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Tipping Point Nov 2011 FINAL

Tipping Point Nov 2011 FINAL

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Published by: Asad Rauf on Apr 20, 2012
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  • Contents
  • Summary Conclusions
  • The Tipping Point
  • #1: Contagion to Europe’s Core
  • #2: The Global Economy
  • #3: Global Financial System Stability
  • #4: The Fate of the Euro Itself
  • Key Takeaways for Issuers and Investors
  • Looking Ahead: 10 Key Risks
  • 5 Recent Problem Areas
  • #1: Confidence
  • #2: Liquidity and Solvency Concerns
  • #3: Political Failures
  • #4: Competitiveness Concerns
  • #5: Stress in Bank Funding Markets
  • Key Upcoming Dates
  • Time to Expedite the “Grand Plan”
  • Pillar # 1: Greek Debt Haircut
  • Pillar # 1: Greek Debt Haircut
  • Pillar # 2: EU Bank Sector Capital (& Guarantees)
  • Pillar # 3: Leverage EFSF to ~ €1 Trillion
  • Pillar # 3: Leverage EFSF to ~ €1 Trillion
  • “Grand Plan” Missing Pieces: Greek Debt Haircut
  • “Grand Plan” Missing Pieces: EU Bank Sector
  • “Grand Plan” Missing Pieces: EFSF Leverage Plan
  • Looking Ahead: Risk of Additional Downgrades
  • Disclaimer

Deutsche Bank Capital Markets and Treasury Solutions

The Tipping Point?
Time to Call the ECB

Corporate Solutions & Strategy Tom Joyce
(212) 250-8754 / tom.joyce@db.com

Michael Dyadyuk
(212) 250-0470 / michael.dyadyuk@db.com

November 2011
Javier Guzman
(212) 250-3464 / javier.guzman@db.com

“The name given to that one dramatic moment in an epidemic when everything can change all at once is the tipping point.” Malcolm Gladwell, author of the “Tipping Point” “The ECB has to go beyond a narrow interpretation of its mission and should be prepared for foreseeable intervention in the secondary market, not as the central bank has done up to now… It has to be able to be a lender of last resort.” Anibal Cavaco Silva, Portuguese President “Our membership of the Euro is a guarantee of monetary stability and creates the right conditions for sustainable growth. Our membership of the Euro is the only choice. Our task is disproportionately great in relation to the time we have at our disposal.” disposal ~ Lucas Papademos, Greece’s Prime Minister “Only Napoleon did more than me, but I’m taller than him.” “Italy does not feel the crisis The restaurants are full ” crisis. full.” ~ Silvio Berlusconi, Italian Prime Minister “Contagion has become very much a phenomenon, and it’s a phenomenon of globalization.” Contagion it s globalization. ~ Lawrence Summers, former U.S. Treasury Secretary (1999 – 2001)



1. Executive Summary: The Tipping Point

2. Recent Escalation of the Crisis

3. Searching for a Solution A. Time to Call the ECB B. Time to Expedite the “Grand Plan”

4. 4 Outlook for the Euro


1. Executive Summary: The Tipping Point

Summary Conclusions
The Tipping Point
   Markets have lost confidence in the EU's institutional structures and framework Italy represents a critical new and dangerous phase of the crisis (the "Tipping Point") Italy and Spain have € 300 bn and € 120 bn of 2012 issuance (€ 930 billion combined over next 3 years) - Italian sovereign bond market is broken The "stakes" have never been higher (including the fate of the Euro itself) Politics has become “the” obstacle: All 5 "peripheral" countries have had leadership change in 2011 The economy (recession) has become “the” unknown variable Continued Euro bank sector de-leveraging likely under almost any scenario (over $2 trillion estimate for next 18 months) g , ( ) Longer term, external (current account) deficits matter more than fiscal deficits 2012 will become the year of either a more integrated Europe, or a disintegrating one
Source: Deutsche Bank Global Markets Research - Economics, Credit, Rates, and FX 4

Key Resolution Steps Needed
1. More progress on credible fiscal austerity (especially Italy) 2. Rapid resolution of the EMU's original sin - lack of fiscal integration (Dec 9 EU Summit meeting) 3. Restore confidence to re-open bank funding markets 4. Time to expedite the "Grand Plan" - Larger Greece debt restructuring - Bank capital raises and debt guarantees - Additional bail-out funds for Greece 5. Time to call the ECB 5 Ti t ll th - Investor reluctance on EFSF € 1 trillion leverage plan - Ineffectiveness of ECB monetary policy transmission mechanism to keep bond yields low - Adjustment away from current bond purchase program needed (away from temporary, limited and sterilized) - ECB should announce large, targeted buying plan (i.e. € 200 bn over 12 months)

   

Contagion to Europe’s core g p 2.The Tipping Point What Is Now At Stake? 1. 3 Global financial system stability 4. 4 The fate of the Euro itself Source: IMF 5 . The global economy 3.

5 5.5 6.5 75 7.5% 3.0 Yield d (%) 4.5 25 2.5 1.0 40 Germany 10y Yield G 10 Yi ld France 10y Yield F 10 Yi ld Germany 10y Yield Germany 10y Yield Italy 2y Yield Italy 2y Yield Italy 10y Yield Italy 10y Yield Nov.0 Yield d (%) France 10-Year Bond Yield 4.0 Source: Bloomberg 6 .5 25 Gap: 169 bps 2.5 4. 9: Italian 10y yield reached nearly 7.0 1.5 Nov 10: French-German 10y spread reaches 20-year wide of 169 bps 3.0 Gap: 510 bps 2.#1: Contagion to Europe’s Core Italian 2 & 10-Year Bond Yield 7.5 3.0 2.0 6.5 1.0 5.0 1.0 3.

