
passing judgment that the Greek government is at great
risk of going bankrupt. Larger and more important
economies, like Spain and Italy, have also experienced
interest rate pressure as they cope with their own
budget challenges.
Since November 2011, the yields on ten-year bonds
issued by the governments of Spain and Italy have
hovered in the 6% to 7% range. While high in
comparison to the broad market for government bonds
issued during the same time period, it is a signal that
Spain and Italy may face significant risk, but are not
yet beyond hope. The risk for Italy is that it may be
unable to afford its debt service costs if the bond market
demands that interest rates remain near or above 7%.
Italy is dealing with a current debt-to-GDP ratio of
120. If interest rates remain high, the result could be a
downward spiral for its financial situation.
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One major concern about the problems facing nations
like Greece, Spain and Italy is the fear that a “contagion”
may occur — spreading through the rest of Europe like
a virus. Even some of the strongest economies in Europe
have felt the effects.
France, like Germany, currently carries a AAA rating on
its debt, although yields on French bonds are generally
higher than on German bonds. This suggests that
investors may perceive a somewhat higher degree of
risk with French debt even though both countries carry
the same credit rating. As the crisis deepened, the yield
spread between French and German bonds widened, yet
even Germany, considered to be the financial foundation
of the EU, has seen weak demand for its bonds in recent
offerings, driving its yields higher.
Compounding the problem, and a major difference
between the financial crisis in Europe compared to the
mortgage debt problems that led to the U.S. financial
crisis in 2008, is that European banks play a much
larger role in the economy than banks do in the U.S.
economy. In Europe, banks hold substantial amounts of
bonds issued by EU member countries. As the European
financial crisis builds, member countries may default,
potentially putting the European banking system at risk.
This is one reason why so much concern has been raised
about the financial stability of major European banks.
National sovereignty and cultural differences
In our view, the most troubling design flaw of the
EMU structure (that it is a monetary union without
a being true fiscal union), to some extent, reflects the
relationships and long histories that exist between the
EU countries. The European Economic Community
was a way for the countries recovering from World War
II to help each other grow and gain economic power
on the global economic stage, which at the time was
dominated by the U.S. The U.S. in fact, encouraged this
development in the wake of its significant Marshall Plan
investment in the belief that strong trading partners
would be less likely to become military adversaries.
Nevertheless, these countries retained meaningful
cultural differences and a strong sense of national
sovereignty. These factors have no doubt contributed
to the limitations that exist in the current EU monetary
Important disclosures provided on page 6.
Situation Analysis
The European Crisis And What May Lie Ahead
union and may represent the largest obstacles to
overcome if a long-term resolution of the European
financial crisis is to be achieved.
We regularly hear of measures being
implemented in an effort to avert the
European debt crisis. Why do these steps
seem to be so ineffective?
The bond market appears to want structural issues
in the EMU to be addressed. This means significant
and potentially painful cuts in spending. So far, in our
opinion, Europe’s leaders have only taken steps to
address some of the symptoms of the larger problem,
not the cause. For example, the European Financial
Stability Facility (or EFSF) has been created to provide
emergency funds to countries at risk of default. In
exchange for emergency funding, the EU required
recipient countries to cut spending in an effort to reduce
their budget deficits. The spending cut requirements
vary by country, but are meaningful.
In Greece, required cuts amount to approximately
14% of family disposable income, on average. Cuts in
Portugal amount to 7% of family disposable income.
In Spain, the impact is a 5% cut to family disposable
income. However, as presently funded, the EFSF would
not have the capacity to come to the rescue of a large
economy, such as in Italy.
It should be noted that total government debt of Europe
combined is no greater than that of the U.S. The primary
concern is that individual member countries carry far
more debt than they can afford in terms of interest
payment obligations on this debt. In short, individual
nations need to aggressively reduce spending in many
areas, including pensions and social support programs.
On another front, the ECB has also provided liquidity
to European banks to keep them solvent and has
made sizable purchases of bonds issued by member
countries to help keep interest rates down and relieve
budgetary pressures.
The bonds issued by several EMU member nations
have been severely discounted in the bond market.
Even incremental bond purchases by the ECB have not
reversed the trend of declining asset values. European
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banks, and the entire European banking system, are at
risk. European banks appeared to face a critical liquidity
crisis at the end of November 2011, similar in some
ways to the liquidity crisis that resulted in the abrupt
collapse of Lehman Brothers in 2008. To avert the
potential crisis, global central banks provided discounted
dollar-based financing to the EU banks. While this may
have solved a short-term liquidity problem, it is not a
long-term solution to the growing crisis.