Michael Spencer 7 2012E 2010 2010 2010 2010 2010 .7% 10% 8.7% 7 7% 12% Global GDP Growth (2010-2012) Emerging Asia Latin America 6% 2.#2: The Global Economy Will Europe Push the U.4% 0% 4% 3.High correlation on U.Even a 5% drop in Euro Zone GDP would only reduce exports by less than 1/2% of U.S.S.3% 2011E 2012E 2011E 2012E 2011E 2012E 2011E 2012E 2011E  Most standard macro models do not adequately capture the impact of “financial and funding channel” contagion  The Euro crisis continues to be the # macro risk in #1 the global economy Source: Deutsche Bank Global Markets Research – Peter Hooper. Into Recession? 2 Scenarios: 1. Thomas Mayer.U.3% 8% 7. / EU consumer & business confidence .Bank funding markets and financial channels 2% 0. doubledip  Channels of contagion: .2% EU GDP decline) .S.S.High correlation on U. trade exposure is low vis-àvis U.S.S.Moderate worsening of Euro zone recession ( “muddle through” scenario) Detail  Most probable outcome  Not enough to cause U. GDP  Less likely outcome  Would likely drive U. Torsten Slok. / EU stock markets .S.S. Severe downturn in the Euro zone (disruptive credit event scenario) (> 5% EU GDP decline) 2. doubledip . GDP (1 .

5 Pric ce (EUR) 2.0 4.0 6.5 15 1.0 Price (USD) Oct 10: Dexia is nationalized 3.0 5. 2011  Operational: Q2-2011 loss of € 4 billion  October 31: Filed for bankruptcy  8th largest U S bankruptcy U.0 1.0 2.0 0.S.0 Stock Price Decline Oct 31: MF Global files for bankruptcy 9.  Assets: $41 bn  Sovereign exposure: $6 bn to European sovereigns Moody s non Moody’s and Fitch downgrade to “noninvestment grade”  Operational: Q3-2011 loss of $192 million (from European debt trading losses) 8 Size Drivers Source: Bloomberg .0 3.0 8.0 Key Date  October 10: Nationalization  Top 15 global bank  Assets: € 517 bn  Sovereign exposure: Over € 20 bn to peripherals  Reliance on wholesale funding E Encumbered assets b d t  Moody’s Review for downgrade on Oct 3.5 0.#3: Global Financial System Stability Stock Price Decline Systemic risk will y remain high until Europe moves more aggressively toward resolution 3.0 0.0 7.0 2.5 10.0 1.

2% . Bloomberg.9% 8.6% 4.S.6% 6.5 trillion  Total Debt: € 8.3% 2. is over 50 years of history and the world’s largest currency and trade union Source: IMF.#4: The Fate of the Euro Itself Over 60 Years of History 1951: European Coal and Steel Community (ECSC) established (EU predecessor) 1957: Treaty of Rome signed 1965: Merger Treaty signed 1973: UK.4% 2. China Russia Switzerland Norway Japan Turkey India South Korea Brazil Total Trade (EUR Bn) € 2 850 2.850 € 412 € 395 € 245 € 190 € 121 € 109 € 103 € 68 € 67 € 64 % of Total 100. Denmark and Ireland join EU 1979: European Parliament is elected 1981: Greece enters EU 1986: Spain and Portugal enter EU 1992: Maastricht Treaty signed 1998: ECB established through the Treaty of Amsterdam 1999: Euro established with 11 founding members 2001: Greece enters euro 2010: May: Greece € 110 bn bailout. Eurostat (2010) 9 World’s Largest Currency & Trade Union  # of Countries: 17  Total Population: 330 million  Total GDP: € 9. European Commission.2% 3.0% 100 0% 14.4 trillion Rank Partner Extra EU27 E EU27 1 2 3 4 5 6 7 8 9 10 U. Creation of EFSF Nov: Ireland € 85 bn bailout 2011: May: Portugal € 78 billion bailout July: Initial Greece restructuring announced Oct: Europe announces “Grand Plan” Grand Plan At stake.6% 3 6% 2.8% 3. quite simply.4% 13.

) US)  High credit spread correlation between EU and U. banks  Continued correlation between new issue volumes and volatility  Better market access for higher rated. Credit trading strategist: Richard Salditt 10 .Economics. volatility and systemic risk will remain high Source: Deutsche Bank Global Markets Research . FX and commodities risk advised  Euro "tail risk" downside protection increasingly important (especially given current “Tipping Point”)        For Investors Higher Hi h rated.Key Takeaways for Issuers and Investors What Are the Key Takeaways in the Meantime? For Issuers  Systemic risk will remain high until resolution (i. and FX. MF Global)  Contagion to global economy could be significant  Funding market stress will remain unpredictable and high (EU & U.. non-financials over fi d fi i l financials i l Lower beta names over higher beta and cyclicals On the run benchmarks over less liquid alternatives Higher LCH haircuts (initial margin) for Italian bonds on Nov 9 was a critical trigger event Primary dealer bond inventory and trading volumes at record lows Liquidity could be exacerbated by "year-end effect" EUR / USD is probably the worst instrument to express negative Euro area views (peripheral bonds and equities are a much b tt gauge of stress) d iti h better f t ) Italian bond yields have become the new barometer to evaluate the crisis  Until confidence is restored and Europe accelerates its crisis response via the ECB. (i e Dexia. Rates.S.S.e. non-financial names  More active hedging of rates. Credit.

Dexia.’ gg You have to be a true optimist to believe that policy makers are going to catch them all. France losing its AAA rating (and negative implications for EFSF) 3. Deutsche Bank FX Strategist 11 . Downside on EUR / USD (given current “Tipping Point” moment) 4. Unsustainable Italian bond yields (especially if p ) German Bundesbank resists ECB expansion) 2. European recession deeper than expected / Italian growth 8. Greece exit) “It is an understatement to suggest ‘there are a lot of balls in the air.e. 9. 9 Continued bank funding market stress 5. Greek debt sustainability / PSI execution 10.” ~ Alan Ruskin.Looking Ahead: 10 Key Risks Risks 1.e. Beginning of Euro unwind (i. Execution risk on new EFSF insurance/ SPV plan to “ring-fence Italy and Spain” g y p 7. 4 Larger systemic risk events (i e Dexia MF Global) (i. Year-end effect: Selling pressure on bank balance sheets going into year end Risks 6.

2. Recent Escalation of the Crisis .

Confidence 2. Political failures 4. Competitiveness concerns 5. Stress in bank funding markets 13 .5 Recent Problem Areas • Recent escalation of the Euro crisis has occurred around 5 key problem areas in particular: 1. 2 Liquidity d l Li idit and solvency concerns 3.

S.#1: Confidence Italian 10y Bond Yield 7. downgrade event on Aug 5 2. JPY and CHF 8% 6% 4% 2% 0% EUR / Japanese Yen EUR / Japanese Yen EUR / Swiss  EUR / Swiss Franc    Nov 7: EFSF € 3 bn bond prices wide at MS+104 bps Nov 8: PM Berlusconi finally agrees to resign Nov 9: LCH increases haircut on Italian bonds 7.0 The Euro has weakened sharply against safe-haven alternatives such as the Yen and the Swiss Franc 6.5 EUR vs.0 ‐2% ‐4% 5. Collision with U. Extreme Greece and Italian political turmoil after “Grand Plan” announced on Oct 27 Source: Bloomberg 14 11‐Nov 16‐Sep 23‐Sep 30‐Sep 5‐Aug 4‐Nov .5 55 ‐6% ‐8% 5.5 Yield (%) 6.0 ‐10% ‐12% 4.5 45 ‐14% 14% 14‐Oct 21‐Oct 12‐Aug 19‐Aug 26‐Aug 28‐Oct 2‐Sep 9‐Sep 7‐Oct 1‐Jul 8‐Jul 11‐Nov 5‐Aug 16‐Sep 23‐Sep 30‐Sep 15‐Jul 22‐Jul 29‐Jul 4‐Nov 12‐Aug 19‐Aug 26‐Aug 14‐Oct 21‐Oct 28‐Oct 2‐Sep 9‐Sep 7‐Oct  The global capital markets have lost confidence in the institutional structures and framework of the Euro g y  2 stages of crisis escalation in last 90 days 1.

924 bn Gov’t Debt / GDP 160% 67% 121% Private Sector Debt / GDP ~ 175% ~ 330% ~ 145% Type of Risk Solvency Liquidity Liquidity Italy Shouldn’t Be A Solvency Issue…  120% debt / GDP is high but stable  50% of public debt owned domestically  Europe’s largest sovereign debt market (3rd largest globally)  Large. Bank of Italy. Deutsche Bank Global Markets Research 15 .#2: Liquidity and Solvency Concerns Liquidity vs. wealthy and unlevered private sector  3rd largest euro zone economy and 4th in the EU … But a Liquidity Issue  Over € 2 trillion of sovereign debt outstanding  10-year yields traded near 7.087 bn € 1.5% (Nov 8 – 9)  Market demanding: .Large structural and fiscal austerity .Strong. Solvency Risk GDP € 220 bn € 1. Bank of Greece .590 bn Total Debt € 350 bn € 733 bn € 1. credible government leadership  LCH imposing higher margin requirements on Italian debt (haircut increased Nov 9)  Large ECB (or EFSF) liquidity backstop needed The Italian political turmoil during Nov 2nd week nearly turned a liquidity issue into a credit event Source: Bank of Spain . IMF.

Greece’s Papademos formerly at ECB (Frankfurt)  Papandreou’s high stakes political gamble (confidence vote and referendum proposal)  Berlusconi’s resistance to departure  Delays on comprehensive fiscal austerity Italy s .PM Zapatero will not run for re-election  Mar 23: Socrates resigns  Jun 21: Replaced by Passos Coelho  Vigorous debate over details of “Grand Plan”  French delays on own austerity before April election  Jan 22: Cowen resigns  Jan 26: Replaced by Kenny  Escalation of the Euro crisis in 2011 has resulted in political leadership change in all 5 peripherals  New more Euro-centric leadership: .#3: Political Failures Multiple Levels of Political Risk  G German Bundesbank intransigence regarding B d b ki t i di more expansive ECB role 2011: Political Leadership Change  Nov 8: Berlusconi resigns  Nov 13: Replaced by Monti  Nov 10: Papandreou resigns  Nov 11: Replaced by Papademos  Limited Italian bond-buying to effectively “forcey g y out” Berlusconi  Awaiting more aggressive Italian fiscal austerity  N 20 S Nov 20: Spanish election i h l ti .Italy’s Monti previously at European Commission (Brussels) 16 .

IMF. S&P.5% 17 . Malta National Statistics Office. Slovak Government 2011E GDP Growth Rates 2011E Fiscal Deficits Italy: -4.f GDP % of ‐10% 10% ‐5% 0% 5% Luxemb bourg Nether rlands Ger many A ustria Be lgium Es stonia Finland ‐6% 6% 0% 2% ‐4% ‐2% 4% Competitiveness concerns have recently focused on Italy in particular 6% 8% Ir eland Slo ovakia Estonia Luxembourg Slovakia Finland Germany Austria Slovenia France Italy Malta Spain Cyprus Por rtugal Greece #4: Competitiveness Concerns 2011E Current Account Balance Italy: -3. Deutsche Bank Global Markets Research.0% Spain Italy Cyprus Italy: 0.8% % of GDP ‐12% ‐8% ‐6% ‐4% ‐2% 0% ‐10% Malta Belgium Ireland Greece Spain France Portugal Slovenia Cyprus Slovakia Luxembourg Italy Netherlands Malta Belgium Austria Estonia Germany Finland Portugal Greece Slovenia Netherlands Ireland France Source: OECD.

with the Euro basis swap recently widening to nearly -120 bps 120 .2011 Peak CDS level since July 21. 2011 Bps 400 300 200 100 0 MS Source: Bloomberg 18 BAC SocGen GS Citi BNP Barclays UBS DB CS JPM HSBC .#5: Stress in Bank Funding Markets Euribor-OIS 250 200 150 Euro Basis Swap ‐250  Overnight inter-bank funding costs in Europe have increased significantly (~65 bps since July 1) Still well below levels during the financial crisis of 2008 Bps ‐200 200  US$ funding costs have also increased significantly. 2011) 700 600 500 CDS on Nov 14.Still below levels during the financial crisis of 2008 Bps ‐150 100 50 0 ‐100 ‐50 Feb‐09 Feb‐10 Feb‐11 Aug‐08 Aug‐09 Aug‐10 Aug‐11 Nov‐08 Nov‐09 Nov‐10 May‐09 May‐10 May‐11 Nov‐11 0 Aug‐08 Feb‐09 Aug‐09 Feb‐10 Aug‐10 Feb‐11 Aug‐11 Selected Bank CDS Spread (as of Nov. 14.

the “year-end effect” for bank balance sheets this year could create heightened pressure for sovereign bond markets 19 . 2012  ECB Governing Council meeting  EU Summit (leaders expected to discuss EFSF and fiscal union)  Bank capital raising “plans” due for meeting € 106 billion target  Target date for completion of Greece 50% debt haircut exercise (could be sooner)  F French P id ti l election h Presidential l ti  Deadline for EU Banks to meet € 106 billion capital target With elevated stress in both the sovereign crisis and bank funding markets. Washington.30 December Detail  Spanish general election expected (4 months earlier than expected)  U S / EU Summit in Washington DC U. EU.Key Upcoming Dates Date November 20 November 28 November 29 .  IMF EU and ECB to finalize details of Greece € 130 bn second rescue package December 8 December 9 December 25 January 2012 April A il 2012 June 30.  Eurogroup / ECOFIN Finance Ministers meetings  “Troika” review of Greece finances to determine 7th quarterly aid installment IMF.S.