What do we think the investment markets would like to
see out of the EU? Some possibilities include:
• Assurance that the largest and most important
economies facing budgetary struggles — Italy and
Spain for example — will not default on their debts.
• A firm commitment to defend key economies.
Smaller countries, like Greece, may be beyond
saving, but bankruptcies at that level may be less
threatening to the entire EU than similar problems in
one of Europe’s major economies.
• A clear policy that protects the European banks
from insolvency. Any policies that merely convey an
intention to protect banks, but come up short of a
firm commitment, may be seen by capital markets as
window dressing.
What prevents EU leadership from acting
decisively to address structural issues?
Europe’s leaders appear unwilling to provide full support
to member countries and European banks without an
assurance that nations facing the biggest problems will
undertake significant structural reforms. Political leaders
in countries such as Germany also must contend with
a potential backlash from their own citizens if they are
perceived as going too far with a rescue package. These
leaders will want some control in the development of
specific structural reforms before committing substantial
financial support required to bridge through the crisis
period. Yet the challenge of the EU not being a fiscal
union comes into play here. Control of individual
national budgets still remains with each respective
country. This limits the ability of the EU to dictate
the terms of any solution to be implemented in any
member nation.
Important disclosures provided on page 6.
Situation Analysis
The European Crisis And What May Lie Ahead
Some members of the EMU appear reluctant to give
any control over their finances to a central European
authority and will likely try to maintain their
independence as long as possible. America faced
similar challenges when the original 13 colonies had
to forge a true union of states, but that occurred
when these were new entities and therefore, may
have been more flexible. EMU member countries
may be challenged by centuries of history, both
good and bad.
What do we expect to occur in the
months ahead?
Pressure appears to be building within Europe to
address the crisis in a more substantive way. In our
opinion, failure by Europe’s leaders to take decisive
action is likely to be so damaging that there will be
no choice but to compromise and make the culturally
difficult decisions required to stabilize the EMU.
However, given the high level of apparent political
resistance to creating strong fiscal bridges across the
EU, our sense is that real compromise may not occur
until the crisis becomes more severe and a clear sense
develops that few options exist. This may indicate
that opposing sides within the EU are not yet ready
to compromise in meaningful ways.
Until structural reform decisions are made, we
believe financial conditions within the EU will
worsen. There is concern by some that delaying
substantive action for too long could lead to an
irreversible crisis and possibly the collapse of
the euro and all or part of the economic union.
While EU leadership debates various solutions
and financial pressures mount, investors may not
be willing to wait for political compromise to be
achieved. In these conditions, investors may tend to
be skeptical that politicians will act appropriately
and may react, for example, by selling European
bonds now and holding cash until EU leadership
identifies a workable solution. Our concern is that
excess selling by investors could create a short-term
liquidity crisis and a breakdown in normal market
trading. This occurred in early 2008 related to
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failure of Bear Stearns and the firm was forced into
an emergency sale to JP Morgan. This also occurred
in September of 2008 with the collapse of Lehman
Brothers, a key event that deepened the global
financial crisis.
As financial conditions rapidly declined in Europe
in November 2011, global central banks acted in
a coordinated fashion to avert another Lehman-
type liquidity crisis from occurring. In our opinion,
more needs to be done, but it will take time. A
major structural reform of the EU will probably
require a referendum vote in each member nation.
The immediate crisis is progressing too rapidly to
accommodate the likely time frame required for
deeper structural reforms.
Still, meaningful crisis response strategies can
be implemented in the short term. These include
securing the European banking system and
reinforcing the financial stability of larger economies
in crisis such as Italy and Spain. However, we
think the EU is likely to continue to struggle with
the challenges ahead. This means that markets
are likely to continue to experience high, periodic
volatility in the near term as events unfold and as
investors react.
What impact may there be on the
capital markets?
During the final months of 2011, capital markets
diverged regarding the European crisis and situation.
Global stock markets have reacted favorably to the
announcement from EMU leadership, primarily
Germany and France, of plans to build a stronger
fiscal arrangement and supervision capability within
the EMU. In addition, Italy is proposing a spending
cut of approximately $40 billion over three years to
try to address its budget imbalances. Global stock
markets also cheered the concerted central bank
action in late November 2011 to provide inexpensive
liquidity to European banks.
Important disclosures provided on page 6.
Situation Analysis
The European Crisis And What May Lie Ahead
The bond market has been much more reserved in
its reaction. Bond investors appear skeptical of EU
action until more concrete plans are defined. Interest
rates have moved only modestly lower as a result.
What should investors make of these different
market reactions? The bond market appears to be
acting as expected. Bond investors tend to be more
cautious and risk-averse than stock investors. For
most in the fixed income market, the first priority is
the ability of the debt issuer to repay the investor.