3. Searching for a Solution .

Time to Call the ECB .A.

EFSF 22 . Ineffectiveness of current ECB monetary policy transmission mechanism to keep bond yields low p y Source: Deutsche Bank Global Markets Research – Thomas Mayer. 5-year  Pricing: MS + 6 bps  Date: June 15.Time to Call the ECB EFSF Financings to Date  Date: Nov 7. Torsten Slok. Mark Wall. 10-year  Pricing: MS + 17 bps g p 4. Giles Moec.e. Italian bond market is now broken Sharp contagion of the crisis to Italy the week of Nov 7 Why Larger ECB Role Now? 1. 10-year  Pricing: MS + 104 bps (+177 bps over German bunds)  Date: June 22 2011 22. 2011  Size: € 5 bn. Investor reluctance on the EFSF € 1 trillion leverage plan Insurance guarantee plan SPV 2. Weakness of the EFSF’s € 3 billion financing on Nov 7 Contagion from Greece and Italy turmoil Less confidence in credit resilience of guarantors (i. 2011  Size: € 3 bn.  Size: € 3 bn. Peter Hooper. France) Uncertainty around EFSF leverage plan 3.

Fed) . Depart from current bond purchase program ("limited" and "temporary") 2. Pre-announce a volume of purchases such as EUR 200 billion over 12 months . Bloomberg Ja an‐11 .Time to Call the ECB Key Steps Needed From ECB  Significant expansion of ECB balance sheet (analogous to U. Mark Wall. ECB. Formal end to "sterilization" of purchases ( p (already y underway due to unlimited liquidity facilities) 3. Giles Moec."Unlimited" commitment more impactful but politically unrealistic 200 180 160 140 EUR Billi ions ECB Sovereign Bond Purchases Total: € 187 billion 120 100 80 60 40 20 0 Se ep‐10 Fe eb‐11 M Mar‐11 A Apr‐11 A ug‐10 Dec‐10 A ug‐11 Se ep‐11 Ju un‐10 Ju un‐11 J Jul‐10 O Oct‐10 J Jul‐11 No ov‐10 May‐11 May‐10 O Oct‐11 23  ~ € 50 billion of Greek bonds  Over € 100 billion of largely Italian and Spanish bond p purchases since August g Source: Deutsche Bank Global Markets Research – Thomas Mayer.To fulfill role previously planned for fully levered EFSF  Key steps recommended in new ECB approach: 1. Torsten Slok. Peter Hooper.S.

Mark Wall. credible Italian fiscal austerity  Progress on EU fiscal "integration" at Dec 9 EU Summit. Monti  Passage of large. Torsten Slok 24 . Giles Moec.” ~ Jens Weidmann. The prohibition of monetary financing in the Euro Area is one of the most important achievements in central banking and p y y. Peter Hooper. it is also a key lesson from the experience of hyperinflation after World War I.Time to Call the ECB Key Pre-Conditions Needed for New Approach  Strong. or earlier (recognizing that true political and/or fiscal union is not a realistic goal)  At least "passive tolerance" from a reluctant German Bundesbank in Frankfurt Draghi will not get unanimous support Potential Consequences of ECB Not Expanding Role  Degradation of ECB balance sheet through current limited approach  Loss of ECB credibility over time  Possible bank system runs from Southern periphery to Northern banks  The fate of the Euro itself “One of the severest forms of monetary policy being roped in for fiscal purposes is monetary financing. y p yp specifically for Germany. credible Italian Government under Mario g. Head of Germany’s Bundesbank (& ECB Council Member) Source: Deutsche Bank Global Markets Research – Thomas Mayer. in colloquial terms also known as the financing of public debt via the money printing press.

Euro Zone and peripheral interest rates have increased over the same period Note: Eonia rate is an effective overnight interest rate computed as a weighted average of all overnight unsecured lending transactions in the interbank market Source: Deutsche Bank Global Markets Research . and that further SMP purchases are necessary to contain interest rates in the region 25 .Francis Yared  Peripheral bond yields: Now negatively correlated to the Eonia rate  Core European yields: Decreasing their correlation to Eonia (20% drop in French yield correlation)  This suggests that monetary policy alone is not enough.Time to Call the ECB ECB Monetary Policy Transmission to Euro Zone Ineffective Total ECB Lending ECB Sovereign Bond Purchases  The ECB monetary policy transmission mechanism has become ineffective at keeping Euro bond yields low .Even though the 10y Eonia rate declined over 30 bps since September.

2011:     LTRO: MRO: Other: Total: € 374 bn € 193 bn € 217bn € 784 bn Source: Deutsche Bank Global Markets Research – Thomas Mayer. Peter Hooper. money market funds As of Nov.7 trillion U. Bloomberg 26 . Mark Wall.Time to Call the ECB Continued Liquidity Support Until Bank Funding Stress Subsides Total ECB Lending LTRO 1000 900 800 700 MRO Other liquidity providing operations Other liquidity providing operations ECB Liquidity Facilities € 784 bn  3-month and 6-month Longer Term Refinancing Operations (LTRO) “Full allotment” Unlimited EUR Billions 600 500 400 300 200 100 0  12-month LTRO Reintroduced Oct 6 “Full allotment” Unlimited O Oct‐07 O Oct‐08 O Oct‐09 A Apr‐07 A Apr‐08 A Apr‐09 A Apr‐10 O Oct‐10 A Apr‐11 Jan‐07 Jan‐08 Jan‐09 Jan‐10 Jan‐11 Jul‐07 Jul‐08 Jul‐09 Jul‐10 Jul‐11  US$ Funding Coordination with 5 global central banks announced Sept 15 Critical given pull-back from $2. 14. Giles Moec. Torsten Slok.S. ECB.

will ultimately be needed to resolve the crisis Source: Federal Reserve 27 1 Oct‐11 Jan‐06 6 Jan‐07 7 Jan‐08 8 Jan‐09 9 Jan‐10 0 Jan‐11 1 Jul‐06 Jul‐07 Jul‐08 Jul‐09 Jul‐10 Jul‐11 .500.0 0 1.000.Time to Call the ECB Evolution of U.500.0 0 Central Bank Liquidity Swaps Central Bank Liquidity Swaps Primary Credit MBS U.0 0 2.000.5 trillion today Comparably aggressive growth of the ECB Balance Sheet is a key “missing ingredient” in Europe’s Grand Plan and.0 0 500.S. Treasury Securities US$ Bn B Asset‐Backed Funding Facility Term Asset‐Backed Loan Facility Treasuries MBS 6 Oct‐06 7 Oct‐07 8 Oct‐08 9 Oct‐09 0 Oct‐10 Apr‐06 6 Apr‐07 7 Apr‐08 8 Apr‐09 9 Apr‐10 0 Apr‐11 1   The Fed aggressively grew its Balance Sheet from ~ $800 billion in 2008.0 0 1.000. Federal Reserve Balance Sheet Expansion CP Funding Facility Money Market Funding Facility TALF Federal Agency Debt Securities Repos Other Credit Rescue Funds for AIG 0 3.S.0 0 2. to over $2. we believe.

Time to Expedite the Grand Plan .B.

Time to Expedite the “Grand Plan” Pillars Greek Debt Haircut July 21. assumes 100% participation Source: EBA.5  Based on July 2011 stress test results  No haircuts on banking book sovereign exposures (trading book only) € 106 billion  June 2012 deadline to meet target  Mark-to-market of sovereign exposures  Debt guarantee program re-introduced Pillar 3 Leverage EFSF to ~ € 1 Trillion € 440 billion  Upsized from ~ € 250 billion  Expansion of new powers to buy bonds and support banks ~ € 1 Trillion  Assumes 4 – 5x leverage through new: 1) Insurance guarantee scheme 2) SPV investment vehicle Pillar 4 Additional Greek Bailout € 109 billion  ~ € 20 billion for Greek banks € 130 billion  € 30 billion for Greek banks  € 30 billion collateral sweetener for PSI debt restructuring (1) € 210 bn of the € 350 bn of Greek debt outstanding is held privately. 2011 Agreement 21 %  Loan maturities extended from 7.5 75 years to as much as 30 years  Based on Greece Debt / GDP target in 2020 of approx 160% October 27 “Grand Plan” 50%  Key details on new bonds still TBD  Based on Greece Debt / GDP target in 2020 of approx 120% Pillar 1 Pillar 2 EU Banking Sector Capital (& Debt Guarantees) € 2 5 billion 2. EU Commission 29 .

Pillar # 1: Greek Debt Haircut Debt / GDP of European Peripherals  160% 160% 140% 120% 100% 80% 60% 40% 20% 0% Spain Portugal Ireland Italy Greece Target Debt / GDP T D b reduction from Europe’s “Grand Plan” PSI Plan Overview Haircut: 50% on all bonds held by private sector Debt reduction target: – €100 bn area (50% write-down of € 210 bn of the €350 bn total Greek debt)  120% – Target reduction of Debt / GDP from160% to 120% – Reduced interest payments of approx €6 bn per year  Participation / New bonds: P ti i ti N b d – Voluntary (would therefore not trigger CDS) – New bond details still TBD (maturity. European Council Open to restructuring after 2013 only Nov 2010 21% Greek debt haircut announced d July 2011 50% Greek debt haircut announced d Oct 2011 30 . coupons) – New bonds expected to be issued under English law   Restructuring “sweetener”: € 30 bn of collateral to support bond swaps Conditionality: – More stringent Troika monitoring of Greece – Commitment to € 15 billion of privatizations Restructuring not on “the table” May 2010 Source: IMF.

6 bn €5.6 bn €18.2 bn €1.0 bn €19. and a restructuring that “side-stepped” CDS triggers.5 bn €3. Wall Street Journal 0 5 10 15 20 25 30  EU trading restrictions.0 bn €22.4 bn €1.6 bn €7. Greece EUR Bn €24. Wall Street Research.4 bn €1.4 bn €9.2 bn €0.0 bn €6.7 bn 0 10 20 30 40 50  Greek banks have the largest exposure to Greek sovereign debt by a large margin  Many banks have already done a full mark-to-market Source: EBA. have marginalized this market 31 .S.6 bn €5.9 bn Size of CDS Markets on Sovereign Debt France Italy Germany Spain Belgium Portugal U.8 bn €3.Pillar # 1: Greek Debt Haircut Top Banks’ Holdings of Greek Sovereign Debt Greece G France Germany Cyprus Belgium UK Portugal Italy Netherlands Austria EUR Bn €48.6 €6 6 bn €5.9 bn €2.

2 bn €14.9 months (June 2012) ( ) Source of Capital: .Step # 2: Government (if needed) .Step # 1: Private sector .8 bn €5.9bn €1.8 bn €7.Pillar # 2: EU Bank Sector Capital Indicative Bank Capital Shortfalls by Country Greece Spain Italy France Portugal Germany Belgium Cyprus Austria Sweden S d Norway Slovenia 0 5 10 15 EUR Billion 20 25 30 Plan Overview & Observations  €30.0 bn €26.6 bn €2. Wall Street Journal .3 bn €0.5 methodology for RWA     Timeline: 6. Basel 2.4 €1 4 bn €1. Wall Street Research.2 bn €4.3 bn Recap requirement: € 106 billion Scope: 70 banks (details on individual banks TBD) Test criteria: 9% Core Tier 1 target ratio MTM treatment of sovereign bond holdings as of Sept 2011.St # 3 EFSF (if needed) Step 3: d d)     Greek banks receiving most capital (approx €30 bn given 50% haircut on ~ €50 bn of Greek bond holdings) Higher than expected capital shortfalls for Spanish and Italian banks (2/3 of total) Lower than expected capital shortfalls for French and German banks EBA (bank regulator) asked to work with the ECB.8 bn €8.1 bn €3. EIB and EU Commission to explore options for a coordinated bank debt new issue guarantee scheme – Guarantee not to come from pooled resources – Therefore likely to only benefit AAA rated countries 32 Total: €106 bn Source: EBA.