It is no surprise that the bond market historically
exhibits much less volatility than the stock market.
In the short term, the bond market is likely to
continue to maintain a “show me” stance and
demonstrate little change.
Stock investors may try to anticipate the upside
impact of current and foreseeable events. Relatively
small developments in the near term can have a
lasting effect over the long run. The result is that
fluctuations in the stock market can be of greater
magnitude and occur more rapidly than in the
bond market.
In our opinion, without further good news about
progress in the EMU, stock markets are likely to
drift lower. The positive news of the central bank
action may gradually recede in investors’ minds
without evidence that additional progress is being
made. Conversely, U.S. and emerging market
stocks may be poised for better performance in the
foreseeable months, supported by decent and slowly
improving economic fundamentals in the U.S. and
stimulative policies in emerging countries.
Again, we believe markets will remain volatile for
the foreseeable future. The path to a resolution
to the EU crisis is likely to be far from perfect.
Ultimately, we expect the EU crisis to abate
and as it does, global capital markets will likely
respond favorably.
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What should investors do?
In light of the crisis in Europe and our assessment
of the potential short- and long-term outcomes,
investors should pay close attention to their goals
across various time horizons.
In our opinion, assets required to achieve more
immediate goals (in the next one to three years)
should be managed conservatively given our outlook
that markets will remain volatile over any given
short-term time period. Conversely, long-term
investors may be better served by maintaining or
re-building prudent growth-oriented positions
within their portfolios, consistent with their
investment objectives.
We believe the events in Europe in recent months
have resulted in more attractive values in equity
markets that may reward investors over time. If
EU leadership is successful in navigating through
the crisis, building positions in stocks at today’s
value may reward investors.
Bonds may be in a more vulnerable position if the
crisis wanes and because U.S. interest rates are likely
to move higher with corresponding value declines in
bonds owned. Cash investments in instruments like
money market funds offer little reward potential in
the long term because yields are far below inflation,
which is likely to remain stubbornly high during the
foreseeable future.
Because we believe that volatility is likely in the
shorter term, investors may want to consider hedged
styles of investment management when appropriate.
These have historically performed better than
traditional long only styles in such an environment.
Important disclosures provided on page 6.
 Situation Analysis
The European Crisis And What May Lie Ahead Page 6

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IMPORTANT DISCLOSURES

This information was developed on December 27, 2011 and represents the opinion of U.S. Bank. It does not constitute investment advice and is issued without regard to specific
investment objectives or the financial situation of any particular individual. Since economic and market conditions change frequently, there can be no assurance that the trends described
here will continue or that the forecasts will come to pass. The information presented is for discussion purposes only and is not intended to serve as a recommendation or solicitation
for the purchase or sale of any type of security. The factual information provided has been obtained from sources believed to be reliable, but is not guaranteed as to accuracy or
completeness. U.S. Bank is not responsible for and does guarantee the products, services or performance of its affiliates or third-party providers.
Past performance is no guarantee of future results.
Based on our strategic approach to creating diversified portfolios, guidelines are in place concerning how investments should be allocated to specific asset classes based on client
goals, objectives and tolerance for risk. Not all recommended asset classes will be suitable for every portfolio. Hedged equity and hedged fixed income investment strategies are typically
available via hedge funds which may not be appropriate for all clients due to the speculative nature and high degree of risk involved in these investments.
Equity securities are subject to stock market fluctuations that occur in response to economic and business developments. International investing involves special risks, including
foreign taxation, currency risks, risks associated with possible difference in financial standards and other risks associated with future political and economic developments. Investing
in emerging markets may involve greater risks than investing in more developed countries. In addition, concentration of investments in a single region may result in greater volatility.
Investing in fixed income securities are subject to various risks, including changes in interest rates, credit quality, market valuations, liquidity, prepayments, early redemption, corporate
events, tax ramifications, and other factors. Investment in debt securities typically decrease in value when interest rates rise. The risk is usually greater for longer term debt securities.
Investments in lower rated and non rated securities present a greater risk of loss to principal and interest than higher rated securities. Alternative investments very often use speculative
investment and trading strategies. There is no guarantee the investment program will be successful. Alternative investments may not be suitable for every investor, even if the investor
does meet the financial requirements. It is important for investors to consult with their investment professional prior to investment in these investments. Hedge funds are speculative and
involve a substantially more complicated set of risk factors than traditional investments in stocks or bonds, including the risks of using derivatives, leverage and short sales, which can
magnify potential losses or gains. Restrictions exist on the ability to redeem units in a hedge fund.
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