and unrated leveraged loans)  Subject to regulator oversight to ensure no excessive deleveraging  Subordinated debt tenders and debt for equity swaps available for banks with large amount of paper trading below par  Potentially as much as €45 bn available Contingent capital TBD  Unlikely to be popular until clarity that CoCos would be eligible under Basel 3  Market estimates suggest €10 – 30 billion area. Deutsche Bank Global Markets Research 33 . although possibly quite less  Stronger banks likely to pursue conventional rights issues Disposal of RWAs TBD Liability management €20 – 30 billion area g Rights issuance / common equity €10 – 20 billion area Source: EBA.Pillar # 2: EU Bank Sector Capital Potential Capital Raising Actions (To Reach $106 Billion) Actions Retained earnings Dividends / hybrid distributions Employee compensation Potential Size €30 billion area €10 – 15 billion area €5 – 15 billion Comment  E i t path f profitable b k t meet capital shortfalls Easiest th for fit bl banks to t it l h tf ll  Combination of distribution cancellation and scrip dividends  Increased deferred compensation and equity consideration for employees  Focus on capital intensive assets (e.g.. correlation loan books. first loss securitization pieces.

Fees based on implied subsidy . only AAA rated country banking systems likely to benefit  Much of the detail still TBD (EBA required to coordinate with ECB. Dealogic 34  Maturity wall of ~ € 800 billion in 2012  € 2 trillion over next 5 years .Pillar # 2: EU Bank Sector Capital (& Guarantees) 2012 – 2014 European Senior Bank Debt Redemptions € 900 € 800 € 700 € 600 EUR Bn Bank Debt Issuance Guarantees   Coordinated State guarantees on new bank bonds Scheme will be harmonized.Potential restructuring Source: Deutsche Bank Global Markets Research.. European Council. EU) – Therefore. EIB and EU Commission) € 845 € 673 € 583 € 500 € 400 € 300 € 200 € 100 €0 2012 2013 2014 Observations   DB expects take up of guaranteed funding scheme to be low Usage of such scheme will trigger S f State Aid penalties on same basis as October 2008 EU guidance: .e.Business constraints . but guarantee will not come from pooled sources (i.

6 13.5 12.0) total capacity: ~ €440 billion  EFSF (2. Ireland.5 21. Ireland and Portugal bailouts)  EFSF (3.1 21 ‐ 4.4 0.0) size: would l (3 0) i ld lever 4 5 t ~ €1 T illi area 4-5x to Trillion (although smaller leverage of 3-4x may be more likely) (1) Effective lending capacity of € 440 bn minus bailouts for Portugal.0: ~ € 1 Trillion 2 Plans: Detail  EFSF to provide partial first loss p p insurance on new sovereign debt issuance (20 – 30% expected) . based on seniority: 1.4 78.0) unused capacity: €250 billion (net of Greece.7 25.4 EFSF 2. Deutsche Bank Global Markets Research DB believes the € 1 trillion leverage plan for the EFSF announced on Oct 27 may no longer be a viable option y g p 35 .7 139.0 119.3 0.0 € 255.8 € 451. Insurance Guarantee Plan  SPV with multi-tranche capital structure.5 44.8 0.1 15.7 1.9 7.2 7.9 27 92.5 3. Mezzanine capital participation instrument: targeted at sovereign wealth funds 3.Pillar # 3: Leverage EFSF to ~ € 1 Trillion EFSF 2.4 2.4 19. and Greece Source: European Council.5 21.1 12.3 52.Unclear if insurance will be attached or separately traded instrument 2.4 89.9 1.0: € 450 Billion Germany France Netherlands Austria Finland Luxembourg Belgium Spain Slovenia Estonia  Slovakia Italy Malta  Cyprus Ireland  Portugal  Greece  Gross Total Net Total EFSF 1.1 158. Special Purpose Vehicle (SPV) for private sector capital p AAA / Aaa / AAA AAA / Aaa / AAA AAA / Aaa / AAA AAA / Aaa / AAA AAA / Aaa / AAA AAA / Aaa / AAA AA+ / Aa1 / AA+ AA / Aa2 / AA+ AA / Aa2 / AA AA / Aa2 / AA AA‐ / A1 / A+  A+ / Aaa / A+ A+ / Aa2 / AA‐ A / A1 / A+ A‐ / A2 / A‐ BBB+ /Baa3 / BBB+ / / BBB‐ / Baa1 / BBB‐ CCC / Caa1 / B+ Effective capacity 1. Senior debt instrument: targeted at traditional fixed income investors 2. EFSF first loss absorbing tranche  EFSF (2.9 7 11 12.4 € 440.9 1.7 37 1.5 EFSF 3.9 € 779.0 211.

36 . respectively (based on 25% guarantee / 40% recovery) Key Question: Will investors buy Italian bonds at yields which reflect the theoretical value of the first loss guarantee?  CDS can be used as a proxy to reflect the value of the proposed EFSF insurance guarantee scheme  Higher first loss protections are analogous to higher CDS protection for any given recovery rate  Using CDS replication. 200 bps and 175 bps. DB has measured the theoretical value of th EFSF insurance scheme at th ti l l f the i h t various recovery rates Source: Deutsche Bank Global Markets Research – Frances Yared.Pillar # 3: Leverage EFSF to ~ € 1 Trillion EFSF Insurance Scheme Pricing Considerations Amount of Equivalent CDS for Various Levels of Guarantee and Recovery First Loss Protection Guarantee Value Assuming 25% First Loss Protection at Various Recovery Rates otect o a ous eco e y ates 30% 25% 20% CDS Recovery Implied Equivalent Amount  of CDS protection for 100m bond 0% 10% 20% 30% 40% 50% 60% 30 33 38 43 50 60 75 25 28 31 36 42 50 63 20 22 25 29 33 40 50  Th expected value of the guarantee for Italy and Spain The t d l f th t f It l dS i 10y bonds is approx.

Sovereigns issue bonds with guarantee aimed at reducing yields (unclear if guarantee will be attached or separately traded instrument) 3a. Trust repays investors 20% . targeted but not yet clear) – Considering € 250 bn as the EFSF base fire power. EFSF funds possibly held in a Trust to ensure payment to investors in case of default (other contingent funding arrangements also under consideration to avoid grossing up member state balance sheets in advance of trigger event) 3b. the EU would be subordinated to the private sector .30% of losses on default 37 2 *** In both structures. EFSF provides sovereign issuers with partial first loss insurance – Leverage size depends on percentage of insurance provided (20 – 30% insurance or 4-5x leverage targeted.Pillar # 3: Leverage EFSF to ~ € 1 Trillion Detailed Overview of Option 1: Insurance Scheme For illustrative purposes only – actual structure TBD (critical details to be discussed with investors and Rating Agencies) Description 1. actual could be lower 3a EFSF $ Trust 1 25% First Loss Insurance $ (in case of default) 3b Investors Sovereign Issuers $ Bonds B d New Bonds with credit enhancement 2. the fund would be able to insure approx € 1 trillion of new issuance (theoretically).

SPV is created: multi-tranche capital structure expected: .30% expected) 38 . or even extend loans for bank recaps EFSF first loss tranche EFSF 4 Bond M k t B d Market (primary or secondary) 5 *** or to even extend loans for bank recaps 5. EFSF provides partial first loss insurance (% guarantee currently unknown but 20 .Pillar # 3: Leverage EFSF to ~ € 1 Trillion Detailed Overview of Option 2: Creation of SPV For illustrative purposes only – actual structure TBD (critical details to be discussed with investors and Rating Agencies) Description 1. SPV purchases sovereign debt.EFSF first loss absorbing tranche (EU subordinated to private sector) 2.Senior debt tranche (with ratings): targeted at traditional fixed income investors 1 SPV 2 Investors Senior debt tranche 3 Mezzanine capital       SWFs China Japan BRICS Middle East IMF role? . relieving some of the burden of the ECB  SPV could possibly purchase primary or secondary p debt. Foreign official sector (IMF) and non-European sovereigns provide mezzanine capital 4. Issues senior bonds backed by EFSF contingent capital (to further lever size) 3.Mezzanine capital participation instrument: targeted at sovereign wealth funds .

given the required discussions and negotiations with both investors and the Rating Agencies Appears l A less likely that investors will assign the same value to the “insurance” of new issue lik l th t i t ill i th l t th “i ” f i bonds as theoretical calculations would suggest (i.e. the SPV could possibly purchase primary bonds. critical details still to be determined (and escalation of the crisis to Italy)       39 . nearly 200 bps for 10 year Italian bonds) Still unclear if the guarantee would be attached to the bonds or if they would trade separately ( (the latter may offer a g y good solution for the p potential impact of the p p plan on existing bonds) g ) While the insurance scheme may be generally more targeted toward primary bonds.Sharp crisis escalation since Oct 27 In both structures. execution of the € 1 trillion EFSF leverage plan has become more difficult. the EU would effectively become subordinated to private capital (a new and important development) It could take significant time to work through final structure details.Pillar # 3: Leverage EFSF to ~ € 1 Trillion Important Additional Points on the EFSF Leverage Plan  Given recent escalation of the crisis to Italy. secondary bonds or even extend loans for bank recaps Execution risk and complexity on the structure is high especially at this stage with so many high. and may no longer be a viable option ..Investor reluctance .

if not higher. 50%) attract target investor participation rate above 90%? Will sufficient measures be put in place to ensure high voluntary participation?  What will be next steps if investor participation is lower than expected?  What will be the terms of the new bonds received by investors (maturity. and the “side-step” of CDS triggers in the voluntary Greece restructuring.“Grand Plan” Missing Pieces: Greek Debt Haircut “Grand Plan” Missing Pieces: Greek Debt Haircut  Maturity and coupon of new bonds  Details related to planned €30 billion in credit enhancement on new bonds  Investor participation rate on “voluntary” exercise  Details around NPV calculation based on proposed haircut and terms of new bonds Key Questions  Will such a large haircut (i. lead to the demise of the sovereign CDS market? “The implementation challenge is as high. than the design challenge.” ~ Mohamed El-Erian. coupon etc)? (maturity coupon.  Will the restructuring exercise be completed before January as planned?  Will Greece’s debt burden post-exercise (at 120% of GDP) be sustainable?  Will such large haircuts reduce the pressure on Greece around structural reform and fiscal austerity?  Will the combination of EU trading restrictions. PIMCO 40 .e..

will banks continue to de-lever balance sheets in size and pull back sharply on credit extension? 41 . EBA will not publish bank by bank data. p y .“Grand Plan” Missing Pieces: EU Bank Sector “Grand Plan” Missing Pieces: EU Bank Sector  Types of qualifying capital that constitute "highest quality”  Final individual bank capital shortfalls (current #s are indicative only. such that bank funding markets re-open?  How extensively will the new bank debt guarantee scheme be utilized (presumably by banks in AAA countries only)?  Given high market uncertainty (sovereign crisis. they leave it to the banks to disclose themselves)  Scope of permissible deleveraging to reach target (will be subject to close regulator monitoring)  Details on bank debt guarantee scheme Key Questions  What will be the capital target plans for the weakest banks (presumably Government or EFSF capital as required)?  Is the capital target size large and rigorous enough to restore confidence. regulatory). rather. economic. p ( y.

200 bps)?  Will the guarantee be attached or trade separately (possibly aimed at alleviating pressure on existing bonds)?  What will be the impact of the guarantee on the trading levels of existing bonds?  Will SPV structure attract outside sovereign wealth fund (i. rather than smaller and more restricted AAA fund?  Who. ) Key Questions  Is the plan still viable given crisis escalation since Oct 27?  Will investors value guarantee to full theoretical value (i. . p g  Execution risk related to complexity of capital structure. Brazil. instead of 4-5x as planned)  % guarantee on EFSF bond insurance plan (20 – 30% area expected)?  Timing and scope of bond purchases ( f (primary vs. is Europe’s lender of last resort? 42 .. in the end. China.“Grand Plan” Missing Pieces: EFSF Leverage Plan “Grand Plan” Missing Pieces: EFSF Insurance / SPV Leverage Plan  Final size (will be much smaller if leverage is only 3-4x.e. BRICs) and private capital in size? IMF role? p y p ..g y q y g p ( . secondary market purchases) )  Role of the IMF (Capital contribution? Oversight role? Exercise control? Conditionality?)  SPV capital structure (seniority of tranches)  Collateral.e. corporate governance and/or covenant issues in the new SPV structure? Will there be one large SPV or several different ones?  How much time will it take to gather sufficient investor and rating agency feedback to finalize structure?  Should EU instead pursue a larger and more flexible AA rated EFSF. etc) . guarantees and/ or conditionality required by foreign public sector investors (China.

Moody’s “developing” outlook reflects the uncertainty about the exact market value of the securities creditors would receive in an exchange ./ Negative CC / Negative AAA / Stable AAA / Stable AAA / Stable AAA / Stable AAA / Stable AAA / Stable A+ / Stable AA+ / Negative AA. Watch CCC / Stable  Ratings on “negative” watch or outlook in red font 43 Source: Moody’s./ Negative AA -/ Negative A+ / Stable A+ / Negative A+ / Stable BBB / Negative BBB+ / Negative BBB.Looking Ahead: Risk of Additional Downgrades Selected European Country Credit Ratings Rating / Outlook Germany France AAA Austria Finland Luxembourg Netherlands Slovakia Belgium Spain Investment Grade (below AAA) Slovenia Estonia Italy Malta Cyprus Ireland Sub Investment Grade Portugal Greece Aaa / Stable Aaa / Stable Aaa / Stable Aaa / Stable Aaa / Stable Aaa / Stable Aaa / Stable Aa1 / Neg. Fitch. Watch A1 / Negative Aa3 / Stable A1 / Stable A2 / Negative A2 / Negative g Baa1 / Negative Ba1 / Negative Ba2 / Negative Ca / Developing AAA / Stable AAA / Stable AAA / Stable AAA / Stable AAA / Stable AAA / Stable A+ / Positive AA+ / Negative AA. Watch BBB+ / Stable BBB. S&P./ Stable A / Negative A / Stable BBB+ / Neg./ Neg./ Negative AA / Negative AA.

Outlook for the Euro .4.

25 1.2011 Q1-2012 Q3-2012 Q4-2012 EUR / USD 1.Outlook for the Euro EUR Currency Performance (2011) EUR / USD 15% 10% 5% 0% ‐5% ‐10% ‐15% ‐20% EUR / CHF EUR / JPY DB EUR 2011 – 2012 Forecasts Currency Q4 . the EUR declined significantly against the Yen d th S i F Y and the Swiss Franc ( til SNB and BOK (until d intervention)  DB 2012YE EUR/ USD Forecast: 1.86 0. the EUR has held up well vs.25 1.86 0.30 1.Downside risks could be significant depending on crisis resolution Source: Deutsche Bank Global Markets Research – Bilal Hafeez.23 EUR / JPY 101 99 105 111 EUR / GBP 0.30 1.25 g p g .27 1.25 1. the USD  However. George Saravelos 45 .79 EUR / CHF ‐25% 1. Alan Ruskin.25  DB 2011YE EUR/ USD Forecast: 1.84 0.30  Despite the escalation of the crisis.

30 DB 2011E Year-End: $1.7% vs.S.25 DB 2012E Year-End: $1.35 Drivers of Recent EUR / USD Weakness 1.2% of GDP vs. Alan Ruskin.25 “EUR is probably the worst instrument to express Euro area negative views.45 . EUR views with both periphery bonds and equities purer gauges of stress.Outlook for the Euro Why Has EUR / USD Held Up So Strong? EUR / USD (2011) 1.China retains strong investment in core Europe 2. current account deficit of -3.EUR FDI in the 12 months through August of +0.EU maintains a current account deficit of -0.50 1 50 Drivers of 2011 EUR Resilience 1. Capital fl 1 C it l flows t core E to Europe (C/A + FDI) .Correlation between S&P 500 and EUR near all time highs g 1.1% 1.30  Contagion to France is key turning point for capital flows into core Europe .” ~ Alan Ruskin. George Saravelos 46 .1% 1. U. US FDI of -1.40 EUR / USD 1. DB FX Strategist Source: Deutsche Bank Global Markets Research – Bilal Hafeez.1% . EUR has traded as a “risk” currency .S t data revealed 3 consecutive months of negative Sept d t l d ti th f ti foreign inflows  Escalation of the crisis causing heightened risk aversion and wide scale “risk-off” trades 1.

further escalation of the crisis could be sharply negative for EUR / USD Source: Deutsche Bank Global Markets Research – Bilal Hafeez. signaling that the euro is being portrayed by the market as a risk asset  However.Outlook for the Euro S&P 500 and EUR/USD Highly Correlated  EUR / USD has been resilient to the European p crisis. Alan Ruskin. EUR bearish outlook will increase if risk aversion due to an escalation of the crisis increases Given the current “Tipping Point” moment. George Saravelos 47 . partly because of its behavior as a risk currency  Correlation between EUR and S&P 500 is close to all-time highs.

George Saravelos 48 . Alan Ruskin. Swedish Krona (SEK) and the Japanese Yen (JPY) Source: Deutsche Bank Global Markets Research – Bilal Hafeez. top performing currencies are all of current account surplus countries  Top performing currencies in 2011 have included the Swiss Franc (CHF). USD vs NOK SEK CHF JPY 2% 0% ‐2% ‐4% US EU Japan Sweden Norway Switzerland 0% ‐5%  Sovereign account surpluses have become a good proxy for currency performance  In 2011.Outlook for the Euro What Has Been a Critical Driver of Euro and Other Currencies in 2011? 2011E Current Account Balances 14% 12% 10% 8% 6% 4% 5% 15% 10% 25% 20% 2011 Performance of Selected Currencies vs. Norwegian Krone (NOK).

3 – 4 G-20 Summit crossed an important psychological barrier in G 20 terms of their willingness to consider Greek exit The economic. the Treaty f Lisbon id d d li it “exit l ” (voluntary b i only) f th basis l ) for the first time in the history of the EU (simply “notice” required without specific reason) Mechanism provides formal framework for EU exit “Voluntary” exit only    Mechanism   What Would Be The Potential Cost and Implications?  Economic cost could be > 30% of GDP  Significant devaluation of the local currency and private sector assets  Sovereign default (larger restructuring) g ( g g)  Capital controls  Collapse of Greek banking system      Massive disruption in EU payment systems EU Greek corporate exposure are far in excess of sovereign Possible peripheral bank runs Negative impact on international trade Significant political and credibility costs 49 . banking system and political costs of Euro unwind would far exceed the cost of maintaining current EMU construct (even if only 1 country exits) In D I December 2009 th T t of Li b provided and explicit “ it clause” ( l t b 2009. How Would Greece Euro Exit Mechanics Work?  Probability Low (but rising) Merkel and Sarkozy comments at Nov.Outlook for the Euro In Downside Scenario.

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